In July, the Internal Revenue Service finalized at last its regulations on “inversion transactions”. Internal Revenue Code section 7874, adopted in 2004, eliminates many of the benefits associated with these transactions. A corporate group with a U.S. parent would reorganize under a new foreign parent, the shareholders of the old U.S. parent exchanging their stock for an interest in the foreign acquiring affiliate. The transactions generally resulted in gain realization for the shareholders, but not for the corporate group members. This one-time shareholder-level gain was ideally sheltered by losses or otherwise.
The inverted structure increases opportunities to move profits outside of the U.S. taxing jurisdiction, by means of loan transactions, licenses or outright asset transfers. Several layers of rules restrict deductibility or require gain realization on transactions with foreign parent corporations. A U.S. group with the right profile (i.e., losses, credits, etc.) could in fact incur little additional tax.
Under the 2004 Code amendments, the taxable income of an “expatriated entity” cannot be less than the “inversion gain” of the entity. This rule applies for any taxable year which includes any portion of the “applicable period”, which lasts for 10 years from the start of the inversion transaction.
“Inversion gain” includes income or gain recognized by reason of certain property transfers by the expatriated entity (including related U.S. persons), at any time during the applicable period. “Inversion gain” also includes income accrued during the applicable period, by reason of a license of any non-inventory property by the expatriated entity, including related U.S. persons. To be included, the income or gain may be recognized, received or accrued either as part of the inversion transaction, or after the transaction if the property transfer or license is to a foreign related person.
Thus, the minimum shareholder or partner-level gains that occur in an inversion transaction, can no longer be sheltered by losses and deductions, in the case of shareholders or partners related to the acquired entity. If the acquired entity or related U.S. shareholders license non-inventory property to the new foreign parent (rather than transfer properties outright), the license income is also subject to tax, and cannot be sheltered by losses or deductions. Most tax credits are unavailable against the special tax on inversion gains, i.e., the credits are reduced by the product of the inversion gain and the highest rate of corporate tax, i.e., 35%. The foreign tax credit is available, but the inversion gain is treated as U.S. source, adding nothing to the total available credit.
An expatriated entity includes certain domestic corporations or partnerships, with respect to which a foreign corporation is a “surrogate foreign corporation”. “Expatriated entity” also includes any U.S. person related to the domestic corporation or partnership. To be treated as an expatriated entity, substantially all of the properties held (directly or indirectly) by the domestic corporation, or constituting a business of the domestic partnership, must be acquired (directly or indirectly) by the “surrogate foreign corporation”.
A foreign corporation may be treated as a surrogate, if it engages in the foregoing acquisition. At least 60 percent of the stock (by vote or value) of the foreign corporation must end up being held by former shareholders of the domestic corporation (by reason of their old stockholdings), or by former partners of the domestic partnership (by reason of their domestic partnership interest), as the case may be. All partnerships under common control are treated as one partnership for this purpose, unless excepted by regulation.
The foreign corporation or partnership will not be a surrogate, if, after the acquisition, the expanded affiliated group has substantial business activities in the foreign parent’s home country (when compared to the total business activities of the group).
Stock acquired by the former shareholders or partners in a public offering by the foreign corporation is not included in measuring the 60% ownership. Also disregarded, is stock held by members of the “expanded affiliated group”.
“Expanded affiliated group” is defined specially for this purpose as an affiliated group, in which the threshold for inclusion is group ownership of more than 50% of the votes and value of the included corporation. Normally, the threshhold is at least 80% group ownership. Hence, the special 50% rule is relieving, for purposes of the home country exception.
A special rule applies if at least 80 percent of the stock of the foreign corporation is held by former shareholders of the domestic corporation. Instead of the above regime, the foreign corporation is treated as a domestic corporation, hence fully subject to U.S. taxation.
The acquisition of the U.S. business must be pursuant to a plan or series of related transactions. A deeming rule applies, if the foreign corporation acquires substantially all of the properties of the domestic corporation or partnership, at any time during the 4-year period beginning 2 years before the above 60% ownership is met. In that case, the acquisition is treated as pursuant to a plan.
In determining whether any of the above conditions are met, any transfer of properties or liabilities is disregarded, if part of a plan a principal purpose of which is to avoid the purposes of these Code amendments.
[to be continued]