Coming regulations will reduce tax benefits of inversions by preventing certain uses of controlled foreign corporations and closing loopholes in the Sec. 7874 anti-inversion provisions.
The IRS and Treasury Department signaled plans to crack down on corporate tax inversions with an announcement by Treasury and an IRS Notice.
In a corporate inversion, a multinational company based in the United States replaces its U.S. parent with a foreign parent, thereby potentially avoiding U.S. taxation on some or all of its profits. The actions Treasury announced in late September are designed to reduce the tax benefits and therefore the incentives for inversions. Treasury’s actions will generally curtail the inverted company’s ability to access the foreign subsidiaries’ overseas earnings without paying U.S. tax; however, the new rules only apply to deals closed on or after Sept. 22, 2014.
Treasury will take action in four areas:
First, it will act under Sec. 956(e) to prevent the use of so-called hopscotch loans. Hopscotch loans involve repatriation of foreign earnings by having controlled foreign corporations (CFCs) make loans to their new foreign parent instead of to the former U.S. parent. In the future, such loans will be considered U.S. property for purposes of the anti-avoidance rule.
Second, Treasury will act under Sec. 7701(l) to prevent a decontrolling strategy, in which the new foreign parent buys enough stock in the CFC to take control away from the former U.S. parent, giving the foreign parent access to the deferred earnings of the foreign subsidiary without paying tax. Treasury will treat the new foreign parent, in this situation, as owning stock in the former U.S. parent instead of the CFC.
Third, Treasury will act under Sec. 304(b)(5)(B) to stop inverted companies from transferring cash or property from a CFC to the new foreign parent, avoiding U.S. tax.
Finally, Treasury will act under Sec. 7874 to strengthen the requirement that former owners of the U.S. entity own less than 80% of the new combined entity. These steps will include limiting the ability of companies to count passive assets that would inflate the new foreign parent’s size; preventing U.S. companies from making extraordinary dividends to reduce their pre-inversion size; and stopping “spinversions,” in which a U.S. entity transfers assets to a new foreign entity, which it spins off to its shareholders.
The IRS provided further details in Notice 2014-52, describing planned regulations.
First, the IRS will issue regulations under Sec. 7874(c)(6) (which permits regulations to be issued to treat stock as not stock), providing that, if more than 50% of the gross value of all “foreign group property” constitutes “foreign group nonqualified property,” a portion of the foreign acquiring corporation’s stock will be excluded from the denominator of the ownership fraction for purposes of determining if a company is a surrogate foreign corporation. The 50% test is applied after the acquisition and all transactions related to the acquisition, if any, are completed.
Second, regulations will be issued under Secs. 7874 and 367 that are intended to prevent transactions to avoid the substantiality test that applies to certain transfers of property. Under the substantiality test, at the time of the transfer, the fair market value (FMV) of the transferee foreign corporation must be at least equal to the FMV of the U.S. target company. The transferee foreign corporation’s FMV generally does not include assets acquired outside the ordinary course of business within the 36-month period preceding the exchange if they produce, or are held for the production of, passive income or are acquired for the principal purpose of satisfying the substantiality test. Under the proposed rules, non-ordinary-course distributions the domestic entity (including a predecessor) made during the 36-month period ending on the acquisition date are treated as part of a plan, a principal purpose of which is to avoid the purposes of Sec. 7874, and will be disregarded.
To make it more difficult for corporations to avoid the 80% ownership requirements in the expanded affiliated group (EAG) rules, a third change provides that, if stock described in Sec. 7874(a)(2)(B)(ii) of a foreign acquiring corporation is received by a former corporate shareholder or former corporate partner of the domestic transferring corporation, and, in a transaction related to the acquisition, the transferred stock is transferred again, the transferred stock is not treated as held by a member of the EAG for applying the EAG rules. The transferred stock is included in the numerator and the denominator of the ownership fraction.
Finally, the regulations will contain provisions to address certain tax-avoidance strategies by (1) preventing the evasion of Sec. 956 through post-inversion acquisitions by CFCs of obligations of (or equity investments in) the new foreign parent corporation or certain foreign affiliates; (2) preventing the avoidance of U.S. tax on pre-inversion earnings and profits of CFCs through post-inversion transactions that otherwise would terminate the CFC status of foreign subsidiaries and/or substantially dilute the U.S. shareholders’ interest in those earnings and profits; and (3) limiting the ability to remove untaxed foreign earnings and profits of CFCs through related-party stock sales subject to Sec. 304.
- Treasury Department Fact Sheet
- Notice 2014-52
By Alistair Nevius, J.D., the JofA’s editor-in-chief, tax, and Sally P. Schreiber , J.D., a JofA senior editor.