The IRS has issued final regulations that target tax-motivated inversion transactions and certain post-inversion tax avoidance transactions. The final regulations retain the thresholds and substantiation requirements of the 2016 final, temporary and proposed regulations (the 2016 regulations), but make limited changes to the 2016 regulations to improve clarity and reduce unnecessary complexity and burdens on taxpayers. These changes also ensure that the final regulations do not impact cross-border transactions that are economically beneficial and not tax-motivated.
Generally, in an inversion transaction, a U.S.-based multinational expatriates by changing its tax residence from the United States to another country in an effort to avoid or reduce U.S. taxes.
Comment. Subject to certain limitations, the transaction allows the inverted company to reduce future taxes on U.S.-source earnings, such as by deducting interest paid on loans from the new foreign parent. In addition to U.S. tax base erosion, inversions may have other effects on the U.S. economy, such as reduced employment when the headquarters are moved overseas.
Code Sec. 7874 limits inversions that are tax-motivated, by generally targeting transactions in which the following occur:
- a foreign corporation acquires substantially all of the properties of a domestic corporation (domestic entity acquisition);
- immediately after the transaction, the former shareholders of the domestic corporation make up a significant portion of the shareholders of the acquiring foreign corporation; and
- after the domestic entity acquisition, the expanded affiliated group (EAG) that includes the foreign acquiring corporation does not have substantial business activities in the foreign country in which, or under the law of which, the foreign acquiring corporation is created or organized when compared to the total business activities of the EAG.
Under (2) above, if the former shareholders of the domestic corporation hold 80 percent or more of the stock of the foreign corporation after the transaction, the foreign corporation is treated as a domestic corporation for U.S. tax purposes. If the former shareholders hold at least 60 percent but less than 80 percent of the stock of the foreign acquiring corporation after the transaction, then the transaction is respected but use of tax attributes is limited. Transactions where the former shareholders of the domestic corporation hold less than 60 percent of the stock of the foreign acquiring corporation are generally not limited. The percentage of stock is referred to as the ownership percentage, and the fraction used to calculate the ownership percentage is referred to as the ownership fraction.
The Tax Cuts and Jobs Act of 2017 (TCJA) ( P.L. 115-97) reduced, but did not completely eliminate, the incentives for tax-motivated inversions.
Changes Made by the Final Regulations in General
Similar to the 2016 regulations, the final regulations under Code Sec. 7874 provide rules for:
- identifying domestic entity acquisitions and foreign acquiring corporations in certain multiple-step transactions;
- calculating the ownership percentage and, more specifically, disregarding certain stock of the foreign acquiring corporation for purposes of computing the denominator of the ownership fraction and, in addition, taking into account certain non-ordinary course distributions (NOCDs) made by a domestic entity for purposes of computing the numerator of the ownership fraction;
- determining when certain stock of a foreign acquiring corporation is treated as held by a member of the EAG; and
- determining when an EAG has substantial business activities in a relevant foreign country.
However, the final regulations clarify the prior rules, provide additional exceptions to their application, and reduce complexity and unnecessary burdens on taxpayers, including by providing guidance on how to apply particular mechanical rules. Specifically, the final regulations make clarifying changes to some of the stock exclusion rules: the passive assets rule, the serial acquisition rule, and the third country rule. Clarifying changes are also made to the substantial business activities test.
In addition, the final regulations add additional exceptions to the serial acquisition rule and the third country rule to narrow their scope. To reduce complexity and ambiguity, changes are made to the passive assets rule, the NOCD rule, and the rules coordinating the application of the stock exclusion rules with the EAG rules.
The final regulations further provide rules under Code Sec. 7874 and other provisions to reduce the tax benefits of certain post-inversion tax avoidance transactions. Such rules generally prevent the post-inversion dilution of U.S. shareholders’ interests in expatriated foreign subsidiaries.
Passive Assets Rule
The final regulations apply the passive assets rule only for purposes of determining the ownership percentage by value. The passive assets rule is also modified so that stock excluded under any of the stock exclusion rules is not taken into account. In addition, property that gives rise to stock excluded under any of the stock exclusion rules is not taken into account for purposes of this rule.
Serial Acquisitions of Domestic Entities
The final regulations retain the 36-month look-back period for the serial acquisition rule, but make three technical clarifications or modifications to this rule. Specifically, the final regulations:
- clarify that the determination of the foreign acquiring corporation’s stock attributable to a prior domestic entity acquisition does not take into account stock of the foreign acquiring corporation deemed to have been received under the NOCD rule or Code Sec. 7874(c)(4) in the prior domestic entity acquisition;
- provide an additional exception to the definition of the term “prior domestic entity acquisition” to exclude a domestic entity acquisition that occurs within a foreign-parented group and qualifies for the internal group restructuring exception; and
- define a predecessor of a foreign acquiring corporation for purposes of the serial acquisition rule.
The final regulations also:
- provide exceptions to the third-country rule in certain cases where transactions are not driven by tax planning;
- include several clarifications or modifications to the NOCD rule;
- modify one of the requirements of the de minimis exception applicable to the disqualified stock rule, the passive assets rule, and the NOCD rule;
- broaden the coordination of the stock exclusion rules with the EAG rules; and
- for purposes of the substantial business activities test, define a “tax resident” as a body corporate liable to tax under the laws of the country as a resident.
The applicability dates of the rules in the final regulations are generally the same as the applicability dates of the rules as set forth in the 2016 regulations. However, differences between the final regulations and the 2016 regulations generally apply on a prospective basis, with an option for taxpayers to apply the differences retroactively. Since taxpayers may have relied on the 2016 regulations, the modifications to the final regulations generally apply prospectively. However, domestic entity acquisitions completed before July 12, 2018, continue to be subject to those rules as set forth in the 2016 regulations, but generally with an option for taxpayers to apply the differences retroactively.