Global Tax Alert | 23 January 2014
US IRS and Treasury issue Temporary Regulations regarding treatment of certain stock of a foreign corporation under Section 7874
On 16 January 2014, the Internal Revenue Service (the IRS) and the Treasury Department (the Treasury) issued temporary and proposed regulations under Section 7874 of the Internal Revenue Code (the Temporary Regulations)1 that provide guidance for determining stock ownership of a “foreign acquiring corporation”2 for purposes of the ownership test of Section 7874(a)(2)(B)(ii). The Temporary Regulations set forth the rules announced in Notice 2009-783 (the Notice) with certain modifications.
Section 7874 generally applies to transactions involving the acquisition of a domestic entity by a foreign corporation. If the conditions of Section 7874 are otherwise satisfied, the consequences of the provision will depend on the percentage ownership of the stock of the foreign acquiring corporation held by the former owners (shareholders or partners) of the domestic entity by reason of their interest in the domestic entity (the Ownership Test). If the former owners of the domestic entity own 60% or more (but less than 80%) of the foreign acquiring corporation, the acquired domestic entity will be denied certain tax attributes to shelter any “inversion gain” recognized within 10 years after the acquisition. On the other hand, if the former owners of the domestic entity own 80% or more of the foreign acquiring corporation, the foreign acquiring corporation will be treated as a domestic corporation for all US federal income tax purposes.4
Section 7874(c)(2)(B) contains a rule (the statutory public offering rule) that expressly excludes shares issued in a public offering from being considered in computing the ownership percentage. The statutory public offering rule is principally designed to preclude the avoidance of Section 7874 by engaging in (for example) a unilateral inversion of a US corporation to a foreign jurisdiction coupled with a public offering of the stock of the resulting foreign corporation. If the shares received in the public offering were counted for purposes of the Ownership Test, they would dilute the ownership percentage of the legacy owners of the domestic entity in the resulting foreign corporation and thus could potentially circumvent the application of Section 7874. In the Notice, the IRS and Treasury essentially extended the statutory public offering rule to private placements. Commentators, however, expressed concern that the Notice was overly broad and could cause Section 7874 to apply to transactions that were, in substance, third party sale transactions rather than “typical” inversion transactions.
Consistent with the Notice, the Temporary Regulations expand the scope of the statutory public offering rule to disregard certain stock of a foreign acquiring corporation received in private placements. The Temporary Regulations also set forth an “exclusion rule” which limits the statutory public offering rule's application to “disqualified stock” of the foreign acquiring corporation. Disqualified stock is not considered when assessing whether the Ownership Test has been satisfied.5
Disqualified stock includes stock of the foreign acquiring corporation, whether or not publicly traded, that is transferred in exchange for “nonqualified property,” which means (i) cash or cash equivalents; (ii) marketable securities, (iii) certain related party obligations, and (iv) and any property acquired with a principal purpose of avoiding the purposes of Section 7874.6 Disqualified stock is also stock received in exchange for property when, pursuant to the same plan (or series of related transactions), the recipient of such stock subsequently transfers it in exchange for the satisfaction or the assumption of one or more obligations associated with the property exchanged for such stock (the associated obligation rule).7 In any case, regardless of the nature of property transferred in exchange for the stock of a foreign acquiring corporation, stock is disqualified stock only to the extent that the transfer of the stock in the exchange increases the fair market value of the assets of the foreign acquiring corporation or decreases the amount of its liabilities.8 Thus, stock of a foreign acquiring corporation acquired by a person from a shareholder of the foreign acquiring corporation in a transaction potentially related to the acquisition will not constitute disqualified stock even if purchased in exchange for nonqualified property.
The Temporary Regulations also introduce a new de minimis exception to the exclusion rule. This de minimis exception is designed to address commentators' concerns about the rules applying to what effectively amount to third party sale transactions. For instance, if a PE (Private Equity) fund formed a foreign corporation to acquire a domestic entity for cash, and the equity in the domestic entity held by its management is “rolled over” into the new foreign acquiring corporation, the Notice would have disregarded the stock of the foreign acquiring corporation received by the PE fund because it was received for cash. Therefore, even if the domestic entity's management received only a minimal amount of the stock of the foreign acquiring corporation due to the roll over, Section 7874 would cause the foreign acquiring corporation to be treated as a domestic corporation for US federal income tax purposes. To prevent this result, the Temporary Regulations provide that the exclusion rule will not apply if the ownership percentage of the former owners of the domestic entity in the foreign acquiring corporation, determined without regard to the exclusion rule, is less than 5% (by vote and value) and if the former owners of the domestic entity, in the aggregate, own (directly and constructively) less than 5% of the stock of any member of the EAG that includes the foreign acquiring corporation after the acquisition.9
Finally, the Temporary Regulations make a number of technical modifications to the Notice, such as clarifying the interaction between the exclusion rule and the EAG rules of Section 7874(c)(2)(A) and explaining the effect on the Ownership Test of post-acquisition transfers of the foreign acquiring corporation's stock by former owners of the domestic entity.10
The Temporary Regulations are generally effective on or after 17 September 2009, the date of the Notice. However, certain provisions of the Temporary Regulations that modify the Notice (listed in Treas. Reg. Section 1.7874-4T(k)(2)) are effective prospectively as of 16 January 2014, unless the taxpayer makes an election to apply such provisions to all acquisitions that occur between 17 September 2009 and 16 January 2014. The Temporary Regulations expire on 13 January 2017.
The Temporary Regulations are substantially consistent with the principles outlined in the Notice. The Temporary Regulations are also generally consistent with a regulatory trend that is making it more difficult for US taxpayers to feel confident that their cross-border transactions avoid the expanding reach of Section 7874. For example, as noted above, the statutory public offering rule has essentially been expanded by the Temporary Regulations to numerous transactions (e.g., private placements) even though they do try to minimize some potential for over-inclusiveness. In addition, many new rules require intensive factual scrutiny, including an assessment of taxpayer intent. For example, the Temporary Regulations add four new regulatory anti-abuse rules (e.g., in the definition of nonqualified property), whose application is predicated upon the taxpayer engaging in a particular transaction or series of transactions with “a principal purpose” to avoid the purposes of Section 7874.11 Given the relatively low threshold of such tests, taxpayers will need to carefully assess their potential exposure to the various Section 7874 rules that may not be applicable on their face. Finally, taxpayers may need to determine whether a particular outlier transaction is “related” to an acquisition by a foreign acquiring corporation described in Section 7874(a)(2)(B)(i), or, in the case of such an acquisition, whether particular liabilities are “associated” with a trade or business assumed by the foreign acquiring corporation. In sum, while the Temporary Regulations still offer the possibility of being able to engage in a cross-border transaction that avoids Section 7874, successful navigating of all of the rules will continue to pose a significant challenge to most US taxpayers.
1. Treas. Reg. Sections 1.7874-4T and -5T. The text of the Temporary Regulations serve as the text for the proposed regulations.
2. See Treas. Reg. Section 1.7874-4T(i)(4).
3. 2009-2 C.B. 452.
4. Section 7874(b).
5. Disqualified stock is excluded from the denominator of the “ownership fraction” which is used to compute the ownership percentage of the legacy domestic entity's owners in the acquiring foreign corporation for purposes of the Ownership Test.
6. Treas. Reg. Section 1.7874-4T(c) and (i)(7). For this purpose, “marketable securities” do not include stock of a corporation or an interest in a partnership that becomes a member of the expanded affiliated group (EAG) that includes the foreign acquiring corporation in a transaction (or series of transactions) related to the acquisition, unless a principal purpose for acquiring such stock or partnership interest is to avoid the purposes of Section 7874. See Treas. Reg. Section 1.7874-4T(i)(6); see also Treas. Reg. Section 1.7874-4T(j), Example 3. The EAG is defined by reference to consolidated return Section 1504(a) affiliation, but includes foreign corporations and is applied at a more than 50% level. See Section 7874(c)(1).
7. Treas. Reg. Section 1.7874(c)(1)(i) and (ii).
8. Treas. Reg. Section 1.7874(c)(2).
9. Treas. Reg. Section 1.7874-4T(d)(1)(i) and (ii).
10. See Treas. Reg. Section 1.7874-4T(i)(2).
11. Compare Section 269 (disallowance of tax benefits where the principal purpose an acquisition of control is tax evasion or avoidance).
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP, International Tax Services
- • Jose Murillo, Washington, DC
+1 202 327 6044
- • Paul Pencak, Chicago
+1 312 879 5152
- • Steven Surdell, Chicago
+1 312 879 4123
- • Gary Scanlon, Chicago
+1 312 879 3401
Ernst & Young LLP, Transaction Advisory Services
- • Donald Bakke, Washington, DC
+1 202 327 6103
- • Brandon Hayes, San Jose
+1 408 947 5615
EYG no. CM4126