By Anthony Diosdi
Many foreign investors (who are not domiciled in the U.S.) are advised to hold U.S. real property through U.S. corporations which in turn are owned by foreign corporations. Foreign investors are told to use these multi-tiered corporate blocker structures to avoid the U.S. estate and gift tax. At one time, multi-tiered corporate blocker structures could protect foreign investors from U.S. federal estate and gift tax.
All this was possible because prior to the 2004 calendar year, a U.S. corporation may reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation with a foreign parent corporation. These transactions were commonly referred to as asset inversion transactions. In asset inversions, a U.S. corporation generally recognized gain (but not loss) under Section 367(a) of the Internal Revenue Code as though it had sold all of its assets, but the shareholders generally did not recognize gain or loss, assuming the transaction met the requirements of a reorganization under Section 368. To remove the incentive to engage in corporate inversion transactions, Congress included several provisions in the 2004 JOBS Act aimed at corporate inversions. One of these provisions was Section 7874 to the Internal Revenue Code.
After Section 7874 was enacted, holding U.S. real property through a U.S. corporation that is wholly owned by a foreign corporation can result in an “inversion.” If this were to take place, a foreign corporation that holds a U.S. corporation could be treated as a U.S. corporation for U.S. tax purposes. In other words, an estate plan that holds U.S. property through a U.S. corporation wholly owned by a foreign corporation will not protect foreign investors from the U.S. federal estate tax. Since foreign investors (who are not domiciled in the U.S.) only have a $60,000 exemption on the value of their U.S. situs assets excluded from their gross estate for U.S. gift and estate tax purposes, a structure such as the one described above may have disastrous U.S. federal estate tax consequences.
This article will discuss one variation of the “inversion” transaction, which involves the transfer of shares by non-U.S. individuals of a U.S. corporation owning U.S. real estate to a foreign corporation in exchange for shares of the foreign corporation.
Summary of U.S. Federal Estate and Gift Tax Law
The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. Non-U.S. domiciliaries are allowed to exclude only the first $60,000 in value of U.S.-situs assets from their U.S. estates, unless an applicable treaty allows a greater credit. On the other hand, U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $12.06 million. As a result of the high estate and gift tax, for many foreign investors in U.S. real property, the most important consideration is estate and gift tax planning. Many investors are told to hold U.S. real estate through multi-tiered blocker structures. For reasons discussed below, this method of estate planning will no longer provide its desired result.
Overview of Internal Revenue Code Section 7874 and the Anti-Inversion Rules
The U.S. government has recognized that inversions provide tax savings in two significant ways. First, an inversion may reduce U.S. tax on foreign-source income by effectively shifting income away from a U.S. corporation to its related foreign corporation (“income shifting”). In turn, this potentially achieves pure territorial tax treatment for the group, rather than worldwide income treatment. Second, an inversion may reduce U.S. tax through earnings stripping with foreign related-party debt, where a U.S. subsidiary pays interest to its foreign parent and the interest may then be deductible for U.S. federal tax purposes. In light of these abuses, the U.S. government has issued numerous anti-inversion rules over the years to prevent U.S. multinational corporations from relocating their domicile to foreign jurisdictions.
Legislative History of the Inversion Rules
Prior to March of 2003, a U.S. corporation could reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation of a multinational corporate group with a foreign parent corporation. These transactions were commonly referred to as inversion transactions. Inversion transactions could take many different forms, including stok inversions, asset inversions, and various combinations of and variations on the two. In a stock inversion, a U.S. corporation forms a foreign corporation, which in turn forms a domestic merger subsidiary. The domestic merger subsidiary would then merge into the U.S. corporation, with the U.S. corporation surviving as a subsidiary of the new foreign corporation. The U.S. corporation’s shareholders would receive shares of the doreign corporation and would be treated as having exchanged their U.S. corporate shares for the foreign corporation shares. An asset inversion would reach a similar result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation.
Inversions were done to remove income from foreign operations from the U.S. taxing jurisdiction. In addition to removing foreign operations from the U.S. taxing jurisdiction, a corporate group was typically able to derive further advantages from an inverted structure by reducing U.S. tax on U.S. source income through various earnings stripping or other transactions.
In 2004, corporate inversion transactions became a prime focus of Congress as a result of several well-publicized inversion transactions during the prior decade (e.g., the inversion transactions involving Tyco Corporation and Cooper Industries). To remove the incentive to engage in corporate inversion transactions, Congress included several provisions in the 2004 JOBS Act aimed at this perceived problem. In particular, Congress enacted Section 7874 of the Internal Revenue Code. Section 7874 defines two different types of corporate inversion transactions and provides a different set of tax consequences to reach each type of inversion transaction.
A Deeper Dive into Internal Revenue Code Section 7874
The anti-inversion rules are designed to prevent corporate inversions by providing different methods of taxation depending on whether the former U.S. shareholders own at least 80 percent of the new foreign corporation or at least 60 percent (but less than 80 percent) of the shares of a new foreign corporation.
The anti-inversion rules apply if pursuant to a plan or series of related transactions: 1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity in a translation; 2) the former shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the foreign-incorprated entity after the transaction; and 3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 50 percent ownership (ie., the “expanded affiliated group), does not have substantial business activities in the entity’s country of incorporation, compared to the total worldwide business activities of the expanded affiliated group. The provision denies the intended tax benefits of this type of inversion by deeming the top-tier foreign corporation to be a domestic corporation for all purposes of the Internal Revenue Code.
In determining whether a transaction meets the definition of an inversion, stock by members of the expanded affiliated group that includes the foreign incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives stock of the foreign incorporated entity (e.g., so-called “hook” stock), the stock would not be considered in determining whether the transaction meets the definition. Similarly, if a U.S. parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned controlled foreign corporation, the stock of the new foreign corporation would be disregarded. Stock in a public offering related to the transaction also is disregarded for these purposes.
In addition, the Internal Revenue Service (“IRS”) is granted authority to prevent the avoidance of the purpose of the proposal through the use of related persons, pass-through or other noncorporate entities, or other intermediaries, and through transactions designed to qualify or disqualify a person as a related person or a member of an expanded affiliated group. In this type of inversion transaction, the anti-inversion rules deny the intended tax benefits by deeming the top-tier foreign corporation to be a U.S. corporation for all U.S. tax purposes.
If U.S. shareholders own at least 60 percent (but less than 80 percent), by vote or value, of the foreign corporation, a different anti-inversion rule applies. Under these rules, the inversion transaction is respected (i.e., the foreign corporation is treated as foreign), but any applicable corporate-level “toll charges” for establishing the inverted structure are not offset by tax attributes such as net operating losses or foreign tax credits. Specifically, any applicable corporate-level income or gain required to be recognized under Internal Revenue Code Sections 304, 211(b), 367, 1001, 1248, or any other provision with respect to the transfer of controlled foreign corporation stock or the transfer of other assets by a U.S. corporation stock or the transfer or license of other assets by a U.S. corporation as part of the inversion transaction or other such transaction to a related foreign person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax credits). These measures generally apply a 10-year period following the inversion transaction.
The anti-inversion rules do not apply where: 1) the transferee is a foreign partnership; 2) less than substantially all of the assets are transferred; or 3) substantial activities are conducted in the country where the new holding copy is located. The Income Tax Regulations provide that the substantial activities test is met only if the following tests are met:
1. Group employees.
A. The number of group employees based in the relevant foreign country is at least 25 percent of the total number of group employees on the applicable date.
B. The employee compensation incurred with respect to group employees based in the relevant foreign country is at least 25 percent of the total employee compensation incurred with respect to all group employees during a testing period.
2. Group Assets
A. The value of the group assets located in the relevant foreign country is at least 25 percent of the total value of all group assets on the applicable date.
B. The group income derived in the relevant foreign country is at least 25 percent of the total group income during a testing period.
Although there are many variations of inversions, a domestic corporation holding U.S. real estate that merges into a foreign corporation to avoid U.S. estate and gift taxes can be classified as inversion. This is because the U.S. corporation holding the real estate becomes a subsidiary of a foreign corporation and the former shareholders of the U.S. corporation will ultimately hold at least 80 percent (by vote or value) of a foreign corporation by reason of holding stock in the U.S. corporation. Although this type of planning will not likely trigger the recognition of the inversion gain, it will deny the intended tax benefit by treating the foreign corporation as a domestic corporation for all purposes of the Internal Revenue Code.
The Effects of Section 7874 on Multi-Tiered Structures Holding U.S. Real Estate Purposes of the U.S. Federal Estate and Gift Tax
A typical multi-tiered corporate structure for estate planning involves a transfer by a foreign investor of stock in a domestic corporation which holds U.S. real property in exchange for stock in the foreign corporation. This type transfer usually qualifies for tax-free treatment under Section 351 of the Internal Revenue Code. Section 351(a) provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for its stock if the transferor or transferors of property are in “control” of the corporation “immediately after the exchange.” Section 351 applies to transfers not only to domestic corporations but also to foreign corporations provided that the transferors of property have “control” immediately after the exchange.
Notwithstanding any negative results because of Section 367 (Section 367 stands sentinel to ensure that (with certain exceptions) a U.S. tax liability (sometimes called a “toll charge”) is imposed when property with untaxed appreciation is transferred beyond U.S. taxing jurisdiction), Section 7874 will result in adverse U.S. federal estate and gift tax consequences because the transfer of shares of a domestic corporation to a foreign corporation is an inversion. The foreign investor who directly owned the shares in the U.S. corporation now owns all of the shares of the foreign corporation, which holds the stock of the U.S. corporation. Neither the foreign corporation or any affiliated members will satisfy the substantial business activities exception because they do not meet the group test since the majority of their assets consists of U.S. real property interests. Because multi-tiered corporate structures that hold U.S. real property trigger the inversion rules, the foreign corporation (acquiring the U.S. corporation holding U.S. real estate) will be treated as a U.S. corporation for all U.S. federal tax purposes. This means, a foreign investor (that is not domiciliary in the U.S.) is treated as holding shares in a U.S. corporation rather than stock in a foreign corporation. Since U.S. corporate stock is treated as U.S. situs property for purposes of the estate tax, utilizing a multi-tiered corporate structure described above to hold U.S. real property is completely worthless for purposes of avoiding the estate tax.
Although it does not appear that a multi-tiered corporate blocker structure will provide protection from the U.S. estate and gift tax, there are several other possible ways to mitigate the U.S. estate tax risk without using a foreign holding company holding structure. For example, a properly structured, a foreign or domestic irrevocable trust will protect the nonresident grantor from U.S. federal estate tax. Placing U.S. property into a partnership or limited liability company may provide protection from U.S. estate and gift tax. If you are a foreign investor who owns U.S. real estate or are considering acquiring U.S. real estate, you should consult with a tax attorney well versed in this area of the law.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi advises both U.S. and international individuals in relation to a broad range of personal taxation and estate planning matters. He has extensive experience of advising on complex cross-border estate planning matters. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.