An Overview of the Anti-Inversion Rules for Expatriating U.S. Companies

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 stock 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 foreign 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). 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.

Types of Inversion Transactions

Most inversion transactions are in the form of stock transactions. A common inversion transaction is a U.S. corporation that forms a foreign corporation, which in turn forms a domestic merger subsidiary. The domestic merger subsidiary then merges into the U.S. corporation, with the U.S. corporation surviving, now as a subsidiary of the new foreign corporation. The U.S. corporation’s shareholders receive shares of the foreign corporation and are treated as having exchanged their U.S. corporation shares for the foreign corporation shares. An asset inversion reaches a similar result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation. An inversion transaction may be accompanied or followed by further restructuring of the corporate group. For example, in the case of a stock inversion, in order to remove income from foreign operations from the U.S. taxing jurisdiction, the U.S. corporation may transfer some or all of its foreign subsidiaries directly to the new foreign parent corporation or other related foreign corporations.

In addition to removing foreign operations from the U.S. taxing jurisdiction, the corporate group may derive further advantage from the inverted structure by reducing U.S. tax on U.S.-source income through other transactions.

Inversion transactions may give rise to immediate U.S. tax consequences at the shareholder and/or the corporate level, depending on the type of inversion. In stock inversions, the U.S. shareholders generally recognize gain (but not loss) under Section 367(a) of the Internal Revenue Code, based on the difference between the fair market value of the foreign corporation shares received and the adjusted basis of the domestic corporation stock exchange. To the extent that a corporation’s share value has declined, and/or it has many foreign shareholders, the impact of the so-called Section 367(a) “toll charge” is reduced. The transfer of foreign subsidiaries or other assets to the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level under Sections 1001, 311(b), 304, 367, or 1248 of the Internal Revenue Code. The tax on any income recognized as a result of these restructurings may be reduced or eliminated through the use of net operating losses or foreign tax credits.

In asset inversions, the U.S. corporation generally recognizes gain (but not loss) under Section 367(a) as though it had sold all its assets, but the shareholders generally do not recognize gain or loss, assuming the transaction meets the requirements of a reorganization under Section 368.

To remove the incentive to engage in corporate inversion transactions, Congress added Section 7874 to 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.

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.

Transactions Involving at Least 80 Percent Identity of Stock Ownership

The first type of inversion is a transaction in which, pursuant to a plan or a 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 transaction; (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-incorporated 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 (i.e., the “expanded affiliated group”), does not have substantial business activities in the entity’s country of incorporation, compared to the total worldwide activities of the expanded affiliated group. This provision of the Internal Revenue Code denies the intended tax benefits of this type of inversion by deeming the top-tier foreign corporation to be a domestic corporation.

In determining whether a transaction meets the definition of an inversion, stock held 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, 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 is disregarded. Stock sold in a public offering related to the transaction also is disregarded for these purposes.

Transactions Involving at Least 60 Percent But Less Than 80 Percent Identity of Stock Ownership

The second type of inversion is a transaction that would meet the definition of an inversion transaction described above, except that the 80-percent ownership threshold is not met. In such a case, if at least a 60 percent ownership threshold is met, then a second set of rules applies to the inversion. 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 Sections 304, 311(b), 367, 1001, and 1248 with respect to the transfer of controlled foreign corporation stock or the transfer or license of other assets by a U.S. corporation as part of the inversion transaction or after such transaction to a related foreign person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax credits).

The above discussed rules apply to certain partnership transactions. Specifically to transactions in which a foreign-incorporated entity acquires substantially all of the properties constituting a trade or business of a domestic partnership, if after the acquisition at least 60 percent of the stock of the entity is held by former partners of the partnership (by reason of holding their partnership interests), provided that the other terms of the basic definition are met.

Below, please see Illustration 1 and Illustration 2 which demonstrates how the inversion rules operate.

Illustration 1.

SamCo, is publicly held U.S. C corporation, owns Foreign Sub, a controlled foreign corporation. Cayman Islands Co, a foreign corporation incorporated in the Cayman Islands, is formed and Cayman Islands Co owns a U.S. acquisition corporation, U.S. Acquisition Co. In a transaction designated to be what would otherwise be a tax-free forward triangular reorganization under Section 368(a)(2)(D) of the Internal Revenue Code, SamCo’s shareholders receive 60 percent of the shares of Cayman Islands Co as SamCo merges into U.S. Acquisition Co. The resulting transaction has the former SamCo shareholders now owning 60 percent of the shares of Cayman Islands Co. U.S. Acquisition Co, which comprises the operating business of SamCo, now owns Foreign Sub and distributes Foreign Sub’s shares to Cayman Islands Co. U.S. Acquisition Co is now composed of the operating business of the former SamCo, now owns Foreign Sub and distributes Foreign Sub shares to Cayman Islands Co.

U.S. Acquisition Co will recognize gain on the distribution of the Foreign Sub shares to the extent their fair market value exceeds basis. In addition, the former Sam Co shareholders will incur tax liability under Section 367(a) to the extent that the fair market value of Cayman Islands Co shares received exceeds their basis in SamCo shares. In addition, because SamCo shareholders own at least 60 percent (but less than 80 percent) of the shares of Cayman Islands Co, all gain recognized may not be reduced through foreign tax credits or net operating losses.

Illustration 2.

Cal LLC is a U.S. LLC that is classified as a partnership for U.S. tax purposes. The partnership is owned by two U.S. citizens. Cal LLC owns Foreign Sub, a controlled foreign corporation. Cayman Islands Co is a Cayman Islands Corporation. Cayman Islands Co establishes a foreign corporation known as Foreign Acquisition Co. In a transaction that is treated as a sale, Cal LLC owners receive shares of Cayman Islands Co. At the same time, Cal LLC merged into Foreign Sub. At the conclusion of the transaction, the former Cal LLC partners now hold 60 percent of the shares of Cayman Islands Co and Cayman Islands Co owns Foreign Acquisition Co.

As a result of the transaction, Cal LLC partners will recognize gain to the extent that the fair market value of the Cayman Islands Co shares received exceeds the basis in the LLC units relinquished. Since the former CA LLC partners owned at least 60 percent of the shares of Cayman Islands Co, any gain realized pursuant to Section 367(a) cannot be reduced through the use of foreign tax credits or net operating losses.

Section 4985

The Internal Revenue Code also contains Section 4985 which applies to inversion transactions. Section 4985 imposes an excise tax on certain individuals who hold stock options and other stock-based compensation in a corporation in the case of certain inversion transactions involving the corporation. The excise tax applies to the value of specified stock compensation held, directly or indirectly, by or for the benefit of a disqualified individual, or a member of the individual’s family (as defined in Section 267), at any time during the 12-month period starting six months before the corporation’s expatriation date. See IRC Section 4985(a)(2). The rate of the excise tax is equal to the preferential rate of tax on long-term capital gains. A disqualified individual is any individual who, is, with respect to a corporation, at any time during the 12-month period starting six months before the corporation’s expatriation date, subject to the requirements of Section 16(a) of the Securities and Exchange Act of 1934 with respect to the corporation or any member of the corporation’s expanded affiliated group, or who would be subject to those requirements if the corporation were an issuer of securities referred to those provision of the securities laws. See IRC Section 4985(e)(1). This group generally includes certain top-level officers, directors, and ten-percent-or-greater shareholders of a corporation. The excise tax is generally imposed only if gain is recognized in whole or in part by any shareholder on account of certain corporate inversion transactions.

Finally, the Internal Revenue Code contains Section 6043A which applies to inversion transactions. Section 6043A requires the acquiring corporation in any taxable acquisition to file an information return with the IRS in any taxable acquisition transaction.

Conclusion

The anti-inversion rules are designed to prevent corporate inversions by providing different methods of taxation depending on whether 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. In addition, the anti-inversion rules apply if U.S. shareholders own 80 percent or more (by vote or value) of the shares of the foreign corporation as a result of the inversion transaction and both (1) the U.S. corporation either becomes a subsidiary of a foreign corporation or transfers substantially all its properties to a foreign corporation and (2) the group does not have substantial business activities in the foreign corporation’s country of incorporation compared to the total worldwide business activities of the group. In this type of inversion transaction, the provision denies the intended tax benefit by deeming the top-tier foreign corporation to be a U.S. corporation for all U.S. tax purposes. By deeming the top-tier foreign corporation a U.S. corporation, the entity would be subject to U.S. tax on its worldwide income.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony has substantial experience advising foreign and domestic technology companies regarding the U.S. tax consequences of digital content and cloud transactions. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

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.