Can Inverting Corporations Use a Foreign Partnership to Avoid the Anti-Inversion Rules?

On March 4, 2023, Congress enacted Section 7874 of the Internal Revenue Code to combat the practice of “inverting” a U.S. corporation into a foreign corporation in order to minimize or avoid U.S. taxation on offshore profits.

The anti-inversion rules apply if the shareholders of the former U.S. corporation own 80 percent or more by vote or value of the shares of the foreign entity 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 of its properties to a foreign corporation and 2) the newly formed foreign company does not have substantial business activities in the foreign corporation’s country of incorporation compared to the total worldwide business activities of the newly formed foreign corporation. If these tests are satisfied, the newly formed foreign company will still be treated as a U.S. corporation for U.S. tax purposes and the new foreign company will continue to be subject to U.S. taxation on its worldwide income.

Below, please see Illustration 1 which discusses how the anti-inversion rules apply when former U.S. shareholders of an inverted U.S. corporation own at least 80 percent (by vote or value) of the shares of the newly foreign company.

Illustration 1.

Tech Co, a publicly held U.S. C corporation, owns Foreign Sub, a controlled foreign corporation. Cayman Co, a foreign corporation incorporated in the Cayman Islands, is formed and Cayman Co forms a U.S. acquisition corporation, U.S. Acquisition Co. In a transaction designed to what would otherwise be a tax-free forward triangular reorganization under Section 368(a)(2)(D) of the Internal Revenue Code, Tech Co’s shareholders receive 100 percent of the shares of Cayman Co as Tech Co mergers into U.S. Acquisition Co. The resulting structure has the former Tech Co shareholders now owning all the shares of Cayman Co and U.S. Acquisition Co which holds the operating business of the former U.S. Tech Co. The new foreign structure also owns Foreign Sub.

Under the anti-inversion rules, the former Tech Co shareholders own 80 percent or more of Cayman Co and both 1) Tech Co shareholders own 80 percent or more of Cayman Co and 2) the group of Cayman Co, U.S. Acquisition Co, and Foreign Sub do not have substantial business activities in Cayman Co’s country of incorporation compared to its total worldwide business activities of the group. As a result, Cayman Co is treated as if it were a U.S. corporation for U.S. federal tax purposes.

If U.S. shareholders own at least 60 percent (but less than 80 percent), by vote or value of the newly formed foreign company, the anti-inversion rules that govern the transaction are different. In such a situation, the foreign corporation is respected as a foreign entity for U.S. tax purposes, but the expatriating U.S. corporation must recognize an “inversion gain” (income or gain from the transfer of assets or property to foreign affiliates as part of the inversion). In these situations, any applicable gain may not be offset by any net operating losses or foreign tax credits for tax years following the inversion transaction.

Below, please see Illustration 2 which discusses how the anti-inversion rules apply when former U.S. shareholders of an inverted U.S. corporation own at least 60 percent (but less than 80 percent), by vote or value of a newly formed foreign corporation.

Illustration 2.

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

Under the anti-inversion rules, in this example, Tech Co will recognize taxable gain on the distribution of all its assets (including the Foreign Sub’s assets) to Cayman Co. The taxable gain is subject to the standard U.S. corporate rate which is currently 21 percent.

The former shareholders of Tech Co will also realize a tax to the extent that the fair market value of the Cayman Co shares received exceeds their basis in their former Tech Co shares. See IRC Section 367(a). In addition, because the former Tech Co shareholders own at least 60 percent (but less than 80 percent) of the shares of Cayman Co, any taxable gain realized for U.S. tax purposes under the anti-inversion rules may not be reduced with foreign tax credits or net operating losses over the next 10 years. Furthermore, there is a separate consequence for certain executives and directors is a 15% excise tax on the value of their stock options and stock-based compensation at the time of the inversion.

Anti-Inversion Rules and Partnerships

Under current law, the Section 7874 anti-inversion rules typically only apply if a U.S. corporation is inverting into a foreign corporation. Generally, the anti-inversion rules of Section 7874 do not apply to an entity acquiring the assets is a standard foreign partnership. Section 7874 does not apply to non-publicly traded foreign partnerships. A non-publicly traded foreign partnership is a pass-through entity for U.S. tax purposes. The Treasury Department and the IRS are aware that foreign partnerships may be utilized to circumvent the anti-inversion rules. Therefore, the Treasury Department and the Internal Revenue Service (“IRS”) has promulgated regulations which provide that a publicly traded foreign partnership will be treated as a foreign corporation for purposes of applying the anti-inversion rules to determine if it is a surrogate foreign corporation. See Treas. Reg. Section 1.7874-2T(k)(1).

A publicly traded partnership is defined as any partnership whose interests are: (1) traded on an established securities market, or (2) readily traded on a secondary market (or its substantial equivalent). See IRC Section 7704(b).  If a publicly traded partnership acquires substantially all of the properties of a U.S. corporation, the anti-inversion rules apply based on the “ownership percentage” of the former U.S. owners after the transaction in the same manner as if the U.S. corporate assets were transferred to a foreign corporation.

In order to potentially utilize a partnership to avoid the anti-inversion rules, U.S. corporations considering inverting to a foreign jurisdiction should only utilize an entity that is treated as a partnership under U.S. law and not a foreign entity that is treated as a publicly traded partnership or corporation.

Application of Section 721(a) to Transfer to Foreign Partnerships

Typically, the transfer of U.S. corporate assets to a foreign corporation is subject to the so-called Section 367(a)(1) toll charge. The core rule of Section 367(a)(1) states that if a U.S. person transfers property to a foreign corporation in an exchange that would otherwise be tax-free under specific nonrecognition provisions, the foreign entity is not considered a corporation for purposes of determining gain recognition. This forces the U.S. transferor to recognize gain on the transferred assets. Section 367 only overrides nonrecognition treatment for transactions explicitly listed relevant Internal Revenue Code Sections, all of which involve corporations as the transferee entity.

Section 367 does not specifically apply to transfers to foreign partnerships and is generally governed by other provisions, primarily Subchapter K of the Internal Revenue Code, although other anti-abuse rules apply. Under Section 721 of the Internal Revenue Code, a U.S. person’s contribution of property to a partnership (whether domestic or foreign) in exchange for a partnership interest is generally a nonrecognition event under Section 721(a). Because Section 721 of the Internal Revenue Code does not require corporate status for the transferee and it is not one of the sections enumerated in Section 367(a)(1), the Section 367(a) gain recognition provisions does not generally apply to transfers to foreign partnerships.

While Section 367(a) itself does not apply to transfers of U.S. corporate assets to a foreign partnerships, specific regulations under Section 721(c) address contributions of appreciated property to a partnership with related foreign partners in certain circumstances. A related foreign partner is a non-U.S. person or entity in a partnership who has a specific, legally defined relationship with a U.S. person (the U.S. transfor”). A foreign person is defined as any individual that is not a U.S. citizen or resident, foreign corporations, foreign partnerships, and foreign trusts or estates. Section 267(b) applies constructive ownership rules. Under these constructive ownership rules, there is an attribution of ownership between partnerships and corporations. These attribution rules will likely attribute ownership between a U.S. inverting corporation and a newly formed foreign partnership. Thus, assets transferred from an inverting U.S. corporation to a foreign partnership will likely be subject to gain recognition similar to a Section 367(a) gain recognition. However, the newly formed foreign partnership will not likely be treated as a U.S. entity under the anti-inversion rules. This means that the newly formed partnership will not likely be taxed on its foreign sourced income.

In addition, the regulations promulgated under Section 721(c) may offer an inverting corporation the ability to defer gain something which is not found in the regulations under Section 367(a). For example, Treasury Regulation Section 1.721(c)(3) details a gain recognition method, allowing U.S. persons contributing appreciated property to a partnership with related foreign persons to defer recognizing gain, provided specific conditions are met, including the partnership adopt the remedial allocation method and apply a consistent allocation method of account (book items to the U.S. transferor gain on an “acceleration event”).

Depending on the situation of the inverting corporation, in some cases, utilizing a foreign partnership may make sense in order to reduce its exposure to the U.S. anti-inversion rules.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is the author of a number of published articles addressing cross-border taxation. Anthony also frequently provides continuing educational programs regarding various international tax topics.

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.