Is a SAFE a “safe” Planning Option for the Anti-Inversion Rules?

Congress has enacted various provisions to tax shareholders who transfer appreciated shares of U.S. corporations for shares of foreign corporations because these transfers may represent the United States’ last opportunity for taxing the appreciation. Internal Revenue Code Section 367 typically taxes any appreciation of U.S. corporate shares to a foreign corporation and provides an adequate deterrence against expatriation. Despite Section 367, Congress became concerned that Section 367 was not detrimental enough to discourage the expatriation of U.S. companies. Congress enacted the anti-inversion rules to prevent corporate inversions by providing different methods of taxation dependent 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 a newly former foreign corporation.

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-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 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 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.

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).

How SAFEs Can Be Utilized In Planning for the Anti-Inversion Rules

A Simple Agreement for Future Equity (“SAFE”) is a contract between a corporation and an investor. A SAFE allows an investor to provide funding to a corporation in exchange for the right to receive equity in the corporation at a future date. SAFEs were first developed by Y Combinator in 2013 as an alternative to convertible notes. A SAFE agreement is a type of convertible security, but unlike a debt instrument, SAFEs do not accrue interest or have a maturity date. However, an ownership interest in a SAFE cannot be characterized as holding an interest in a common or preferred stock. An investor of a SAFE owns no shares of stock, has no voting right, and cannot sell stock to a third party.

As indicated above, the anti-inversion rules are designed to prevent corporate inversions by providing different methods of taxation depending on whether the former 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 the new foreign corporation. If a SAFE is treated as debt for federal income tax purposes in a U.S. corporation prior to its expatriation and as stock in the newly formed foreign corporation, a SAFE can be a valuable tool for purposes of the anti- inversion rules.

To illustrate how a SAFE agreement can potentially be utilized to plan for the anti-inversion rules. Suppose “High Tech Corp” is a corporation incorporated. High Tech Corp is in the process of developing a program that will significantly advance Al. High Tech Co owns a foreign corporation, HAVENco, that is incorporated in the Cayman Islands. High Tech Corp has four shareholders that are not U.S. persons for U.S. income tax purposes. High Tech Corp receives a significant cash investment through a SAFE. High Tech Corp has planned a transaction that would otherwise be a tax-free forward triangular reorganization in which High Tech Corp’s shareholders receive shares of HAVENco as High Tech Corp merges into HAVENco. HAVENco will not have substantial business activities in HAVENco’s country incorporation compared to its total worldwide business activities. The SAFE will convert into 33% shares of HAVENco after the reorganization is completed. The resulting structure has the former High Tech Corp Shareholders now owning 67% of the shares of HAVENco. Because the former High Tech Corp shareholders own at least 60 percent (but less than 80 percent) of the shares of HAVENco, the U.S. shareholders will incur taxable gain to the extent that the fair market value of the HAVENco shares received exceeds their basis in the High Tech Corp shares. However, the Internal Revenue Service (“IRS”) will recognize HAVENco as a foreign corporation. Had the former shareholders of High Tech Corp owned 80 percent or more of HAVENco, the IRS would have treated HAVENco as a U.S. corporation under the anti-inversion rules. The fact that HAVENco may be recognized as a foreign corporation for U.S. tax purposes is significant because HAVENco’s future foreign source income may potentially escape U.S. taxation.

Should the SAFE be treated as a debt Instrument for Purposes of the Anti-Inversion Rules?

Taxpayers have considerable flexibility to structure corporate instruments as debt or equity. In view of the sharply disparate tax treatment of debt and equity, it is hardly surprising that the IRS may be unwilling to accept the taxpayer’s label as controlling. See IRC Section 385. Although distinguishing debt from equity is important in determining the proper tax consequences of a SAFE in a corporate transaction, actually making the distinction often is no easy task. There are no precise rules, but rather a number of factors to be applied in a facts and circumstances balancing act. As one court pointed out:

“Neither any single criterion nor any series of criteria can provide a conclusive answer in the kaleidoscopic circumstances which individual cases present … The various factors . are only aids in answering the ultimate question whether the investment, analyzed in terms of its economic reality, constitute risk capital entirely subject to the fortunes of the corporate venture or represents a strict debtor-creditor relationship. Since there is often an element of risk in a loan, just as there is an element of risk in an equity interest, the conflicting elements do not end at a clear line in all cases. Fin Hay Realty Co. v. United States, 398 F.2d 694, 696-697 (3d Cir. 1968).

Through Internal Revenue Code Section 385, Congress authorized the Treasury Department to “prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated … as stock or indebtedness. Section 385 offers merely suggestions to the Treasury Department as to factors it may include in regulations distinguishing debt-creditor relationships from corporate-shareholder relationships. These suggested factors are:

1. Whether there is a written unconditional promise to pay on demand or on a specific date a sum certain in money in return for an adequate consideration in money or money’s worth and to pay a fixed rate of interest;
2. Whether there is subordination to or preference over any indebtedness of the corporation;
3. The ratio of debt to equity of the corporation;
4. Whether there is convertibility into stock of the corporation;
5. The relationship between the holding of stock in the corporation and holdings of the interest in question.

Overview of Factors Used to Distinguish Debt from Equity

This overview is designed to provide the reader a flavor of the inquiry used to determine debt from equity. The analysis adopts an overall facts and circumstances test and that no one of the following factors will determine the outcome.

Observing the Formalities of a Debt Instrument

Where there is a “written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest,” the instrument is likely to be regarded as debt.

The Debt-Equity Ratio or Thin Capitalization

When a corporation issues excessive liabilities relative to the capital contributions that it has received, the holders of corporate notes risk. Such a corporation is regarded as “thinly capitalized.” Even though the instrument may bear all of the formalities normally associated with a debt instrument, the holders of this debt are depending largely on the profitability of the enterprise rather than underlying assets to assure payment. This type of risk is more typically associated with an equity investment.

Subordination to Other Claims

Another important factor in distinguishing debt from equity is subordination to other claims. Creditor’s claims generally take priority over equity holder’s claims. Thus, if an instrument specifies the holder’s claims are subordinate to general creditor claims, the instrument is more likely to be classified as equity.

Contingency of Payment

In the case of straight or classic debt, the obligation to pay interest is unconditional. On the other hand, a corporation’s obligation to pay interest to the holder of a financial instrument may be contingent upon a certain level of corporate profits or may be left to the discretion of the board of directors in some way. The risk associated with a debt instrument subject to such a contingency is more like the risk associated with an equity interest of a corporation.

Right to Participate in Profits

One key element that distinguishes an equity holder from a debt holder is the right of the equity holder to participate in the corporation’s economic growth. When the holder of an obligation is entitled to share in profits of the corporate enterprise above and beyond the interest specified in the note, the factor will weigh heavily in favor of an equity classification.

Voting and Other Rights of Control

Voting rights and managerial rights are equity characteristics. Lenders typically are not entitled to vote or otherwise participate in the management of the corporation. The presence of such rights can be a factor that causes a financial instrument to be classified as equity.

Identity Between Shareholders and Creditors

When the shareholders of a corporation also lend money to the corporation, the notes taken in return will typically be considered equity.

Acquisition of Essential Assets

Some courts have considered the fact that a note was issued to shareholders in return for essential assets necessary for the corporation’s business as an equity factor. The idea here is that corporations do not typically acquire their core assets through debt issued to shareholders. A shareholder who purports to sell such essential assets to a corporation in return for a note will typically be viewed as equity.

Intent of the Parties

Some courts have explored the intent to establish a debtor-creditor relationship in deciding whether to reclassify a note as equity. An intent test looks at the reasonable expectation of the lender that the debt will be repaid, focusing on the objective criteria.

Treasury Regulation Section 1.385-3(d)

Although a review of the factors discussed provides a good overview addressing the form over substance arguments for purposes, this guidance fails to provide us with specifics on how to treat a SAFE for federal income tax purposes. A SAFE can be classified as a “hybrid” instrument. A SAFE is a “hybrid” instrument because it converts debt into stock. “Final” regulations were promulgated in December, 1980, to be effective for interests in corporations created after April 30, 1981, but the Treasury twice extended their effective date in the face of criticism from various groups. Extensive amendments were proposed in December, 1981, followed by still further extensions of the effective date. In July, 1983, all versions of the regulations were withdrawn. Under these defunct regulations, in virtually all cases, hybrids were treated as preferred stock and not debt for tax purposes. However, these regulations were withdrawn. In October, 2016, the IRS issued revised temporary and final regulations under Section 385. The final and proposed regulations allow the IRS to bifurcate hybrid debt instruments into part debt and part equity. In other words, the regulations under Section 385 allow (but not require) the IRS to bifurcate where appropriate a hybrid instrument to have characteristics as “in part stock and in part indebtedness.” See IRC Section 385(a). However, as of this date, there is no tax authority that has addressed the proper tax treatment of a SAFE. This means that any seeking to utilize a SAFE in the context of the anti-inversion rules must examine and apply to factors discussed above in order to determine if a SAFE can be characterized as both debt and equity for planning purposes. Each SAFE agreement should be individually tailored for the specific and individual circumstances of that particular case. A “one size fits all” approach should never be utilized when considering the use of a SAFE inversion or corporate expatriation planning purposes.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding of the anti-inversion rules and a potential planning option utilizing a financial instrument known as a SAFE. It should be evident from this article that this is an extremely complex subject. It is important to note that this area is constantly subject to new development and changes, as Congress continually entertains new tax laws, the Treasury promulgates new regulations, and federal courts issue new opinions that impact the subject matter discussed in this article. As a result, it is crucial that U.S. companies considering expatriating from the U.S. and/or utilizing a SAFE to obtain financing review its particular circumstances with a qualified international tax attorney.

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.