By Anthony Diosdi
For some time, corporate inversion transactions have been the focus of Congress and has generated a vigorous political debate. This is in part because of concern by some members of Congress that the tax savings arising from inversion transactions were causing U.S. multinational corporate groups to shift business operations, manufacturing plants, and jobs abroad, with a resulting adverse effect on U.S. job opportunities and the overall U.S. economy. In today’s rapidly growing and changing economy, the practice of “inverting” is no longer restricted to large multinational corporations. Smaller companies also are also involved in so-called “corporate inversion” or “corporate expatriation” transactions. This article will discuss the “nuts and bolts” of the corporate anti-inversion rules.
Transactions Involving at Least 80 Percent Identity of Stock Ownership
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.
The Internal Revenue Service or “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.
Below, please see Illustration 1 which provides an example of an inversion transaction in which a top-tier foreign corporation is deemed to be a U.S. corporation for U.S. tax purposes.
Illustration 1.
General Mistake, a publicly held U.S. C corporation, owns FordSub, a controlled foreign corporation or “CFC”. Virgin Islandco, a foreign corporation incorporated in the British Virgin Islands, a tax haven. Virgin Islandco forms a U.S. corporation known as USAcquireco. USAcquireco was formed solely for the purpose of acquiring General Mistake through Section 368(a)(2)(D) tax-free reorganization. The transaction called for General Mistake’s shareholder to receive 100 percent of Virgin Islanco’s shares through a reorganization. The reorganization would result in General Mistake merging into USacquireco. As a result of the reorganization, General Mistake’s shareholders would become shareholders of Virgin Islandco. At the same time, USAcquireco would wholly own FordSub. Both the operating businesses of General Mistake and FordSub would be owned by Virgin Islanco. Virgin Inlandco conducts no business in the Virgin Islands.
Under the anti-inversion rules, the former General Mistake shareholders own 80 percent or more of Virgin Islandco and the group of Virgin Islandco, USAcquirco, and FordSub does not have substantial business activities in Virgin Islandco’s country of incorporation compared to the total worldwide business activities of the group. Consequently, Virgin Islandco is treated as if it were a U.S. corporation that will be subject to U.S. tax on its worldwide income and all the expensive tax planning associated with this transaction is completely worthless.
Transactions Involving at Least 60 Percent but Less than 80 Percent Identity of Stock Ownership
If U.S. shareholders own at least 60 percent (but less than 80 percent), by vote or value, of the foreign corporation, a different set of anti-inversion rules apply. 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 in some cases, foreign tax credits.
Below, please see Illustration 2 which provides an example of these rules.
Illustration 2.
Same facts as Illustration 1. However, in this case, General Mistake’s shareholders receive 60 percent of the shares of Virgin Islandco as General Mistake merges into USAcquiror. The resulting structure now has General Mistake shareholders holding 60 percent of the shares of Virgin Islandco. General Mistake, which comprises the operating business of the former General Mistake, now owns FordSub and distributes FordSub’s shares to Virgin Islandco.
Under Internal Revenue Code Section 367(a), USAcquiror will recognize taxable gain on the distribution of the FordSub and General Mistake’s shares to the extent its fair market value exceeds its basis in its shares. Furthermore, the former General Mistake shareholders should incur the outbound toll charge to the extent that the fair market value of the Virgin Islandco’s shares received exceeds their basis in the General Mistake’s shares. In addition, because the former USAacquirco shares own at least 60 percent (but less than 80 percent) of the shares of Virgin Islandco, all gain recognized may not be reduced by net operating losses or potentially foreign tax credits for the next ten years.
Application to the Anti-Inversion Rules to U.S. Partnerships
The rule against using net operating losses and foreign tax credits also applies to inversions where U.S. partners exchange partnership interests for at least 60 percent of the shares of a new foreign corporation.
Illustration 3.
Let’s assume that a number of U.S. citizens established a U.S. based limited liability company or “LLC” that is taxed as a partnership for U.S. tax purposes. Let’s also assume that the LLC does not own any intangible assets. However, the LLC wholly owns FordSub, a CFC. Now let’s assume that the LLC establishes Virgin Islandco, an entity incorporated in the Virgin Islands. The sole purpose of forming Virgin Islandco was to acquire FordSub. The acquisition of Fordsub of Virgin Islandco is treated as a sale. At the conclusion of the sale, the LLC unit owners received shares of Virgin Islandco as the LLC merged into FordSub. At the conclusion of this transaction, the former LLC unit owners owners now own 60 percent of the shares of Virgin Islandco and US Virgin Inslandco owning FordSub. FordSub is not part of the operating business of the former LLC and owns FordSub.
Although an entity treated as a partnership for U.S. tax purposes will not report any income on the transaction, the former members of the LLC in this case will recognize taxable gain to the extent that the fair market value of the Virgin Islandco’s shares received exceeds the basis in each LLC member’s interests which are relinquished. Because the former LLC members own at least 60 percent of the shares of US Virgin Islandco, any gain recognized pursuant to the outbound toll charge discussed in Section 367(a) may not be reduced by a net operating losses (or potentially foreign tax credits) over the next ten years.
Special Anti-Inversion Excise Tax
When an inversion transaction is taxable, Internal Revenue Code Section 4985 imposes a 20 percent excise tax on certain “specified stock compensation” on certain corporate “insiders.” These provisions override all present and future income tax treaties. 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 of the Internal Revenue Code), at any time during the 12-month period starting six months before the corporation’s expatriation date. See IRC Section 4985(a)(2). 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 in that 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. See H.R. Conf. No. 755, 108th Cong., 2d Sess. 563 (2004).
When Do the Inversion Rules Not Apply?
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 company is located. The temporary and proposed regulations promulgated in 2009 provide some guidance regarding the term “substantial activities” for purposes of the anti-inversion rules. On June 3, 2015, the IRS and the Department of Treasury established a substantial activities test in newly issued regulations. According to these newly promulgated regulations, the substantial activities test is satisfied only if the following test is satisfied:
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 the 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 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.
c. The group income derived in the relevant foreign country is at least 25 percent of the total group income during the testing period.
Conclusion
This article was designed to provide the reader with an introduction to the rules regarding “corporate inversion” or “corporate expatriation” transactions. These transactions can be incredibly complicated. Anyone considering transferring some or all stock or U.S. assets to a foreign corporation should consult with a tax attorney who has a deep understanding of the corporate anti-inversion rules.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other 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.