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 multinational corporations. Smaller companies are considering expatriating from the United States. To combat the practice of “inverting,” Congress has enacted a number of Internal Revenue Code provisions. This article will discuss the different types of inversions that can be used by corporations and other business entities along with the tax consequences or so-called “toll charges” of inverting.
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.
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.
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. Virgin Islandco, a foreign corporation incorporated in a tax haven, is formed and VirginIslandco forms a U.S. acquisition corporation, USAcquireco. In a transaction designed to be what would otherwise be a tax-free triangular reorganization under Internal Revenue Code Section 368(a)(2)(D), General Mistake’s shareholders receive 100 percent of the shares of Virgin Islandco as General Mistake merges into USAaquireco. The resulting structure has the former General Mistake shareholders now owning all the shares of Virgin Islandco. USAcquireco, which is comprised of the operating business of the former General Mistake, now owns FordSub and distributes FordSub shares to Virgin Islandco. Gain on USAaquirco distribution of FordSub shares to Virgin Islandco should be eliminated as a result of foreign tax credits.
Under the anti-inversion rules, the former General Mistake shareholders own 80 percent or more of Virgin Islandco and 2) 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. As a result, Virgin Islandco is treated as if it were a U.S. corporation that will incur tax on its worldwide income (the U.S. shareholders will not have to recognize gain under the outbound toll charge).
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 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.
Below, please see Illustration 2 which provides an example of an inversion transaction
disallowing would have been a tax-free forward triangular reorganization.
Illustration 2.
General Mistake, a publicly held U.S. C corporation, owns FordSub, a controlled foreign corporation. Virgin Islandco, a foreign corporation incorporated in a tax have, is formed and Virgin Islandco owns a U.S. acquisition corporation, USAcquiror. In a transaction designed to be what would otherwise be a tax-free forward triangular reorganization under Section 368(a)(2)(D) of the Internal Revenue Code, General Mistake shareholders receive 60 percent of the shares of Virgin Islandco as General Mistake merges into USAcquiror. The resulting structure has the former General Mistake shareholders now owning 60 percent of the shares of Virgin Islandco. General Mistake, which is comprised of the operating business of the former General Mistake, now owns FordSub and distributes FordSub’s shares to Virgin Islandco.
USAcquiror will recognize gain on the distribution of the FordSub shares to the extent their fair market value exceeds basis. 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. See IRC Section 367(a). Moreover, because the former USAco shares own at least 60 percent (but less than 80 percent) of the shares of Virgin Islandco, all gain recognized may not be reduced any foreign tax credits or net operating losses over the next ten year.
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.
US Partnership, a U.S.-organized limited liability company that is treated as a domestic partnership for U.S. tax purposes has U.S. citizens as its members. US Partnership does not own any intangible assets. US Partnership owns FordSub, a controlled foreign corporation. Virgin Islandco is formed and Virgin Islandco forms a foreign acquisition entity, FordSub. In a transaction that is treated as a sale, US Partnership owners receive shares of Virgin Islandco as US Partnership merges into FordSub. The resulting structure has the former US Partnership owners now owning 60 percent of the shares of Virgin Islandco and US Virgin Inslandco owning FordSub. FordSub is not compromised of the operating business of the former US Partnership and owns FordSub.
Although US Partnership will not report any income on the transaction, the former members of US Partnership should recognize gain to the extent that the fair market value of the Virgin Islandco’s shares received exceeds the basis in the US Partnership membership interests relinquished. Because the former US Partnership’s members own at least 60 percent of the shares of US Virgin Islandco, any gain recognized pursuant to the outbound toll charge may not be reduced via any foreign tax credits or net operating losses over the next ten years.
Special Anti-Inversion Excise Tax
When an inversion transaction is taxable, Internal Revenue Code Section 4985 imposes a 20% 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 against expatriated companies. These transactions can be incredibly complicated. Anyone planning an inversion whereby the operations of a U.S. corporation or other entity becomes a foreign corporation or part of a foreign parent should consult with a tax attorney who has a deep understanding of the corporate inversion rules.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. 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: 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.