In April 2016, Treasury issued temporary and proposed regulations related to inversions under IRC Section 7874. Portions of the proposed regulations were finalized in January 2017. Although a public hearing was not requested or held, Treasury received numerous written comments, and the remaining proposed regulations were finalized earlier this month. The most significant news is that there is virtually no news. Although the final regulations included several clarifications in response to the comments received, they were finalized substantially as proposed. Though extensive, the regulations focus primarily on a single qualifying provision defining tainted continuity of ownership.
The LawSection 7874 provides special status for foreign corporations that, pursuant to a plan or series of related transactions, do all of the following:
- Complete a direct or indirect acquisition of substantially all properties held by a U.S. corporation or partnership
- Leave partners or shareholders of the U.S. target with at least 60 percent of the vote or value of the acquiring foreign corporation’s ownership
- Create a group that does not have substantial business activities in the acquiring company’s country of incorporation compared to the business activities of the entire group
Following are the principal provisions that were proposed in 2016 and recently finalized:
Serial Acquisition Rule
According to the preamble to the finalized regulations, the serial acquisition rule received the majority of comments. Under this rule, stock of the foreign acquiring corporation (or its predecessor) attributable to other domestic acquisitions in the previous three years is excluded when computing the denominator in the continuity of ownership percentage in the second criterion. The rule is designed to keep prior domestic acquisitions from diluting the denominator and distorting the continuity of ownership. In other words, the rule is designed to prevent taxpayers from engaging in multiple nonqualifying inversions as a mechanism to set up future larger inversions that otherwise would trigger the inversion rules.
The final regulations include the following three clarifications:
- Nonordinary course distributions (NOCDs) that would be treated as stock in the hands of continuing owners in the context of an earlier domestic acquisition are not excluded as prior acquisition shares for purposes of the serial acquisition rule.
- Any shares attributable to a prior acquisition completed as part of a restructuring of a group already falling under a foreign parent are not excluded.
- The term “predecessor of a foreign acquiring corporation” is defined.
Passive Assets Rule
Similar to the serial acquisition rule, the passive assets rule excludes from the denominator of the continuity of ownership criterion the stock of a foreign acquiring corporation attributable to group passive assets when the passive assets are substantial. The final regulations clarify that the impact of the rule applies only to the extent the criterion is dependent on value rather than voting power. The purpose of the rule is to prevent maneuvering around the continuity of ownership criterion by issuing stock to noncontinuing owners for contribution of passive assets.
Third Country Rule
The third country rule disregards stock in a foreign acquiring corporation for purposes of computing the denominator in the continuity of ownership criterion to the extent that the foreign acquiring corporation stock is attributable to ownership in a second foreign corporation in a third country (acquired foreign corporation). The rule does not apply unless continuity of ownership percentage would be at least 60 percent without the application of the third country rule. In other words, the third country rule will increase the continuity of ownership percentage only of a transaction that otherwise meets the continuity of ownership criterion, for instance, to boost ownership to 80 percent in order to treat the acquiring foreign corporation as a U.S. corporation for U.S. tax purposes.
The final regulations add exceptions to the third country rule when the group as a whole has substantial business activities in the acquired foreign corporation’s country of residence and when both the acquiring and acquired foreign corporations are resident in countries that do not impose an income tax.
The value of NOCDs are added to the numerator for purposes of determining the continuity of ownership criterion on a value basis. NOCDs are specified distributions to shareholders or partners of the acquired domestic entity. The final regulations include seven clarifications or modifications relating to the definition of NOCDs, allocation of NOCDs among the domestic entity shareholders, and attribution of NOCDs to members of the acquiring corporation’s group when necessary.
De Minimis Exceptions
The proposed regulations contained language designed to prevent the rules outlined here from creating a technical inversion when actual continuity of ownership is minimal – less than 5 percent by vote and value – absent the application of special rules outlined previously. The final regulations adopt the de minimis exceptions and ease the identification requirements with respect to a domestic owner.