On Nov. 19, 2015, the IRS and Treasury released Notice 2015-79 to announce additional regulations are expected that will make inversion transactions more difficult under Section 7874 of the Internal Revenue Code and will limit their potential tax benefits. Section 7874 attempts to prevent U.S. companies from merging into foreign companies without a significant change in the ownership or operations of the U.S. business. In general, Section 7874 applies if three circumstances are met:
- A foreign corporation acquires substantially all the property of a U.S. corporation.
- The former owners of the domestic entity meet a specified ownership percentage in the acquiring foreign corporation.
- The group that includes the acquiring corporation does not have substantial business activities in the country in which the acquirer is organized.
If the ownership in an acquiring foreign corporation by the former interest holders is 80 percent or greater, the foreign acquirer will be considered a U.S. company. If the ownership is at least 60 percent but less than 80 percent, the ability to use certain tax attributes of the U.S.-acquired company will be denied.
The notice indicates that Treasury will issue regulations that will:
- Limit the ability of U.S. companies to merge with foreign companies where the new foreign parent is located in a jurisdiction that is not the historic tax residence of the foreign acquirer. The regulation will ignore the stock issued by the new foreign parent for purposes of meeting the ownership requirement. This rule will increase the likelihood of taxpayers failing the 80 percent or 60 percent ownership tests.
- Limit the ability to inflate the value of the foreign company prior to the inversion. The effect of ignoring the stock also will make it more difficult for the former shareholders to meet the ownership percentage tests.
- Strengthen the substantial business activities test by requiring the new foreign parent to be a tax resident in the foreign country and not merely organized in the country.
The forthcoming regulations will reduce the benefits associated with inversion transactions in two additional ways. First, they will expand the scope of items considered inversion gain for which U.S. tax attributes cannot be used to offset the U.S. tax. Under the notice, dividends from passive income generated from restructuring or transferring the operations of foreign subsidiaries will be considered inversion gain. Second, any built-in gain in a controlled foreign corporation (CFC) will be required to be recognized when a CFC is restructured, regardless of the amount of the deferred earnings.
Although the new regulations have not yet been issued, the new rules as announced in the notice are intended to be effective for transactions occurring after Nov. 19, 2015.