On Monday, September 22, 2014, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued Notice 2014-52 (the Notice), announcing an intention to issue regulations that would (1) tighten the anti-inversion rules of section 7874 (and section 367(a)), and (2) limit the ability of foreign acquirers of U.S. targets to access the earnings of controlled foreign corporations of such U.S. targets in a tax-efficient manner. In general, these future regulations would apply to inversion transactions, as defined by the Notice, completed on or after the date of the Notice, September 22, 2014. The Notice therefore has almost no effect on corporate groups that have already undertaken inversion transactions.

The Notice represents the Treasury's efforts, within the limits of current law, to curtail future inversion transactions by making it more difficult to avoid the adverse effects of sections 7874 and 367(a) and by reducing some of the opportunities for post-inversion tax efficiencies. The Notice also announces that the Treasury and the IRS are considering additional guidance, including guidance to address earnings stripping, and requests comments on these and other issues. Taxpayers considering cross-border combinations in which a U.S. target is acquired by a foreign acquirer must take into account the rules outlined in the Notice in evaluating the tax consequences and advisability of such transactions.

Background

Section 7874 applies to the acquisition of a U.S. target by a foreign acquirer if three criteria are satisfied: (1) the foreign acquirer acquires substantially all of the property of the U.S. target; (2) the former shareholders of the U.S. target acquire at least 60 percent of the stock of the foreign acquirer by reason of their shareholdings in the U.S. target (the shareholder continuity test); and (3) after the transaction, the foreign acquirer (taking into account its expanded affiliated group, or EAG) does not have substantial business activities in its country of organization.

If the shareholder continuity is at least 60 percent, but less than 80 percent, the transaction is considered an inversion and section 7874 denies the use of certain tax attributes to reduce taxes on outbound transfers by the U.S. target. If the shareholder continuity is at least 80 percent, section 7874 deems the foreign acquirer to be treated as a U.S. corporation for U.S. tax purposes.

Expanded Barriers to Inverting

Section 2 of the Notice describes regulations that would modify the rules governing the application of the shareholder continuity test, or ownership fraction, which tests the percentage ownership of former owners of the U.S. entity in the combined entity for purposes of section 7874 (and, in one case, for purposes of a similar test under section 367(a)). These new rules are intended to make it more difficult to reduce the ownership fraction and thereby avoid the adverse consequences of sections 7874 and 367.

Passive Assets of Foreign Acquirer

The Notice expresses concern about transactions involving foreign corporations with substantial cash or other liquid assets. In previous guidance (Notice 2009-78 and Treas. Reg. § 1.7874-4T), the Treasury Department and IRS addressed transactions in which investors used "nonqualified property" (defined generally as cash, marketable securities, or related-party obligations) to inflate the value of the foreign acquirer and thereby reduce the ownership fraction. The Notice extends this guidance to apply when greater than 50 percent of the gross value of the foreign acquirer is attributable to nonqualified property, regardless of whether the nonqualified property was acquired as part of the acquisition. In such cases, a portion of the stock of the foreign acquirer is excluded from the denominator of the ownership fraction. In issuing this new rule disregarding stock of so-called foreign "cash boxes," the Notice cites section 7874(c)(6), which provides for regulatory authority "to treat stock as not stock."

Non-Ordinary Course Distributions by U.S. Target

The Notice also expresses concerns about so-called "skinny down" transactions in which the U.S. target distributes property to its shareholders in order to reduce its value and thereby reduce the ownership fraction. Accordingly, the Notice indicates an intention to issue regulations that would disregard all "non-ordinary course distributions" made by the U.S. target during the 36-month period ending on the acquisition date. Non-ordinary course distributions are the excess of all distributions during the year over 110 percent of the average of distributions made during the prior 36-month period. For this purpose, a distribution includes any distribution made by the U.S. target, whether treated as a dividend, a spin-off under section 355, a redemption under section 302(a), or section 356 boot in a reorganization. The Notice relies on regulatory authority in section 7874(c)(4) to disregard transfers of property, including contributions or distributions, with a tax-avoidance purpose.

The Notice also addresses the use of "skinny down" distributions to reduce the size of the U.S. target and thereby satisfy the 50 percent "substantiality" test of Treas. Reg. § 1.367(a)-3(c) and avoid gain recognition at the shareholder level. In order to address such transactions, the new rules for non-ordinary course distributions will also apply for purposes of Treas. Reg. § 1.367(a)-3(c). This modification represents a significant change in policy.

Spin-offs and Other Subsequent Transfers of Stock of Foreign Acquirer

The Notice addresses cases where stock of the foreign acquirer is transferred subsequent to a transaction that would otherwise qualify for an exception from section 7874 under the EAG rules of Treas. Reg. § 1.7874-1. The Notice provides that the EAG rules generally will not apply to transactions in which the stock of the foreign acquirer is subsequently transferred, with two exceptions. As a result, so-called "spinversion" transactions, in which a U.S. parent corporation transfers a U.S. target subsidiary to a foreign acquirer and then spins off the foreign acquirer to its shareholders, will be subject to section 7874 and will not qualify for an exception under the EAG rules.

The first exception applies to "U.S.-parented groups" and provides that the EAG rules will apply, and therefore may exempt a transaction from section 7874, if the foreign acquirer remains a member of the U.S.-parented group after all related transfers. The second exception, which is broader and provides a welcome clarification of current law, applies to "foreign-parented groups." It applies not only to transfers in which the foreign acquirer remains a member of the foreign-parented group, but also to transfers of stock of the foreign acquirer outside of the foreign-parented group. In such cases, the EAG rule would apply in the same way it would have applied in the absence of the subsequent transfer. The rules for foreign-parented groups would permit, therefore, a foreign parent corporation to transfer a U.S. subsidiary to a foreign corporation and then spin off the foreign corporation to its shareholders. Such a transaction does not violate the policies of section 7874 because the U.S. subsidiary was already owned by a foreign parent corporation prior to the transaction.

Limits on Post-Inversion Planning

Section 3 of the Notice describes regulations that the Treasury Department and the IRS intend to issue to limit the U.S. tax benefits of certain post-inversion transactions, in particular transactions that would permit tax-efficient access to the earnings of controlled foreign corporations (CFCs) of the U.S. target. These rules generally apply to taxpayers that engaged in inversion transactions occurring on or after September 22, 2014, in which the shareholder continuity test is satisfied at the 60-80 percent level, and they apply for the 10 year period following such transactions. However, regulations under section 304 would apply to all taxpayers, regardless of whether they engaged in an inversion transaction.

Loans and Equity Investments by U.S. Target CFCs

The Notice targets a post-inversion planning technique used by foreign acquirers to access earnings and profits, or E&P, of CFCs of the U.S. target, which the Notice refers to as "expatriated foreign subsidiaries." In general, under section 956, U.S. shareholders of CFCs must include in gross income any increase in the amount the CFC has invested in U.S. property, to the extent of that U.S. shareholder's share of current or accumulated E&P of the CFC. U.S. property generally includes stock or loan obligations of a U.S. shareholder, but not stock or loan obligations of foreign persons, including foreign affiliates.

The Notice would change the definition of U.S. property by requiring that, for ten years following an inversion, any obligation or stock of a "non-CFC foreign related person" held by an expatriated foreign subsidiary will be treated as U.S. property for purposes of section 956. A non-CFC foreign related person is a foreign person which (1) was not a CFC of the U.S. target prior to the inversion and (2) is either related to, or under the same common control as the U.S. target. Thus, following an inversion, a loan or equity investment from an expatriated foreign subsidiary to a foreign acquirer or other foreign affiliate would constitute an investment in U.S. property under section 956. An expatriated foreign subsidiary that is a pledgor or guarantor of an obligation of a non-CFC foreign related person will likewise be considered as holding that obligation. The longstanding present law exception for short-term loans will not apply to this class of obligations. The Notice cites as authority section 956(e), which authorizes regulations to prevent avoidance of section 956 including in the case of reorganizations. This represents a novel use of such authority, which historically has been understood to address cases in which CFC earnings were accessed for the benefit of U.S. shareholders.

Transactions that Decontrol or Significantly Dilute U.S. Interests in CFCs

The Notice targets certain transactions in which CFCs of the U.S. target are decontrolled following an inversion transaction in a manner that avoids tax under sections 367(b) or 1248, which generally operate to tax the E&P of CFCs upon certain sales or dispositions by U.S. shareholders. The "specified transactions" identified by the Notice involve the issuance of stock of the expatriated foreign subsidiary to the foreign acquirer or other non-CFC foreign affiliate in exchange for property (e.g., a note), or other transactions that dilute the interests of the U.S. target in favor of such foreign affiliate, without triggering U.S. tax. Exceptions are provided for cases in which the U.S. target is required to include in income gain or other income equal to the proceeds from the transfer, or the expatriated foreign subsidiary remains a CFC and the stock of the expatriated foreign subsidiary that is owned by all U.S. shareholders does not decrease by more than 10 percent. The Notice provides that such specified transactions will be recharacterized as a transfer of property from the foreign affiliate to the U.S. target in exchange for "deemed instruments" that mirror the terms of the stock of the expatriated foreign subsidiary, followed by a contribution of property by the U.S. target to the expatriated foreign subsidiary in exchange for stock of the expatriated foreign subsidiary, with the result that the expatriated foreign subsidiary is not decontrolled and remains a CFC with respect to the U.S. target. Accordingly, a distribution on the stock of the expatriated foreign subsidiary actually owned by the foreign affiliate will be treated as a distribution to the U.S. target (and therefore subject to tax), followed by a distribution by the U.S. target to the foreign affiliate.

The Notice also provides that regulations under section 367(b) will be amended to provide for an income inclusion, in the form of a deemed dividend, in the case of specified transactions involving CFC stock through certain foreign-to-foreign reorganizations. An income inclusion would be required without regard to whether current regulatory exceptions are met, and the income would be treated as foreign personal holding company income and therefore subject to current U.S. tax.

Regulations under Section 304(b)(5)(B)

The Notice announces the regulatory expansion of an anti-abuse measure added to section 304 by Congress in 2010. The Notice observes that taxpayers may be engaging in transactions in which a foreign acquirer sells stock in a U.S. target to its CFC in exchange for cash or property of the CFC. In general, the cash or property distributed by the CFC is treated as a dividend to the foreign acquirer, as if the property were distributed by the CFC to the extent of its E&P and then by the U.S. parent corporation to the extent of its E&P. In 2010, Congress enacted section 304(b)(5)(B) to prevent the CFC's tax deferred E&P from permanently escaping U.S. taxation by being deemed to be distributed directly to a foreign corporation. Section 304(b)(5)(B) prevents the distribution of the CFC's E&P if more than 50 percent of the dividend would neither be subject to U.S. tax nor includible in the E&P of a CFC.

The Notice expresses concern that taxpayers are avoiding the application of section 304(b)(5)(B) by structuring transactions so that more than 50 percent of any dividend is sourced from the U.S. target, and therefore is subject to U.S. withholding tax (eligible to be reduced by tax treaty). The Notice provides that, for purposes of applying section 304(b)(5)(B), the determination of whether more than 50 percent of the dividend is subject to tax or includible in the E&P of a CFC will be made by taking into account only the E&P of the CFC. This regulation will apply to all taxpayers, regardless of whether the group previously engaged in an inversion transaction.

Effective Dates

In general, the Notice applies prospectively. The regulations that will be promulgated under sections 304, 367, and 7874 will apply only to acquisitions or transfers completed on or after September 22, 2014. Taxpayers may elect to apply the favorable rule governing subsequent transfers of stock of the foreign acquirer when a U.S. target is a member of a foreign-parented group to acquisitions completed before September 22. The section 956 and decontrol provisions will apply on or after September 22, to groups that complete an inversion transaction on or after September 22. The Notice does not contain any grandfather provision and will therefore apply to inversions transactions that are pending but have not closed as of the date of the Notice. The Notice states that no inference is intended as to the treatment of transactions described therein under current law, and that the IRS may challenge such transactions.

Requests for Comment and Possibility of Future Guidance

The Notice also announces that the Treasury Department and IRS expect to issue additional guidance to limit inversion transactions. In particular, the Treasury Department and the IRS are considering so-called earnings stripping transactions, with an emphasis on addressing strategies that utilize intercompany debt. Public comments are requested on such further guidance, which would apply prospectively. If guidance is limited to inverted groups, the guidance would apply to any group that completed an inversion transaction on or after September 22. The Treasury Department is also reviewing its tax treaty policy with respect to inverted groups.

The Treasury Department and the IRS also requested comments on whether the CFC decontrol provisions should include an exception for transactions undertaken to integrate similar businesses. The exception would be limited to circumstances in which the inverted group does not "exploit that form" to avoid U.S. taxation on a CFC's pre-inversion E&Ps.

For additional information, please contact any of the following lawyers:

Layla Asali, lasali@milchev.com, 202-626-5866

Rocco Femia, rfemia@milchev.com, 202-626-5823

Jeffrey Tebbs, jtebbs@milchev.com, 202-626-1480

The information contained in this communication is not intended as legal advice or as an opinion on specific facts. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information, please contact one of the senders or your existing Miller & Chevalier lawyer contact. The invitation to contact the firm and its lawyers is not to be construed as a solicitation for legal work. Any new lawyer-client relationship will be confirmed in writing.

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