Internal Revenue Code § 367 has periodically been strengthened to impose in certain situations shareholder gain on transfers of appreciated US property to a foreign corporation, which would otherwise be non-taxable if it wasn’t a foreign transaction. In 2004, after inversions became more popular, a corporate level anti-inversion law was enacted with § 7874 to impose gain on the corporation if certain criteria were met, such as ownership by US shareholders of the foreign acquiring corporation, and not enough “substantial business activities” within the foreign corporation’s home country. If the foreign corporation after the acquisition of the US entity has 80% of the same ownership as the domestic entity did before the transaction, then the foreign corporation is treated as a US entity for US tax purposes. If the common ownership is over 60% but less than 80%, the transaction is treated as an inversion transaction, but the foreign corporation is respected as foreign. It is under the latter transaction in which many strategies were put in place to avoid the purpose of § 7874 and to avoid US tax.
Most recently in November of this year, the IRS and Department of the Treasury issued Notice 2015-79, stating the IRS and Treasury’s intention to issue regulations to § 7874, which will further address some of the strategies tax planners have used to avoid US taxation through inversion transactions. Specifically, the transactions covered under this notice are those in which the foreign acquiring corporation has substantial business activities in the foreign country, but is otherwise not subject to tax in that country, and when a US entity combines with a foreign acquiring entity, but the common parent of those entities is in a different country than the foreign entity, and that country may offer more opportunities to avoid US tax.
The first situation may occur when the management or control of the foreign corporation is in a different country than where the corporation is established, and thus the “substantial business activities” still occur in the foreign country enough to where inversion won’t be recognized by the United States. Similarly, based upon certain entity classifications, an entity can be classified as a corporation for US tax purposes, but be seen as transparent in the foreign country, thus satisfying the substantial activity test in the eyes of the IRS, but otherwise not subject to tax in the foreign country. In order to prevent this, the IRS and treasury intend to issue regulations which will require the foreign corporation to be taxed in the foreign jurisdiction in order for § 7874 not to impose inversion gain on the inversion transaction.
The second situation results when a new foreign parent owns the foreign acquiring corporation and the US entity, and that parent owns enough of the combined group (more than 20%) to where that group won’t be treated as a US entity for 7874 purposes. Because it is doubtful that this is done to achieve a substantial business purpose other than tax avoidance, the IRS and the Treasury intend to issue regulations in which certain stock of the third country parent will be ignored when determining the 80/20% test to determine US ownership after the transaction. This will ensure that the US entity was not combined with a foreign entity that is owned by a parent in another country simply to avoid US tax.