IRS Finalizes Regulations that Close Corporate Inversion Loopholes
The IRS has issued final regs aimed at curbing inversion tactics that corporations use to avoid U.S. income taxes.
Basically, corporate inversions (also called “expatriation transactions”) generally involve a U.S. corporation engaging in a series of transactions with the effect of moving its headquarters from the U.S. to a lower-taxed foreign jurisdiction. The transactions might be affected in two ways:
1. By the U.S. corporation becoming a wholly owned subsidiary of a foreign corporation (through a merger into the foreign corporation’s U.S. subsidiary), or
2. By transferring the U.S. corporation’s assets to the foreign corporation.
These tactics generally allow the corporation to avoid U.S. taxes on foreign operations and distributions to the foreign parent. There also are opportunities to reduce income from U.S. operations by payments of fees, interest, and royalties to the foreign entity.
Final regs substantially adopt temporary regs
The regs, like temporary regs issued in 2016, address transactions that are structured to avoid Internal Revenue Code Section 7874 on rules relating to expatriated entities and their foreign parents and Code Section 367, which governs transfers of property involving foreign corporations.
Here is an overview of the final regs:
Calculation of the ownership percentage
The final regs change the rules for determining what percentage of the foreign corporation’s stock (by vote or value) the U.S. corporation’s shareholders own. Under the 2016 regs, the passive assets rule applied for determining the ownership percentage by vote and value. That rule excludes stock of the foreign acquiring corporation attributable to certain passive assets.
Under the final regs, the rule applies only for purposes of determining the ownership percentage by value.
The 2016 regs contain various rules under which certain stock is disregarded for purposes of the ownership percentage rules. The final regs modify the passive assets rule so that stock disregarded under any of the stock exclusion rules isn’t considered in applying the passive assets rule.
Code Sec. 7874 provides that the transfer of properties or liabilities (including by contribution or distribution) is disregarded if it is part of a plan whose principal purpose is to avoid the inversion rules. The 2016 regs provide a non-ordinary course distribution (NOCD) rule.
The final regs clarify and refine the definition of “distribution.” The 2016 regs define the term broadly but provide several exclusions, including, in general, an exclusion for a distribution that occurs following an asset reorganization. The final regs clarify that the exclusion doesn’t apply to a distribution under Code Sec. 355 (distributions of a controlled company), regardless of whether it’s in connection with a corporate reorganization described in Code Sec. 368.
Coordinating ownership fraction with EAG rules
Existing Sec. 7874 regs coordinate the application of:
1. Rules that disregard certain stock of the foreign acquiring corporation for purposes of determining the ownership fraction, with
2. The expanded affiliated group (EAG) rules.
The final regs broaden this coordination to other rules that similarly disregard certain stock of the foreign acquiring corporation for purposes of determining the ownership fraction — namely, the serial acquisition rule, the third-country rule and the disregarded transfers rule.
Substantial business activities test
The final regs define a tax resident as a corporation liable to tax under the laws of the country as a resident. When the relevant foreign country doesn’t impose corporate income tax, the tax residence requirement doesn’t apply.
Rules addressing certain postinversion tax avoidance transactions
For purposes of determining whether an entity is an expatriated foreign subsidiary (EFS), the final regs provide that downward attribution from a non-U.S. person to a U.S. person doesn’t apply. Without this modification, in certain cases the term “EFS” would be over-inclusive and, as a result, the term “non-EFS foreign related person” would be under-inclusive. Similarly, the final regs provide that, generally when determining if an entity is a controlled foreign corporation (CFC), downward attribution from a non-United States person to a United States person doesn’t apply.
The applicability dates of the rules in the final regs are generally the same as the applicability dates of the rules as set forth in the 2016 regs, although there are exceptions. For more information, contact your advisor.