In a recently updated International Practice Unit (IPU), the IRS provided guidance to its auditors on when the anti-inversion provisions under Code Section 7874 — rules relating to expatriated entities and their foreign parents — apply. The guidance also covers the tax consequences of an 80% and a 60% inversion.
Corporate inversions (also called “expatriation transactions”) generally involve a U.S. corporation that engages 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 effected 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 by transferring its assets to the foreign corporation. According to the tax code’s rules relating to expatriated entities and their foreign parents, a foreign corporation is treated as a U.S. corporation if, under a series of transactions:
- The foreign corporation completes, after March 4, 2003, the direct or indirect acquisition of substantially all the properties held directly or indirectly by a U.S. corporation,
- Former shareholders of the U.S. corporation obtain 80% or more of the foreign corporation’s stock (by vote or value) by reason of holding their U.S. shares (the “80% test”), and
- The foreign corporation, and corporations connected to it (the expanded affiliated group), don’t have substantial business activities in the foreign corporation’s country of incorporation or organization when compared to the total business activities of the group. (“Substantial business activities” means, for this purpose, 25% of the firm’s employees, assets and sales being in the foreign country.)
In addition, a separate set of rules apply to inversion transactions where the domestic corporation’s shareholders obtain at least 60% but less than 80% of the foreign corporation’s stock (the “60% test”).
Through an inversion, U.S. tax can be avoided on foreign operations and distributions to the foreign parent, and there are opportunities to reduce income from U.S. operations by payments of fees, interest, and royalties to the foreign entity.
In a transaction that would constitute an 80% inversion, the transaction isn’t taxable to either the U.S. shareholders of the domestic corporation or the domestic corporation. Accordingly, the acquiring corporation will be taxable by the U.S. on its worldwide income, and any controlled foreign corporations (CFCs) owned by a domestic corporation immediately before the inversion will remain CFCs immediately after the inversion. In addition, any pre-existing non-U.S. subsidiaries of the new foreign parent could become CFCs after the inversion.
Following are some of the tax consequences of an 80% inversion:
- When the acquiring foreign corporation is treated as a domestic corporation, the “conversion” is treated as an inbound reorganization (in effect, a deemed change in place of incorporation to the U.S. for U.S. federal tax purposes) occurring at the later of the end of the day immediately preceding the first date properties are acquired as part of the acquisition or immediately after the formation of the foreign corporation.
- A foreign corporation that is treated as a domestic corporation under the expatriated section of the code may not elect noncorporate status under the check-the-box rules. Its classification is defined by statute as a domestic corporation.
- The acquiring foreign corporation, treated as a domestic corporation, is taxable by the U.S. on its worldwide income and is required to file a corporate income tax return. All foreign corporations in which the acquiring “surrogate foreign corporation” (SFC) has direct or indirect interests exceeding 50%, by vote or by value, are CFCs, and thus the acquiring foreign corporation must file Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.”
If a 60% inversion occurs:
- The foreign corporation is treated as an SFC,
- The foreign corporation is respected and treated as a foreign corporation for U.S. federal tax purposes, and
- During the “applicable period,” any “inversion gain” required to be recognized by an expatriated entity may not be offset by certain tax attributes and any tax specifically attributable to inversion gain may not be offset by certain tax credits.
In the event of a 60% inversion, the following generally applies at the expatriated entity level:
- The taxable income of the expatriated entity for any tax year that includes any portion of the applicable period must be at least equal to the amount of the entity’s inversion gain for the tax year.
- If the expatriated entity may otherwise offset its income tax with credits, the expatriated entity’s inversion gain must remain effectively subject to federal income tax at the maximum corporate rate without reduction by those tax credits.
- For purposes of determining the credit allowed, inversion gain will be treated as U.S. source income.
The above provisions potentially restrict the expatriated entity’s use of various tax attributes (such as net operating losses) to offset any inversion gain and any tax attributable to inversion gain. Tax attribute limitation is the primary tax cost at the expatriated entity level when utilizing a 60% stock inversion structure. However, there may also be tax costs at the expatriated entity shareholder level when utilizing a 60% stock inversion structure.
These strategies include, but aren’t limited to, changes in transfer pricing and an increase in intercompany debt owed to the foreign parent or one of its foreign affiliates, which may serve to strip U.S. earnings from the U.S.
Consult with your tax advisors for further and more detailed information about this IPU.