IRS Tax: IRS addresses inversion rules on stock acquired for cash or marketable securities

The Internal Revenue Service on September 17 issued Notice 2009-78 under section 7874, providing guidance on determining whether a foreign corporation is treated as a surrogate foreign corporation. The notice announced the government's intent to issue regulations applicable to transactions completed on or after September 17, 2009.


Background

A foreign corporation is treated as a surrogate foreign corporation under section 7874 if, pursuant to a plan or series of related transactions: (1) the foreign corporation acquires "substantially all" (a still undefined term) of the properties of a U.S. corporation or partnership (acquisition); (2) former owners of the U.S. corporation or partnership acquire 60 percent or more (by vote or value) of stock of the foreign corporation in exchange for their interests in the U.S. corporation or partnership (disregarding stock owned by members of an expanded affiliated group (EAG) and stock sold in a public offering related to the acquisition); and (3) the foreign corporation does not have substantial business activities in its country of incorporation. For purposes of section 7874, the EAG is an affiliated group under section 1504(a), with a 50 percent threshold, attribution through partnerships, and inclusion of foreign corporations.

If former owners hold at least 80 percent (by vote or value) of a surrogate foreign corporation by reason of having held interests in the domestic entity, the surrogate foreign corporation is treated as a domestic corporation for all U.S. federal income tax purposes. If former shareholders or partners hold at least 60 percent but less than 80 percent of a surrogate foreign corporation by reason of having held stock in the domestic entity, the surrogate foreign corporation is treated as a foreign corporation for U.S. federal income tax purposes but section 7874 restricts the use of deductions and credits to shelter "inversion gain" and may impose minimum U.S. taxable income thresholds upon the domestic entity acquired by the surrogate foreign corporation.


Notice 2009-78

The regulations anticipated by the notice include the following:
- In applying the ownership requirement for section 7874 to an acquisition by a foreign corporation (or publicly traded partnership), generally, equity issued by the acquirer will be disregarded in both the numerator and the denominator of the ownership continuity percentage if it is issued for: (1) cash or cash equivalents; (2) "marketable securities" as defined in section 453(f)(2); and (3) any other property acquired in a transaction with a principal purpose of avoiding the purposes of section 7874. This will be the case even if the cash and marketable securities(including from the disposition of such instruments) are to be used in the active conduct of the continuing business.
- However, for this purpose, "marketable securities" generally shall not include equity issued by a member of the EAG (as defined in section 7874(c)(1)) that, after the acquisition being tested, includes the foreign acquirer, unless a principal purpose of the issuance of the stock was the avoidance of the purposes of section 7874.
- For purposes of the EAG exception to the rules for "marketable securities," a partnership is treated as a member of the EAG if it would be a member if it were a corporation.

These provisions would cause section 7874 to apply to a foreign corporate joint venture formed between a U.S. and a foreign multinational where the U.S. multinational contributes a U.S. subsidiary and the foreign multinational contributes primarily cash (or other disqualified property), unless the U.S. multinational receives less than 50 percent (by vote and value) of the joint venture corporation.

Further, these provisions would cause section 7874 to apply when shareholders transfer the shares of a domestic corporation to a foreign corporation when a new investor concurrently contributes cash to that foreign corporation, even if the new investor obtained a greater-than-20-percent equity interest (or even a 99 percent equity interest) in the foreign corporation and even if the cash is required for the business needs of the EAG that includes the domestic corporation.

Mitigating the public offering rule for certain transactions – The notice also addresses taxpayer concern that the public offering rule (by which stock of the foreign corporation is not taken into account) applies to all public issuances of a foreign corporation's stock. The notice provides an example involving a publicly traded foreign corporation (FT) and publicly traded domestic corporation (DT) in which application of the public offering rule would be inappropriate.

In the example, as part of a business combination, FT and DT intend to transfer their respective stock to a newly formed foreign corporation (FA) that will be publicly traded. To this end, FA acquires all of the FT and DT stock in exchange solely for newly issued FA stock. If the inversion rules operate so that FA stock held by FT shareholders is considered "sold in a public offering," DT's former shareholders would be treated as owning 100 percent of FA's stock and FA would be treated as a domestic corporation for all U.S. federal tax purposes. The IRS notes that a similar "inappropriate" result would occur if FT merged into FA, with FT shareholders receiving FA stock in exchange for their FT stock. To prevent such inappropriate results, the FA stock received by FT shareholders in exchange for their FT stock is taken into account for purposes of determining the ownership continuity percentage.