Notice imposes a range of restrictions on inversion transactions

Transcription

1 from International Tax Services Notice imposes a range of restrictions on inversion transactions October 1, 2014 In brief The Treasury Department (Treasury) and Internal Revenue Service (IRS) issued Notice (the Notice) on September 22, 2014, addressing certain cross-border business combination transactions, termed inversions in the Notice. Treasury and IRS view such transactions as motivated in substantial part by the ability to undertake post-transaction steps that Treasury and the IRS characterize as tax avoidance transactions. The Notice announces the intention to issue regulations under five Internal Revenue Code sections, and it takes a two-pronged approach. First, it addresses the treatment of cross-border business combination transactions themselves under Sections 7874 and 367. That guidance involves the following: Disregarding certain stock of a foreign acquiring corporation that holds a significant amount of passive assets for purposes of the ownership continuity test ratio, meaning transactions with foreign corporations without active businesses are no longer possible and preventing contributions of passive assets to increase the size of the foreign acquirer. Disregarding certain non-ordinary course distributions by the US company, also for purposes of the ownership continuity test ratio, meaning US companies cannot attempt to shrink their size in advance of a transaction. Changing the treatment of certain transfers of the stock of the foreign acquiring corporation such as in a spin-off that will not qualify for the Section 7874 expanded affiliated group exception, meaning a US company will not be able to use a spin off to effectuate a redomicilation. Second, Notice addresses post-transaction steps that taxpayers may undertake with respect to US-owned foreign subsidiaries, under Sections 304(b)(5)(B), 956(e), and 7701(l), making it more difficult to access foreign earnings without incurring added US tax. The Section 304 guidance would tighten the limitation under Section 304(b)(5)(B) and thereby further limit the ability to bypass the former US parent company (with the CFC s E&P) where the new foreign parent sells shares of the former US parent company to a lower-tier CFC.

2 The Section 956(e) guidance would treat as US property post-inversion acquisitions by controlled foreign corporations (CFCs) of debt or equity interests in the new foreign parent corporation or certain foreign affiliates, regardless of whether the funds involved were made available to a US shareholder. The Section 7701(l) guidance would maintain CFC status for existing foreign subsidiaries of the US company even when the new foreign parent or another foreign affiliate makes an equity investment that gives it a majority interest. Specifically, the foreign acquirer would be treated as though it had made the investment in the US parent company and not the CFC (introducing deemed equity interest including through intervening legal entities if necessary). The Notice s guidance generally applies only to business combination transactions completed on or after September 22, 2014, except for the Section 304 provision, which applies to all stock acquisitions completed on or after September 22, 2014 that meet Section 304 criteria. The Notice indicates that future guidance in this area will apply prospectively from the date of issuance, and only to groups that completed their business combination transactions on or after September 22, The Notice does not address limitations on deducting intercompany interest expense under Section 163(j) or other transactions viewed as reducing the US taxable income base. However, the Notice invites comments on those issues and indicates that Treasury and the IRS will issue additional guidance to further limit cross-border business combinations viewed as inversion transactions, as well as the US federal income tax consequences of post-transaction arrangements. The Notice also signals that Treasury is reviewing its tax treaty policy regarding inverted groups. In detail Anti-abuse rules for Section 7874 s ownership continuity test Section 7874 background Section 7874 requires certain US federal income tax consequences for expatriated entities; that is, US companies related to a surrogate foreign corporation. Section 7874(a) defines a surrogate foreign corporation as any foreign corporation that completes (after March 4, 2003) the direct or indirect acquisition of substantially all property (i) held by a US corporation or (ii) constituting a trade or business of a US partnership, where the former shareholders (or partners, in the case of a partnership) of the US entity own at least 60% of the foreign acquiring corporation by reason of their interest in the US entity, and the acquisition is undertaken pursuant to a plan. Section 7874(b) treats the foreign acquiring corporation as a US corporation for US federal income tax purposes if the former owners of the US company own at least 80% of the foreign corporation by reason of their equity interest in the US company. However, Section 7874 will not apply if (1) a foreign entity s expanded affiliated group (EAG) has substantial business activities in the country where the entity is organized, or (2) more than 50% of the acquisition occurred before March 4, Regulations and other guidance have further expanded Section 7874 s scope and impact. Section 7874 limits, for 10 years, an expatriated entity s ability to use its tax attributes to reduce tax on certain transactions with related foreign persons. Section 7874(c) includes rules disregarding certain stock and transactions from the ownership continuity calculation for this purpose. It also deems an acquisition plan to be in place if the transaction meets the Section 7874 acquisition criteria within two years before or after the ownership criteria are satisfied. Section 7874(c)(2)(B) (the statutory public offering rule) provides that foreign acquiring corporation stock sold in a public offering related to a Section 7874(a) acquisition is excluded from the denominator of the fraction used for purposes of calculating the ownership percentage (ownership fraction). Recently-issued Treas. Reg. section T (see Tax Insights, Temporary Section 7874 regulations cover the inverted company ownership issues promised in Notice ) modifies the statutory public offering rule by providing that disqualified stock is generally not included in the denominator of the ownership fraction. Disqualified stock generally includes foreign acquiring corporation stock that is transferred to a person (other than the US entity) in exchange for nonqualified property, meaning (i) cash or cash equivalents, (ii) marketable securities, (iii) certain obligations, or (iv) any other property acquired with a principal purpose of avoiding Section 7874 s purposes. 2 pwc

3 Both Section 7874(c)(6) and 7874(g) authorize regulations for, respectively, determining whether a corporation is a surrogate foreign corporation (including regulations to treat stock as not stock) and preventing the avoidance of Section 7874 s purposes, including through transactions designed to remove members of an EAG. Observation: Notice contains the first anti-abuse rules announced under the authority of Section 7874(c)(6). Disregarding certain stock of a foreign acquiring corporation Notice provides for regulations modifying Section 7874 in two ways that affect the ownership continuity test. The first, in section 2.01, involves transactions between a US corporation and a foreign corporation that has substantial passive assets. The Notice states that Treas. Reg. sec T does not apply to nonqualified property held (directly or indirectly) by the foreign acquiring corporation that was not acquired by the foreign acquiring corporation in a transaction related to the acquisition. Thus, stock of the foreign acquiring corporation may be included in the denominator of the ownership fraction and decrease that fraction, even though part of the stock value is attributable to nonqualified property. Treasury and IRS intend to issue regulations under Section 7874(c)(6) providing that, if more than 50% of the gross value of all foreign group property constitutes foreign group nonqualified property, a portion of the foreign acquiring corporation stock will be excluded from the ownership fraction s denominator, thus increasing the ownership fraction. This more-than-50% test is applied after the acquisition and all related transactions are completed. Notice defines foreign group property as any property held by the EAG after the acquisition (and all related transactions) are completed, other than the following: (i) property directly or indirectly acquired in the acquisition that was, at the time, held directly or indirectly by the US entity; and (ii) an equity interest in an EAG member, or an EAG member s debt. Foreign group nonqualified property generally means foreign group property that is nonqualified property (other than property giving rise to Section 1297(b)(2)(A) passive foreign investment company (PFIC) income or Section 954(h) or (i) financial services-type income). Property that otherwise would not be foreign group nonqualified property nevertheless is treated as such if, in a transaction related to the acquisition, such substitute property is acquired in exchange for other transferred property that would be foreign group nonqualified property had such transferred property not been exchanged. Notice provides a formula to determine the portion of the foreign acquiring corporation s stock to disregard if the 50% threshold is satisfied. Specifically, the portion of foreign acquiring corporation stock to be excluded from the denominator of the ownership fraction is the product of (i) the value of foreign acquiring corporation (other than (a) stock held by reason of ownership in the US entity, and (b) stock excluded from the denominator because it is either held by an EAG member or is disqualified stock); and (ii) a fraction (foreign group nonqualified property fraction), the numerator of which is the gross value of all foreign group nonqualified property, and the denominator of which is the gross value of all foreign group property. (For this purpose, property the foreign acquiring corporation receives that gives rise to disqualified stock excluded from the denominator of the ownership fraction is excluded from both the numerator and the denominator of the foreign group nonqualified property fraction.) The regulations will also contain a rule incorporating the principles of existing regulations regarding the interaction of the EAG rules with the rule that excludes disqualified stock from the denominator of the ownership fraction as applied to foreign acquiring corporation stock that the Notice excludes from the ownership fraction denominator. Example Notice provides an example illustrating this rule disregarding certain foreign acquiring corporation stock, with these facts (see Diagram 1 below): 1. Foreign corporation FA has 20 shares of a single class of stock, all owned by Individual A. 2. FA acquires all the stock of DT, a US corporation, solely in exchange for 76 shares of newly issued FA stock (DT acquisition). 3. In a related transaction, FA issues Individual A four shares of stock in exchange for $50x of cash. 3 pwc

4 4. After the DT acquisition, FA holds Asset A ($150x gross value), which is foreign group nonqualified property, and Asset B ($100x gross value), which is not foreign group nonqualified property, in addition to the DT stock and $50x of cash. The Notice analyses these facts as follows: Four shares of FA stock issued to Individual A in exchange for $50x of cash, which is nonqualified property, are disqualified stock and excluded from the denominator of the ownership fraction. After the DT acquisition, FA has the DT stock and foreign group property with a $300x gross value, $200x of which is foreign group nonqualified property (Asset A and cash). Because 66.67% of foreign group property s gross value is foreign group nonqualified property ($200x/$300x), the 50% threshold is satisfied, and part of the FA stock will be excluded from the ownership fraction denominator. Because FA has only one class of stock, the multiplicand of the computation is 20 shares (100 shares of FA stock outstanding less the 76 shares of FA stock that are held by reason of and the four shares of disqualified stock). Those 20 shares are multiplied by the foreign group disqualified property fraction. The numerator of the fraction is $150x ($200x less $50x of cash that gives rise to disqualified stock) and the denominator is $250x ($300x less the $50x of cash that gives rise to disqualified stock). Thus, the FA stock excluded from the ownership fraction denominator is the product of 20 shares multiplied by $150x / $250x, or 12 shares. Thus, the ownership fraction denominator is 84 shares (100 shares less four shares of disqualified stock and 12 shares excluded under this rule), and the ownership fraction is 90.4 percent (76/84). Diagram 1 Observation: This rule targets what Treasury and IRS understand to be a technique by which US companies could enter into cross-border merger transactions that would not trigger Section 7874 because the foreign acquiring corporation would acquire sufficient liquid assets to dilute the ownership fraction. Disregarding certain non-ordinary-course distributions The second part of Notice that provides for regulations modifying the Section 7874 ownership continuity test is section Those regulations will disregard certain distributions (as defined therein) made by a US target company that 4 pwc

5 are not in the ordinary course of business. To the extent that the new rule applies, the overall ownership percentage of the owners of the US entity considered will increase. In addition to the Section 7874 ownership test applicable in cross-border merger transactions, Section 367 may apply to foreign acquisitions of US assets. Section 367(a)(1) generally causes a US person transferring property to a foreign corporation in certain non-recognition transactions to be taxable on any gain from the transfer. Treas. Reg. sec (a)- 3(c) provides an exception to this general rule for certain transfers of US target company stock if the US target company complies with certain reporting requirements and if four regulatory conditions are satisfied. One of the conditions is that the foreign transferee corporation meet an active trade or business test, which contains a substantiality test. The substantiality test requires the fair market value of the transferee foreign corporation at the time of the transfer to be least equal to the US target company s fair market value. In this regard, the regulations contain an anti-stuffing rule that provides that the transferee foreign corporation s fair market value generally does not include assets acquired outside the ordinary course of business within three years before the exchange if they would produce passive income or were acquired for the principal purpose of satisfying the substantiality test. However, while the current regulations disregard certain stuffing transactions with respect to the transferee foreign corporation, they do not generally disregard transactions undertaken to reduce the value of the US company that is transferred. The Notice provides new rules that target US entities distributing property to their former shareholders or partners to (i) reduce the Section 7874 ownership fraction by reducing the numerator and/or (ii) satisfy the Section 367 substantiality test. The new Section 7874 rule provides that non-ordinary course distributions made by the US entity (or a predecessor) during the 36-month period ending on the acquisition date will be treated as part of a plan with a principal purpose of avoiding the purpose of Section Accordingly, such distributions will be disregarded for such purposes. With respect to the application of Section 7874, the Notice defines non-ordinary course distributions as the excess of all distributions the US entity made to its ownership interests during a tax year, less 110% of the average of the distributions the US entity made during the 36 month period immediately preceding such tax year. Importantly, this rule applies to any distribution, regardless of its tax treatment, and includes a transfer of money or other property by the US entity to its owners that is made in connection with a Section 7874(a)(2)(B)(i) acquisition, as well as a redemption transaction taxable to the shareholders under Section 302(a) (including many stock buy backs) or boot in a spin-off or reorganization transaction. The Notice also provides that Treas. Reg. sec (a)-3(c) will also be amended to incorporate the principles used under the Section 7874 test described above. As a result, in considering the value of a US target corporation and a foreign acquiring corporation under the substantiality test of those regulations, the new rules would limit the ability of taxpayers to reduce the value of the US company to meet the regulatory test. Observation: This rule is intended to address a technique Treasury and IRS understand US companies may use to facilitate a cross-border merger transaction that would not trigger Section Along with the preceding rule, the first exercise of Treasury and the IRS s administrative authority is to disregard transfers of property that are undertaken to avoid the purposes or application of Section However, the rule does not contain a subjective element consistent with the principle purpose to avoid language in Section 7874(c)(4). The scope of any future regulations under Treas. Reg. sec (a)-3(c) is uncertain, however. The Notice simply provides that the principles of the rules announced under Section 7874 will be used for the regulations under Section 367. This may mean that Treasury and the IRS intend to issue regulations that will also consider the average of distributions by the US entity over a period of time. Alternatively, Treasury and the IRS may determine that any distribution by the US entity within a certain period of time before the transfer of the US entity stock is disregarded. New Section 7874 treatment of post-transaction spinoffs Notice , section 2.03, discusses long-standing government concerns about the impact of certain divisive corporate transactions following a cross-border merger transaction, such as a Section 355 spinoff or Section 368 reorganization. These corporate transactions implicate another Section 7874 statutory rule affecting the ownership ratio calculation, the statutory EAG rule (Section 7874(c)(2)(A)), which provides that foreign acquiring corporation stock held by EAG members is excluded from the ownership fraction numerator and denominator. The open question prior to the issuance 5 pwc

6 of the Notice was whether subsequent transfers of the foreign acquiring corporation s stock would be taken into account in determining the EAG, and thus, the application of the statutory EAG rule and its exceptions. The Notice observes that application of the statutory EAG rule does not always lead to the appropriate result, as when a US entity has minority shareholders. Accordingly, Treas. Reg. sec provides two exceptions to the rule: the internal group restructuring exception and the loss of control exception (together with the statutory EAG rule, the EAG rules). If either of these exceptions apply, the statutory EAG rule is effectively modified such that foreign acquiring corporation stock held by EAG members is excluded only from the numerator of the ownership fraction, but not the denominator, and decreases the ownership fraction. The internal group restructuring exception generally applies when the US entity and foreign acquiring corporation are members of an affiliated group (with an 80% vote and value requirement) with the same common parent both before and after the acquisition. The loss of control exception applies when the US entity s former owners do not hold more than 50% of any EAG member s stock after the acquisition. Treas. Reg. sec T addresses the effect on the ownership fraction numerator when the US entity s former owners receive foreign acquiring corporation stock by reason of holding ownership interests in the US entity, and then transfer that stock to another person. Those rules provide that the transferred stock will continue to be characterized as stock received by reason of the shareholders former ownership in the US entity, and thus, would be included in the ownership fraction numerator unless the EAG rules exclude the stock from the ownership fraction. However, prior to the issuance of the Notice, it was unclear whether a subsequent transfer of the foreign acquiring corporation s stock should be taken into account in determining the EAG. Notice concludes that foreign acquiring corporation stock received by a former owner of the US entity and subsequently transferred in a transaction related to the acquisition should be included in the ownership fraction numerator and denominator for purposes of applying the EAG rules, subject to two exceptions. Specifically, the Notice provides that foreign acquiring corporation stock that a former owner of the US entity receives, and subsequently transfers, is not treated as held by an EAG member for purposes of the EAG rules. Accordingly, the transferred stock is included in the ownership fraction numerator and denominator. The two exceptions to this general treatment apply to US-parented groups and foreign-parented groups, respectively. In general, the US-parented group exception applies only to transfers of foreign acquiring corporation stock that remain within the US group. However, the foreign-parented group exception is broader, and may apply to certain transfers outside the foreign-parented group. In considering these exceptions, all acquisition-related transactions must be taken into account for purposes of determining the relevant groups. The Notice provides that a US-parented group is an affiliated group (using the same Section 1504 criteria as Section 7874 has for an EAG) with a US corporation as the common parent, and a foreignparented group is the foreign equivalent. For a partnership, each partner is treated as holding its proportionate share of stock held by the partnership under the Code s Subchapter K rules. The US-parented group exception treats transferred stock as held by an EAG member if (i) before and after the acquisition, the transferring corporation (or its successor) is a member of a US-parented group; and (ii) after the acquisition, both the person that holds the transferred stock after all related transfers of the transferred stock are completed and the foreign acquiring corporation are members of that group. The foreign-parented group exception treats transferred stock as held by an EAG member if (i) before and after the acquisition, the transferring corporation (or its successor) is a member of the same foreign-parented group; and (ii) after the acquisition, the transferring corporation is an EAG member (or would be absent a subsequent transfer of foreign acquiring corporation stock by a member of the foreign-parented group in an acquisition-related transaction). Both exceptions therefore consider the transferred stock in determining whether it is held by a member of the EAG, and, as a general matter exclude the transferred stock from the ownership fraction numerator. Thereafter, through the application of the EAG rules, the transferred stock may be excluded from the denominator of the ownership fraction as well. Examples Notice provides several useful examples that illustrate the application of these rules. 6 pwc

7 Example 1 Divisive D reorganization/section 355 spin off (see Diagram 2 below): D, a US corporation, owns all of the stock of DT, a US corporation, and other subsidiaries. The DT stock does not represent substantially all of D s property for Section 7874 purposes. As part of a divisive D reorganization, D transfers all of its DT stock to FA, a newly formed foreign corporation, solely in exchange for 100 shares of FA stock (DT acquisition) and distributes all the FA stock to its shareholders. The 100 shares of FA stock is stock of a foreign corporation (FA) held by reason of holding stock in a US corporation (DT). Thus, the ownership fraction under Section 7874 is 100/100 without applying the EAG rules. Because the FA shares were subsequently transferred, Treas. Reg. sec T(a) provides that the transferred shares will continue to be treated as shares received by reason of the ownership of D, thus resulting in an ownership fraction of 100/100. Further, as set forth in the Notice, the general rule is that the transferred stock will not be considered to be held by any member of the EAG for purposes of applying the EAG rules. This general rule is subject to two exceptions. Under the facts of the example, D is the common parent of a US-parented group, and thus the requirements of the USparented exception are considered. Based on the facts, D is the common parent of the US-parented group both before and after the DT acquisition (i.e., immediately after the DT stock is acquired by FA, but prior to the distribution of the FA stock). However, the second requirement of the US-parented exception is not in the example, because the FA stock is distributed outside the US-parented group. That is, the shareholders of D who receive the transferred FA stock, and FA, are not members of the US-parented group after the DT acquisition. Accordingly, the general rule applies, and the ownership fraction is 100/100. Diagram 2 To illustrate the difference in the scope of the US-parented exception and the foreign-parented exception, the Notice provides an alternative scenario that assumes all of the facts in Example 1, except that D is a foreign corporation and the 7 pwc

8 common parent of a foreign-parented group. Under the alternative facts, the foreign-parented group exception applies because (i) before the acquisition of the DT stock, the transferring corporation, D, and the US entity, DT, are members of a foreign-parented group of which D is the common parent, and (ii) after the acquisition of DT by FA, the transferring corporation, D, would be a member of the EAG absent the subsequent distribution of the FA stock by D to its shareholders. As a result, the general rule in the Notice does not apply, and the transferred FA stock is considered in the numerator but not the denominator of the ownership fraction. In addition, as a result of the DT acquisition qualifying as an internal group restructuring under Treas. Reg. sec (c)(2), the ownership fraction is 0/100. Example 2 F Reorganization of Foreign Corporation in Foreign-Parented Group (see Diagram 3 below): Individual A owns all the stock of FT, a foreign corporation, which owns all the stock of DT, a US corporation. FT has no other property and no liabilities. In an F reorganization, FT transfers all of its DT stock to FA, a newly formed foreign corporation, in exchange for 100 shares of FA stock (DT acquisition), and distributes the FA stock to individual A in liquidation of FT. The 100 shares of FA stock is stock of a foreign corporation (FA) held by reason of holding stock in a US corporation (DT). Treas. Reg. sec T(a) provides generally that the FA shares received by FT will continue to be treated as stock received by reason of owning stock in DT for purposes of the ownership fraction. However, the foreign-parented group exception applies because (i) before the acquisition of the DT stock, FT (the transferring corporation) and DT (the US entity) were members of a foreign-parented group of which FT was the common parent, and (ii) after the acquisition, and without regard to the subsequent distribution of the FA stock by FT to individual A, FT would be a member of the EAG. In addition, as a result of the DT acquisition qualifying as an internal group restructuring, the ownership fraction is 0/100. Diagram 3 In Example 1 s alternative facts and analysis (see Diagram 4 below), FA subsequently issues 200 shares of stock to individual B in exchange for qualified property, in a transaction related to the DT acquisition. Notice does not apply the foreign-parented group exception here because, taking into account FA s issuance of 200 shares to individual B, 8 pwc

9 FT would not be a member of the EAG absent the subsequent distribution. Accordingly, the ownership fraction is 100/300. Diagram 4 Observation: This provision appears to be aimed at a specific planning technique for avoiding Section 7874 treatment by removing US persons from ownership continuity in the process of a cross-border merger transaction. Expanding Section 956(e) to include certain foreign-to foreign flows Beyond using Sections 7874 and 367 to narrow the opportunities for US companies to complete cross-border merger transactions, Notice seeks to discourage such transactions by removing some perceived benefits of undertaking them. Section 3.01 of the Notice takes an approach based on Section 956 rules, which seek to prevent a US shareholder from repatriating a CFC s E&P in a manner that does not subject the US shareholder to US taxation. Specifically, where a CFC holds specified US property at the close of any quarter of a tax year, Section 956(a) requires its US shareholders to determine whether they must include some amount currently in income. Section 956(c) provides a list of US property types subject to Section 956, as well as a list of exceptions. Section 956(e) generally provides Treasury and the IRS authority to write regulations to prevent the avoidance of Section 956. Notice states that after an inversion transaction, a foreign-parent corporation may effectively receive earnings of a CFC held by the US target corporation without being subject to Section 956. The Notice announces regulations under Section 956(e) to address this potential result. The essence of the rule is that it extends the application of Section 956 to an investment that an expatriated foreign subsidiary makes in a non-cfc foreign related person, i.e., a foreign related person under Section 7874(d)(3), other than an expatriated foreign subsidiary. For this purpose, an expatriated foreign subsidiary generally is a CFC of which an expatriated entity is a US shareholder on or before the acquisition date. Thus, the new rule treats what is, in form, an investment in or obligation of a foreign person as an investment in US property under Section 956. The new rule applies if the investment held by the expatriated foreign subsidiary is debt or stock with respect to a non- CFC foreign related person, that is acquired by the expatriated foreign subsidiary during the applicable period (beginning from the time when properties are first acquired as part of the cross-border merger transaction and ending 10 9 pwc

10 years after the last date such properties are acquired). Further, an expatriated foreign subsidiary that is considered to pledge its assets or guarantee a non-cfc foreign related person s obligation for Section 956 purposes will also be considered as holding such obligation. The Notice specifies that Notice s exception to Section 956 treatment will not apply to a foreign related person s debt or stock that is treated as US property under this rule, but the Notice requests comments on whether any of the exceptions set forth in Section 956(c) should apply. Observation: The rule announced under the authority of Section 956(e) is essentially a foreign-to-foreign antihopscotch rule. Although Section 956(e) clearly provides authority for Section 956 anti-abuse regulations, this provision appears to go well beyond any previous administrative guidance that Treasury and the IRS have provided in this area. The new rule deems a purely foreign investment to be US property when the investment occurs within a certain period of time after a specific cross-border transaction has occurred. Preventing the de-control of certain CFCs Notice , section 3.02, addresses another post- inversion transaction that Treasury and the IRS view as facilitating the avoidance of Section 956. Specifically, the Notice describes certain transactions that may be undertaken to de-control an expatriated foreign subsidiary, thereby causing the CFC to become a non-cfc for US tax purposes, potentially facilitating additional transactions to avoid US income taxation on the CFC s pre-transaction E&P. The Notice provides examples of transactions that could result in de-control after a cross-border merger transaction, such as a foreign acquiring corporation issuing a note or transferring property to an expatriated foreign subsidiary in exchange for stock representing at least 50% of the vote and value of the expatriated foreign subsidiary. As the Notice explains, the expatriated foreign subsidiary would no longer be a CFC, and the US shareholders would no longer be subject to subpart F (including Section 956) with respect to that subsidiary. Section 957(a) defines a CFC as a foreign corporation that is more than 50% owned (by vote or value) by US shareholders (as specifically defined). CFCs are subject to the Subpart F anti-deferral rules that require the current inclusion by the CFC s US shareholders of certain income that the CFC has earned but not repatriated in a dividend to those US shareholders. The Notice addresses this de-control concept with a multi-pronged set of rules, using primarily Sections 7701(l) and 367(b). Specifically, the Notice announces that future regulations will define certain de-controlled foreign corporations as CFCs, even though they would not otherwise meet the statutory definition under Section 957(a). To achieve this result, Treasury and IRS will issue regulations under a) Section 7701(l) to recharacterize certain transactions, and b) Section 367(b) that will require an income inclusion in certain non-recognition transactions that dilute a US shareholder s ownership of a CFC. Section 7701(l) authorizes anti-abuse regulations recharacterizing conduit (multiple-party) financing transactions. The primary impetus for the rules was the treatment of back-to-back financing arrangements, and the primary mechanism is to treat the transaction as running directly among any two or more of the parties. The Notice observes that the rules can apply to other fact patterns as well, such as fast-pay stock in a corporation, whose holders are treated by the Section 7701(l) regulations as having acquired instruments issued by other shareholders of the corporation, instead of having acquired interests in the corporation directly. Section 367(b) authorizes anti-abuse regulations for certain transfers involving foreign corporations, including rules addressing gain, dividend income, and E&P relating to a US person s sale or exchange of interests in a foreign corporation. Specifically, under the current regulations, an exchanging shareholder may have to recognize a deemed dividend if, immediately before the exchange, it is either (i) a US person that is a Section 1248 shareholder of the foreign acquired corporation, or (ii) a foreign corporation in which a US person is a Section 1248 shareholder of such foreign corporation and the foreign acquired corporation. This income recognition will only apply if, immediately after the exchange, either (i) the stock received by the exchanging shareholder is not stock in a CFC of which the US person is a Section 1248 shareholder, or (ii) the foreign acquiring corporation (as defined under Section 367(b)), or the foreign acquired corporation, is not a CFC for which the US person is a Section 1248 shareholder. The existing Section 367 regulations provide that a Section 1248 amount included as a deemed dividend is not Section 954(c) foreign personal holding company income (FPHCI). However, the CFC look-through rule of Section 954(c)(6) 10 pwc

11 also provides that certain CFC-to-CFC payments are not treated as FPHCI to the extent attributable to CFC income that is neither subpart F income nor effectively-connected US income. That rule authorizes anti-abuse regulations, which were announced in Notice , which clarifies that Section 954(c)(6) also governs gains treated as dividends under Section 964(e) (which provides treatment similar to Section 1248 for CFC sales of foreign corporation stock). New Section 7701(l) rules The new section 7701(l) regulations will provide that a specified transaction completed during the applicable period relating to a cross-border merger transaction (see above) will generally be recharacterized. For this purpose, a specified transaction involves the transfer of an expatriated foreign subsidiary s stock (specified stock) to a specified related person (i.e., a non-cfc foreign related person (as defined above), a US partnership with any partner that is a non-cfc foreign related person, or a US trust with any beneficiary that is a non-cfc foreign related person). As of the date on which the specified transaction occurs, the future regulations will recharacterize the transaction for all purposes of the Code as an arrangement directly between the specified related person and the direct or indirect US shareholders of the expatriated foreign subsidiary. Therefore, if an expatriated foreign subsidiary issues specified stock to a specified related person, the specified transaction will be recharacterized as follows: The specified related person will be treated as transferring the property to acquire the specified stock (transferred property) to the expatriated foreign subsidiary s direct and indirect US shareholders in exchange for instruments deemed issued by those US shareholders (deemed instruments). The direct and indirect US shareholders will be treated as having contributed the transferred property (or proportionate share of such property), including through any intervening entities, to the expatriated foreign subsidiary in exchange for expatriated foreign subsidiary stock. This rule applies only if the US shareholders are related to the specified related person under Sections 267(b) or 707(b)(1) (not Section 954(d)(3)), or are under common control with the specified related person for Section 482 purposes. The Notice states that similar principles to this rule will also be applied to recharacterize a specified transaction in which a shareholder transfers specified stock of the expatriated foreign subsidiary to a specified related person. The Notice provides a couple of examples to illustrate the application of the new rules. In Example 2 (see below) the principles of these rules are applied to a shareholder s transfer of stock to a partnership that is a specified related person. The Notice requests comments on this example, and on alternative recharacterizations for transfers to partnerships. Note that, if the specified transaction is a fast-pay arrangement, the existing Treas. Reg. sec (l)-3 fast-pay rules will still apply. The Notice provides that deemed instruments will have the same terms as the specified stock. Thus, if the expatriated foreign subsidiary makes a distribution with respect to specified stock, related distributions with respect to stock will be treated as made by the expatriated foreign subsidiary (through intervening entities, if any) to the direct and indirect US shareholders. The US shareholders will then be treated as making payments to the specified related persons with respect to the deemed instruments. An expatriated foreign subsidiary will be treated as the paying agent of its US shareholders for the deemed instruments. Rules similar to the Section 7701 regulations regarding transactions that affect benefited stock will apply to transactions affecting specified stock. Notice contains two exceptions to the new Section 7701(l) de-control rules. First, a specified transaction will not be recharacterized if the specified stock was transferred by a shareholder of the expatriated foreign subsidiary and existing US federal income tax rules require the shareholder to (i) recognize and include all of the gain in the specified stock, or (ii) have a Section 367(b) deemed dividend included in income with respect to the specified stock (including by reason of the rules described just below). The second exception applies if (i) the expatriated foreign subsidiary is a CFC immediately after the specified transaction and all related transactions, and (ii) the value of stock in the expatriated foreign subsidiary (and any lower-tier expatriated foreign subsidiary) owned by the direct or indirect US shareholders of the expatriated foreign subsidiary immediately before the specified transaction (and any related transaction) does not decrease by more than 10% as a result of those transactions. 11 pwc

12 The new de-control rules also treat a deemed dividend from a specified transaction as included in FPHCI, regardless of Section 954(c)(6). New Section 367(b) rules Paralleling the new concept of a specified transaction is the concept of a specified exchange under Section 367(b). The Notice announces a new rule that an exchanging shareholder in a specified exchange of expatriated foreign subsidiary stock must include in income the Section 1248 amount attributable to that stock as a deemed dividend, without regard to the conditions in the existing Section 367(b) regulations. This treatment will apply to specified exchanges completed during the Section 7874 applicable period (see above). Notice defines a specified exchange as an exchange in which an expatriated foreign subsidiary s shareholder exchanges expatriated foreign subsidiary stock for another foreign corporation s stock in a Section 367(b) transaction. The new Section 367(b) rules provide an exception incorporating the principles of the second exception to the new Section 7701(l) rules (regarding specified transactions that do not decrease, in the aggregate, the value of the US shareholder s stock ownership in an expatriated foreign subsidiary by more than 10%. The Notice also provides that future regulations will ensure that a deemed dividend resulting from a specified exchange will not qualify for an exception to FPHCI, and that Section 954(c)(3) or (c)(6) will not apply to the deemed inclusion in gross income. Examples The Notice provides several examples of the new rules that address de-control transactions. The facts for each example are variations on the same basic scenario: i. FA, a foreign corporation, wholly owns DT, a US corporation, which, in turn, wholly owns FT, a foreign corporation that is a CFC. FA also wholly owns FS, a foreign corporation. ii. FA acquired DT in an inversion transaction completed on January 1, iii. Accordingly, DT is a US entity, FT is an expatriated foreign subsidiary, and FS is a specified related person with respect to FT. Example 1 (see Diagram 5 below): On February 1, 2015, FA acquires $10x of FT stock from FT, representing 60% of the total vote and value of the FT stock, in exchange for $10x of cash. FA s acquisition of the FT stock from FT is a specified transaction, because stock of an expatriated foreign subsidiary was transferred (by issuance) to a specified related person (FA). FA s acquisition of the FT stock is recharacterized, with the result that FT continues to be a CFC. DT is treated as: having issued a deemed instrument to FA in exchange for $10x of cash. having contributed the $10x of cash to FT in exchange for FT stock. Any distribution with respect to the FT stock actually acquired by FA will be treated as a distribution to DT, which, in turn, will be treated as making a matching distribution with respect to the deemed instrument that DT is treated as having issued to FA. FT is treated as the paying agent of DT with respect to the deemed instrument issued by DT to FA. 12 pwc

13 Diagram 5 Under alternative facts and analysis for Example 1, FA acquires 60% of the FT stock held by DT in exchange for $4x of cash in a fully taxable transaction. In this case, the specified transaction qualifies for the first exception to the specified exchange rules (full income recognition) and is not recharacterized. Diagram 6 13 pwc

14 Example 2 (see Diagram 7 below): On February 1, 2015, DT transfers all of its FT stock to FPRS, a foreign partnership, in exchange for 40% of the capital and profits interests in the partnership. FA contributes property to FPRS in exchange for the other 60% of the partnership interests. DT s transfer of the FT stock is a specified transaction, because stock of an expatriated foreign subsidiary was transferred to a specified related person (FPRS). DT s transfer of the FT stock is recharacterized as follows, with the result that FT continues to be a CFC: FPRS is treated as having issued 40% of its capital and profits interests to DT in exchange for a deemed instrument treated as issued by DT. DT is treated as continuing to own all of the FT stock. Any distribution with respect to the FT stock actually acquired by FPRS will be treated as a distribution to DT, which, in turn, will be treated as making a matching distribution with respect to the deemed instrument that it is treated as having issued to FPRS. FT is treated as the paying agent of DT with respect to the deemed instrument Diagram 7 Example 3 (see Diagram 8 below): On February 1, 2015, DT exchanges all the FT stock for 60% of the FS stock in a B reorganization. Immediately before the exchange, FT is a CFC in which DT is a Section 1248 shareholder. Immediately after the exchange, FS and FT are CFCs in which DT is a Section 1248 shareholder. DT s exchange of the FT stock is a specified exchange, because DT exchanged stock of an expatriated foreign subsidiary (FT) for stock in a foreign corporation (FS) in a Section 367(b) transaction. 14 pwc

15 Although the specified exchange is also a specified transaction (because there is a transfer of FT stock to a specified related person (FS)), the exchange is not recharacterized because of the first exception to the specified transaction rule. Nevertheless, the rules announced in the Notice with respect to Section 367(b) will apply and require DT to include in income the Section 1248 amount with respect to the FT stock exchanged. The inclusion under Section 367(b) is contrary to the current Section 367(b) regulations in that it effectively ignores the fact that, immediately after the exchange, (i) the FS stock received by DT in the exchange is stock in a corporation that is a CFC for which DT is a Section 1248 shareholder, and (ii) FT is a CFC for which DT is a Section 1248 shareholder. Diagram 8 Request for comments on a possible exception Notice requests comments on whether to provide an exception to re-characterization when (1) a specified transaction is undertaken in order to integrate similar or complementary businesses, and (2) after the cross-border merger transaction, the new group does not exploit its form to avoid US taxation on the expatriated foreign subsidiary s pre-transaction E&P. The request for comments also includes an invitation to comment on the types of arrangements that taxpayers can use to avoid tax after a specified transaction on a CFC s pre-transaction earnings, thus precluding use of the exception. Finally, the Notice requests comments on any rules that may be necessary to administer such an exception. Observation: This elaborate set of rules touches several Code sections and was likely in development for some time before the Treasury and IRS assembled Notice The use of Section 7701(l) for transactions that are not conduit financing arrangements is particularly novel. The future regulations to be issued under Section 367(b) are particularly noteworthy as they would dramatically expand the application of those rules. There may be questions about whether Treasury and the IRS have exceeded the authority granted by Section 367(b). 15 pwc

16 Using Section 304(b)(5)(B) to limit repatriation of untaxed earnings Notice , section 3.03, addresses certain transactions that the government believes taxpayers may engage in after an inversion to reduce a CFC s E&P and facilitate the repatriation of the CFC s cash and other property. The examples in the Notice involve a transaction under Section 304(a)(1) and (2) so called brother-sister and subsidiary-parent Section 304 transactions. In general, Section 304 is designed as an anti-abuse rule to recharacterize a stock sale between related parties that would otherwise give rise to capital gain, as a distribution of earnings from the acquiring and target (issuing) corporations. Section 304(a)(1) applies when one corporation (acquiring corporation) acquires for property the stock of another corporation (target corporation), and the acquiring corporation and target corporation are under common control. In such a case, the statute re-characterizes the stock sale as though the seller of the target corporation instead contributed the target stock to the acquiring corporation for deemed issued stock, and then that deemed issued stock was redeemed by the acquiring corporation with the consideration used to acquire the target stock. The effect of this re-characterization often results in the deemed redemption distribution being treated as a dividend to the seller of the target stock. Similarly, Section 304(a)(2) involves the acquisition by a subsidiary corporation of the stock of its parent. The specific organizational structure is a typical structure that would exist after a US-foreign cross-border business combination, where a foreign parent corporation holds a foreign acquiring corporation that recently acquired the stock of a US corporation (US target) that holds CFCs. In this case, if the US target s CFC uses its property to acquire part of the stock of the US target from the foreign acquiring corporation, Section 304(a)(2) would apply. Under Section 304(a)(2), the value of the consideration paid by the CFC for US target s stock would be considered a distribution in redemption of the US target s stock held by the foreign acquiring corporation. Further, Section 304(b)(2) provides that the amount of any dividend arising in a Section 304(a) acquisition is first sourced from, and to the extent of, the E&P of the acquiring corporation (i.e., the CFC acquiring US target s stock), and then, if necessary, from, and to the extent of, the E&P of the issuing corporation (i.e., the US target corporation). As a further limitation, Section 304(b)(5)(B) provides that the ordering rule in Section 304(b)(2) is modified in certain cases where the acquiring corporation is foreign. Specifically, Section 304(b)(5)(B) provides that no E&P of the foreign acquiring corporation is to be taken into account if more than 50% of the dividends arising from the acquisition would neither be subject to tax in the year the dividends arise, nor included in a CFC s E&P. That rule s intention is to prevent a foreign acquiring corporation s E&P from escaping US federal income taxation, and Section 304(b)(5) includes authority for regulations to carry out that section s purposes. In regard to the Section 304(a) transactions described above, the government is concerned that through the application of Section 304(a), Section 304(b)(2), and Section 304(b)(5)(B), the US target may not recognize any subpart F income (e.g., if the CFC exchanges property it uses in a trade or business to acquire the US target stock), even though Section 1001 would generally cause the CFC to recognize income or gain on the exchange (other than cash). To reach this result, the Notice states that taxpayers may interpret Section 304(b)(5)(B) in such a manner that it does not apply where more than 50% of the dividend is sourced from the US corporation, even though an income tax treaty may in fact require no US withholding tax on the dividend, and the dividend otherwise then sourced from the CFC s E&P would never be subject to US tax. To address the perceived shortcoming in the statute, Notice announces the intent to issue regulations that will address the circumstances when more than 50% of dividends arising under Section 304(b)(2) are subject to tax or includible in a CFC s E&P. That determination will take into account only the acquiring corporation s E&P, and thus will not consider the issuing corporation s E&P (e.g., the US target corporation s E&P in the fact pattern described above). Further, additional rules will be issued to avoid the application of the new rules. For example, if a partnership, option, or other arrangement is used with a principal purpose of avoiding the application of the new rule (for example, to treat a transferor as a CFC), then the arrangement will be disregarded for purposes of applying this rule. The future regulations announced under Section 304(b)(5) will apply as a general matter, without regard to whether an inversion transaction has occurred. Thus, foreign-parented structures must take into account the extension of these rules when engaging in certain restructuring transactions. 16 pwc

17 Examples The Notice provides two examples of the new Section 304(b)(5) rules. Example 1 (see Diagram 9 below): FA, a non-cfc foreign corporation, wholly owns DT, a US corporation. DT wholly owns FS1, a CFC. DT has $51x E&P, and FS1 has $49x E&P. FA transfers DT stock with a value of $100x to FS1 in exchange for $100x of cash. Section 304(a)(2) treats the $100x of cash as a distribution in redemption of the DT stock. That redemption is treated as a distribution subject to Section 301, which Section 304(b)(2) would ordinarily source first from FS1. More than 50% of the dividend arising from the acquisition, taking into account only FS1 s E&P under the new rule, would not be subject to US federal income tax. In particular, no portion of a dividend from FS1 would be subject to US tax or includible in a CFC s E&P. Accordingly, Section 304(b)(5)(B) applies to the transaction, and Section 301(c)(1) would not source any of the $100x distribution as a dividend out of FS1 s E&P. The $100x of cash is treated as a dividend to the extent of DT s E&P ($51x). Diagram 9 Example 2 (see Diagram 10 below): FA, a non-cfc foreign corporation, wholly owns DT, a US corporation. DT wholly owns FS1, a CFC. FA and DT own 40% and 60%, respectively, of the capital and profits interests of PRS, a foreign partnership. PRS wholly owns FS2, a CFC. The FS2 stock has a $100x fair market value. FS1 has $150x E&P. PRS transfers all of its FS2 stock to FS1 in exchange for $100x of cash. DT enters into a gain recognition agreement that complies with the relevant requirements with respect to the 60% portion of FS2 stock that DT is deemed to transfer to FS1 in a Section 367(a) exchange. 17 pwc

18 Section 304(a)(1) treats PRS and FS1 as if PRS transferred its FS2 stock to FS1 in a Section 351(a) contribution solely for FS1 stock, and, in turn, FS1 redeemed such FS1 stock in exchange for $100x of cash. That redemption is treated as a distribution subject to Section 301. More than 50% of the dividend arising from the acquisition, taking into account only FS1 s E&P under the new rule, would be subject to US federal income tax. In particular, 60% of a dividend from FS1 would be included in DT s distributive share of PRS s partnership income and therefore subject to tax. Accordingly, Section 304(b)(5)(B) does not apply, and Section 301(c)(1) treats the entire $100x distribution as a dividend out of FS1 s E&P. Diagram 10 Observation: The 2010 legislation providing that Section 304 takes the acquiring corporation s E&P into account first was intended to narrow taxpayers options for characterizing such transactions. The new rules in Notice apparently reflect the view of Treasury and the IRS that the 2010 statutory change did not limit those options enough. The Notice seems to have provided an opportunity to issue these new Section 304 rules in conjunction with others, but the Section 304 limitations announced here are not aimed primarily at inversion transactions. Effective dates The rules announced in the Notice generally are intended to apply only to cross-border business combination transactions completed on or after September 22, The sole exception is the Section 304(b)(5)(B) provision, which applies to all stock acquisitions completed on or after September 22, 2014 that meet Section 304 criteria. In addition, taxpayers may elect to apply that rule to post-transaction stock transfers to transactions completed before September 22, The Notice indicates that future guidance in this area will apply prospectively from the date of issuance, and only to groups that completed their business combination transactions on or after September 22, However, the Notice makes clear that no inference is intended regarding the current-law treatment of these transactions. 18 pwc