In Private Letter Ruling 201432002 (the “PLR”), the IRS ruled that a foreign-to-foreign “F” reorganization did not implicate the Section 7874 anti-inversion rules. As a result, a foreign corporation (that was 100 percent foreign owned) was not deemed to be a U.S. corporation for U.S. federal income tax purposes, despite the fact that it was deemed to transfer substantially all of the properties of a domestic subsidiary corporation to a foreign corporation that had no substantial business activities in its country of incorporation. The specific exception relied on by the IRS to reach this conclusion was the “expanded affiliated group rule.”
In the wake of the PLR’s publication, many commentators have cited the ruling for the proposition that, in an inbound situation, a foreign-to-foreign F reorganization would not trigger the Section 7874 inversion rules. This seems to be an overbroad reading of the PLR. In fact, the PLR seems to imply that, had the foreign target corporation not been more than 50 percent owned by another corporation, Section 7874 likely would have applied to the F reorganization at issue. This result is clearly at odds with the legislative intent underlying Section 7874 and could lead to some surprising results, as further discussed below.
Section 7874, Generally
To respond to perceived abuses associated with so-called “inversion” transactions, Congress enacted Section 7874 in 2004. The legislative history to this Section makes it clear that Congress was specifically concerned with the ability of a U.S. corporation to reincorporate in a foreign country, thereby replacing a U.S. parent of a multinational group with a foreign parent. Section 7874 was designed to eliminate some of the tax advantages sought by such transactions.
Under Section 7874, a foreign corporation will be treated as a domestic corporation for all purposes of the Code if, pursuant to a plan (or series of related transactions) (i) the foreign entity completes the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation; (ii) after the acquisition at least 80 percent of the stock (by vote or value) of the entity is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation (“Ownership Test”); and (iii) after the acquisition, the expanded affiliated group (“EAG”) which includes the foreign entity does not have substantial business activities in the foreign country in which, or under the laws of which, the entity is created or organized, when compared to the total business activities of the EAG.
For the purposes of determining post-acquisition ownership of the foreign corporation by the former shareholders of the U.S. corporation, certain stock of the foreign corporation is not taken into account in determining ownership under Section 7874(a)(2)(B)(ii) (“Ownership Fraction”). Section 7874(c)(2) provides that such disregarded stock includes (i) stock of the foreign corporation held by members of the EAG that includes the foreign corporation, and (ii) stock of the foreign corporation sold in a public offering related to the acquisition.
For this purpose, an EAG is an affiliated group of corporations as defined under Section 1504(a) but without regard to Section 1504(b)(3), except that Section 1504(a) is applied by substituting “more than 50 percent” for “at least 80 percent” each place it appears.
Facts of the PLR
Under the facts of the PLR, US Co was a U.S. limited liability company that had elected to be treated as a corporation for U.S. federal income tax purposes. All the shares of US Co were owned by Foreign Sub 2, a Country C entity classified as a foreign corporation for U.S. tax purposes. All the shares of Foreign Sub 2 were held by Foreign Sub 1, a Country D entity also classified as a foreign corporation for U.S. tax purposes. Foreign Sub 1 also owned all the interests in FDE 3, a Country E entity that elected to be treated as a disregarded entity for U.S. tax purposes. FDE2 was a Country C disregarded entity which held a majority interest in Foreign Sub 1. FDE1, also a Country C entity disregarded for U.S. tax purposes, held all the interests in FDE2. Parent, a Country F entity classified as a foreign corporation for U.S. tax purposes, held all the interests in FDE1.
US Co was constructing a facility in the United States in order to expand its business operations. In order to help fund the cost of the expansion, Parent decided to conduct stock offerings of Foreign Sub 2. After consulting with its financial advisers and analyzing its options, however, Parent determined that the stock offerings would be better effectuated under Country G law.
In anticipation of the stock offerings, Parent planned to cause FDE3 to form FA, a Country G corporation. Parent would then convert Foreign Sub 2 into FA through an “F reorganization.” Specifically, Foreign Sub 1 would first contribute all its shares of Foreign Sub 2 to FDE3. FDE3 would then contribute all the shares of Foreign Sub 2 to FA in exchange for additional shares of FA. Lastly, Foreign Sub 2 would make an entity classification election pursuant to Treasury Regulation Section 301.7701-3(c) to be treated as a disregarded entity for U.S. tax purposes.
After the F reorganization, Parent planned to initiate offerings of FA shares via a private placement with an unrelated private investor (of no more than a 20% interest) and an initial public offering on a Country G stock exchange. After the public offering, the private investor that acquired the FA shares in the private placement and the public shareholders would together hold no more than 49% of the outstanding shares of FA.
Under Section 1.367(b)-2(f), in the case of a foreign-to-foreign F reorganization, a deemed transfer of assets of the target occurs. More specifically, the Regulations deem: (i) a transfer of assets by the foreign target to the acquiror in exchange for stock of the acquiror and the acquiror’s assumption of the foreign target’s liabilities; (ii) a distribution of such stock by the foreign target to its shareholders; and (iii) an exchange by the foreign target’s shareholders of their stock for stock of the acquiror.
Accordingly, in the F reorganization described in the ruling, Foreign Sub 2 would be deemed to transfer all of its assets, i.e., the shares of US Co, to FA in exchange for stock of FA. The stock of FA would then be distributed to Foreign Sub 1. Finally, Foreign Sub 1 would be deemed to exchange its Foreign Sub 2 stock for the FA stock.
In the PLR, the first and third of the three conditions under Section 7874(a)(2)(B) were clearly satisfied (in other words, it was clear that the transaction would cause FA, directly or indirectly, to acquire substantially all of the properties held, directly or indirectly, by a domestic corporation, in this case US Co. It also was clear that there were no substantial business activities in Country G). Thus, the issue in the PLR was whether the second condition was satisfied, i.e., the Ownership Test. Under this test, if after the deemed transfer of US Co to FA, at least 80 percent of the stock of FA was held by former shareholders of US Co (i.e., Foreign Sub 2), FA would be treated as a domestic corporation for U.S. tax purposes pursuant to a literal reading of Section 7874.
The IRS ruled first that any FA shares treated as received by Foreign Sub 2 in connection with such an F reorganization would be shares described in Section 7874(a)(2)(B)(ii), i.e., shares of the foreign corporation held by former shareholders of the domestic corporation. Thus, these shares of FA count toward the 80% threshold for purposes of the Ownership Test. The ruling specified that this is true even though those FA shares are then deemed to be distributed to Foreign Sub 2’s shareholders (i.e., Foreign Sub 1) as part of the F reorganization.
The PLR then went on to discuss the exceptions contained in Section 7874(c)(2), which allow certain stock to be disregarded for purposes of the Ownership Fraction. In particular, these exceptions apply to carve out stock of the foreign acquirer held by members of the EAG that includes the acquirer (the “EAG exception”), and stock of the acquirer that is sold in a public offering related to the transfer by Foreign Sub 2 (the “public offering exception”). The IRS held in the PLR that, pursuant to the public offering exception, shares issued by FA pursuant to the private placement and the public offering would not be included in the denominator of the Ownership Fraction. Additionally, the IRS held that the FA shares treated as issued in exchange for the shares of US Co pursuant to the F reorganization would be excluded from both the numerator and the denominator of the Ownership Fraction pursuant to the EAG exception.
Consequently, the IRS ruled that the Ownership Fraction would be zero over zero and thus the ownership requirement of Section 7874(a)(2)(B)(ii) was not satisfied. As a result, FA was not treated as a domestic corporation under Section 7874.
Analysis and Implications of the PLR
The PLR held that, because of the EAG exception (and the public offering exception), the ownership requirement was not met, such that there was no inversion for Section 7874 purposes.
Before reaching an analysis of the EAG exception, however, the IRS also ruled that the FA shares deemed received by Foreign Sub 2 will be counted for purposes of the Ownership Test. This suggests that, in the absence of the EAG exception that would permit these shares to be ignored, the Section 7874 inversion rules would apply to cause FA to be treated as a domestic corporation.
In the PLR, the shares could be ignored under the EAG (and public offering) exception(s). But in many other foreign-to-foreign F reorganizations, that may not be the case. For example, in a foreign-to-foreign F reorganization involving individual shareholders of a foreign target, rather than a more than 50 percent corporate owner, as was the case in the PLR, there would not appear to be any applicable exception to permit the shares deemed received to be disregarded. Thus, in such an example, the shares would seem to be counted for purposes of the Ownership Test, and an inversion could result. This can produce some very harsh and unanticipated consequences.
To illustrate, assume a foreign individual shareholder (“FI”) wholly-owns a foreign holding company (“Holdco”), which in turn owns the following: (i) 100% of the stock of a foreign corporation that conducts an active business in its home country; (ii) a 99% interest in a UK limited liability partnership; and (iii) 100% of a U.S. corporation (US Sub) that conducts an active U.S. business. Assume that for valid business reasons, the foreign shareholder desires to redomesticate Holdco to a different non-U.S. jurisdiction. This transaction would be treated as an F reorganization under Section 368(a)(1)(F), which, based on the IRS’s literal reading of Section 7874 as set forth in the PLR and the relative values of the respective entities, would seem to trigger an inversion.
This is because the Regulations under Section 367 cause a deemed transfer of US Sub stock by the target (i.e., Holdco) in exchange for shares of the acquirer, followed by a distribution of the acquirer’s shares to FI in exchange for his target shares. Because FI is an individual, he cannot be a “member of [an] expanded affiliated group,” and therefore his acquirer stock cannot be excluded under the EAG exception. Based on these facts, the outcome for FI may be quite different than the outcome for the taxpayer in the PLR. This may cause the wholly-owned foreign subsidiary to become a controlled foreign corporation (CFC) for U.S. federal income tax purposes and as a result cause the deemed US parent (Holdco) to include in its income any Subpart F income or Section 956 inclusions, to the extent relevant. It could also cause the UK LLP to be converted from a partnership to a corporation in an outbound Section 367 transaction since, prior to the “inversion”, the UK LLP was never “relevant” for U.S. tax purposes under the entity classification regulations. In addition, any distributions by Holdco (which is now treated as a U.S corporation) would be subject to a 30 percent U.S withholding tax, unless reduced by an applicable income tax treaty. Finally, under this fact pattern, there would be many potential U.S. tax filing obligations of which the foreign shareholder is unlikely to be aware of, and if not complied with, the IRS would seem to have an unlimited statute of limitations under Section 6501(c)(8) to assess any taxes, penalties and interest.
The above clearly is not what Congress had in mind when it enacted Section 7874. Nonetheless, based on a literal reading of the statute, this arguably is the technically correct result. Whether the IRS would ever attack such a transaction on inversion grounds is a separate practical issue, but such a result is not beyond the realm of possibility.