Edward Tanenbaum		Diana Wessells

Section 7874 applies if, pursuant to a plan, (1) a foreign corporation acquires, directly or indirectly, substantially all of the properties held directly or indirectly by a US corporation; (2) the foreign acquiring corporation or any affiliated corporation (based on greater than 50% common ownership) does not have substantial business activities in the country in which the foreign acquiring corporation is organised; and (3) immediately after the transaction, former shareholders of the US corporation own at least 60% of the stock (by vote or value) of the foreign corporation by reason of holding stock in the domestic corporation. The stock ownership test disregards stock held by members of the expanded affiliated group (EAG) that includes the foreign acquiring corporation.

If former shareholders of the US corporation own at least 60% (but less than 80%) of the stock of the foreign acquiring corporation by reason of holding stock in the US corporation, a special tax regime applies for a 10-year period pursuant to which the US corporation is restricted from using certain tax attributes to offset income realised on the transfer of stock or properties, including by way of license, as a part of the inversion transaction onto a foreign related person. If the former shareholders of the US corporation own 80% or more of the stock of the foreign acquiring corporation by reason of holding stock in the US corporation, the foreign acquiring corporation is treated for all tax purposes as a US corporation.

The final regulations

The final regulations provide that stock owned by members of an EAG is excluded from both the numerator and denominator of the fraction used to determine the percentage of continuing ownership. Although this rule will prevent many transactions from being ensnared by section 7874, the existence of minority shareholders of the US corporation nevertheless can cause the unfavourable provisions of section 7874 to apply.

The final regulations continue to provide relief from this outcome in two instances: (1) Transactions that occur as part of an internal group restructuring involving a US entity, provided that the common parent of the EAG held, directly or indirectly, at least 80% (by vote and value) of the stock of the US corporation before the acquisition, and holds at least 80% (by vote and value) of the stock of the acquiring foreign corporation afterwards (internal group restructuring); and (2) acquisitive transactions between unrelated parties where the former shareholders of the US entity do not hold, in the aggregate, either directly or indirectly, more than 50% of the stock (by vote or value) of any member of the EAG (loss of control).

In these types of transactions, stock owned by members of the EAG is included in the denominator, but not the numerator, of the ownership fraction.

The preamble to the final regulations provides a few points of clarification in connection with these rules. First, "plain vanilla preferred stock" described in section 1504(a)(4) is taken into account for purposes of determining the ownership fraction, although such stock is ignored for purposes of determining whether corporations constitute an EAG.

Secondly, the internal restructuring exception discussed above looks to the stock ownership of the EAG parent in determining whether the 80% threshold is met for the exception to apply. Additionally, the stock ownership for this 80% threshold is now measured by vote and value, rather than by vote or value.

New warnings from the preamble

The preamble also reveals Treasury's view of the appropriate effect of section 7874 on three types of transactions that are not specifically addressed by the final regulations.

First, the preamble states that, where a foreign corporation acquires substantially all of the properties of a US corporation in a title 11 or similar case, creditors of the US corporation that receive stock of the acquiring foreign corporation in the transaction are considered former shareholders of the US corporation for purposes of determining whether the 60% threshold or the 80% threshold is satisfied, and that Treasury is considering the issuance of regulations to this effect.

Secondly, Treasury is considering the issuance of regulations providing, in general, that, where two or more US corporations are acquired by a foreign corporation, the ownership fraction applies to the US corporations as a whole, rather than on a separate basis.

Finally, the preamble signals Treasury's intention to issue regulations that would prevent the structuring of acquisitions of US entities by foreign corporations through the use of intervening partnerships. Future regulations would treat the former shareholders of the US target corporation, through their interest in an intervening domestic partnership, as holding stock of the foreign acquiring corporation by reason of holding stock in the US corporation.

Although the preamble, rather than the final regulations themselves, contains these warnings, taxpayers should be aware of the government's views concerning these transactions and should plan accordingly.

Edward Tanenbaurn at (edward.tanenbaum@alston.com), New York and Diana Wessells (Diana.Wessells@alston.com), Washington, DC