US: Important new developments in M&A
David Forst of Fenwick &?West discusses the impact of new developments in M&A in the US.
The Obama Administration, in its Fiscal Year 2015 Budget, has proposed to significantly curtail so-called "acquisition inversions". Under current law, if at least 80% of the new foreign parent's stock is held by shareholders of the former domestic parent by reason of holding such stock, then the new foreign parent is treated as a domestic corporation (unless the new foreign parent conducts "substantial business activities").
Under the Obama Administration's proposal, the 80% threshold would be reduced to 50%. Therefore, a foreign corporation that acquires a domestic corporation would be treated as domestic if more than 50% of the shares of the foreign acquirer are held by former shareholders of the domestic corporation. The proposal also would repeal the rule on loss of tax attributes on 60% inversions, treating such rule as superfluous.
Additionally, even if the above 50% test is met, the foreign parent would still be treated as domestic if it has substantial business activities in the US and is primarily managed and controlled from the US. There is no further detail on the level of activity in the US that would trigger domestic treatment.
The proposals are stated to be effective for transactions completed after December 31 2014.
In addition, the US Treasury Department has issued new regulations under the Code section 7874. Under section 7874(c)(2)(B) (statutory public offering rule), stock of the foreign acquiring corporation, which is sold in a public offering related to the acquisition, is not taken into account for purposes of calculating the ownership percentage. The statutory public offering rule furthers the policy that section 7874 is intended to curtail inversion transactions that "permit corporations and other entities to continue to conduct business in the same manner as they did prior to the inversion".
This rule was modified by Notice 2009-78 which provides that the issuance of stock of a foreign corporation for cash or other "nonqualified property" in any transaction (not just a public offering), which is related to the acquisition, is not to be taken into account in calculating the ownership percentage.
This can present issues in a purely foreign acquisition of a US company, where, for example, the foreign company capitalises a new foreign subsidiary with cash to effect the acquisition, and executives of the US target company receive some stock of the acquiring company.
In adopting the rules announced in the Notice, the IRS made certain modifications. The new regulations institute what is termed the "exclusion rule". Under this rule, subject to a de minimis exception, "disqualified stock" is excluded from the denominator of the ownership fraction. Disqualified stock is generally stock issued for cash, marketable securities, and in a new category: An obligation owed by a member of the expanded affiliated group that includes the foreign acquiring corporation, a former shareholder or partner of the domestic entity and certain persons related to the above. The use of foreign acquirer stock in the satisfaction or assumption of an obligation of the transferor is treated similarly as if the foreign acquirer stock was received in exchange for non qualified property. Further, disqualified stock also includes stock that the transferee subsequently exchanges for the satisfaction or assumption of a liability associated with the property exchanged.
The regulations also state that disqualified stock does not include stock transferred in an exchange that does not increase the fair market value of the net assets of the foreign acquiring corporation (with hook stock excluded from this exception).
The regulations add a de minimis rule that can be helpful and was not provided in the Notice. This rule provides that stock is not treated as disqualified stock if the ownership percentage determined, without regard to the disqualified stock rule, is less than 5%, and after the acquisition and all related transactions are completed, former shareholders in the aggregate own less than 5% of the stock of any member of the expanded affiliated group that includes the foreign acquiring corporation.
Other Obama Administration proposals
The Obama Administration, in its Fiscal Year 2015 Budget, has proposed to extend the application of section 338(h)(16) to all transactions covered by section 901(m). Section 338(h)(16) provides that (subject to certain exceptions) the deemed asset sale resulting from a section 338 election is not treated as occurring for purposes of determining the source or character of any item for purpose of applying the foreign tax credit rules to the seller. Instead, for these purposes, the gain is generally treated by the seller as gain from the sale of the stock. Accordingly, the gain would be passive basket, US source income.
Section 901(m) denies a credit for certain foreign taxes paid or accrued after a covered asset acquisition (CAA). A CAA includes a section 338 election made with respect to a qualified stock purchase as well as other transactions that are treated as asset acquisitions for US tax purposes but the acquisition of an interest in an entity for foreign tax purposes (including acquisitions of partnerships and entities treated as disregarded for US tax purposes).
Another Obama Administration proposal would reduce the amount of foreign taxes paid by a foreign corporation in the event a transaction results in the reduction, allocation, or elimination of a foreign corporation's earnings and profits other than a reduction by reason of a dividend or a section 381 transaction. Certain transactions result in a reduction, allocation, or elimination of a corporation's earnings and profits other than by reason of a dividend or by reason of section 381. For example, if a corporation redeems a portion of its stock and the redemption is treated as a sale or exchange, there is a reduction in the earnings and profits (if any) of the redeeming corporation under section 312(n)(7). As another example, certain section 355 distributions can result in the reduction of the distributing corporation's earnings and profits pursuant to section 312(h).
Under the proposal, the amount of foreign taxes that would be reduced in such a transaction would equal the amount of foreign taxes associated with such earnings and profits. The proposal would be effective for transactions occurring after December 31 2014.
The Obama Administration repeated its proposal to codify Rev. Rul. 91-32, which provides for look-through treatment when a non-US person sells a partnership interest, causing the gain to be treated as effectively connected income to the extent attributable to a US trade or business of the partnership. Section 741 precludes look-through treatment, providing that the sale of a partnership interest is to be treated as the sale of a capital asset. Nevertheless, in FAA 20123903F, the IRS continued to hold to its position in Rev. Rul. 91-31, stating that a nonresident alien's gain, from the sale of their interest in a US partnership, constituted effectively connected income subject to US tax. Of course, the Obama Administration's proposal to codify this result is tantamount to an admission that the IRS position rests on shaky legal ground.
New regulations under section 367(a)(5); section 367(b) and 1248(f)
Treasury and the IRS issued final regulations under section 367(a)(5). Treas. Reg. §section1.367(a)-7 adopts, with modest changes, the 2008 proposed regulations on the same subject. Treas. Reg. section 1.367(a)-7(b)(1) states the general rule: Except as specifically provided in the new regulations, the exceptions to section 367(a)(1) gain recognition provided in section 367(a) and the regulations under that section do not apply to a transfer of section 367(a) property by a US transferor to a foreign-acquiring corporation in an outbound section 361 exchange, and the US transferor must recognise any gain (but not loss) realised on the transfer.
One exception to the general gain recognition rule applies if the section 361 exchange also qualifies for non-recognition under a provision that is not enumerated in section 367(a)(1), such as asection 1036 exchange. In such a case, the US transferor recognises gain or loss on the transfer but the amount of loss recognised cannot exceed the amount of gain recognised.
A second, elective exception to the general gain recognition rule, more likely to find application, applies where four conditions are satisfied as follows:
First, immediately before the reorganisation, the US transferor must be controlled within the meaning of section 368(c) by five or fewer domestic corporations, referred to as "control group members".
Second, the US transferor must recognise gain with respect to stock owned by non-control-group members and, in certain cases, with respect to stock owned by control group members.
Third, each control group member's aggregate basis in the stock received in exchange for -or, in the case of a section 355 distribution, with respect to – the US transferor's stock is reduced by the excess of the amount of inside gain attributable to the control group member's stock, reduced by the gain (if any) recognised by the US transferor with respect to the relevant control group member, exceeds the control group member's outside gain (or outside loss, treated as a negative number) in the stock received in the section 361 exchange.
Fourth, the US transferor complies with the requirements of Treas. Reg. section 1.6038B-1(c)(6)(iii), relating to the requirement to report gain that was not recognised by the US transferor upon certain subsequent dispositions by the foreign acquiring corporation.
To invoke the elective exception, the US transferor and each control group member must elect to apply the exception in the manner described in the regulations and must enter into a written agreement setting forth the identities of the parties, the amount of gain (if any) recognised by the US transferor, and the amount of the basis adjustments (if any) applicable to each control group member's stock received in the section 361 exchange. Each party must retain a copy of the agreement and must provide a copy to the IRS within 30 days of any request.
The new section 367(b) regulations provide that the US transferor must include in income the section 1248 amount attributable to the stock of the foreign acquired corporation only if immediately after the section 361 exchange the foreign acquiring corporation or the foreign acquired corporation is not a CFC with respect to which the US transferor is a section 1248 shareholder. See revised section 1.367(b)-4(b)(1)(iii), Ex. 4.
The new section 1248(f) regulations provide that a domestic distributing corporation that is a section 1248 shareholder of a foreign corporation that distributes stock of the foreign corporation in a distribution to which section 337, 355(c)(1) or 361(c)(1) applies must generally include in income as a dividend the section 1248 amount attributable to the stock distributed.
No ruling policy
The IRS has been paring back the eligibility to apply for private rulings, and Rev. Proc. 2013-32 furthers this retrenchment in the M&A context. Under the Rev. Proc. rulings will not be issued on matters addressing whether a transaction qualifies for non-recognition treatment under sections 332, 351, 355 or 1036, or on whether a transaction constitutes a reorganisation within the meaning of section 368, regardless of whether the transaction presents a significant issue and regardless of whether the transaction is an integral part of a larger transaction that involves other issues on which the service will rule.
The ruling does state, however, that it will continue to rule on issues under the non-recognition provisions if the issue is "significant". An issue is "significant" if it is an issue of law, the resolution of which is not essentially free from doubt, and that is relevant to determining the tax consequences of the transaction. Examples provided in the Rev. Proc. include the applications of Treas. Reg. sections 1.368-1(d) and 1.368-2(k).
The Service will not rule on the application of one non-recognition provision if the application of an alternate provision is not essentially free from doubt. For example, the Service may decline to rule on an issue under section 368 with respect to an upstream merger of a wholly owned subsidiary into its sole corporate shareholder if qualification of the transaction under section 332 is essentially free from doubt. It is essentially free from doubt that the tax consequences of the section 332 qualification would be the same as the tax consequences that would result if the transaction constituted a reorganisation within the meaning of section 368.
In addition, the service will only rule on the tax consequences (such as non-recognition and basis) that result from the application of non-recognition provisions to the extent that a significant issue is presented under the related code section that addresses such tax consequences. For example, a section 351 exchange that does not present any significant issues under section 351 may present significant issues regarding the application of section 358 (basis) to the transferor in the exchange. In such a case, the Service will rule only on the significant issue under section 358.
Fenwick & West
Tel: +1 650 335 7254
Fax: +1 650 938 5200
David Forst is the practice group leader of the tax group of Fenwick & West. He is included in Legal Media Group's Guide to the World's Leading Tax Advisers. He is also included in Law and Business Research's International Who's Who of Corporate Tax Lawyers (2009, 2010, 2011, and 2012). David was named one of the top tax advisers in the western US by International Tax Review, is listed in Chambers USA America's Leading Lawyers for Business (2011-2012), and has been named a Northern California Super Lawyer in Tax by San Francisco Magazine.
David's practice focuses on international corporate and partnership taxation. He is a lecturer at Stanford Law School on international taxation. He is an editor of, and regular contributor to, the Journal of Taxation, where his publications have included articles on international joint ventures, international tax aspects of mergers and acquisitions, the dual consolidated loss regulations, and foreign currency issues. He is a regular contributor to the Journal of Passthrough Entities, where he writes a column on international issues. David is a frequent chair and speaker at tax conferences, including the NYU Tax Institute, the Tax Executives Institute, and the International Fiscal Association.
David graduated with an AB, cum laude, Phi Beta Kappa, from Princeton University's Woodrow Wilson School of Public and International Affairs, and received his JD, with distinction, from Stanford Law School.