US Inbound: Inbound § 7874 issues
We've discussed in this column some of the dangers that § 7874, the US's anti-inversion rules, can pose in a non-inversion, inbound investment context, especially as the IRS broadens these rules in a continuing effort to prevent inversions. Stated simply, § 7874 at the very least needs to be seriously considered in all inbound transactions, whether acquisitions or otherwise. In an inbound acquisition context, for example, funding a foreign acquisition vehicle with cash for a cash acquisition can present problems if some stock will be issued to employee shareholders of the US target company in an otherwise 100% cash acquisition. See our column of March 2014. We also discussed inbound acquisition issues that can arise under the Levin brothers' proposed § 7874 modifications (which have a retroactive effective date to May 2014). See our column of July/August 2014.
The IRS's latest effort in this area is Notice 2014-52, and, like nearly all measures aimed at curbing a perceived abuse, it has a much broader application than inversion transactions. The Notice can create serious inbound acquisition issues if the US target company, within the preceding three years, effected any stock buybacks, shareholder redemptions, dividends, spin-offs, etc. Those transactions are "undone" for the purposes of applying § 7874, with the possible severe effect that the foreign acquirer can become a US corporation for US tax purposes.
To add to these issues, and to further emphasise the need to consider § 7874 in an inbound investment context, consider LTR 201432002. That ruling addressed a foreign parent company that was planning an IPO to help finance its US subsidiary's capital investment and operations. The risk was that the foreign parent company could become a US company under § 7874 or suffer other § 7874 penalties.
In the ruling, FS-2, a foreign corporation, owns USCo, a domestic corporation. FS-2's shares are held by FS-1, also a foreign corporation. FP owns a majority of the stock in FS-1, and investors own the balance.
To effect the IPO of FS-2 and to raise the necessary capital, FS-1 will contribute the shares of FS-2 to IPOCo, a foreign corporation formed in a different country. There's nothing unusual with a change in place of organisation for such a purpose and nothing that the IRS should consider as abusive. Immediately thereafter, FS-2 will elect to become a disregarded entity for US tax purposes. The IRS treated the contribution and check-the-box liquidation as an F reorganisation of FS-2 into IPOCo.
After a private placement of some of IPOCo's common shares with an unrelated private investor, IPOCo will issue shares in the IPO to public investors outside the US. The private investor and the public shareholders of IPOCo together will own less than 50% of the outstanding shares of IPOCo.
Under §?7874, a foreign corporation can be treated as a US corporation if, among other things, (1) the foreign corporation completes the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation, and (2) after the acquisition at least 80% of the stock of the foreign corporation (by vote or value) is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation.
In particular, the concern in the ruling was the deemed acquisition of USCo stock in the F reorganisation. Under § 7874(c)(2), certain stock of the foreign corporation is not taken into account in determining ownership for this purpose. This includes stock of the foreign corporation held by members of the foreign corporation's expanded affiliated group and stock of the foreign corporation sold in a public offering related to the acquisition. Under the regulations, stock issued for cash in a private placement is also not taken into account.
The IRS ruled that the shares issued by IPOCo in the IPO and the private placement would not be included in the denominator of the ownership fraction. This left only the stock deemed issued in the F reorganisation. In the key ruling, the IRS held that the IPOCo shares treated as issued in exchange for the shares of USCo in the F reorganisation would be excluded from the ownership fraction under the expanded affiliated group exception.
As a result, held the IRS, the ownership fraction would be zero over zero. Accordingly, the 80% requirement would not be satisfied. IPOCo would not be treated as a US corporation under § 7874, and other possible § 7874 penalties would not apply.
A ruling should not have even been necessary here, but §?7874 left some doubt as to its application in this routine transaction. Indeed, the financing transaction easily could have run afoul of § 7874. Expanded affiliated group status was crucial: FS-1 had to continue to own more than 50% of IPOCo. This placed a limit on the number of shares that could be issued in the private placement and the IPO. Also, there could not be a third-party owner of FS-2/IPOCo at the beginning and end of the transaction. If there were, the expanded affiliated group rules would not have saved the day.
Clearly § 7874 is important. It could be argued that it has no place in the Internal Revenue Code and/or that it is way too broad. Both are reasonable arguments. But § 7874 is in the IRC, and it must be considered.
Jim Fuller (email@example.com) and David Forst (firstname.lastname@example.org)
Fenwick & West
Tel: +1 650 335 7205; +1 650 335 7274