The US "domestic entity acquisition" ("DEA," aka "inversion") rules must be considered whenever any stock or options of a foreign acquiring corporation ("FA") are issued in a transaction with a US corporation or partnership ("USco") to former USco equity holders. Common settings of unsettling problems are transactions with no thought of engaging in a covered transaction.
Further, awareness of the rules is critical to due diligence regarding a potential later acquisition of an FA, as its foreign status for US tax purposes might be questioned. Similarly, a subsequent acquisition of USco or any US affiliate from FA may have unanticipated consequences under these rules.
To say the rules result in many traps for the unwary is an understatement.
Genesis and Basic Rule
The US Congress became concerned that inversion transactions (which originally were self-inversions in which a foreign holding company was created, but later took the form of "foreign minnow swallowing US whale" acquisition inversions) were a means of inappropriately minimizing US tax. To address these concerns, Congress enacted Section 7874 of the Internal Revenue Code in 2004. Affirmative inversions in the targeted sense have largely disappeared (including due to restrictions on creating internal debt leverage), but the hangover of the DEA rules continues.
Under Section 7874, in general, where USco is acquired by FA and former shareholders or partners of USco, "by reason of" holding shares or partnership interests in USco, own more than 80%, by vote or value, of the stock of FA, then FA is treated as a US corporation for all US federal tax purposes (regardless of income tax treaties). If former USco owners own at least 60% but less than 80% ownership by reason of the USco transfer, then FA is respected as foreign but USco may be subject to certain adverse tax consequences. These tests ("Ownership Test") are governed by unfavorable rules of calculation, noted below.
An exception exists, but rarely can be met in practice, if FA's "expanded affiliated group" ("EAG")1 does not have "substantial" business activities in the non-US country in which FA is organized and tax-resident relative to the total business activities of the post-acquisition EAG. Such activities will be deemed to exist in the relevant foreign country only if at least 25% of the EAG's employees (by number and compensation), tangible and real property, and gross income from unrelated persons are located in or derived from such country.
Typical Scenarios and Traps
The DEA rules typically become applicable in three contexts. One scenario is a strategic acquisition with a substantial stock component, in particular, a "merger of equals," including certain high profile US-Europe combinations. In these transactions, a foreign parent typically is the choice of the parties in the context of the transaction, rather than the result of affirmative shopping for a foreign address. For such transactions, the most important tax planning consideration is relative size: for reasons noted below, keeping ownership of FA by former USco equity owners below 60% is very advantageous. (Successful transactions can occur at 60%-79%, if FA is in a suitable country, the excise tax amount is acceptable and cash repatriation and IP restructuring is not important.) Traps involve the distorted calculation of the Ownership Test, noted below. Restrictions on creating debt leverage under the Section 385 regulations will apply in any event. Lurking in the background of any locational decision today is the promise (or threat) of US tax reform.
A second major setting involves private equity purchases. Though such transactions generally involve purchases for cash, often some stock cannot be avoided. For example, assume a private equity group forms FA that it funds with cash and FA purchases all the equity of USco. Assume USco management held equity in USco and is permitted to roll over into equity of FA (shares and/or options). If the rollover amount results in management holding 5% or more of FA (thus exceeding a de minimis exception), then FA may be treated as a domestic corporation for US tax purposes.
The third category is internal restructurings, perhaps in connection with an IPO or formation of a joint venture. For example, assume a foreign group wants to float 30% of a US company and creates FA as a holding company to offer the shares. Or a US group wants to joint venture with a foreign company and transfers USco to a FA JV co. Or an individual or partnership prefers to hold a USco through a foreign corporation. Each of these cases may result in FA being treated as a domestic corporation for US tax purposes.
Sanctions if 60-79.9% Ownership Continuity
Although 80% ownership of FA by former USco owners is the threshold for generally calamitous treatment of FA as a US corporation, even at the 60% threshold various negative consequences can result. For example, income or gain recognized by USco by reason of the transfer or license of any non-inventory assets to a foreign affiliate during a 10-year period cannot be offset by net operating losses, and the tax cannot be reduced by credits. For this purpose, any US affiliate of USco following the inversion, whether previously owned by the group or subsequently acquired, is subject to the same rules during the 10 year period following the inversion. A purchaser of such an entity may find that the restrictions carry over to its own group.
A second sanction is a 15% excise tax on the value of "specified stock compensation" of insiders held at any point during a 12 month window straddling the transaction date. This tax can apply to non-US insiders and also can apply to grants by FA during the 6 months following the transaction.
Third, Regulations provide various complex rules to prevent repatriation from controlled foreign corporations, and transferring or diluting US ownership of shares or assets.
While not technically a sanction, 60% or greater ownership of FA by former US owners would prevent use of a third country as the tax residence of FA, as noted below.
Thumb on the Scale in Testing Ownership Continuity
The Regulations provide a variety of rules designed to make it more likely that the Ownership Test will be met and result in the anti-inversion sanctions being applied. For example, stock (referred to as "disqualified stock") in FA is disregarded (eliminated from the denominator of the Ownership Test) if issued for liquid assets, or for other assets if intended to avoid the purposes of the statute, in a transaction "related" to the acquisition of USco. For this reason, if a newly formed FA acquires USco in exchange for equity interests in excess of a 5% de minimis amount, the anti-inversion sanctions generally will apply.
Further, if more than 50% of the gross value of the FA group's property constitutes cash, marketable securities and certain other types of assets, a corresponding portion of the FA stock is excluded from the denominator of the Ownership Test (thereby increasing the ownership percentage of the former owners of USco).
Moreover, FA shares issued to former shareholders of a USco in a previous acquisition that closed within 36 months of the date a current acquisition is signed are excluded (eliminated from the denominator) for purposes of the Ownership Test of the current acquisition. The result again is an increase in the ownership percentage of the former owners of USco. And the current acquisition, even if not crossing the Ownership Test, will be backed out of the size of FA for testing a future acquisition within the 36 month period.
Even more dramatically, if USco and the foreign merger partner decide to organize FA in a third jurisdiction, then the shares of FA issued to the owners of the foreign merger partner generally are disregarded under the Ownership Test.
In addition to the above rules potentially reducing the size of FA for purpose of the Ownership Test, the "non-ordinary course distribution" ("NOCD") rules may increase the size of USco for purposes of the Ownership Test. NOCDs made by USco (or a predecessor) during the 36-month period ending on the acquisition date are disregarded (subject to a de minimis rule), such that additional shares of USco are deemed to be outstanding immediately before the acquisition in an amount corresponding to such disregarded NOCDs. For this purpose, NOCDs mean the excess of all distributions made during a taxable year within the 36 month period by USco with respect to its stock over 110 percent of the average of such distributions during the thirty-six month base period immediately preceding such taxable year. A distribution means any distribution, regardless of whether it is taxable or not or whether it is a spin-off (demerger), or a distribution in redemption of stock.
In conclusion, attention to the DEA rules should be paid whenever equity interests in a US entity are transferred for equity in a non-US company.
- IRC § 7874(c)(1) defines EAG as, in essence, a group of corporations, whether US or foreign, connected by more than 50% ownership measured by both vote and value.