IRS Pronouncements Tighten Rules Surrounding Foreign Transactions

Editor’s Note: This blog is part two of a two-part blog series on corporate tax inversion. Read part one to explore the benefits and costs of tax inversions.

As foreign countries continue reducing their tax rates, the pressure is on domestic companies to either repatriate foreign earnings through complex transactions or consider inversion. The Internal Revenue Service (“IRS”) recently issued two notices that tighten the rules surrounding any cross-border transaction that could be perceived as abusive.

IRS Notice 2014-32

Earlier this year, the IRS issued Notice 2014-32, which altered and clarified regulations under section 367(b), relating to taxation of cross-border triangular reorganizations. Historically, former U.S. shareholders of a U.S. target (UST) would acquire the majority of the foreign parent’s stock, thereby successfully inverting. From the taxpayer’s position, there would be no gain recognized by the former U.S. shareholders of the UST on the exchange of UST stock for the foreign parent’s stock. Under existing section 367(b) regulations, UST shareholders could avoid US taxation if the parent was foreign.

Notice 2014-32 specified that the regulations will close this loophole for potential inversions and impose tax on the U.S. shareholders of the UST.

IRS Notice 2014-52

In Q3, the IRS issued Notice 2014-52 to take “targeted action to reduce the tax benefits of—and when possible, stop—corporate tax inversions.” Notice 2014-52 specifically focuses on two actions:

1. Stop Inversion Transactions: The Notice makes it more difficult for U.S. entities to invert by strengthening the requirement that the former owners of the U.S. entity own less than 80% of the new combined entity. In particular, the Notice:
1. Limits the ability to count passive assets that are not part of the entity’s daily business functions that could be used to inflate the new foreign parent’s size, and therefore, avoid the 80% rule;
2. Disregards stock of the foreign parent attributable to passive assets in the context of the 80% requirement, which would apply if at least 50% of the foreign corporation’s assets are passive;
3. Prevents U.S. companies from reducing their size pre-inversion by making extraordinary dividends, and
4. Prevents a U.S. entity from inverting a portion of its operations by transferring assets to a newly formed foreign corporation that it is spun off to its shareholders—a practice known as “spinversion.”
   
   
2. Make Post-Inversion Transactions Taxable: The Notice tightens the rules by making previously non-taxable post-inversions transaction taxable and, thus, making inversions themselves less attractive foe taxpayers.  
1. Limits “Hopscotch” Loan Applications: The Notice prevents inverted companies from accessing a foreign subsidiary’s earnings through the use of loans, which are known as “hopscotch” loans. Currently, if a controlled foreign corporation (“CFC”) makes a loan to its U.S. parent, the U.S. parent is treated as if it received a taxable dividend from the CFC. However, some inverted companies have the CFC make the loan to the new foreign parent instead of its historical U.S. parent. The “hopscotch” loan made to the new foreign parent is not “U.S. property” and is not taxed as a dividend to the historical US parent. The Notice removes benefits of these “hopscotch” loans by providing that such loans are considered “U.S. property.” The same dividend rules now apply as if the CFC had made a loan to the U.S. parent prior to the inversion.
2. Prevents De-Control of the CFC: The Notice prevents inverted companies from restructuring a foreign subsidiary to access the subsidiary’s earnings tax-free. After an inversion, some U.S. companies avoid U.S. tax on the deferred earnings of their CFCs by having the new foreign parent buy enough stock to take control of the CFC away from the former U.S. parent. This “de-controlling” strategy allows the new foreign parent to access the deferred earnings of the CFC without ever paying U.S. tax on them. Under the Notice, the new foreign parent is treated as owning stock in the former U.S. parent, rather than the CFC. The CFC would remain a CFC whose profits and deferred earnings would continue to be subject to U.S. tax. .
3. Prevents the Affirmative Use of Section 304 Transactions: The Notice prevents inverted companies from transferring cash or property from a CFC to the new parent to completely avoid U.S. tax. These transactions involve the new foreign parent selling its stock in the former U.S. parent to a CFC with deferred earnings in exchange for cash or property of the CFC, effectively resulting in a tax-free repatriation of foreign cash or property bypassing the U.S. parent. The Notice eliminates the ability to use this strategy.

Notice 2014-52 also announced that the Treasury and IRS are considering additional guidance to address inversions, particularly U.S. base erosion. 

For more guidance on either Notice 2014-32 or Notice 2014-52, contact Elena Mossina, partner-in-charge of international tax at Sikich.