United States Alert - 8 June 2012
Section 7874 regulations issued on substantial business activities
By Jeff O’Donnell and Richard Castanon
On 7 June 2012, the Internal Revenue Service (IRS) and Treasury Department issued new final and temporary regulations under §7874 of the Internal Revenue Code, providing guidance on determining whether a foreign corporation is treated as a surrogate foreign corporation.1 Significantly, the new temporary regulations under §7874 rewrite the rules for qualifying under the substantial business activities exception to §7874, which will have a dramatic impact on the ability of U.S. multinationals to redomesticate outside the U.S.
The final regulations under §7874 (Treas. Reg. §1.7874-2) generally adopt the temporary regulations under §7874 published in June 2009 (T.D. 9453) as final, with only minor clarifying changes. In this regard, the final regulations clarify that a foreign corporation’s acquisition of its own stock from a partnership or another corporation is an acquisition of the transferor’s properties for purposes of §7874(a)(2)(B)(i); thus, for example, a downstream merger of a U.S. corporation or partnership into its foreign subsidiary will be treated as satisfying the acquisition requirement of §7874(a)(2)(B)(i).
The preamble and the final regulations under §7874 do not provide guidance on various open issues raised in the preamble to T.D. 9453, such as divisive §355 transactions, which could remain the subject of governmental consideration and for which guidance thereon may be issued in the future (including potentially with retroactive effect). However, the preamble to the final regulations does indicate that the government will be considering the “plan” issue for when an acquisition of multiple domestic entities by a single foreign corporation will be tested as a single acquisition for purposes of §7874(a)(2)(B)(ii); in the meantime, no change to the temporary rule was made when the §7874 regulation was finalized.
As stated above, the more significant development was the publication of the new temporary regulations under §7874 (Treas. Reg. §1.7874-3T, the “Temporary Regulations”). The Temporary Regulations replace (i) the facts and circumstances test for determining whether a foreign corporation avoided the application of the §7874 rules because the acquiring “surrogate foreign corporation” conducts substantial business activities by it and other members of its expanded affiliate group in its country with (ii) a bright-line test for such activities. Specifically, in applying the substantial business activities requirement for §7874 to an acquisition by a foreign corporation or publicly traded partnership (the “surrogate foreign corporation”), the “expanded affiliated group” of the surrogate foreign corporation (“EAG,” as defined below) must have substantial business activities in the foreign country in which, or under the laws of which, the entity is created or organized, when compared to the total business activities of such EAG. Under the prior 2009 temporary regulations, this test for substantial business activities was done on the basis of all the facts and circumstances, including historic presence, location of management, and the like. As noted, this facts and circumstances test has been eliminated by the Temporary Regulations. Instead, under the new test of the Temporary Regulations, in order to qualify for the substantial business activities exception at least 25% of the EAG’s (i) employees must be based in the foreign country (a percentage requirement for both headcount and compensation); (ii) tangible assets must be located in the foreign country as measured by value; and (iii) income from unrelated customers must be derived in the foreign country.
This new test for substantial business activities is effective for redomestications that are completed on or after 7 June 2012 (except for those completed after that date but pursuant to transactions that are the subject of SEC filings or binding agreements made on or before 7 June 2012).
A foreign corporation is treated as a surrogate foreign corporation under §7874 if pursuant to a plan or series of related transactions: (i) the foreign corporation acquires “substantially all” (an undefined term) of the properties of a U.S. corporation or partnership (“acquisition”); (ii) former owners of the U.S. corporation or partnership acquire 60% or more (by vote or value) of stock of the foreign corporation in exchange for their interests in the U.S. corporation or partnership (disregarding stock owned by members of an expanded affiliated group and stock sold in a public offering related to the acquisition); and (iii) the foreign corporation does not have substantial business activities in its country of incorporation.2 For purposes of §7874, the EAG is an affiliated group under §1504(a), with a 50% threshold, attribution through partnerships and inclusion of foreign corporations.3
If former owners hold at least 80% (by vote or value) of a surrogate foreign corporation by reason of having held interests in the domestic entity, the surrogate foreign corporation is treated as a domestic corporation for all U.S. federal income tax purposes.4 If former shareholders or partners hold at least 60% but less than 80% of a surrogate foreign corporation by reason of having held interests in the domestic entity, the surrogate foreign corporation is treated as a foreign corporation for U.S. federal income tax purposes, but §7874 restricts the use of deductions and credits to shelter “inversion gain” and may impose minimum U.S. taxable income thresholds upon the domestic entity acquired by the surrogate foreign corporation.5
As mentioned above, the 2009 temporary regulations under §7874 had a facts and circumstances test for determining whether a surrogate foreign corporation’s EAG had substantial business activities in the surrogate foreign corporation’s country of incorporation. After consideration of the comments received and the policies of §7874, the IRS and Treasury decided to replace the facts and circumstances test with a bright-line test for substantial business activities. The government’s rationale was that a bright-line rule would provide greater certainty and improved administrability.
Under the bright-line test, as noted, the question is whether the surrogate foreign corporation’s EAG has at least 25% of its (i) employees based in the foreign acquirer’s country of incorporation (requiring the requisite percentage by both headcount and compensation); (ii) tangible assets and real property located in the foreign country measured by value; and (iii) income from unrelated customers derived in the foreign country.
Employee headcount is determined on the “applicable date,” meaning (consistently applied) either (i) the date of the acquisition under §7874(a)(2)(B)(i) or (ii) the last day of the month immediately preceding the date of the acquisition. In other words, a taxpayer can choose either date to see if its facts meet the bright-line test. One determines employee compensation in respect of EAG employees during the “testing period,” meaning the one-year period ending on the applicable date. An employee is considered based in the foreign acquirer’s foreign country only if the employee spent more time providing services in that country than in any other single country during the testing period.
EAG assets are determined by reference to tangible personal property or real property held for use in the active conduct of a trade or business by members of the EAG, provided the property is owned by an EAG member on the close of the acquisition date. An EAG asset is considered located in the acquirer’s foreign country only if physically present in the country on the close of the acquisition date and for more time than in any other country during the testing period. Valuation must be determined consistently and on a gross basis (i.e. without reduction based on liabilities) using either adjusted tax basis or fair market value, translated (if necessary) into U.S. dollars at the spot rate. Tangible property that is rented by EAG members from a person other than an EAG member is treated as an EAG asset, provided that it is used in the active conduct of a trade or business and is being rented by EAG members at the close of the acquisition date. An EAG asset that is rented is valued at eight times the net annual rent paid or accrued with respect to the property by EAG members. The term “net annual rent” means the annual rent paid or accrued with respect to property, less any payments received or accrued from subleasing such property (or other similar arrangement).
EAG income means gross income of EAG members from transactions in the ordinary course of business with customers that are unrelated persons during the “testing period,” i.e. the one-year period ending on the applicable date. The term “unrelated person” is defined using §954(d)(3) principles, except that the provision is applied by substituting “one or more members of the EAG” for “a controlled foreign corporation” and “the controlled foreign corporation” each place they appear. Gross income is translated into U.S. dollars, if necessary, using a weighted average exchange rate for the testing period. EAG income is considered derived in the foreign acquirer’s foreign country only if it is derived from a transaction with a customer located in such country. This rule is important because it prevents businesses from treating income as derived from a country based on the sourcing principles of §861, such as a services business arguing that it derived significant income from a country where services are performed even if the customer is located elsewhere.
In applying the substantial business activities test, if one or more EAG members own, in aggregate, more than 50% (by value) of the interests in a partnership, such partnership will be treated as a corporation that is a member of the EAG. Thus, all items of such a partnership are taken into account; conversely, no items of a partnership are taken into account unless the partnership is treated as a member of the EAG under this special 50% rule.
1The new final (T.D. 9591) and temporary (T.D. 9592) regulations will be published in the Federal Register on 12 June 2012.
4§7874(b). Section 7874 overrides any conflicting provisions contained in current or future treaties. §7874(f).
5§7874(a) and (e).