Final IRS rules on corporate inversions maintain tight standards for “substantial business activities”
The IRS has issued final regulations on corporation inversions, which are a type of transaction by which a U.S. corporation reincorporates in a foreign jurisdiction by replacing the U.S. parent with a foreign parent. Inversions have proved controversial, with many lawmakers and policy makers criticizing them as vehicles for large businesses to evade U.S. taxes.
In some cases the inversion transaction can be legitimate if, for example, it has substantial business activities in the foreign country. The IRS’s newly finalized guidance affirms the government’s tight standards for determining whether a corporate group has substantial business activities in a foreign country. In general, the final regulations adopt without substantial changes the 2012 temporary regulations that require 25 percent of the corporate group’s employees, assets, and income to be connected to the country of the group’s foreign parent. The final regulations apply to acquisitions completed on or after June 3, 2015.
According to the Obama administration and other lawmakers, some U.S. corporations have escaped U.S. taxes by incorporating a foreign parent to head a multinational group. By having a foreign parent, foreign subsidiaries would avoid U.S. taxes, and the group could claim certain tax benefits (such as interest deductions and “earnings stripping”) to reduce taxes on U.S.-source income, the administration reported.
Criticism has increased in recent years after a number of large U.S. pharmaceutical companies announced inversions or attempted to plan one. As such, the government has taken an active role in attempting to curb the practice. Recently, for example, the IRS issued administrative guidance (Notice 2014-52) intended to reduce some of the benefits of inversions.
Substantial business activities
Temporary regulations adopted in 2006 provided a facts and circumstances test for determining substantial business activities. Temporary regulations adopted in 2009 retained the facts and circumstances test, but eliminated examples and a 10-percent safe harbor that were in the 2006 regulations. The government then issued temporary regulations in 2012 that removed the facts and circumstances test and replaced it with a 25-percent bright-line test for the employees, assets and income of the expanded affiliated group (EAG) (the group that includes the foreign parent and the U.S. subsidiary).
Changes in final regulations
The IRS has clarified that an entity is not a member of the EAG unless it is an EAG member on the “acquisition date” of the inversion. However, members of an EAG are determined by considering all transactions related to the acquisition, including transactions that occur after the acquisition date.
Under the deemed corporation rule in the 2012 regulations, a partnership is treated as a corporation and a member of the EAG if more than 50 percent of its interests are owned by members of the EAG. In the final regulations, the IRS adopted a look-through rule that, to determine the corporations in the EAG, treats each partner of a partnership as holding its proportionate share of stock held by the partnership.
In applying the 25-percent tests under the existing anti-abuse rules, certain assets, employees or income are excluded from the numerator, but included in the denominator, where the transfer of these items is associated with a plan that has a principal purpose of avoiding Code Sec. 7874. The IRS modified the test to exclude items associated with a transfer of property to the EAG from both the numerator and the denominator. Otherwise, the IRS affirmed the anti-abuse rules.
The test for a group’s assets requires that the asset be physically present in the particular foreign country on the date of the inversion, and that the asset be physically present in that country for more time than in any other country during the prior year. The IRS modified the test so that assets used in transportation do not have to be physically present on the inversion date.