On September 22, 2014, the Internal Revenue Service (the “IRS”) and the Treasury Department (the “Treasury”) issued Notice 2014-52 (the “Notice”) announcing that the Treasury and the IRS intend to issue regulations that will address inversion transactions and certain post-inversion transactions that the IRS and the Treasury characterize as tax avoidance transactions. According to the Treasury, the forthcoming regulations are intended to reduce the potential tax savings that could be extracted from inversion transactions and generally tighten the rules on cross-border mergers. The Notice is generally applicable to acquisitions completed on or after September 22, 2014 (even if completed pursuant to an agreement in place prior to that date), and to certain transactions completed on or after that date where the inversion transaction is also completed on or after that date.
The Notice describes regulations the IRS and Treasury intend to issue with respect to two categories:
- Limiting for ten years after the inversion the new foreign parent’s ability to access earnings of controlled foreign corporations (“CFC”) by:
- Preventing inverted companies from accessing earnings of existing CFCs using “hopscotch” transfers or using “de-controlling” transactions.
- Preventing tax-free transfers of property or cash from a CFC to the new foreign parent in certain Section 304 transactions.
- Limiting the ability of U.S. corporations to satisfy the ownership threshold necessary for an expatriation to be respected by:
- Limiting the ability of a U.S. corporation to invert with a foreign corporation that has substantial liquid assets (e.g., so-called “cash boxes”).
- Limiting the ability of U.S. corporations to satisfy the various ownership tests by making “skinny-down” distributions (including a per se test for Section 7874 and an anti-“skinny-down” rule for Section 367).
- Limiting the ability of U.S. corporations to take advantage of the internal group restructuring exception to engage in what the IRS calls “spinversions”.
The Notice is generally targeted at “inversion transactions,” defined by the Notice as effectively those cross-border combinations where stock holders of the U.S. party end up holding between 60 percent and 80 percent of the combined entity, with some exceptions noted below. The scope of the Notice could make “mergers of equals” relatively more attractive.
The Notice does not change the 80 percent ownership threshold required for an “inverted corporation” not to be treated as a domestic corporation, does not modify the “substantial business activities” exception, and does not specifically address “earnings stripping” through additional leverage. However, the IRS and Treasury reserved further action on the last point, and specifically stated their expectation that, “to the extent any tax avoidance guidance applies only to inverted groups, such guidance will apply to groups that complete inversion transactions on or after September 22, 2014.”
Section 7874 generally targets “expatriation” transactions in which a foreign corporation or publicly traded foreign partnership acquires substantially all of the assets of a U.S. corporation or partnership (including by way of acquiring the ownership interests in such corporation or partnership) unless such foreign entity has “substantial business activities” in the jurisdiction of its organization. Whether Section 7874 applies to a transaction therefore depends on the percentage of the foreign entity that is held by the U.S. Stockholders (as defined below) (the “Ownership Fraction”). We refer to these ownership requirements as the “Ownership Condition”.
If at least 80 percent (by vote or value) of the foreign acquiring corporation is held by the former shareholders or partners of the expatriated U.S. entity “by reason of holding” stock or a capital or profits interest in the expatriated entity (the “U.S. Stockholders”) and the “substantial business activities” test is not satisfied, the foreign acquiring corporation is treated as a domestic entity for U.S. tax purposes.
If at least 60 percent (by vote or value), but less than 80 percent, is held by the U.S. Stockholders and the “substantial business activities” test is not satisfied, the foreign acquiring corporation is respected as foreign, but is subject to various tax disadvantages, including U.S. tax on any “inversion gain” recognized in the ten years following the transaction. The majority of announced transactions that are reported in the media as “inversion transactions” fall within this range, and these are also the “inversion transactions” that are the focus of the Notice.
If less than 60 percent (by vote or value) of the foreign acquiring corporation is held by the U.S. Stockholders, the transaction is considered an acquisition of a U.S. corporation by a foreign corporation and Section 7874 does not apply.
The Notice describes new regulations that the IRS and Treasury intend to issue with respect to post-inversion transactions intended to permit access to CFC’s earnings that have been deferred offshore and not subject to U.S. tax and the application of the Ownership Condition as follows:
A. LIMITING FOR TEN YEARS AFTER THE INVERSION THE NEW FOREIGN PARENT’S ABILITY TO ACCESS THE EARNINGS OF CFCs AFTER THE INVERSION
1. Prevent Inverted Companies from Accessing Earnings of Existing Controlled Foreign Corporations Using “Hopscotch” Transfers
Under current law, a shareholder of a foreign corporation (including a CFC) generally defers recognition of current U.S. tax on its pro rata share of the CFC’s active business income until that income is repatriated to the U.S. However, Section 956 subjects U.S. shareholders to tax on their pro rata share of the CFC’s deferred profits when the CFC makes investments in certain U.S. property. The Notice observes that, under current law, an inversion transaction may permit the new foreign parent of the group (a group that still consists of U.S. shareholders and their CFCs) to circumvent Section 956 and access the CFC’s profits. For example, a CFC may make a loan directly to the new foreign parent (a so-called “hopscotch” loan), which, under current law, is not subject to the rules of Section 956. According to the Notice, the IRS and Treasury intend to issue regulations that will provide (solely for purposes of Section 956) that any obligation or stock of a foreign related person acquired by a CFC within 10 years after the inversion will be treated as U.S. property and, thus, will give rise to taxable income to the U.S. parent.
2. Prevent “De-controlling” of Controlled Foreign Corporations
According to the Notice, inversion transactions facilitate the avoidance of Section 956 through additional techniques, such as the “de-controlling” strategy where, for example, the new foreign parent transfers property in exchange for more than 50 percent of the CFC, with the result that the CFC ceases to be controlled by its previous U.S. parent and is no longer a CFC. As a consequence, the profits of the former CFC are available to its new non-U.S. shareholders without being subject to U.S. tax, and the U.S. shareholders no longer recognize income under the CFC rules. According to the Notice, subject to some limited exceptions, the IRS and Treasury intend to issue regulations that will recharacterize such transactions in such a way that the new foreign parent will be treated as if it owns recharacterized instruments in the U.S. parent (rather than the CFC) and the U.S. parent will continue to own the CFC. Consequently, the CFC status of the foreign subsidiary will be maintained and the U.S. parent will continue to be subject to U.S. tax on the CFC’s income under the CFC rules.
The new regulations will also expand the circumstances in which an exchanging U.S. corporation will be required to include income in certain nonrecognition transactions that dilute a U.S. shareholder’s ownership of a CFC (for example, when the U.S. corporation exchanges the shares of a CFC for stock in another foreign corporation, and after the exchange the U.S. corporation ownership interest is decreased). These regulations will be issued under Section 367(b).
3. Prevent Certain Section 304 Transactions from Accessing the Earnings and Profits of Controlled Foreign Corporations Without Tax
This part of the Notice addresses post-inversion transactions intended to allow the foreign acquiring corporation tax-free access to earnings and profits of a CFC. One example mentioned in the Notice suggests that the foreign acquiring corporation may sell a portion of the stock of the U.S. parent to a wholly owned CFC of that U.S. parent in exchange for property and cash of the CFC. According to the Notice, the Treasury and IRS understand that taxpayers interpret the current rules under Section 304(b)(5)(B) to allow dividends to be sourced from earnings and profits of the CFC under certain circumstances without being subject to U.S. tax. According to the Notice, the Treasury and the IRS intend to issue regulations under Section 304(b)(5)(B) that will prevent such tax-free access to the CFC’s earnings and profits. These regulations will apply as a general matter, whether or not an inversion transaction has taken place.
B. LIMITING THE ABILITY OF U.S. CORPORATIONS TO SATISFY THE OWNERSHIP THRESHOLD NECESSARY FOR AN EXPATRIATION TO BE RESPECTED
The Notice describes regulations that will provide the following three measures in an attempt to make it more difficult for U.S. entities to meet the Ownership Condition:
1. Limit the Ability of a U.S. Corporation to Invert with a Foreign Corporation that has Substantial Liquid Assets
According to the Notice, the IRS and Treasury are aware that taxpayers may be pursuing inversion transactions with foreign corporations that have substantial liquid assets that are not used in such foreign corporations’ daily business functions (such as cash or marketable securities). Under Section 1.7874-4T of the Treasury Regulations, promulgated as of January 16, 2014, stock attributable to such liquid assets do not affect the Ownership Fraction as long as they are not acquired in transactions related to the inversion transaction and the inversion transaction is structured as a stock (rather than asset) acquisition. Retreating from this recent position, future regulations, according to the Notice, will provide that a ratable share of the stock of a foreign corporation which has at least 50 percent liquid assets will be disregarded for the purpose of determining the Ownership Condition. Assets used in active banking or financing business will not be subject to this rule.
2. Limit the Ability of U.S. Corporations to Satisfy the Various Ownership Tests by Making “Skinny-Down” Distributions
According to the Notice, the IRS and Treasury are aware that a U.S. corporation contemplating an inversion may decrease its value before the inversion by distributing property to its shareholders in order to reduce the Ownership Fraction. Similarly, in order to avoid the shareholder-level tax under Section 367(a)(1) (which generally imposes tax on U.S. shareholders in cross-border mergers where the U.S. party is larger than its merger partner), a U.S. corporation may distribute property to its shareholders in contemplation of an acquisition.
In order to limit the effectiveness of these distributions (also known as “skinny-down” dividends), the Notice provides that under future regulations, the U.S. corporation’s non-ordinary course distributions (defined as the excess of all distributions during a taxable year over 110 percent of the average of distributions in the 36-month period immediately preceding such taxable year) made during the 36-month period ending on the acquisition date, will be treated as part of a plan the principal purpose of which is to avoid the application of Section 7874, and, thus, will be disregarded for purpose of this section. Such distributions include share buybacks, Section 355 spin-offs, and certain other transactions. Note that the “36-month” per se rule implemented by these regulations will treat as part of a plan transactions that (based on the facts and circumstances) could be otherwise unrelated to the inversion transaction.
Separately, future regulations will provide a similar rule to “skinny-down” distributions under Section 367(a), apparently even where the combination does not fall within the 60-80 percent range of an inversion transaction.
3. Limit the Ability of U.S. Corporations to Take Advantage of the Internal Group Restructuring Exception
Under the current rules, stock of the foreign acquiring corporation is not taken into account in determining whether the Ownership Condition is satisfied when stock of the foreign acquiring corporation is held by members of the “expanded affiliated group” (“EAG”) that includes the foreign acquiring corporation. According to the Notice, in cases where a U.S. parent contributes the stock of a U.S. subsidiary to a newly formed foreign subsidiary, followed by a spin-off of the shares of the foreign subsidiary (what the Notice calls a “spinversion”), taxpayers have taken advantage of the internal group restructuring exception in order to avoid being subject to Section 7874. According to the Notice, future regulations will prevent this practice by providing that the stock of the spun-off foreign corporation will not be treated as held by a member of the EAG.
The new regulations will include exceptions for such transactions: one exception applies to “U.S.-parented groups” and the other exception applies to “foreign-parented groups.” In general, the U.S.-parented group exception applies to transfers of stock of the foreign acquiring corporation that remain within the U.S.-parented group. The foreign-parented group exception is broader, applying not only to transfers of stock of the foreign acquiring corporation that remain within the foreign-parented group, but also to transfers of stock of the foreign acquiring corporation outside the foreign-parented group, subject to the restriction generally that the EAG rules would have applied had the foreign-parented group not transferred any stock of the foreign acquiring corporation outside the group (including stock of the foreign acquiring corporation received in the acquisition and other stock of the foreign acquiring corporation held by the foreign-parented group).
SCOPE AND EFFECTIVE DATE
According to the Notice, the regulations will generally apply to transactions completed on or after September 22, 2014 (even if completed pursuant to an agreement in place prior to that date). In addition, the regulations with respect to “hopscotch” transfers and de-controlling of CFCs (as described in sections A(1) and A(2) above, respectively), will apply to transactions completed on or after September 22, 2014, but only if the inversion transaction is also completed on or after that date.
The Notice states that the Treasury and IRS expect to issue additional guidance to further limit inversion transactions that are contrary to the purposes of Section 7874 and the benefits of post-inversion transactions. According to the Notice, the Treasury and the IRS are particularly considering guidance to address “earning stripping”, including through intercompany debt. While the Notice asserts that such future guidance will apply prospectively, the Notice also states that the Treasury and the IRS expect that any tax avoidance guidance that will apply only to inverted groups, will apply to groups that completed the inversion on or after September 22, 2014.
 A CFC is any foreign corporation where more than 50 percent of its stock (by vote or value) is owned by “U.S. Shareholders.” For purposes of the CFC definition, a “U.S. Shareholder” is any U.S. citizen, resident or domestic entity who owns (taking into account attribution and constructive ownership rules) 10 percent or more of the combined voting power of all classes of stock entitled to vote of such foreign corporation. See Sections 957(a) and 951(b).
 A foreign entity will have “substantial business activities” in the relevant foreign country after the acquisition only if at least 25 percent of the employees, assets, and income of the foreign entity are located in, or in the case of income, derived from, that relevant foreign country. See Treasury Regulation Section 1.7874-3T(b).
 For ease of reference, we will refer to all such interests as “stock.”
 See Section 7874(b). For additional background on Section 7874, please see the Sullivan & Cromwell LLP publication entitled “Corporate Expatriation Transactions: IRS and Treasury Issue Regulations on the ‘Substantial Business Activities’ Exception and Finalize Regulations on Surrogate Foreign Corporations Under Section 7874” (June 13, 2012), which may be obtained by following the instructions at the end of this publication.
 “Inversion gain” is any income or gain recognized by reason of the inversion transaction (which includes gain recognized on the transfer or sale of assets to the non-U.S. corporation) and certain gain and licensing income recognized by an expatriated entity during the ten-year period. See Section 7874(d)(2), (f). The U.S. tax on the inversion gain may not be offset by credits, net operating losses or other tax attributes. See H.R. Conf. Rep’t No. 108-755.
 Subject to certain exceptions, Section 367(a)(1) generally requires that a U.S. person who transfers property to a foreign corporation in a transaction that would otherwise qualify for nonrecognition of gain under Sections 332, 351, 354, 356, or 361, would generally recognize gain.
 In general, an “expanded affiliated group” is a group of corporations connected by a chain of at least 50 percent ownership (as measured by vote and value).
The full and original memorandum was published by Sullivan & Cromwell LLP on September 24, 2014, and is available here.