IRS issues additional guidance on Sec. 7874 inversions.

• Author: Karges, Martin H.

Sec. 7874 was enacted in 2004 to combat certain expatriations of U.S. companies to foreign (and presumably low-tax) jurisdictions (hereafter referred to as "inversions"). Treasury and the Service continue to expand the guidance on this Code provision; see Karges and Hendon, Tax Clinic, "Corporate Inversions and the Affiliated-Owned Stock Rule," TTA, May 2006, p. 269. New proposed and temporary regulations provide welcome clarifications as to what constitutes a "surrogate foreign corporation"; see REG-112994-06 and TD 9265 (both dated 6/5/06).

The new temporary and proposed regulations address the exception for "substantial business activities" in the foreign country, for purposes of determining whether the foreign entity is treated as a surrogate foreign corporation. under Sec. 7874(a)(2)(B). The new rules also attempt to clarify the meaning of "indirect acquisition" of properties and ownership "by reason of" holding stock in the domestic corporation (or an interest in the domestic partnership). In addition, the new regulations contain anti-abuse provisions to target the use of publicly traded foreign partnerships, options and similar interests to avoid Sec. 7874.

General Principles

Under Sec. 7874(a)(2)(B), a corporate inversion may generally occur when three requirements are met:

1. A foreign corporation acquires (directly or indirectly) substantially all of the properties of a domestic corporation (or the trade or business of a domestic partnership);

2. After the acquisition, at least 60% of such foreign corporation's stock (determined by vote or value) is held by the domestic corporation's former shareholders (or the domestic partnership's former partners) "by reason of" holding stock in the domestic corporation or an interest in the domestic partnership; and

3. After the acquisition, the expanded affiliated group (EAG) (which includes the foreign acquirer) does not have substantial business activities in the acquirer's country of incorporation, when compared to the total business activities of such EAG.

The result of such an "inversion" is that the foreign acquiring company becomes a surrogate foreign corporation with respect to the domestic corporation or partnership that is the expatriated entity. The tax treatment of the surrogate foreign corporation varies, depending on the level of shareholder continuity. If the percentage of stock (by vote or value) in the surrogate foreign corporation held by former shareholders is 60% or more...