The principal tax-avoidance purpose: a poison pill for inversions?

• Author: Xie, Ning

Much has been written about inversion transactions and recent developments under Sec. 7874, but little is known about how the IRS might use the principal-tax-avoidance-purpose doctrine to challenge an inversion transaction. This item considers possible challenges by the IRS using the principal tax-avoidance purpose under Sec. 7874.

Sec. 7874 Does Not Override Other Code Sections

Sec. 7874 plainly applies in a corporate setting, but it is unclear whether it applies to a foreign partnership. Treasury solicited comments before issuing temporary regulations in 2005, and one commenter argued that Sec. 7874 should not govern a foreign acquiring partnership (T.D. 9238). But Treasury rejected this argument and stated it believed that a taxpayers use of the so-called check-the-box election constituted a principal purpose of tax avoidance. Moreover, the IRS and Treasury even threatened to issue retroactive regulations to address these transactions.

A year later, Treasury again considered the applicability of the check-the-box regulations in an inversion context. This time, commenters primarily argued that

the entity classification rules of [section][section]301.7701-2 and 301.7701-3 are intended to allow taxpayers to choose whether a foreign eligible entity is a corporation or partnership for Federal income tax purposes, and section 7874(b) does not impinge on that freedom of choice, but only deems a foreign corporation to be a domestic corporation. [T.D. 9265]

Treasury conceded that this entity-classification argument had "a stronger foundation." In the preamble to the 2006 regulations, the IRS and Treasury "recognize[d] that the use of a foreign partnership that is not publicly traded, or the use of a domestic partnership, to acquire the properties of a domestic corporation might enable taxpayers to avoid the purposes of section 7874 in certain cases" (T.D. 9265).

It seems, therefore, that the principal-tax-avoidance-purpose doctrine under Sec. 7874 should not prevail when this doctrine conflicts with other existing Code sections, unless Congress expressly states otherwise. This is significant for tax planning because taxpayers may rely on other sections to insulate their structure from Sec. 7874. In other words, as long as a transaction does not technically trigger Sec. 7874, then the principal-tax-avoidance-purpose doctrine should not disturb the transaction.

Valid Business Purpose Is Not Enough to Defend a Transaction That Is Technically...