US Senator Levin introduces bill to tighten inversion rules under Section 7874

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1 2 June 2014 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date US Senator Levin introduces bill to tighten inversion rules under Section 7874 Executive summary On 20 May 2014, Sen. Carl Levin (D-MI) introduced The Stop Corporate Inversions Act of 2014 (the Bill), which is intended to significantly expand the scope of transactions subject to the anti-inversion rule of Section The Bill introduces a new category of foreign corporations that would be treated as domestic for US federal tax purposes under Section 7874(b). Specifically, the Bill would treat as domestic any foreign corporation that acquires substantially all the properties held directly or indirectly by a domestic corporation or substantially all the properties (or substantially all the properties constituting a trade or business) of a domestic partnership, and either: (1) more than 50% of the stock of the foreign corporation is owned by former shareholders or former partners of the domestic entity by reason of their interests in the domestic entity; or (2) the foreign acquiring corporation has significant domestic activities and its mind and management is primarily in the United States. The effective date of the Bill is retroactive to 8 May 2014, and will sunset two years after that date. According to Sen. Levin, the two-year sunset is intended to give Congress time to consider a long-term solution as part of general corporate tax reform. 1 The Bill is substantially similar to an international proposal in President Obama s FY 2015 Budget Proposal (the Green Book), and legislation proposed in the House of Representatives by Rep. Sander M. Levin (D-MI). 2 Neither the Green Book nor the House bill, however, provide for a sunset. Background The current application of Section 7874 depends upon whether a foreign acquiring corporation is treated as a surrogate foreign corporation with respect to a domestic corporation or partnership. Under Section 7874, a foreign acquiring corporation will be treated as a surrogate foreign corporation if the following three tests are all met:

2 The foreign acquiring corporation acquires substantially all of the properties held directly or indirectly by a domestic corporation (or that constitute the trade or business of a domestic partnership) (the Acquisition Test) 3 After the acquisition, at least 60% of the stock (by vote or value) of the foreign acquiring corporation is held by the former shareholders of the domestic corporation or partners in the domestic partnership by reason of holding an interest in the domestic corporation or partnership (the Ownership Test) 4 The EAG that includes the foreign acquiring corporation does not have substantial business activities in the foreign country where the foreign acquiring corporation is created or organized compared to the total business activities of the EAG (the Substantial Business Activities Test) 5 The EAG has sufficient substantial business activities in the country of incorporation of the foreign acquiring corporation only if at least 25% of the group employees (by headcount and compensation), group assets, and group income are located or derived in the relevant foreign country. 6 If each of these tests of surrogate foreign corporation status are satisfied and the former shareholders (or partners) own less than 80% of the foreign acquiring corporation (by vote or value), the domestic corporation or partnership is treated as an expatriated entity and is subject to Section 7874 s unique taxing regime. 7 If, however, the former shareholders (or partners) own 80% or more of the foreign acquiring corporation, the foreign acquiring corporation will be treated as a domestic corporation for all US federal income tax purposes. 8 Detailed discussion The Bill introduces a new category of foreign corporation subject to domestic corporation treatment under Section 7874(b). Specifically, the Bill would amend Section 7874(b) to treat a foreign corporation as a domestic corporation if it is either a surrogate foreign corporation owned 80% or more by foreign owners of the domestic acquired entity (as under current law) or an inverted domestic corporation. 9 For this purpose, an inverted domestic corporation is a foreign entity that completes, after 8 May 2014, and before 9 May 2016, an acquisition that satisfies the Acquisition Test and either: After the acquisition, the foreign acquiring entity is owned more than 50% by former shareholders (or former partners) by reason of holding stock in the domestic acquired corporation of the stock of the foreign corporation (the Modified Ownership Test) or The management and control of the EAG that includes the foreign entity occurs, directly or indirectly, primarily within the United States, and such EAG has significant domestic business activities (the Management and Domestic Activities Test). 10 The Bill authorizes the IRS to issue regulations regarding when management and control of an EAG occurs directly or indirectly, primarily within the United States. 11 Such regulations will provide that the management and control of an EAG is treated as occurring, directly or indirectly, primarily within the United States if substantially all of the executive officers and senior management of the EAG who exercise day-to-day responsibility for making decisions involving strategic, financial, and operational policies of the EAG are based or primarily located within the United States. 12 For this purpose, executive officers and senior management include individuals who in fact exercise such day-to-day responsibilities, regardless of their title. 13 Such regulations will be effective for periods after 8 May For purposes of determining whether a foreign entity has significant domestic business activities, the Bill incorporates the four conditions of the Substantial Business Activities Test articulated in Treas. Reg. Section T, except that the Bill uses a disjunctive test rather than the conjunctive test of the current regulations. The Bill would also bifurcate the group employee condition into two conditions. Thus, only one of four conditions would need be satisfied for a foreign corporation to be treated as having 2 International Tax Alert

3 substantial business activities. As such, an EAG will have significant domestic business activities if at least 25% of: (A) The employees of the EAG are based in the United States (B) The employee compensation incurred by the EAG is incurred with respect to employees based in the United States (C) The group s assets are located in the United States or (D) The group s income is derived in the United States 15 These threshold requirements are determined in the same manner as the determinations made under Treas. Reg. Section T, except that references to foreign country and relevant foreign country are treated as references to the United States. Further, the Bill authorizes the IRS to issue regulations that would decrease the threshold percentages below 25 percent for purposes of determining whether a foreign corporation has significant domestic business activities. The Bill, however, would provide an exception from inverted domestic corporation status if, after the acquisition, the EAG that includes the foreign acquiring corporation has substantial business activities in its country of incorporation, as determined under Treas. Reg. Section T (i.e., 25% of gross assets, income, and employees). 16 However, the Bill authorizes the IRS to issue regulations that would increase the threshold percentage in any of the tests for purposes of testing whether a foreign corporation is an inverted domestic corporation within the meaning of Section 7847(b)(2). 17 Implications According to Sen. Levin, the Bill is intended to create a moratorium on corporate inversions until Congress can complete the greater task of comprehensive tax reform. 18 At the same time, Sen. Levin himself has noted, There is no comprehensive tax reform legislation pending in either chamber of Congress. There is no debate scheduled. There is, in fact, not a single comprehensive tax reform proposal that has been formally introduced as legislation. 19 While the Bill is intended to stop what it characterizes as abusive inversions, concern exists that its broad scope may cause it to apply beyond its intended target and may limit many combinations of unrelated US and foreign corporations. The Management and Domestic Activities Test, in particular, could result in the forced domestication of a foreign corporation upon the acquisition of a domestic target (even a domestic target of minimal value), which could have the unintended effect of reducing inbound investment into the United States. Under the Bill, a foreign corporation s acquisition of substantially all of the assets of a domestic target necessitates the application of the inverted domestic corporation test of Section 7874(b)(2). If, before the acquisition, the foreign corporation has significant US business activities and its mind and management primarily resides in the United States, the acquisition of any domestic target, regardless of its size, could act as a trip-wire for the application of Section 7874(b) to that foreign acquiring corporation. The proposed changes to Section 7874 are retroactive to the date of the Bill s introduction. Senator Ron Wyden (D-OR), the chairman of the Senate Finance Committee, has stated that such an approach is not unprecedented, that in fact the committee has taken a retroactive approach in the past. 20 It is unclear whether the Bill, if passed into law, would retain its retroactive application. International Tax Alert 3

4 Endnotes 1. See Summary of the Stop Corporate Inversions Act of 2014 (20 May 2014) ( newsroom/press/release/summary-of-the-stop-corporate-inversions-act-of-2014#sthash.ijomfgof.dpuf) (the Bill Summary). 2. H.R { LEVIN_013_xml.pdf} 3. Section 7874(a)(2)(B)(i). 4. Section 7874(a)(2)(B)(ii). 5. Section 7874(a)(2)(B)(iii). The EAG is defined by reference to consolidated return Section 1504(a) affiliation, but includes foreign corporations and applies at a more than 50% level. See Section 7874(c)(1). 6. See Treas. Reg. Section T(b). 7. See, e.g., Section 7874(e). Section 4985 could also apply and result in the imposition of an excise tax on certain shareholders of the domestic entity. 8. Section 7874(b). 9. Proposed Section 7874(b)(1) and (2). 10. Proposed Section 7874(b)(2)(A) and (B). 11. Proposed Section 7874(b)(4)(A). 12. Proposed Section 7874(b)(4)(B). 13. Id. 14. Proposed Section 7874(b)(4)(A). 15. Proposed Section 7874(b)(5). 16. Proposed Section 7847(b)(3). 17. Id. 18. See Bill Summary. 19. See Levin Senate floor statement on the Stop Corporate Inversions Act (20 May 2004). { senate.gov/newsroom/speeches/speech/levin-senate-floor-statement-on-the-stop-corporate-inversionsact#sthash.p0oj8y7u.dpuf}. 20. See Andrew Velarde, Inversion Rule Tightening to Wait for Tax Reform, Wyden Says, 2014 TNT 98-1, 20 May 2014, 2014, Tax Analysts. 4 International Tax Alert

5 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services Jose Murillo, Washington, DC Steven Surdell, Chicago Ernst & Young LLP, Transaction Advisory Services Gary Scanlon, Chicago International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Central Mark Muktar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City South America Alberto Lopez, New York 5 International Tax Alert

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