2015 In Review: Tax Regulators Attempt To Strike Back

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1 Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY Phone: Fax: In Review: Tax Regulators Attempt To Strike Back Law360, New York (January 4, 2016, 4:20 PM ET) -- Alan S. Kaden Michael J. Alter Among the many significant tax headlines in 2015, two are particularly noteworthy. First, the government put the brakes on two categories of high-profile spinoffs just as the spin cycle accelerated to a velocity not experienced since the mid-1990s. And second, desperate to construct additional roadblocks to inversion transactions, the government released its second notice on the topic in as many years. We recap these developments below. Braking the Spin Cycle In mid-september, the IRS shook up the spinoff world, announcing, in Notice and Rev. Proc , a moratorium on spinoff private letter rulings when either the distributing corporation or the controlled corporation holds a relatively small active trade or business or significant investment assets. The pronouncements seemed to target specific high-profile transactions such as Yahoo s proposed spinoff of its stake in Alibaba and the opco/propco real estate investment trust (REIT) spinoff structure that had gained favor among corporations with significant real estate assets, such as hospitality and gaming companies. Less than a week prior to issuance of Notice and Rev. Proc , Yahoo announced that the IRS had declined to issue it a private letter ruling blessing its proposed spinoff of its 384 million shares of Alibaba stock (fair market value, at the time of announcement, approximately $40 billion) and its smallbusiness division. Shortly thereafter, the IRS explained its rationale. In Notice , the IRS announced that it is most concerned about transactions that result in the distributing corporation or the controlled corporation owning a substantial amount of cash, portfolio stock or securities, or other investment assets in relation to the value of all of its assets and its active trade or business assets. Such investment asset-rich spinoffs may (1) fail certain of Section 355 s core

2 requirements in particular, the requirements that the spinoff not represent a device to distribute earnings and profits, be undertaken for a valid corporate business purpose, and involve the separation of entities each engaged in one or more active businesses and (2) contravene the policy behind the General Utilities repeal. The announcement represented a dramatic reversal of or at least an intent to reconsider prior ruling policy regarding these types of transactions (see, e.g., PLR , approving the spinoff of a corporation the principal asset of which was a large stake in a publicly traded corporation), as well as the IRS s audit and litigation strategy. Undeterred, Yahoo quickly announced that it intended to proceed with its proposed spinoff on the basis of a will -level opinion of counsel, apparently willing to risk a potential showdown with the IRS over billions of dollars of tax. Shareholder unrest over the potential tax liability ultimately led Yahoo to reverse the direction of the spinoff (reducing the potential tax liability but not alleviating any of the concerns outlined in Notice ). Taxpayers and practitioners anxiously await the government s next move with respect to small active trade or business and investment asset-rich spinoffs. The IRS believes similar concerns exist when one of the corporations party to a spinoff promptly elects REIT status. In each of a handful of high-profile transactions, a corporation with significant real estate assets succeeded in separating those assets from its active business in a tax-free transaction. However, the corporations remained tethered, as the corporation conducting the active business continued to control the real estate through a long-term lease from the now-separated real estate company. The end result was that, by then making a REIT election, the real estate company was no longer subject to corporate tax on its income (lease payments it receives), significantly lowering the effective tax rate of the previously combined enterprise. Penn National Gaming Inc. blazed the trail for these opco/propco structures in 2013 by contributing many of its casino properties to a newly formed corporation, propco, and then distributing all of the shares of propco to its shareholders. Prior to the distribution, propco leased most of its properties back to Penn, opco, pursuant to a long-term triple-net lease agreement; after the distribution, propco elected REIT status. In conjunction with the IRS s increasingly permissive views on qualifying REIT assets, government approval of this transaction in private letter ruling led several other companies (including Windstream and Darden) to proceed with their own opco/propco spinoffs. Others (including McDonald s and Sears) were reported to have considered it. The momentum behind the opco/propco structure hit a speed bump when the IRS announced, in Notice , that the structure raised significant concerns under current law and, in Rev. Proc , that no rulings would be issued while the IRS studied the area. In a move that left many practitioners befuddled, the IRS subsequently issued a favorable opco/propco private letter ruling to Darden on its spinoff of many of its restaurant properties into a REIT. The new no-rule policy did not technically apply to Darden due to a grandfathering provision in Rev. Proc , but the same provision did not stop the IRS from declining to issue Yahoo a favorable ruling. The Protecting Americans From Tax Hikes Act of 2015 (PAFTHA), enacted on Dec. 18, 2015, as part of an omnibus appropriations bill, slams the door on opco/propco spinoffs by (1) prohibiting REIT elections by the distributing or controlled corporation for 10 years following a tax-free spinoff, and (2) denying taxfree treatment to spinoffs in which the distributing or controlled corporation (but not both) is an REIT. An exception permits an REIT to effect a tax-free spinoff of a taxable REIT subsidiary (TRS) of which the REIT has owned 80 percent for at least three years, assuming both the REIT and the TRS have been an

3 REIT and a TRS, respectively, for at least three years. The PAFTHA rules regarding opco/propco spinoffs apply to any distribution not described in a ruling request submitted to the IRS on or before (and still pending as of) Dec. 7, Third-Country Inversions The pace of inversion transactions, in which a foreign corporation acquires a U.S. company, with the shareholders of the U.S. company typically receiving a controlling stake in the combined company, remained steady in 2015 despite efforts by the government to make such transactions less available and less attractive to would-be inverters. On Nov. 19, 2015, the Treasury and the IRS released Notice (the 2015 notice ), the sequel to the tax regulators 2014 effort (Notice , or the 2014 notice ). The IRS has already announced that regulations reflecting these notices and more are forthcoming. Section 7874 of the Internal Revenue Code, the government s primary anti-inversion weapon, provides that if a foreign corporation that does not have substantial business activities in its home country (an exceedingly difficult standard to satisfy) acquires a U.S. company, and the shareholders of the U.S. company receive at least 60 percent (but less than 80 percent) of the foreign corporation stock, certain out-from-under transactions (e.g., a transfer of a U.S. company-owned controlled foreign corporation, or CFC, to the new foreign parent) engaged in during the 10-year post-transaction period will be fully taxable to the U.S. company. Despite this potential toll charge, the inversion is still successful when the dust clears, a new foreign parent sits atop the U.S. company. If, however, the shareholders of the U.S. company receive 80 percent or more of the foreign corporation s stock, the foreign corporation will be treated, for U.S. tax purposes, as if it were a U.S. corporation a failed inversion. The most impactful provisions of the 2014 notice in particular, the rule taxing repatriation of offshore cash via hopscotch loans were aimed at limiting the post-inversion benefits available to inverted U.S. companies. In contrast, the focus of the 2015 notice is to make it more difficult to engage in a successful inversion. But without congressional action, the regulators are constrained by Section 7874 s 80 percent statutory ownership threshold. Thus, rules aimed at preventing inversions from occurring require particular creativity and a broad interpretation of the Treasury s regulatory authority hence, the 2015 notice s inventive third-country rule. In a nutshell, this rule prevents (by taxing the foreign acquiring corporation as a U.S. corporation) a U.S. company from combining with a company tax-resident in one (generally less tax-hospitable) foreign country if in the same transaction, or in a related transaction, the newly combined company migrates to another (generally more tax-hospitable) foreign country (such as Ireland or the United Kingdom) unless shareholders of the U.S. company will own less than 60 percent of the combined company, or the thirdcountry parent corporation already owns a substantial pre-existing business. Complications abound in applying the third-country rule to real-world transactions. Under Section 7874, certain issuances of stock are disregarded for purposes of the 60 percent and 80 percent calculations. The application of these disregarded stock rules at each step of a third-country transaction is unclear. Moreover, the word related has the potential to bring ostensibly separate transactions (whether occurring before or after the inversion transaction) within the scope of the rule. As an example, the simultaneous acquisition by a newly formed Irish holding company of both a U.S. company and a Canadian company clearly runs afoul of the third-country rule. Shifting the facts, the acquisition of a U.S. company by a Canadian company, followed some time later by the merger of the Canadian company into an Irish holding company, may or may not be impermissible under the third-country rule.

4 Section 7874 itself includes a presumption that all transactions occurring during the two years preceding, and during the two years following, an inversion transaction are part of the same plan as the inversion transaction. However, unlike the analogous spinoff rules pertaining to the existence of a plan or series or related transactions, there are no safe harbors and no specific plan factors under Section And given the intended chilling effect of the third-country rule, practitioners should not expect pro-taxpayer clarifying guidance to be forthcoming. The foundation of the government s third-country rule is weak. It is premised on the assumption that the purpose of Section 7874 s 80 percent test is to separate transactions with nontax business purposes from purely tax-motivated transactions, and that the Treasury has the authority to enforce the spirit of the statute even where, by its terms, it does not apply. The 2015 notice reflects the government s position that there is a very low likelihood that the decision to migrate to a third country is ever motivated by a nontax business purpose, even if U.S. company shareholders receive less than 80 percent of the foreign parent stock. Thus, the third-country rule treats these transactions as failing the 80 percent test. Despite repeated suggestions from the government that earnings stripping rules are forthcoming (i.e., rules that would restrict an inverted company s ability to shift U.S. income to lower-taxed foreign affiliates through intercompany debt and royalty payments), these rules are noticeably absent from both notices. In some ways, the third-country rule might be viewed as a surrogate earnings stripping rule in that the government views the choice of any third-country jurisdiction as facilitating tax avoidance. In the words of the 2015 notice, the third country may have a more favorable income tax treaty with the United States... with the result that U.S. withholding taxes on dividends, interest, and royalties paid by the domestic entity may be reduced or eliminated. A favorable treaty, together with a low localcountry tax rate, are the predicates to an effective earnings-stripping transaction. By limiting the ability of U.S. companies to shop a la carte for tax homes outside the U.S., the government hopes to blunt the effect of earnings stripping and similar transactions. Early indications suggest that, like the 2014 notice, the 2015 notice will have limited effect on actual transactions. Certain transactions that contemplated third-country migrations will need to be restructured two U.S. companies that signed agreements prior to the release of the 2015 notice, CF Industries and Pozen, have since announced they will complete their pending transactions by relocating to the jurisdiction of their merger partners rather than to a third country. But the biggest story is not the government s failure to halt proposed third-country transactions. Instead, center stage is Pfizer s post notice announcement that it will combine with Allergan (already domiciled in tax-friendly Ireland) in the largest inversion to date, a transaction that is not meaningfully affected by the 2015 notice. If there is a lesson to be drawn from the government s latest volley, it is that the regulators creativity cannot fill the void left by congressional inaction. By Alan S. Kaden, Michael J. Alter, Shane C. Hoffmann and W. Reid Thompson, Fried Frank Harris Shriver & Jacobson LLP Alan Kaden is a partner in Fried Frank's Washington, D.C., office and chairman of the office's tax department. Michael Alter is a tax partner in the firm's Washington office.

5 Shane Hoffmann and W. Reid Thompson are tax associates in the Washington office. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. All Content , Portfolio Media, Inc.