KIRKLAND ALERT. U.S. Treasury Department and the IRS Release Inversions Notice. Background. Attorney Advertising

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1 KIRKLAND ALERT September 2014 U.S. Treasury Department and the IRS Release Inversions Notice Background In an action that surprised absolutely no one, on September 22, 2014, the U.S. Treasury Department ( Treasury ) and the Internal Revenue Service ( IRS ) released Notice (the Notice ) to address so-called inversion transactions. The Notice describes regulations that Treasury intends to issue that are explicitly intended to discourage, if not stop altogether, these transactions. In general, the Notice applies to inversion transactions completed on or after September 22, The Notice thus does not affect inversion transactions completed before that date (although the IRS is not barred from challenging transactions under current law), but it does expressly apply to transactions that have been signed or announced but which did not close before September 22, In some ways, the scope of the Notice is limited, focusing principally on attempts by inverted corporations to access their trapped cash (cash held by foreign subsidiaries and affiliates) without paying U.S. tax. The following is a brief summary of certain of the key provisions set forth in the Notice. In some ways, the scope of the Notice is limited, focusing principally on attempts by inverted corporations to access their trapped cash (cash held by foreign subsidiaries and affiliates) without paying U.S. tax. In particular the regulations described in the Notice will: Cause a hopscotch loan between a controlled foreign subsidiary of a U.S. corporation and its new foreign parent to create taxable dividend income to the U.S. corporation; Prohibit transactions designed to decontrol controlled foreign subsidiaries of a U.S. corporation in order to access their trapped cash ; Address certain inversion transactions that Treasury finds particularly offensive, such as transactions involving foreign corporations with excessive passive assets, or pre-transaction distributions by an inverting U.S. company designed to make an inversion possible; and Address certain spinversion transactions. The Notice does not address so-called earnings-stripping transactions creating interest deductions in the United States (e.g., through intercompany notes), but requests comments regarding approaches such guidance could take. The Notice states that any such future guidance that applies only to inverted groups would have a September 22, 2014 effective date. It is clear that Treasury s intention in issuing the Notice was to put a halt to inversion transactions. Consequently, depending on future events and whether there is Attorney Advertising

2 KIRKLAND ALERT 2 Congressional action or inaction, Treasury in the future may decide to issue additional, broader rules in an attempt to further limit inversion transactions. Curtailing the Use of Hopscotch Loans Perhaps the most significant aspect of the Notice is a provision designed to prevent so-called hopscotch loans. Under Section 956 of the Internal Revenue Code (the Code ), when a foreign subsidiary of a U.S. corporation makes an investment in United States property, the amount of such investment is treated as a dividend paid to the U.S. corporation in the year the investment is made, subject to certain limitations. For this purpose, United States property includes stock in U.S. corporations and obligations of U.S. persons. This rule effectively prohibits a U.S. corporation from accessing the cash of its foreign subsidiary via an upstream loan without incurring an immediate U.S. tax liability. However, under current law, a foreign subsidiary of an inverted U.S. corporation could make a loan to its new foreign parent or a foreign affiliate of its new foreign parent (rather than to its direct U.S. parent) after an inversion transaction without triggering an immediate U.S. tax liability since an obligation of a foreign person is generally not considered United States property, at least if the cash is used outside the United States. These loans are aptly called hopscotch loans because the loan jumps over the foreign subsidiary s direct U.S. parent. Perhaps the most significant aspect of the Notice is a provision designed to prevent so-called hopscotch loans. Notice directly attacks the use of hopscotch loans for inverted companies. Under the regulations described in the Notice, any obligation of a foreign related person will be treated as United States property (and therefore subject to the income inclusion rules) if such obligation is acquired by a foreign subsidiary of an inverted U.S. corporation within 10 years of the closing of the inversion transaction. A foreign related person includes the new foreign parent of the group and any commonly controlled foreign brother-sister corporation or partnership, but would exclude any foreign corporation that was a subsidiary of the inverted U.S. corporation on or before the closing of the inversion transaction (meaning that foreign subsidiaries of the inverted U.S. corporation could still make loans between each other without causing an immediate U.S. tax liability). Importantly, the characterization rule in the Notice can apply to transactions other than hopscotch loans. For example, the Notice characterizes as United States property any equity investment in a foreign related person, and can also apply where the foreign subsidiary of the U.S. inverted corporation acts as a pledger or guarantor of an obligation of a foreign related person. CFC Decontrol Transactions In the Notice, the IRS expressed concern that inverted groups were engaging in transactions that had the effect of the U.S. group losing control over its controlled foreign subsidiaries that held trapped cash, thereby permitting earnings of foreign subsidiaries to accrue without U.S. tax. Such transactions might also permit the U.S. group to freely access the trapped cash without incurring any U.S. tax.

3 KIRKLAND ALERT 3 The regulations described in the Notice will recharacterize certain post-inversion decontrol transactions among affiliates that occur in the 10-year period following the inversion in a manner that will result in the U.S. group being treated as continuing to control the foreign subsidiary (for U.S. federal tax purposes), notwithstanding that as a legal matter the U.S. group would no longer actually own a controlling position. In particular, in any transaction in which stock in a foreign subsidiary of the U.S. group is transferred (including by issuance) to a specified related person, the transaction would be recharacterized as an arrangement (with the same terms and conditions) directly between the specified related person and one or more 10% U.S. shareholders of the foreign subsidiary, followed by a further deemed transaction between the U.S. shareholder and the foreign subsidiary (through any intervening entities as necessary). This results in the U.S group being treated as continuing to control the foreign subsidiary and therefore to be subject to the various anti-deferral regimes in the Code applicable to controlled foreign subsidiaries. A specified related person includes a foreign related person (as defined above) or a U.S. partnership that has one or more foreign related persons as a partner. The Notice also is aimed at post-inversion transactions where the U.S. group does not lose control of the foreign subsidiary, but still may give the group access to its trapped cash without material U.S. tax. The Notice also is aimed at other post-inversion transactions where the U.S. group does not lose control of the foreign subsidiary, but the group may gain access to its trapped cash without material U.S. tax. For example, where the stock acquired by the specified related person was not sufficient to cause the U.S. group to lose control of the foreign subsidiary, the foreign subsidiary might still be able to distribute cash or other property to the specified related person without significant U.S. tax (e.g., through a later redemption or disproportionate distribution). In a post-inversion transaction occurring in the 10-year period following the inversion where less than control of a foreign corporation is acquired by a specified related person in an otherwise tax-free transaction, the rules described in the Notice would treat the U.S. shareholder as receiving dividend income equal to the share of the foreign subsidiary s earnings and profits attributable to the transferred stock. There are certain narrow exceptions to these rules, and the IRS is considering whether to provide additional exceptions related to the integration of complementary businesses if certain conditions are met. This unusual set of rules is likely to have a significant impact on much of the socalled out from under planning that inverted U.S. companies engage in post-inversion. Pre-Transaction Distributions The regulations described in the Notice will provide rules that are intended to prevent an inverting U.S. corporation from down-sizing itself vis à vis a potential transaction partner by distributing property to its shareholders pre-transaction in order to reduce its shareholders post-transaction ownership below the thresholds that invoke the inversion rules (generally an 80% test) and the rules that require shareholders of the U.S. corporation to recognize gain in the transaction (generally a 50% test).

4 KIRKLAND ALERT 4 With respect to the inversion rules, non-ordinary course distributions made by the U.S. corporation in the 36-month period ending on the acquisition date will be disregarded for purposes of applicable ownership test. With respect to any taxable year, non-ordinary course distributions mean the excess of all distributions made during that taxable year by the U.S. corporation with respect to its stock or partnership interests, over 110% of the average of such distributions during the 36-month period immediately preceding the relevant taxable year. The term distribution is defined broadly, and includes not only dividend distributions, but also stock redemptions, Code Section 355 distributions (e.g., spin-offs) and any transfer of money or other property to shareholders that is made in connection with the inversion transaction (e.g., boot in a reorganization) to the extent that the money or other property is directly or indirectly provided by the U.S. corporation. In some inversion transactions, a U.S. entity may combine with a foreign acquiring entity, whose assets consist of a significant amount of cash or other passive assets (including certain marketable securities). Foreign Cash Boxes In some inversion transactions, a U.S. entity may combine with a foreign acquiring entity whose assets consist of a significant amount of cash or other passive assets (including certain marketable securities). If the historic shareholders of the inverting U.S. corporation own less than 80% of the foreign acquiring corporation after the combination, the foreign acquiring corporation may be respected as foreign under the inversion rules, even if the foreign acquiring corporation s size was inflated by virtue of holding passive assets unrelated to the business or operational needs of the group. The regulations described in the Notice will generally provide that, if 50% of the gross value of all property held by the foreign acquiring corporation and its group members consists of cash or other passive assets, then a portion of the stock of the foreign acquiring corporation will be disregarded in determining the percentage ownership of the shareholders of the foreign acquiring corporation for purposes of the 80% ownership test (with the result that the historic shareholders of the U.S. inverting corporation will be deemed to hold a greater percentage of the foreign acquiring corporation than they would in the absence of this rule). This rule will apply regardless of whether the foreign acquiring corporation acquired the cash and passive assets in a transaction related to the inversion transaction. The Notice contains exceptions for certain entities engaged in the active conduct of a banking, financing, or similar business. Anti- Spinversion Rules The regulations described in the Notice also will provide a set of rules aimed at certain divisive transactions that the IRS calls spinversions. The rules apply to a transaction where a U.S. entity transfers assets to a foreign corporation, and then distributes the stock of the foreign corporation to its shareholders. Where these spinversion rules apply, the foreign corporation will be treated as a domestic corporation for federal income tax purposes, thus defeating any tax benefits from the inversion.

5 KIRKLAND ALERT 5 Future Actions The Notice makes it clear that the IRS is continuing to consider what other guidance it could issue in the absence of Congressional action that could have the effect of curtailing inversion transactions. The Notice solicits suggestions for further actions that the IRS could take. In addition the Treasury Department has stated that it is reviewing tax treaty policy with respect to withholding tax benefits obtained by inverted groups. Therefore, there could be additional guidance forthcoming, some of which may be retroactive to September 22, If you have any questions about the matters addressed in this Kirkland Alert, please contact the following Kirkland authors or your regular Kirkland contact. Michael Carew 300 North LaSalle Chicago, IL (312) Todd F. Maynes, P.C. 300 North LaSalle Chicago, IL (312) Dean S. Shulman 601 Lexington Avenue New York, NY (212) Sara B. Zablotney 601 Lexington Avenue New York, NY (212) This communication is distributed with the understanding that the author, publisher and distributor of this communication are not rendering legal, accounting, or other professional advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use. Pursuant to applicable rules of professional conduct, this communication may constitute Attorney Advertising KIRKLAND & ELLIS LLP. All rights reserved.