A deeper look at forthcoming US Treasury regulations affecting certain inversion transactions

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1 4 December 2015 International Tax Alert A deeper look at forthcoming US Treasury regulations affecting certain inversion transactions EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary On 19 November 2015, Treasury and the IRS announced (Notice ) that forthcoming Treasury regulations will increase the likelihood that Section 7874 will apply to foreign acquisitions of domestic entities and further limit the potential US tax benefits of certain post-inversion transactions. Notice also makes significant retroactive amendments to the cash box and nonordinary course distribution (NOCD) rules of Notice , which have the effect of narrowing the application of the regulations. More specifically, Notice (the Notice) provides that the forthcoming regulations will provide the following: Expanding the scope of Section 7874 The expanded affiliated group that includes the foreign acquiring corporation cannot have substantial business activities in the foreign country in which the foreign acquiring corporation is created or organized unless the foreign acquiring corporation is subject to tax as a resident of that country; therefore foreign acquiring corporations that are organized in one country but tax resident in another will not have access to the substantial business activities exception.

2 2 International Tax Alert Stock of the foreign acquiring corporation issued to former shareholders of a foreign target corporation acquired by the foreign acquiring corporation in a transaction related to the acquisition of the domestic entity will be disregarded when the tax residence of the foreign acquiring corporation differs from that of the foreign target corporation, so use of such so-called third-country acquirers may increase the likelihood that the inversion provisions will apply. Any property acquired with a principal purpose of avoiding the purposes of Section 7874 can constitute nonqualified property, regardless of whether the transaction involves an indirect acquisition of nonqualified property within the meaning of Treas. Reg. Section T. Increasing the amount of inversion gain The definition of inversion gain will be expanded to include income or gain recognized by the domestic entity from any indirect transfer or license of property, which would include, for example, a subpart F income inclusion by reason of a transfer or license of property by a controlled foreign corporation of the domestic entity. For purposes of a calculating inversion gain, a foreign related partnership will be treated as an aggregate of its partners. If an exchanging shareholder would be required to include in income the Section 1248 amount attributable to stock of an expatriated foreign subsidiary under Notice , the regulations will require the shareholder to recognize under Reg. Section 1.367(b)-4 all of the gain realized upon an exchange of the stock, without regard to the Section 1248 amount with respect to the expatriated foreign subsidiary, subject to the small dilution exception described in Notice Narrowing application of the regulations announced in Notice An additional exclusion to the cash box rules will be provided for property that gives rise to income described in the insurance exception of Section 1297(b)(2)(B) and certain qualifying insurance, financing, and banking property owned by domestic subsidiaries of the foreign acquiring corporation. A de minimis exception will be added to the NOCD rules that will apply if, without regard to the exclusionary rules of Reg. Section T(b) and Notice , former owners of the domestic entity own less than 5% (by vote and value) of the foreign acquiring corporation and, after the acquisition and all transactions related to the acquisition, former owners of the domestic entity, in the aggregate, own directly and constructively less than 5% (by vote and value) of any member of the foreign acquiring corporation s expanded affiliate group. The regulations modifying the ownership and substantial business activities tests under Section 7874 will be effective for acquisitions occurring on or after 19 November The regulations limiting the benefits of certain post-inversion planning will be effective for exchanges, transfers and licenses occurring on or after 19 November 2015, but only if the inversion transaction is completed on or after 22 September The corrections to the cash box and NOCD rules announced in Notice will apply to acquisitions completed on or after 19 November Taxpayers may elect, however, to apply these new rules to acquisitions completed before 19 November Importantly, Notice does not modify the earningsstripping rules of Section 163(j), notwithstanding Treasury s indication in Notice that it was considering issuing such guidance, with the expectation that, if applicable only to inversion transactions, the rules would apply retroactively to acquisitions completed on or after 22 September Notice states, however, that Treasury is still considering issuing guidance to address earnings-stripping and requests comments on the matter. Detailed discussion In general, Section 7874 applies if a foreign acquiring corporation is treated as a surrogate foreign corporation with respect to a domestic corporation or partnership (the domestic entity). For this purpose, a foreign acquiring corporation is a surrogate foreign corporation if: 1. The foreign acquiring corporation directly or indirectly acquires substantially all of the properties held directly or indirectly by a domestic corporation, or that constitute a trade or business of a domestic partnership (acquisition and the Acquisition Test) 2. After the acquisition, at least 60% of the stock, by vote or value, of the foreign acquiring corporation is held by the former shareholders or partners (former owners) of the domestic entity by reason of holding an interest in the domestic entity (Ownership Test)

3 International Tax Alert 3 3. After the acquisition, the expanded affiliated group (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 (Substantial Business Activities Test or SBAT). 1 If these three tests are met and the former owners hold less than 80% of the foreign acquiring corporation (by vote or value), the domestic entity (and any related domestic person) is treated as an expatriated entity and the use of its attributes is generally limited when determining any US federal tax due on inversion gain. 2 If, however, the former owners own at least 80% of the foreign acquiring corporation, the foreign acquiring corporation is treated as a domestic corporation for all US federal income tax purposes, notwithstanding any other provision of law or income tax treaty. A. Regulations to address transactions contrary to the purposes of Section 7874 (Section 2) Section 2 of the Notice describes forthcoming regulations that will generally: (1) increase the likelihood that the Ownership Test will be satisfied by disregarding certain stock of the foreign acquiring corporation issued in a transaction related to the acquisition, and (2) prevent the EAG s business activities located in the country of the foreign acquiring corporation from being taken into account for purposes of the SBAT test. 1. Applying the SBAT if the foreign acquiring corporation is not tax-resident in its country of incorporation (Section 2.01(b)) On 3 June 2015, Treasury issued final regulations providing that the SBAT will be satisfied only if 25% of group assets, group income and group employees (by headcount and compensation) of an EAG, as those terms are defined in the regulations, are located or derived in the foreign acquiring corporation s country of incorporation (relevant foreign country). 3 Importantly, prior to the issuance of Notice , this bright-line rule applied even if the foreign acquiring corporation was not a tax resident in the relevant foreign country, which can be the case if the country determines tax residence based on the location where the entity is managed and controlled or if the entity is fiscally transparent in the relevant foreign country. The Notice explains that Treasury is concerned the current rule permits an EAG to effectively replace its US tax residence with a tax residence in another country (or in some cases, no other country) without regard to the location of any substantial business activities conducted by the EAG. To curtail this result, pending regulations will provide that an EAG cannot have substantial business activities in the relevant foreign country when compared to the EAG s total business activities unless the foreign acquiring corporation is subject to tax as a resident in the relevant foreign country. These regulations will apply to acquisitions completed on or after 19 November Stock of the foreign acquiring corporation issued in third-country transactions (Section 2.02(b)) The Ownership Test is determined by means of an ownership fraction with a numerator equal to the shares of the foreign acquiring corporation owned by former owners of the domestic entity by reason of their interest in the domestic entity and, subject to certain exceptions, a denominator equal to the total shares of the foreign acquiring corporation outstanding immediately after the acquisition. 4 Section 7874(c)(6) grants the Secretary authority to prescribe regulations to determine whether a corporation is a surrogate foreign corporation, including to treat stock as not stock. Moreover, Section 7874(g) grants the Secretary authority to provide regulations necessary to prevent the avoidance of Section 7874 through the use of related persons, pass-throughs, or other non-corporate entities or intermediaries, or transactions designed to have persons cease to be (or not become) members of the EAG or related persons. In certain transactions, a US company may combine with an existing foreign corporation under a new foreign parent whose tax residence differs from that of the existing foreign corporation (i.e., a third-country parent). The Notice states that Treasury is concerned the decision to use a third-country parent is driven generally by tax planning, including the facilitation of US tax avoidance following the acquisition. For example, the third country may have a more favorable income tax treaty with the US with regard to withholding taxes on dividends, interest and royalties paid by the domestic entity to the third-country parent or a less restrictive tax regime for controlled foreign corporations. To address these concerns, regulations will be issued that, if the four requirements listed below are met, would disregard, for purpose of determining whether the Ownership Test has been satisfied, certain stock of a foreign acquiring corporation that is issued to the shareholders of an existing foreign corporation. The stock of the foreign acquiring corporation that otherwise would be included in

4 4 International Tax Alert the denominator of the ownership fraction will be excluded from the denominator to the extent the stock is held by former owners of the foreign target corporation by reason of holding stock in the foreign target corporation (based on the principles of Section 7874(a)(2)(B)(ii)): First, in a transaction related to the acquisition (foreign target acquisition), the foreign acquiring corporation directly or indirectly acquires substantially all of the properties held directly or indirectly by another foreign corporation (foreign target corporation). 5 Second, the gross value of all property directly or indirectly acquired by the foreign acquiring corporation in the foreign target acquisition exceeds 60% of the gross value of all foreign group property, for this purpose excluding foreign group nonqualified property. 6 Third, the tax residence of the foreign acquiring corporation is not the same as that of the foreign target corporation before the acquisition or any related transactions. A change in the location of the management and control of a foreign target corporation is treated as a transaction for this purpose. Fourth, ignoring the third-country transaction rule, the Ownership Test would be at least 60% but less than 80%. If, in one or more transactions related to the acquisition, the foreign acquiring corporation directly or indirectly acquires multiple foreign target corporations that are tax residents of the same foreign country, all of the transactions that otherwise would qualify separately as a foreign target acquisition will be treated as a single foreign target acquisition and the foreign target corporations will be treated as a single entity. These regulations will apply to acquisitions completed on or after 19 November Clarification of rules that disregard certain stock transferred in exchange for nonqualified property (section 2.03(b)) Section 7874(c)(2)(B) provides that stock of a foreign acquiring corporation issued in a public offering related to the acquisition is not be taken into account for purposes of the Ownership Test, 7 thus generally increasing the percentage of stock of the foreign acquiring corporation owned by former owners of the domestic entity by reason of their interest in the domestic entity, and increasing the likelihood that the Ownership Test will be met. Temporary regulations released in January 2014 (the Temporary Regulations) 8 modified the statutory public offering rule by providing that only disqualified stock is treated as stock issued in a public offering and thus subject to the statutory exclusion rule of Section 7874(c)(2)(B). 9 Disqualified stock is stock of the foreign acquiring corporation that is transferred, in a transaction related to the acquisition, to a person (other than a domestic entity) in exchange for (i) cash or cash equivalents, (ii) certain marketable securities, (iii) certain obligations (collectively, these categories are referred to as specified nonqualified property ), and (iv) any other property acquired in a transaction (or a series of transactions) related to the acquisition with a principal purpose of avoiding Section 7874 (referred to in the Notice as avoidance property ). 10 In addition to the specific exclusionary rules, such as the statutory public offering rule, Section 7874(c)(4) provides generally that the transfer of properties or liabilities (including by contribution or distribution) will be disregarded if the transfers are part of a plan a principal purpose of which is to avoid the purposes of Section The Notice states that Treasury is concerned taxpayers are interpreting the scope of avoidance property too narrowly by concluding that property can be avoidance property only to the extent the property is used to transfer indirectly specified nonqualified property. To address this concern, Treasury and the IRS intend to issue regulations that clarify the meaning of avoidance property under Treas. Reg. Section T(i)(7)(iv) to include any property (other than specified nonqualified property) acquired with a principal purpose of avoiding the purposes of Section 7874, regardless of whether the transaction involves an indirect transfer of specified nonqualified property. Conforming modifications to the Temporary Regulations are to be made consistent with this change (and other revisions described in Notice ), including a new example illustrating these clarified standards. These regulations will apply to acquisitions completed on or after 19 November Limiting tax benefits of post-inversion planning (Section 3) Section 3 of the Notice describes regulations to be issued to limit the US tax benefits of certain post-inversion planning.

5 International Tax Alert 5 4. Definition of inversion gain (section 3.01(b)) Section 7874(a)(1) requires the taxable income of an expatriated entity for any tax year that includes any portion of the applicable period (within the meaning of Section 7874(d)) 11 to be no less than the inversion gain of the entity for the tax year. Inversion gain means: Any income or gain recognized on the transfer during the applicable period of stock or other properties by an expatriated entity Any income received or accrued during the applicable period by reason of a license of any property by an expatriated entity As part of the acquisition described in Section 7874(a)(2)(B)(i) or After such acquisition, if the transfer or license is to a foreign related person, except that post-acquisition income resulting from the transfer of property described in Section 1221(a)(1) (i.e., inventory) in the hands of the expatriated entity will not be inversion gain 12 For an expatriated entity that is a partnership, the inversion gain rule applies at the partner level. 13 An expatriated entity may not generally offset inversion gain by its tax attributes, including net operating losses and foreign tax credits. 14 Under prior law, income recognized by an expatriated entity under Section 951(a)(1)(A) (Subpart F income) as a result of a post-inversion transfer or license of property by a CFC would not constitute inversion gain, because that term is expressly limited under Section 7874(e)(2) to income or gain recognized as a result of a transfer by the expatriated entity (i.e., the US corporation acquired in the inversion). Thus, the expatriated entity may offset its resulting Subpart F income inclusion by tax attributes. The Notice states that Treasury is concerned this type of post-inversion indirect stock or property transfer removes foreign operations from US taxing jurisdiction while avoiding US tax, which it considers contrary to the policy of Section 7874(a)(1) and (e)(1). To address this concern, regulations will be issued to provide that inversion gain includes income or gain recognized by an expatriated entity from an indirect transfer or license of property, such as a Subpart F income inclusion, during the applicable period attributable to a transfer or license of property: (i) as part of the acquisition, or (ii) after such acquisition, if the transfer or license is to a specified related person 15 (with the exception that this clause does not apply to Section 1221(a)(1) property in the hands of the CFC). Regulations will also be issued that will provide that, if a related foreign partnership transfers or licenses property, a partner of the partnership will be treated as having transferred or licensed its proportionate share of that property, as determined under the rules and principles of Sections 701 through 777, for purposes of determining inversion gain. These regulations will apply to transfers or licenses of property occurring on or after 19 November 2015, but only if the inversion transaction is completed on or after 22 September Regulations under Section 367(b) regarding certain exchanges of stock of an expatriated foreign subsidiary (section 3.02(b)) Congress enacted Section 367(b) in part to preserve the continued application of Section 1248 in connection with certain nonrecognition transactions involving exchanges of stock of a foreign corporation. In this respect, the regulations under Section 367(b) generally require an immediate income inclusion by an exchanging shareholder as the result of a nonrecognition transaction if Section 1248 shareholder or CFC status is not preserved in the exchange. 16 If the exchanging shareholder is a foreign corporation, the income inclusion does not constitute foreign personal holding company income. 17 Notice describes amendments to Treas. Reg. Section 1.367(b)-4 that will require an exchanging shareholder to include in income as a deemed dividend the Section 1248 amount attributable to the stock of an expatriated foreign subsidiary exchanged for stock of another foreign corporation (a specified exchange) during the applicable period, without regard to whether CFC or Section 1248 shareholder status is preserved in the exchange. 18 If the exchanging shareholder is a CFC, the resulting deemed dividend will not be excluded from Subpart F income by reason of Treas. Reg. Section 1.367(b)-4(c)(1) and will not qualify for the same country exception of Section 954(c)(3)(A)(i) or the look-thru rule of Section 954(c)(6) (to the extent in effect). The regulations will, however, provide an exception to the application of this modified provision in Treas. Reg. Section 1.367(b)-4 if the specified exchange does not decrease, in the aggregate, the Section 958(a) US shareholder s interest in an expatriated foreign subsidiary (or lower-tier expatriated foreign subsidiary) by more than 10%.

6 6 International Tax Alert Since the release of Notice , Treasury has become concerned that certain non-recognition transactions that require inclusion of the Section 1248 amount attributable to the exchanged stock may allow the US shareholder to avoid US tax on unrealized appreciation in the assets held by the expatriated foreign subsidiary (e.g., intangibles that have appreciated in value, but have yet to be commercialized) in excess of the subsidiary s undistributed earnings and profits (E&P). To address these concerns, the regulations under Section 367(b) will be amended to require an exchanging shareholder to recognize the entire gain realized on the exchange of stock of an expatriated foreign subsidiary in a specified exchange. Specifically, the regulations will provide that, if an exchanging shareholder would be required, under the rules described in Notice , to include in income as a deemed dividend the Section 1248 amount with respect to stock of an expatriated foreign subsidiary, the exchanging shareholder also must recognize all realized gain with respect to the stock, after taking into account any increase in basis resulting from a deemed dividend with respect to the exchange provided in Treas. Reg. Section 1.367(b)-2(e)(3)(ii). For this purpose, the amount of realized gain that would be recognized is reduced by the amount of gain recognized under other applicable provisions of the Code, such as Section 356. Moreover, the first exception to recharacterization provided under Section 3.02(e)(i) of Notice will be modified to apply only if, as a result of the transfer, all of the gain in the specified stock is recognized. Notice includes an example illustrating this new rule. This new regulation will apply to exchanges occurring on or after 19 November 2015, but only if the inversion transaction was completed on or after 22 September B. Corrections and clarifying changes to certain rules in Notice (Section 4) 1. Regulations to disregard certain stock attributable to passive assets (Section 4.01(b)) Notice describes regulations to be issued that will exclude from the denominator of the ownership fraction a portion of the stock of the foreign acquiring corporation if more than 50% of the gross value of the foreign group property of the foreign acquiring corporation s EAG constitutes foreign group nonqualified property (50% test). The regulations, however, will exclude property that gives rise to certain banking, financing and insurance income described in Sections 954(h), (i) and 1297(b)(2)(A) from the definition of foreign group nonqualified property. Foreign group property of the EAG that would not otherwise constitute foreign group nonqualified property may nonetheless constitute nonqualified property if such property (substitute property) was acquired in exchange for foreign group nonqualified property (transferred property) in a transaction related to the acquisition. Notice provides that the regulations to be issued will also exclude property that qualifies for the insurance exception of Section 1297(b)(2)(B) from the definition of foreign group qualified nonqualified property, although this property will be subject to the special rule for substitute property. Under Section 1297(b)(2)(B), passive income does not include income derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business and would be subject to tax under subchapter L if it were a domestic corporation. Recently issued proposed regulations provide guidance for determining whether income qualifies for this exception. 19 Separate guidance under Section 1297(b)(2)(B) is also anticipated to prevent companies from inappropriately applying this exception. In response to comments that foreign group nonqualified property may inappropriately include, under Notice , property held by a domestic corporation engaged in the active conduct of a banking or insurance business that is owned by the foreign acquiring corporation prior to the acquisition, regulations will be issued to provide that the general definition of foreign group nonqualified property does not include property held by a domestic subsidiary of the foreign acquiring corporation if: The domestic corporation is subject to tax as an insurance company under subchapter L, but only to the extent the property is required to support, or is substantially related to, the active conduct of an insurance business or The property gives rise to income described in Section 954(h), determined by substituting the term domestic corporation for the term controlled foreign corporation and without regard to: 1) the phrase located in a country other than the United States in Section 954(h)(3)(A)(ii)(I); and 2) any inference that the tests in Section 954(h) should be calculated or determined without taking into account transactions with customers located in the United States.

7 International Tax Alert 7 The substituted asset rule may nonetheless apply to treat any such property as foreign group nonqualified property under the substitute asset rule. This additional exception will generally apply to acquisitions completed on or after 19 November Taxpayers may, however, elect to apply these rules to acquisitions completed before 19 November De minimis exception to the non-ordinary course distribution rule (Section 4.02(b)) The NOCD rules described in Notice will disregard certain distributions (taxable or nontaxable) made by the domestic entity during the 36 months ending on the acquisition date. Commenters have noted that the NOCD rules could cause Section 7874 to apply to an acquisition even though the former owners of the domestic entity actually own no, or only a de minimis amount of, stock in the foreign acquiring corporation after the acquisition by reason of holding an interest in the domestic entity. For example, assume the foreign acquiring corporation acquires all the stock of the domestic entity solely for $100x cash, and the domestic entity has $5x of NOCDs on the date of the acquisition. In that case, the NOCD rule would deem the value of the domestic entity to be $105x, presumably resulting in the foreign shareholders receiving $5x of foreign acquiring corporation stock, solely for purposes of Section In certain cases, this amount of stock could result in Section 7874 applying, even at its 80% threshold. In response to this concern, Notice provides that regulations will include a de minimis exception to the NOCD rules, similar to the exception for disqualified stock in Treas. Reg. Section T(d)(1), which will apply if: The ownership percentage, determined without regard to Treas. Reg. Section T(b) and the cash box and NOCD rules of Notice , is less than 5% (by vote and value) After the acquisition and all transactions related to the acquisition are completed, former shareholders (or partners), as applicable, of the domestic entity in the aggregate own (applying the attribution rules of Section 318(a) with the modifications described in Section 304(c)(3)(B)) less than 5% (by vote and value) of the stock of (or a partnership interest in) any member of the EAG that includes the foreign acquiring corporation. If the de minimis exception applies, the NOCD rules of Notice will not apply. The statutory anti-abuse rule of Section 7874(c)(4), however, will still apply to any distributions made with a principal purpose of avoiding the purposes of Section The new de minimis exception will apply to acquisitions completed on or after 19 November Taxpayers may, however, elect to apply the de minimis exception to acquisitions completed before 19 November Transactions that de-control or dilute ownership in CFCs Notice describes regulations to be issued that will recharacterize certain transactions (a specified transaction) completed during the applicable period in which stock of an expatriated foreign subsidiary (specified stock) is transferred (including by issuance) to a specified related person. A specified related person includes a non-cfc foreign related person, a US partnership with non-cfc foreign related partners, or a US trust with one or more beneficiaries that are non-cfc foreign related persons. The purpose of these regulations is generally to de-control or dilute a shareholder s ownership in a foreign subsidiary in a manner that does not result in an immediate income inclusion but creates the possibility of avoiding US tax on pre-transaction E&P of the foreign subsidiary. Notice described two exceptions to recharacterization treatment, one of which applies if: The expatriated foreign subsidiary is a CFC immediately after the specified transaction and all related transactions The amount of stock (by value) in the expatriated foreign subsidiary (and any lower-tier expatriated foreign subsidiary) that is owned, in the aggregate, directly or indirectly by the Section 958(a) US shareholders of the expatriated foreign subsidiary immediately before the specified transaction and any transactions related to the specified transaction does not decrease by more than 10% as a result of the specified transaction and any related transactions (small dilution exception). Notice states that Treasury is concerned that taxpayers are applying the small dilution exception based on the relative value of a shareholder s interest in an expatriated foreign subsidiary, rather than based on the shareholder s percentage of the stock owned (by value), which the Notice describes as inconsistent with the purpose of the rule. To clarify the proper scope of the small dilution exception, the regulations to be issued will substitute the phrase the percentage of stock (by value) for the phrase the amount of stock (by value). A similar clarification will be made to the

8 8 International Tax Alert small dilution exception for specified exchanges subject to Treas. Reg. Section 1.367(b)-4. This modification will apply to specified transactions and specified exchanges occurring on or after 19 November 2015, but only if the inversion transaction is completed on or after 22 September Implications Following the approach adopted by Notice , Notice announces additional forthcoming regulations that will increase the likelihood that a corporate re-domiciliation will be subject to Section 7874 and decrease the tax benefits of certain transactions completed following a less than 80% but at least 60% inversion. In this regard, the rules addressing third-country transactions will likely have the greatest effect by limiting the ability of the parties to the transaction in choosing a preferred jurisdiction for the new foreign parent of the combined group. The Notice essentially reads a subject to tax requirement into the Section 7874 Ownership Test a concept found in neither the statute nor the legislative history. If the new foreign parent company is not subject to tax in the same jurisdiction as the foreign target, the Notice disregards the shares issued to the foreign target corporation s shareholders for purposes of the Ownership Test. The Notice cites the grant of authority in Section 7874(c)(6) (B) for support of this new subject-to-tax test. Read in isolation, Section 7874(c)(6)(B) does indeed provide the Secretary with broad authority to treat stock as not stock. Significantly, however, Section 7874(c)(6)(A) provides the Secretary with broad authority to treat items such as options, warrants and convertible debt instruments as stock. When read together, Section 7874(c)(1)(A) and (c)(1)(b) support the logical inference that they are intended as corollary provisions. Thus, Section 7874(c)(6)(A) provides the Secretary with the authority to treat as stock those instruments that are the economic equivalent of stock (such as options, warrants, etc.) but are not stock in legal form. Similarly, Section 7874(c)(6)(B) provides the Secretary with authority to treat as not stock those instruments that are labeled as stock in legal form but that lack the economic and/ or legal rights typically associated with stock. Again, nothing in the statute suggests that the foreign parent corporation must be subject to tax in any particular jurisdiction as a condition precedent to the inclusion of the shares exchanged by the foreign target shareholders in the Ownership Test. Regardless of what one thinks of the interplay between Section 7874(c)(6)(A) and (B), it is fairly clear that the Ownership Test has its antecedents in the 50% test of Treas. Reg. Section 1.367(a)-3(c). The development of that test clearly indicated a relatively high level of foreign target shareholder continuity (50% in Section 367) in the ongoing venture in and of itself imbued the combination transaction with sufficient non-tax business purpose so as to pass muster under Section 367. Similarly the relatively high level of foreign target shareholder continuity (40% or 20% in Section 7874) suggests sufficient business purposes. Again, there is nothing in the statute or the legislative history suggesting that the Ownership Test should be coupled together with a subject-to-tax test. On the other hand, the Notice also narrows the scope of certain rules announced in Notice , including on certain foreign insurance companies that, based on regulatory requirements, must be capitalized with significant amounts of passive assets. Although Notice excluded from the general definition of foreign group nonqualified property any property that gave rise to active insurance income described in Section 954(i), few foreign insurers could satisfy the requirement of that provision that 50% of their premiums relate to home-country risk. Thus, under Notice , a typical foreign insurer would likely be considered a cash box, increasing the likelihood that any business combination with a domestic company would be subject to Section 7874, regardless of the relative sizes of the two companies. By excluding property that would qualify for the PFIC insurance exception of Section 1297(b)(2)(B), the Notice generally places foreign insurers in the same position as companies in other industries. To satisfy the PFIC exception, the foreign insurer need only be considered an insurance company under US tax principles, be engaged in insurance as its primary business, and be actively engaged in the conduct of the insurance business. The Code provides no definition of active conduct for this purpose. The proposed regulations under Section 1297, however, would import the meaning given the term in Treas. Reg. Section 1.367(a)-2T(b)(3), except that officers and employees would not be considered to include the officers and employees of related entities. This latter provision, if not corrected in final regulations, may still be a concern to foreign insurers that house their employees in a separate services or management company.

9 International Tax Alert 9 Notice s adoption of a de minimis exception to the NOCD rules of Notice , which is modeled after a similar exception in the disqualified stock rules of Treas. Reg. Section T, is also an important and helpful development. Without this exception, the NOCD rules could have transformed an all-cash acquisition by a foreign company of a domestic entity into an inversion subject to Section 7874, potentially causing the foreign company to be treated as a US company for US federal tax purposes, no doubt a surprising result to the foreign company s shareholders. This non-intuitive result could arise if the domestic entity had made any NOCDs during the three years preceding the acquisition (e.g., large share repurchases, taxfree spin-offs), which would be disregarded under Notice to the extent they exceeded the average amount of distributions in the rolling three-year period preceding the distributions. Thus, for purposes of the Ownership Test, the value of the domestic entity at the time of the acquisition would be treated as including the amount of the NOCDs and, presumably, the foreign corporation would be treated as acquiring this additional, phantom value in exchange for additional, phantom shares. If the amount of the fictional shares of the foreign acquiring corporation deemed issued were great enough, the cash acquisition, which would have resulted in zero actual shareholder continuity, could nonetheless have been subject to Section 7874, possibly even at the 80% threshold. The new de minimis exception prevents this result by requiring at least 5% shareholder continuity (by vote or value). Although the de minimis exception arguably does not go far enough (an acquisition with only 5% shareholder continuity is still far below the 60% and 80% statutory thresholds), the Notice at least affords a foreign acquiring corporation the certainty that an allcash acquisition of a domestic target will not result in the application of Section 7874, regardless of the distribution history of the acquired domestic entity.

10 10 International Tax Alert Endnotes 1 Section 7874(a)(2)(B). The EAG is defined by reference to consolidated return affiliation under Section 1504(a), but includes foreign corporations and applies at a more than 50% level. See Section 7874(c)(1). 2 See Section 7874(a), (d)(2), and (e)(1). 3 T.D. 9720, 80 Fed. Reg (4 June 2015). 4 See also Treas. Reg. Section T(i)(9) ( The ownership fraction is the ownership percentage described in Section 7874(a)(2)(B)(ii), expressed as a fraction. ). 5 The term acquisition is defined under the principles of Section 7874(a)(2)(B)(i) and Treas. Reg. Section (c) (1). An acquisition of an upper-tier foreign corporation that directly owns stock of a lower-tier foreign corporation will be considered a foreign target acquisition of the upper tier corporation only unless the lower-tier corporation was previously acquired in a related transaction. In such case, both the acquisitions of the upper- and lower-tier corporations will be treated as foreign target acquisitions. 6 The regulations intend to adopt the definitions of foreign group property and foreign group nonqualified property provided in Section 2.01(b) of Notice , as modified by Section 4.01(b) of the Notice, as discussed below. 7 Section 7874(c)(2)(B). 8 T. D. 9654, 79 Fed. Reg (17 January 2014). 9 Treas. Reg. Section T(b). 10 Treas. Reg. Section T(c)(1)(ii). Stock received in exchange for property other than nonqualified property may also constitute disqualified stock if the transferee subsequently transfers such stock in exchange for the satisfaction or the assumption of one or more obligations associated with the property exchanged. See Treas. Reg. Section T(c)(1)(i). In either case, stock is disqualified stock only to the extent that the transfer of the stock in the exchange increases the fair market value of the assets of the foreign acquiring corporation or decreases the amount of its liabilities. Treas. Reg. Section T(c)(2). 11 Section 7874(d)(1) provides that the term applicable period means the period beginning on the first date properties are acquired as part of the acquisition described in Section 7874(a)(2)(B)(i) and ending on the date that is 10 years after the last date proper are acquired as part of the acquisition. 12 Section 7874(d)(2). The term foreign related person means a foreign person that is: (i) related within the meaning to Section 267(b) and 707(b)(1), or (ii) under the same common control (within the meaning of Section 482) as the entity. 13 Section 7874(e)(2)(A). 14 See Section 7874(e)(1). 15 For this purpose, the Notice adopts the definition of specified related person described in Section 3.02(e)(1) of Notice , discussed in more detail later. 16 The term Section 1248 shareholder means any US person that satisfies the ownership requirements of Section 1248(a)(2) or (c)(2) with respect to a foreign corporation. Treas. Reg. Section 1.367(b)-1(b). 17 See Treas. Reg. Section 1.367(b)-4(c)(1). 18 Notice , Section 3.02(e)(ii). 19 REG , 80 Fed. Reg (24 April 2015).

11 International Tax Alert 11 For additional information with respect to this alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington, DC Jose Murillo Peg O Connor margaret.oconnor@ey.com Allen Stenger allen.stenger@ey.com Heather M Gorman heather.gorman@ey.com Ernst & Young LLP, International Tax Services, Chicago Gary Scanlon gary.scanlon@ey.com Steven M Surdell steven.surdell@ey.com Paul Pencak paul.pencak@ey.com Ernst & Young LLP, International Tax Services, New York Marie Spaccarotella marie.spaccarotella@ey.com International Tax Services Global ITS, Alex Postma, Tokyo ITS Director, Americas, Jeffrey Michalak, Detroit Ernst & Young LLP, National Director of ITS Technical Services, Jose Murillo, Washington Member firm contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Chris J Housman, New York Central Mark Mukhtar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Beth Carr, San Jose, CA Canada Ernst & Young LLP (Canada) Albert Anelli, Montreal Israel Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mexico Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City Central America Ernst & Young, S.A. Juan C Chavarria Pozuelo, San José South America Ernst & Young Serviços Tributários S.S. Gil F. Mendes, São Paulo

12 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About Ernst & Young s International Tax Services practices Our dedicated international tax professionals assist our clients with their cross-border tax structuring, planning, reporting and risk management. We work with you to build proactive and truly integrated global tax strategies that address the tax risks of today s businesses and achieve sustainable growth. It s how Ernst & Young makes a difference. International Tax Services 2015 EYGM Limited. All Rights Reserved. EYG no. CM NY ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com