Cross-Border M&A: Putting the Recently Finalized US Inversion Regulations into Context Following US Tax Reform

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1 Latham & Watkins Transactinal Tax Practice July 26, 2018 Number 2355 Crss-Brder M&A: Putting the Recently Finalized US Inversin Regulatins int Cntext Fllwing US Tax Refrm New regulatins mre ntable fr what they retain than what they change. Key Pints: The US anti-inversin rules have mre than a 15-year histry f impacting the structure and practicality f certain crss-brder deals, including mergers, acquisitins, and spin-ffs. The recently issued regulatins represent the latest in the series f statutry and regulatry develpments, which will n dubt cntinue t shape the current M&A market. The develpments are particularly imprtant when cmbined with the significant changes in the US tax regime brught abut by recent US tax refrm. On July 11, 2018, the US Department f the Treasury (Treasury) and the Internal Revenue Service (the IRS) issued final regulatins (the Regulatins) cntinuing effrts aimed at curbing crss-brder crprate expatriatin transactins cmmnly referred t as inversins and diminishing the tax advantages assciated with inversins. The Regulatins generally fllw the guidance prvided in ntices and temprary and prpsed regulatins prmulgated during the perid (the Prir Guidance), with certain clarificatins and mdificatins. Differences between the Regulatins and the relevant Prir Guidance are generally technical, and the Regulatins d nt change fundamental plicy decisins reflected in such guidance. 1 This Client Alert utlines ntable changes and cnsideratins raised by the Regulatins given the Tax Cuts and Jbs Act (the 2017 Act). 2 Cnsidering these latest updates in the cntext f hw inversin issues can impact the M&A market is imprtant, including in light f hw the significant 2017 Act fits int the key decisins surrunding crss-brder M&A, selecting a hlding cmpany jurisdictin, and designing a glbal platfrm fr a multinatinal crpratin. The central cncepts are: The Prir Guidance had a fundamental impact n the M&A market by limiting bth: The ability t qualify a transactin under the anti-inversin rules (that is, the rules increased the pssibility that a freign hlding cmpany wuld be treated as dmestic) Latham & Watkins perates wrldwide as a limited liability partnership rganized under the laws f the State f Delaware (USA) with affiliated limited liability partnerships cnducting the practice in France, Italy, Singapre, and the United Kingdm and as affiliated partnerships cnducting the practice in Hng Kng and Japan. Latham & Watkins perates in Suth Krea as a Freign Legal Cnsultant Office. Latham & Watkins wrks in cperatin with the Law Office f Salman M. Al-Sudairi in the Kingdm f Saudi Arabia. Under New Yrk s Cde f Prfessinal Respnsibility, prtins f this cmmunicatin cntain attrney advertising. Prir results d nt guarantee a similar utcme. Results depend upn a variety f factrs unique t each representatin. Please direct all inquiries regarding ur cnduct under New Yrk s Disciplinary Rules t Latham & Watkins LLP, 885 Third Avenue, New Yrk, NY , Phne: Cpyright 2018 Latham & Watkins. All Rights Reserved.

2 Pst-inversin planning, such as certain cash repatriatin and grup restructuring techniques The rules included in the Prir Guidance remain in full frce, with the Regulatins issued last week simply clarifying certain prvisins (the high pints f which are discussed belw). Thus, all f the restrictins impsed under the Prir Guidance remain applicable t current transactins, with n indicatin f regulatry r legislative relief n the hrizn. As enacted, thse prvisins can impact deals that, five years ag, wuld have been far utside the scpe f the anti-inversin rules, thus resulting in a surprise inversin issue fr senir management r investment bankers analyzing a ptential transactin. The 2017 Act was, fundamentally, never intended r designed t make an inversin r crprate expatriatin easier. Rather, the 2017 Act aimed t reduce the appeal f such a transactin and f a freign hlding cmpany structure by enacting a mre cmpetitive US crprate tax regime with a lwer crprate tax rate and a partial participatin exemptin fr freign earnings. Finally, the 2017 Act actually made the inversin trap harsher in that engaging in a transactin in which the inversin fractin (discussed belw) is 60% r mre can nw result in: A recapture f the 2017 Act transitin tax n freign earnings at a full 35% rate withut freign tax credits (as ppsed t a 15.5% rate with such credits) An increased base ersin and anti-abuse tax The taxatin f sharehlders n distributins at rdinary incme (as ppsed t qualified dividend) rates (tgether, the 2017 Act Inversin Penalties) Thus, while under the riginal statutry prvisin many transactins were structured s that the inversin fractin was simply belw 80%, the 2017 Act Inversin Penalties mve the galpsts. Parties will nw find it critical t structure their transactins s that the inversin fractin is belw 60% in rder t avid the 2017 Act Inversin Penalties. Indeed, ne might say that after the 2017 Act, 60 is the new 80. Taking int accunt these factrs and as described in Latham s January 2018 White Paper n the 2017 Act 3 dealmakers and their advisrs will in mst cases cntinue t pt fr a freign hlding cmpany, if such a path is available in a deal, which increases the relevance f these rules and the Regulatins as the business cmmunity and their advisrs lk t a pst-2017 Act M&A market. In that regard, these rules may nly becme mre imprtant ging frward, particularly as the financial benefits assciated with debt investments decreases due t the limitatin impsed by the 2017 Act n interest deductins under Sectin 163(j), 4 a limitatin which becmes mre nerus beginning in The cntinued tightening f tax benefits assciated with debt financing will likely prmpt dealmakers t increase the use f share cnsideratin fr target cmpanies, perhaps cupled with a spin-ff. As has been abundantly clear ver the last several years, whenever a freign acquirer issues equity in a deal, the US anti-inversin rules require analysis, even in cases in which their applicatin seems far frm the riginal intent f the statute. Latham & Watkins July 26, 2018 Number 2355 Page 2

3 Baseline Statutry Prvisins Fr purpses f the fllwing discussin, assume that a US crpratin (DT) and a freign crpratin (FT) seek t cmbine under a new freign hlding crpratin (FA). The first chart in Figure 1 belw depicts the structure immediately befre the transactin, and the secnd depicts the structure after the transactin. Figure 1: Basic Transactin Initial Structure Pst-Acquisitin Structure Under statutry anti-inversin prvisins, a freign crpratin acquiring a US crpratin is treated as a US crpratin fr US tax purpses if, amng ther requirements, bth f the fllwing apply: The amunt f stck (by vte r value) f the freign acquiring crpratin (FA Stck) wned by frmer sharehlders f the acquired US crpratin (Legacy DT Sharehlders) fllwing the acquisitin by reasn f wnership f the acquired US crpratin (the inversin fractin) is at least 80%. The expanded affiliated grup (EAG) f the freign acquirer des nt have substantial business activities in the freign cuntry in which the acquirer is rganized (the relevant freign cuntry). If the Legacy DT Sharehlders wn less than 80%, but at least 60%, f the FA Stck, and the EAG des nt have substantial business activities in the relevant freign cuntry, then certain limitatins apply t the entire crprate grup n the use f tax attributes, an excise tax may apply t certain executive cmpensatin, and the 2017 Act Inversin Penalties wuld als apply. As a general matter, the Prir Guidance was designed t intrduce varius adjustments t the inversin fractin by increasing the numeratr and reducing the denminatr in the inversin fractin, as well as t limit pst-inversin cash mvements and grup restructurings thrugh an array f rules. Latham & Watkins July 26, 2018 Number 2355 Page 3

4 Changes Made by the Regulatins t Prir Guidance Serial Acquisitins If a freign crpratin issues equity in exchange fr a US business, that equity must be tracked fr 36 mnths pursuant t a rule that links such acquisitins fr purpses f the inversin rules (the serial acquisitin rule). In particular, generally reduces the denminatr f the inversin fractin by the amunt f FA Stck attributable t dmestic entity acquisitins that FA (r its predecessr) cmpleted within the prir 36 mnths. See Figure 2 belw. Nte that the serial acquisitin rule is distinct frm the multiple dmestic entity acquisitin rule, which is retained in (e) and integrates related transactins by prviding that FA s acquisitins f unrelated dmestic targets as part f a plan r series f related transactins are treated as the acquisitin f a single dmestic target fr purpses f the inversin rules, thus increasing the numeratr f the inversin fractin. In 2016, the US Chamber f Cmmerce filed suit in the US District Curt fr the Western District f Texas, asserting that Treasury and the IRS (i) lacked the statutry authrity t prmulgate the serial acquisitin rule, (ii) engaged in arbitrary and capricius rulemaking, and (iii) failed t adhere t the ntice and cmment requirements f the Administrative Prcedure Act (the APA). The district curt held that Treasury and the IRS had the statutry authrity t prmulgate the rule and did nt engage in arbitrary and capricius rulemaking, but that they had failed t adhere t the ntice and cmment requirements f the APA and thus the serial acquisitin rule in the temprary regulatins was invalid. Althugh the case is currently n appeal t the Fifth Circuit, in the preamble t the Regulatins, the Treasury highlights the district curt s view that the serial acquisitin rule was substantively valid. The Regulatins adpt the serial acquisitin rule, recnfirming the prir plicy decisins, with three technical clarificatins: The determinatin f the FA Stck that is attributable t a prir dmestic entity acquisitin des nt include FA Stck deemed t be received under the NOCD rules discussed belw. Dmestic entity acquisitins ccurring as part f certain internal restructurings by a freign-parented grup are nt treated as prir dmestic entity acquisitins fr purpses f the serial acquisitin rule. The term predecessr is defined by crss-reference t the NOCD rules. Latham & Watkins July 26, 2018 Number 2355 Page 4

5 Figure 2: The Serial Acquisitin Rule In General Under the serial acquisitin rule, in calculating the inversin fractin fr the DT2 acquisitin, the FA shares attributable t the DT1 acquisitin are excluded frm the denminatr resulting in an inversin fractin f 67% (100/150). If the acquisitins ccurred mre than 36 mnths apart, the inversin fractin fr the DT2 acquisitin wuld be 40% (100/250). Nn-Ordinary Curse Distributins As nted abve, the Prir Guidance intrduced adjustments that can increase the numeratr and decrease the denminatr f the inversin fractin. Althugh a variety f factrs and actins taken by the parties t a transactin can give rise t such adjustments, the ptential increase f the numeratr caused by prir distributins r share buy backs undertaken by DT is ne f the issues that dealmakers and their advisrs mst frequently encunter. In that regard, retains the rules intrduced and refined in the Prir Guidance intended t limit taxpayers ability t reduce the size f DT in advance f an inversin transactin (and thereby favrably reduce the inversin fractin) by paying extrardinary dividends, ften referred t as diet r skinnydwn dividends. As a result, fr purpses f the inversin fractin, any nn-rdinary curse distributins (NOCDs) by DT during the 36-mnth (r ther applicable) perid befre the inversin will be disregarded such that the numeratr (and, generally, the denminatr) will be increased by a number f shares with a fair market value equal t the amunt f NOCDs. As is well knwn in the dealmaking cmmunity, these rules g far beynd the purpse-driven rule in the statute and cver rutine dividends and share buybacks, alng with certain cash cnsideratin prvided t the US cmpany sharehlders in the deal. Latham & Watkins July 26, 2018 Number 2355 Page 5

6 Figure 3: Nn-Ordinary Curse Distributins Initial Structure Pst-Acquisitin Structure The Regulatins make tw clarificatins and ne mdificatin t the Prir Guidance that may be particularly relevant when analyzing a ptential transactin: Stck related t NOCDs that is deemed received by Legacy DT Sharehlders is included in bth the numeratr and denminatr f the inversin fractin, except t the extent such stck is treated as held by a member f the EAG and subject t the rules applicable theret. The definitin f distributin fr purpses f the NOCD rules has been refined t clarify that (i) a deemed distributin under Sectin 752(b) will nt be taken int accunt t the extent it des nt reduce the partnership s value and (ii) all Sectin 355 distributins made by DT will be taken int accunt, even if made as part f a larger asset rerganizatin that is therwise nt treated as a distributin. Observatin: The ntin that a Sectin 355 distributin culd be taken int accunt fr purpses f the NOCD rules was the subject f significant cmmentary when first intrduced as part f the Prir Guidance. 5 Furthermre, the Regulatins cnfirmatin that all prir Sectin 355 distributins within the relevant perid will be treated as distributins under the NOCD prvisins is ne f the mst ntewrthy aspects f these rules. Frm a plicy standpint, this treatment serves as ne f the mst striking examples f hw this brad and mechanical rule nw captures even certain distributins almst certainly nt made with a principal purpse t avid the anti-inversin rules. In particular, as thse dealmakers and advisrs wh have been invlved with such a transactin well knw, Sectin 355 impses ne f the mst meaningful business purpse requirements f any f the Cde prvisins. Mrever, the ptential practical effect f this rule is significant given the generally material value f the business being spun-ff relative t the rest f the grup. Such effect may nly increase ging frward in light f the increased spin-related transactins that can be expected as the market reacts t the interest deductin limitatins impsed under the 2017 Act (discussed abve). Latham & Watkins July 26, 2018 Number 2355 Page 6

7 The Regulatins require the recast f a Sectin 355 distributin by DT f a dmestic cntrlled crpratin (Spinc), such that Spinc is treated as having made a distributin f DT stck equal t the value f DT stck (net f the value f Spinc stck) at the time f the distributin, if the fair market value f Spinc is greater than 50% f the fair market value f DT. In cntrast t the rules under the Prir Guidance, the relative fair market value f Spinc must be determined based n the value f Spinc stck held by bth DT and any persn that is treated as related t DT fr purpses f Sectin The additin f related parties t the analysis increases the prbability that this recast rule wuld apply in a manner that causes the inversin fractin t exceed the 60% threshld r the 80% threshld, as applicable. Figure 4: Sectin 355 Recast Rule Initial Structure Pst-Acquisitin Structure Third Cuntry Rule Regulatins renders permanent the third cuntry rule which, if applicable, excludes FA Stck issued t frmer sharehlders f FT (Legacy FT Sharehlders) by reasn f wnership f FT frm the denminatr f the inversin fractin. See Figure 5. Applicatin f this rule increases the likelihd that the inversin fractin will reach 80% r mre (resulting in FA as being treated as a US crpratin), particularly if FA is newly frmed with little r n histric assets r peratins. Althugh the rules under the Regulatins are generally cnsistent with thse included in the Prir Guidance, the Regulatins add tw exceptins as well as ne mdificatin intended t address ptentially abusive situatins: The third cuntry rule generally will nt apply if either f the fllwing applies: Latham & Watkins July 26, 2018 Number 2355 Page 7

8 The EAG has substantial business activities (as discussed further belw) in the cuntry in which FA is a tax resident. Bth FA and FT are created r rganized in a freign cuntry that des nt impse crprate incme tax and neither FA nr FT is a tax resident f any ther freign cuntry. Recgnizing that a taxpayer culd ptentially avid the third cuntry rule by changing FA s tax residency fllwing an inversin, the Regulatins generally treat a change in tax residency as a transactin. Therefre, if the change in tax residency is dne pursuant t a plan r series f transactins including the inversin, the third cuntry rule wuld apply. Figure 5: Third Cuntry Rule Third Cuntry Rule Applies: FA Treated as US Crpratin Third Cuntry Rule Des Nt Apply: US Ownership Fractin Stays Same Legacy FT Sharehlders deemed t wn 35 f 35 shares f FA Stck (ignring fr this purpse shares f FA Stck held by Legacy DT Sharehlders), s Legacy FT Sharehlder wnership % = 100% Because Legacy FT Sharehlder wnership % > 60%, 35 shares f FA Stck eliminated frm denminatr Legacy DT Sharehlders are therefre deemed t wn 65 f 65 shares f FA Stck, r 100% Legacy FT Sharehlders deemed t wn 13 f 35 ( ) shares f FA Stck (ignring fr this purpse shares f FA Stck held by Legacy DT Sharehlders), s Legacy FT Sharehlder wnership % = 37% Because Legacy FT Sharehlder wnership % < 60%, n reductin t denminatr Legacy DT Sharehlders therefre wn 65 f 100 shares f FA Stck, r 65% Other Clarificatins Included in the Regulatins Pst-inversin planning: The Regulatins generally incrprate the prtins f the Prir Guidance targeting certain pst-inversin planning methds, including thse intended t enable the FA grup t either (i) extract the earnings and prfits f pre-inversin cntrlled freign crpratins (CFCs) thrugh s called hpsctch lans and ther financing techniques r (ii) therwise engage in certain s-called de-cntrlling transactins r ut-frm-under transactins. Accrdingly: The 2017 Act, unexpectedly, retained Sectin 956 as a general matter, thus resulting in cntinuing cncern ver investment in US prperty triggering a US tax Latham & Watkins July 26, 2018 Number 2355 Page 8

9 n earnings that might therwise be distributed tax free under the participatin exceptin. Under , investments by legacy CFCs f DT (Expatriated Freign Subsidiaries) in stck r debt f freign, nn-cfc related parties (Nn-CFC Freign Related Persns) generally are treated as investments in US prperty fr purpses f Sectin 956 (and thus may trigger an incme inclusin under Sectin 951). See Figure 6. Similar rules apply with respect t credit supprt, such as guarantees and pledges f shares, that an Expatriated Freign Subsidiary prvides with respect t an bligatin f a Nn-CFC Freign Related Persn. Imprtantly, fr purpses f determining whether an entity is an Expatriated Freign Subsidiary, the Regulatins prvide that there is n dwnward attributin f wnership frm a freign persn t a US persn. The lack f dwnward attributin in such case distinguishes this determinatin frm that generally prvided in the expanded attributin rules under Sectin 958 fllwing the 2017 Act. Under (l)-4, certain pst-inversin transactins that have the effect f either causing an Expatriated Freign Subsidiary t cease being a CFC r substantially diluting a 958(a) US Sharehlder s (i.e., a US sharehlder that wns directly and indirectly stck f the Expatriated Freign Subsidiary and that is an expatriated entity) wnership f a CFC will be recharacterized fr all purpses f the Cde. Cnsequently, an issuance by the Expatriated Freign Subsidiary t a Specified Related Persn (i.e., a Nn-CFC Freign Related Persn, a US partnership with any partner that is a Nn-CFC Freign Related Persn r a US trust with any beneficiary that is a Nn-CFC Freign Related Persn) fr prperty is treated as (i) the transfer f the prperty by the Specified Related Persn t the 958(a) US Sharehlder(s) in exchange fr a deemed issuance f stck and (ii) the cntributin f the prperty by the 958(a) US Sharehlder(s) t the Expatriated Freign Subsidiary (thrugh intermediate entities, if apprpriate) in exchange fr a deemed issuance f stck (see Figure 7). In additin, the transfer f stck by sharehlders f the Expatriated Freign Subsidiary t a Specified Related Persn is treated as (1) a deemed issuance f stck by the 958(a) US Sharehlder(s) in exchange fr prperty transferred by the Specified Related Persn and (2) if the 958(a) US Sharehlder(s) are nt the transferring sharehlders, a cntributin f the prperty by such 958(a) US Sharehlder(s) t the transferring sharehlders. As described abve and cntrary t Sectin 958 fllwing the 2017 Act, there is n dwnward attributin f stck wned by a freign persn t a US persn fr purpses f determining Expatriated Freign Subsidiary status under these rules. Again, the cntinuing relevancy f these rules is questinable given that earnings can nw generally be distributed pursuant t a participatin exceptin. Latham & Watkins July 26, 2018 Number 2355 Page 9

10 Figure 6: Applicatin f Latham & Watkins July 26, 2018 Number 2355 Page 10

11 Figure 7: Applicatin f (l)-4 FA acquired DT in an inversin transactin. FA subsequently acquires 60% f Freign Subsidiary (CFC) stck in exchange fr $6x cash. Actual Result Recharacterizatin Treatment f FA passive assets: The Regulatins generally retain the rule excluding FA Stck attributable t freign grup nnqualified prperty (generally passive assets, such as cash and marketable securities) frm the denminatr if mre than 50% f the freign grup prperty cnsists f such nnqualified prperty, but mdify the rule such that it nly applies when calculating the inversin fractin based n value and nt by vte. The change is intended t avid difficulties assciated with allcating the excluded amunt amngst classes f stck with different vting pwer. Substantial business activities: As described abve, in rder fr the anti-inversin prvisins t apply, FA s EAG must nt have substantial business activities in the relevant freign cuntry. An EAG will generally be cnsidered t have substantial business activities in the relevant freign cuntry (i.e., the cuntry under the laws f which FA was created r rganized) nly if it meets all three f the fllwing cnditins: At least 25% f the EAG s ttal number f emplyees are based in the cuntry and at least 25% f its ttal cmpensatin is incurred with respect t thse emplyees At least 25% f the value f all EAG assets are lcated in the cuntry At least 25% f the EAG s ttal incme during the relevant testing perid is derived in the cuntry Latham & Watkins July 26, 2018 Number 2355 Page 11

12 In additin, the EAG will nly be treated as having substantial business activities in the relevant freign cuntry if FA is tax resident (i.e., a crprate bdy liable t tax as a resident) in the relevant freign cuntry. If the relevant freign cuntry des nt impse a crprate incme tax, the tax residency requirement des nt apply. De minimis rules: Under the Regulatins, each f the disqualified stck rule, passive assets rule, and NOCD rule cntain a de minimis exceptin applicable if bth: The inversin fractin (calculated withut regard t the applicatin f the disqualified stck rule, passive assets rule and NOCD rule) is less than 5% (by vte and value) Each frmer wner f the dmestic target wns less than 5% (by vte and value) f each member f FA s EAG Crdinatin rules: The Regulatins retain and braden the prvisins crdinating the FA stck exclusin rules (such as the passive assets, serial acquisitin, and third cuntry rules) and the EAG rules (which are used t determine which entities are members f FA s EAG). In additin, the Regulatins clarify that NOCD stck deemed received by Legacy DT Sharehlders is nt taken int accunt fr purpses f the EAG rules. Latham & Watkins July 26, 2018 Number 2355 Page 12

13 If yu have questins abut this Client Alert, please cntact ne f the authrs listed belw r the Latham lawyer with whm yu nrmally cnsult: Nichlas J. DeNvi nichlas.denvi@lw.cm Washingtn, D.C. Sean M. FitzGerald sean.fitzgerald@lw.cm Washingtn, D.C. Laurence J. Stein larry.stein@lw.cm Ls Angeles Jared W. Grimley jared.grimley@lw.cm Hustn Yu Might Als Be Interested In US Tax Refrms Fuel M&A Activity US Tax Refrm: Key Business Impacts, Illustrated With Charts and Transactinal Diagrams US Tax Refrm: Opprtunities and Challenges fr Leveraged Finance US Tax Refrm Resurce Center Client Alert is published by Latham & Watkins as a news reprting service t clients and ther friends. The infrmatin cntained in this publicatin shuld nt be cnstrued as legal advice. Shuld further analysis r explanatin f the subject matter be required, please cntact the lawyer with whm yu nrmally cnsult. The invitatin t cntact is nt a slicitatin fr legal wrk under the laws f any jurisdictin in which Latham lawyers are nt authrized t practice. A cmplete list f Latham s Client Alerts can be fund at If yu wish t update yur cntact details r custmize the infrmatin yu receive frm Latham & Watkins, visit t subscribe t the firm s glbal client mailings prgram. Endntes 1 Fr further discussin f certain prtins f prir prnuncements specifically addressed by the Regulatins, see Latham s 2016 Client Alert, Treasury Issues Stringent Inversin Regulatins, Prpses Far-Reaching Related-Party Debt Rules. 2 Public Law N (Dec. 22, 2017). Shrtly befre final Cngressinal apprval f the Act, the Senate parliamentarian ruled that the previusly attached shrt title, the Tax Cuts and Jbs Act, vilated prcedural rules gverning the Senate s cnsideratin f the legislatin. Accrdingly, the Act des nt bear a shrt title, althugh cmmentatrs generally have cntinued t refer t it as the Tax Cuts and Jbs Act. 3 Latham s January 2018 White Paper can be fund at US Tax Refrm: Key Business Impacts, Illustrated With Charts and Transactinal Diagrams. 4 All references t Sectin refer t sectins f the Internal Revenue Cde f 1986, as amended (the Cde), unless therwise indicated. All references t refer t sectins f the Treasury Regulatins prmulgated under the Cde. 5 See, e.g., New Yrk State Bar Assciatin Tax Sectin, Reprt n the Nn-Ordinary Curse Distributin Rules in Ntice , Reprt N. 1324, July 6, Latham & Watkins July 26, 2018 Number 2355 Page 13