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26 JOURNAL OF INTERNATIONAL TAXATION The transfer of shares by non-U.S. individuals of an existing U.S. corporation owning U.S. real estate to a newly formed foreign corporation in exchange for shares of the foreign corporation can have disastrous U.S. estate consequences for the non-U.S. domiciliary on death.

When Intended Estate Planning Results in an

Accidental

nversion Inversion

ROBERT H. MOORE AND MICHAEL J. BRUNO

not implemented properly, this structure This article will discuss one varia - For many years, could result in an “inversion” that would tion of the “inversion” transaction, the most common structure for non-U.S. result in the foreign corporation being which involves the transfer of shares by individuals 1 to hold U.S. business , treated as a U.S. corporation, for all pur - non-U.S. individuals of an existing U.S. such as U.S. real estate, has been to hold poses of the Code. In that case, the non- Subchapter owning U.S. such assets directly under a U.S. corpora - U.S. individual would not be protected real estate to a newly formed foreign tion and then to have the shares of the U.S. from U.S. federal estate tax. Given that corporation in exchange for shares of corporation owned by a foreign corpora - non-U.S. domiciliaries 2 have only a the foreign corporation (“Share Inver - tion. If implemented properly, this struc - $60,000 exemption on the value of their sion”). It then describes the effect of the ture protects the non-U.S. individual from U.S.-situs assets includable in their gross Share Inversion and associated anti- U.S. federal estate and , and also estate, structures such as the one inversion rules on the recipient foreign allows the non-U.S. individual to control described above, if they result in an inver - corporation and its non-U.S. individ - the timing of shareholder-level tax on div - sion, would have disastrous U.S. federal ual owners. This transaction will be idend distributions. Since the introduc - estate tax consequences to the non-U.S. referred to as the “Base Transaction” tion of Section 7874 in 2004, however, if domiciliary on death. throughout this article.

JOURNAL OF INTERNATIONAL TAXATION 27 Summary of U.S. Federal Tax Rules To fully appreciate the inversion rules’ impact on the Base Transaction, follow - ing is a brief description of certain terms used throughout this article and the basic U.S. federal income, estate, and gift tax rules that apply to individuals. For U.S. federal purpos - es, “U.S. person” includes U.S. corpora - tions 3 and individuals who are either U.S. citizens, U.S. green card holders, or considered to be substantially present in the . 4 Nonresident aliens and foreign corporations (“for - eign persons”) are not considered U.S. persons. 5 U.S. persons are subject to U.S. federal income taxation on their entire worldwide income, regardless of the source of the income. In contrast, foreign persons are subject to U.S. fed - eral income tax on only certain types of “U.S.-source” income. For these pur - poses, U.S.-source income generally includes (1) income effectively connect - ed to a U.S. or business, including gains from the sale of U.S. real proper - estate or gift tax only on the FMV of their situs for U.S. federal estate tax purposes ty (ECI) 6; and (2) certain types of pas - ownership in certain U.S.-situs but not for U.S. federal gift tax purpos - sive income from U.S. sources that are assets transferred during life or on death. es, whereas other assets are considered not derived from a U.S. trade or busi - U.S. citizens and U.S. domiciliaries are U.S. situs for both estate and gift tax pur - ness, such as , rents, and inter - currently entitled to a $5,450,000 million poses. Shares of stock in U.S. corpora - est (“FDAP (fixed or determinable lifetime exemption (adjusted for infla - tions are U.S.-situs property for U.S. annual or periodical) income”). 7 tion); 10 however, a non-U.S. domiciliary federal estate tax, but not for U.S. federal Unlike the U.S. federal income tax, the is permitted to generally exclude only the gift tax purposes. 11 In contrast, certain U.S. federal estate and gift are first $60,000 of his taxable U.S.-situs assets are considered U.S. situs for both applied based on an individual’s citizen - property from the calculation of his U.S. U.S. federal estate and gift tax purposes. ship or domicile (instead of residence). federal estate tax. No similar exemption These assets include in real U.S. citizens and U.S. domiciliaries 8 are from U.S. federal gift tax exists for non- property located in the United States. 12 subject to the U.S. federal estate and gift U.S. domiciliaries. On the other hand, a non-U.S. domicil - tax on the fair market value (FMV) of Noncitizens who are not considered iary is not subject to U.S. federal estate or their worldwide assets (wherever locat - domiciled in the United States are sub - gift tax on his interests in foreign situs ed throughout the world) that they trans - ject to U.S. federal estate or gift tax only property. Shares of stock in foreign cor - fer during life or at death. 9 On the other on the value of their ownership interests porations are considered foreign-situs hand, individuals who are neither U.S. in certain U.S.-situs assets transferred property, and thus, not subject to U.S. citizens nor considered domiciled in the during their lifetime or on death. Proper - federal estate or gift tax. 13 United States are subject to U.S. federal ty that is considered U.S.-situs property For many foreign individual in- for estate and gift tax purposes varies vestors, the most important U.S. tax con - ROBERT H. MOORE is a partner, and MICHAEL J. BRUNO is an associate, in Baker & McKenzie LLP’s Tax depending on the type of property trans - sideration when considering an in- Practice Group. ferred. Some assets are considered U.S. vestment in the United States is how to

28 JOURNAL OF INTERNATIONAL TAXATION l JUNE 2016 l ACCIDENTAL INVERSIONS For many foreign individual investors, the most important U.S. tax consideration is avoiding U.S. federal estate and gift taxes

avoid the U.S. federal estate and gift tax - Base Transaction es. This is primarily because non-U.S. A non-U.S. individual owns stock in a domiciliaries are allowed to exclude only U.S. corporation, which primarily owns the first $60,000 in value of U.S.-situs interests in real estate located in the assets from their U.S. estates. Thus, most United States. In this case, the U.S. cor - non-U.S. domciliaries seek to hold their poration qualifies as a U.S. real proper - U.S.-situs assets, such as U.S. real estate, ty holding corporation (USRPHC) for under a foreign corporation, 14 as shares purposes of the Foreign Investment in in a foreign corporation are explicitly Real Act of 1980 15 (FIRP - excluded from the definition of U.S.- TA), which is discussed below. situs assets. Further, foreign individuals The optimal U.S. tax structure to hold often prefer to have their U.S. invest - this U.S. real estate should avoid U.S. ments held directly by domestic entities, exposure (gift, estate, and such as U.S. corporations, as domestic generation skipping transfer tax) for the entities typically have an easier time non-U.S. individual and his future estate. conducting business in the United States Thus, the non-U.S. domiciliary may form and, where the U.S. branch profits tax a foreign corporation to hold the USR - might apply to a foreign corporation PHC stock (and possibly other U.S. engaged in business in the United States, assets) because stock in a foreign corpo - holding U.S. business assets under a ration is not included in the non-U.S. domestic corporation also allows a non- domiciliary’s U.S. gross estate and is not U.S. investor to control the timing of subject to U.S. federal estate or gift tax. 16 shareholder-level taxation that applies to To accomplish the estate and gift tax distributions. planning goal, the non-U.S. domiciliary would then contribute the shares of the 1 ities are ignored. See Swan Est. , 247 F.2d 144 Section 7701(b)(1)(B). USRPHC to the foreign corporation. 2 (CA-2, 1957); Fillman , 355 F.2d 632 (Ct. Cl., Reg. 25.2501-1(b); see also Estate of Jack , 54 1966). This “Base Transaction” is permitted Fed. Cl. Ct. 590 (2002). 17 3 See Notice 2006-46, 2006-1 CB 1044. under FIRPTA and, until 2004, success - Section 7701(a)(4). 18 4 The same issue can arise if an interest in a fully converted what otherwise was a Sections 7701(a)(30), (b)(1)(A). domestic partnership is transferred to a foreign 5 U.S.-situs (stock in the USRPHC) Sections 7701(a)(5), 7701(b)(1)(B). corporation. However, we will only address the 6 Section 871. transfer of stock in a U.S. corporation for pur - to a foreign-situs asset (stock in the for - 7 poses of this article. eign corporation). 17 Section 7874, how - See Section 871(a)(1)(A). FDAP income typical - 19 ly is subject to a flat 30% withholding H. Rep’t No. 96-1167 at 530, reprinted in 1980- ever, causes the Base Transaction to result (absent an applicable U.S. income tax ), 2 CB 530, 534. without allocable deductions, depending on the 20 in potentially disastrous U.S. estate and Id . at 534, 571. 18 type of U.S.-source income. 21 gift tax exposures, as discussed below. 8 See Petkun, “The Foreign Investment in Real See note 2, supra . Property Act of 1980,” 1 Penn St. Int’l L. Rev. 9 See Sections 2501 (gift tax) and 2001 (estate 11, 12-13 (1982). 22 tax). See Reiner, “Foreign Investment in U.S. Real 10 Overview of FIRPTA See Rev. Proc. 2015-53, 2015-44 IRB 615. Estate: Proposals for Taxing Gains,” 6 Int’l. Tax 11 J. 138, 138-39 (1979). This section reviews the legislative his - See Section 2104 (estate), Reg. 20.2104- 23 1(a)(1). See Jimmy Carter, “Agricultural Foreign Invest - tory of FIRPTA and analyzes the oper - 12 See Reg. 20.2104-1(a)(1). ment Disclosure Act of 1978 Statement on 13 Signing S. 3384 Into Law,” American Presiden - ation of the FIRPTA rules that are Section 2104(a); Regs. 20.2104-1(a)(5), cy Project (October 14, 1978), www.presidency. primarily in Sections 897 and 1445. It 20.2105-1(f). 14 ucsb.edu/ws/?pid=29989. See Reg. 20.2105-1(f). 24 is clear that FIRPTA was intended to 15 A separate piece of legislation passed to Omnibus Reconciliation Act of 1980, P.L. 96- specifically address the unfair treatment and address only U.S. federal “income” tax 499, 94 Stat. 2599, 2682 (December 5, 1980). economic risks to U.S. farmers was the Agricul - consequences of real property gains, 16 However, the foreign corporation may be disre - tural Foreign Investment Disclosure Act of rather than U.S. federal estate or gift tax garded if it appears that it is merely acting as 1978, which required disclose of transfers by a holding company for the nonresident ’s foreign persons of U.S. agricultural real prop - consequences associated with owning shares in the USRPHC, or its corporate formal - erty. 7 U.S.C. sections 3501-3508. U.S. real property.

ACCIDENTAL INVERSIONS l JUNE 2016 l JOURNAL OF INTERNATIONAL TAXATION 29 Legislative history. Before the enact - ment of FIRPTA, a foreign person’s U.S.- source real estate gains were generally not taxable in the United States unless the real property was held in connection with a U.S. trade or business. 19 Sometimes, even when the real property was connected to a U.S. trade or business, the foreign per - son would circumvent U.S. federal tax exposures by putting the U.S. real proper - ty in a holding corporation. Then, when the foreign person wanted to sell its inter - est in the underlying real property, rather than having the holding corporation sell the real property directly, the foreign per - son would sell its shares in the holding detailed rules on the taxation of a for - were engaged in a trade or business corporation, and the resulting gain from eign person’s investment in U.S. real within the United States during the tax the sale was not taxable in the United property interests. The Act year, and (2) the gain or loss were effec - States. 20 Foreign persons were also able of 1984 added Section 1445, which cre - tively connected with that trade or busi - to avoid U.S. tax on U.S.-source real estate ated a withholding mechanism to ness. 28 As a result, recognized net gains gains by using the Section 453 installment enforce the tax owed under Section 897 generally are subject to U.S. federal sale method rules, which enabled them to and resolve collection and filing issues income tax at graduated rates. 29 defer principal payments into years when under prior law. 27 “USRPI” generally means an interest the foreign person was not engaged in a Application of FIRPTA rules. FIRP - (other than an interest solely as a credi - U.S. trade or business, and thereby not TA, as codified principally in Sections tor) (1) in real property located in the subject the payment to tax in the United 897 and 1445, governs the taxation of United States or the Virgin Islands, or (2) States. 21 Aside from the potential tax dispositions of United States real prop - in a U.S. corporation that is (or, during abuses, the unfair advantage of foreign erty interests (USRPIs) by foreign per - the five-year period preceding the dis - persons over U.S. persons in the U.S. real sons. Section 897(a) generally requires position of the interest, was) a USR - estate market also had a significant effect gain or loss from the disposition of a PHC. 30 In general, a U.S. corporation is on the U.S. agriculture industry. Specifi - USRPI by a foreign person to be taken a USRPHC if the FMV of the corpora - cally, foreign investment 22 was causing the into account as if (1) the foreign person tion’s USRPIs is at least 50% of the aggre - price of U.S. land to soar, which put 25 33 smaller U.S. farmers out of business See note 13, supra . Id . See also Reg. 1.1445-1(g)(5). On December 26 because they could no longer compete See Staff of the Joint Committee on Taxation, 18, 2015, Congress passed the Protecting Amer - with rising market prices. 23 98th Cong., 2d Sess., General Explanation of icans from Tax Hikes Act of 2015 (“PATH Act”), the Revenue Provisions of the Deficit Reduc - which increased the FIRPTA withholding tax to 15%, effective for dispositions occurring 60 days In response to these abuses and tion Act of 1984 , 406 (Committee Print 1984); after the date of enactment of the Act. because it was essential to establish equi - Senate Finance Committee Print No. 96-37, 34 96th Cong. at 8 (1980), accompanying S. 2939, See Sections 1445(e), 1446. ty of tax treatment in U.S. real property 35 24 Revenue Reconciliation Act of 1980. See Regs. 1.1445-2(d)(2), 1.1445-5(b)(2). See between foreign and U.S. persons , 27 also Section 897(e) and Temp. Reg. 1.897-6T. 25 See Committee Print 1984, supra note 26. 36 Congress enacted FIRPTA, as modi - 28 Section 897(e)(1). Section 897(a)(1). Gain or loss from the dispo - 37 Section 897(e)(3); Temp. Reg. 1.897-6T(a)(2). fied by the Economic Recovery Tax Act sition of a USRPI is determined under the gen - 38 eral rules in Section 1001. Reg. 1.897-1(h). Temp. Reg. 1.897-6T(a)(1). See also Section of 1981 and the Tax Reform Act of 1984, 29 897(e)(2)(A). See Sections 871(b), 882(a)(1). 39 which made a foreign person’s U.S. real 30 Temp. Reg. 1.897-6T(a)(1). Section 897(c)(1)(A); Reg. 1.897-1(c)(1). See 40 estate gains taxable, as if automatically also Regs. 1.897-1(b), 1.897-1(d); Section See Temp. Regs. 1.897-6T(a)(1), 1.897-5T(d)(1)(iii). effectively connected to a U.S. trade or 897(c)(1)(A)(ii). This requirement is suspended when (1) the 26 31 transfer otherwise qualifies in its entirety for business of the foreign investor. FIRP - Section 897(c)(2); Reg. 1.897-2(b)(1). nonrecognition treatment under Temp. Reg. 32 TA added Section 897, which contains Section 1445(a). 1.897-6T; (2) the transferor does not have any

30 JOURNAL OF INTERNATIONAL TAXATION l JUNE 2016 l ACCIDENTAL INVERSIONS Nowhere does the legislative history indicate that the anti-inversion rules were meant to apply to the Base Transaction

ment may apply when a taxpayer dispos - Notwithstanding the USRPI-for- es of a USRPI in an exchange that qual - USRPI exception, the Temporary Regu - ifies for nonrecognition treatment. 35 lations under Section 897(e) provide an If a USRPI is disposed of in a transac - exception that allows for nonrecogni - tion that otherwise would be governed tion treatment in certain foreign-to-for - by a nonrecognition provision, Section eign exchanges of USRPIs. Specifically, 897(e) says that the nonrecognition pro - this exception provides for nonrecog - vision will apply for purposes of Section nition treatment if a foreign person 897 only if the USRPI is exchanged for exchanges stock in a USRPHC in three an interest, the sale of which would be types of transactions: subject to U.S. federal income tax. 36 For 1. A Type D or Type F reorganization purposes of this rule, a nonrecognition exchange between foreign corpo - provision is any Code provision under rations (and their foreign share - which gain or loss will not be recognized holders). 42 if the requirements of that provision are 2. A Type C reorganization between gate FMV of its (1) USRPIs, (2) interests met (e.g., Section 351). 37 foreign corporations if the transfer - in real property located outside the Unit - The Regulations restate the general or’s shareholders also own more ed States, and (3) other assets used or rule in Section 897(e) using slightly dif - than 50% of the transferee. 43 held for use in a trade or business. 31 ferent terminology. 38 They say that in a 3. A Section 351 transfer (or a Type B To enforce the substantive tax rules transaction in which gain is realized, a reorganization exchange) of USR - in Section 897, Section 1445 imposes on nonrecognition provision will apply only PHC stock to a foreign corporation a transferee (i.e., the buyer) the obliga - to the extent that the transferred USRPI and immediately after the exchange tion to withhold when (1) the transferor is exchanged for another USRPI, which, all of the outstanding stock of the of the property is a foreign person, and immediately after the exchange, would transferee corporation is owned by (2) the property transferred is a USR - be subject to U.S. taxation on its dispo - the same nonresident alien individ - PI. 32 When withholding is required, the sition (“USRPI for USRPI exception”). 39 uals and foreign corporations that transferee of the USRPI generally must The Regulations add that, to qualify immediately before the exchange deduct and withhold 15% of the amount for nonrecognition treatment, the owned the stock of the USRPHC. 44 realized by the transferor; 33 however, transferor of the USRPI generally must The exception under the Temporary special withholding rules may apply in file a U.S. federal income tax return for Regulations further requires that (1) the certain situations. 34 In addition, an the year in which the transfer occurs transferee’s subsequent disposition of exception to the withholding require - and attach a statement that includes the transferred USPRI be subject to U.S. certain required information. 40 For federal income tax; 45 (2) certain filing other ECI for the year in which the transfer example, if a foreign person contributed requirements are satisfied; 46 and (3) occurs; and (3) a notice of nonrecognition is filed for the transfer pursuant to Reg. 1.1445-2(d)(2). a USRPI to a U.S. corporation, which one of “five conditions” in Temp. Reg. 47 Notice 89-57, 1989-1 CB 698. qualified as a USRPHC immediately 1.897-6T(b)(2) exists. 41 Temp. Reg. 1.897-6T. Notice 2006-46. 42 thereafter, and received shares in the In Notice 2006-46, Temp. Reg. 1.897-6T(b)(1)(i). 43 U.S. corporation in the exchange, the 2006-1 CB 1044, the IRS and Treasury Temp. Reg. 1.897-6T(b)(1)(ii). 44 transfer generally would qualify for determined that the five conditions in Temp. Reg. 1.897-6T(b)(1)(iii). 45 See also Temp. Reg. 1.897-5T(d)(1). nonrecognition treatment if certain Temp. Reg. 1.897-6T(b)(2) were no 46 See also Temp. Reg. 1.897-5T(d)(1)(iii). reporting obligations are satisfied. longer necessary and declared that final 47 See Temp. Reg. 1.897-6T(b)(1). As discussed above, to prevent poten - Regulations would eliminate these con - 48 Congressional Research , “Firms That tial abuses, FIRPTA generally denies the ditions. Taxpayers may rely on the Incorporate Abroad for Tax Purposes: Corpo - rate Inversions and Expatriation (updated application of nonrecognition provi - guidance in Notice 2006-46 until final March 5, 2010). sions except in limited cases. For exam - Regulations are issued and, therefore, 49 Joint Committee on Taxation, Background and ple, a foreign person may make a tax-free do not have to satisfy one of the five Description of Present-Law Rules and Propos - als Relating to Corporate Inversion Transactions exchange of a USRPI only if a taxable conditions in Temp. Reg. 1.897- (JCX-52-02, June 5, 2002), pages 3-4. USRPI is received in exchange. 41 6T(b)(2).

ACCIDENTAL INVERSIONS l JUNE 2016 l JOURNAL OF INTERNATIONAL TAXATION 31 The exception to taxation under the Section 897 Temp. Regs. and withholding under Section 1445 for certain Section 351 transactions is practically useless if the goal is U.S. estate and gift tax protection from holding shares in a foreign corporation

Overview of Anti-Inversion Rules a controlled foreign corporation to rec - When we have a tax code that allows 48 53 companies to cut their taxes on their The U.S. government has recognized ognize gain equal to the Section 1248 U.S. business by nominally moving that inversions provide tax savings in two dividend amount if a shareholder of the their headquarters offshore, then we significant ways. First, an inversion may U.S. corporate parent exchanges stock of need to do something to fix the tax reduce U.S. tax on foreign-source income the U.S. corporate parent for stock of a code. In addition, if the tax code disad - by effectively shifting income away from foreign corporation. 54 vantages U.S. companies competing in the global marketplace, then we should a U.S. corporation to its related foreign The second inversion involved the address the anti-competitive provi - corporations (“income shifting”). In turn, 1994 inversion of Helen of Troy Limited, sions of the code. I don’t think anyone this potentially achieves pure territorial a U.S. cosmetic company that redomi - wants to wake up one morning to find tax treatment for the group, rather than ciled in in a transaction that every U.S. company headquartered worldwide income treatment. 49 Second, was tax free for its shareholders. 55 In offshore because our tax code drove an inversion may reduce U.S. tax through response to this inversion, the IRS said in them away and no one did anything about it. This is about competitiveness earnings stripping with foreign related- Notice 94-93, 1994-2 CB 563, that in and complications in the tax code that party (or similar transactions), alliance with Treasury, it would introduce put U.S.-based companies out of step where a U.S. subsidiary pays interest to its guidance on the consequences of inver - with their foreign competitors. We will foreign parent and the interest may then sion transactions because they were con - work with Congress to address these be deductible for U.S. federal tax purpos - cerned that, depending on the facts and important issues quickly. es (“earnings stripping”). 50 In light of circumstances, an inversion transaction The Preliminary Report defined an these abuses, the U.S. government has may create losses improperly or permit inversion as “a transaction through which issued numerous anti-inversion rules the avoidance of income or gain in cir - the corporate structure of a U.S.-based over the past 20 years to prevent U.S. cumvention of the repeal of the General multinational group is altered so that a multinational corporations from relocat - Utilities 56 doctrine or other applicable new foreign corporation, typically locat - ing their domicile to foreign . rules. The IRS soon enacted new Regula - ed in a low or no tax country, replaces the 57 Legislative history. The history of the tions under Section 367. existing U.S. parent corporation as the inversion transaction dates back to two In 2002, Treasury released a prelimi - parent of the corporate group.” The Pre - notable corporate inversions that took nary report on the issues that arise from liminary Report said that inversion place over 20 years ago. 51 The first was the the reincorporation of U.S. multination - transactions “implicate fundamental 1982 inversion of McDermott Inc., a al companies in foreign countries (“Pre - issues of ,” recognizing that: Delaware corporation (“McDermott”), liminary Report”). 58 In a statement The U.S. tax system can operate to where McDermott Inc. shareholders accompanying the Preliminary Report, provide a cost advantage to foreign- transferred their shares to its wholly then Treasury Secretary Paul O’Neill said: based multinational companies over owned foreign subsidiary, McDermott International, Inc. (“McDermott Interna - 50 53 tional”) in exchange for cash and shares Office of Tax Policy, Department of the Treasury, Section 1248 recharacterizes gains from the in McDermott International pursuant to Corporate Inversion Transactions: Tax Policy sale of stock as dividends to the extent of the Implications 11-14 (2002). earnings and profits attributable to the stock. 51 54 a reorganization plan. The IRS argued Bhada , 892 F.2d 39 (CA-6, 1990), aff’g 89 TC 959 H. Rep’t No. 104-586, 104th Cong., 2d Sess. that the former McDermott shareholders (1987); Caamano , 879 F.2d 156 (CA-5, 1990), 156 (P.L. 104-188, August 20, 1996). 55 were taxable under Section 304 52 on the aff’g 89 TC 959 (1987); see also Congressional See Helen of Troy Ltd., Prospectus/Proxy State - Research Service, Ways and Means Commit - ment (January 5 1994); Joint Committee on Tax - transfers of their McDermott stock in tee Democrats, “A Spike in Corporate Inver - ation, Present Law and Selected Policy Issues in exchange for stock in McDermott Inter - sions” (undated), www.bloombergview.com/ the U.S. Taxation of Cross-Border Income (JCX- quicktake/tax-inversion. 51-15, March 16, 2015); Mohan, “The Erosion of national. However, the courts disagreed 52 Under Section 304(a)(1), if one or more persons the States’ Tax Base—A Whopper of a Problem? with the IRS and found that because are in control of each of two corporations and An Examination of Possible Solutions to Corpo - “stock” did not constitute “property” one of the corporations acquires stock in the rate Inversions,” Weekly State Tax Rep’t: News other from a controlling person in return for Archive (Bloomberg BNA), October 10, 2014). 56 within the meaning of Section 317, Sec - property, the property paid for the stock is treat - The General Utilities doctrine permitted a cor - tion 304 did not apply to their stock-for- ed as a distribution in redemption of the acquir - poration to distribute appreciated assets to its stock exchange. In response to the ing corporation’s stock. The tax treatment of the shareholders without recognizing gain under cer - redemption is subject to Section 302 to deter - tain circumstances. See General Utilities and inversion, the IRS issued Section 1248(i), mine whether it is treated as an exchange or as Operating Co ., 296 U.S. 200 (1935). After its which requires a U.S. corporate parent of a distribution of property under Section 301. repeal, a corporation ordinarily must be required

32 JOURNAL OF INTERNATIONAL TAXATION l JUNE 2016 l ACCIDENTAL INVERSIONS The 2004 Committee Report reiter - ated that the inversion rules were tar - geted at “U.S. based global businesses.” Since 2004, there have been numerous Regulations, Rulings, and Notices on inver - sions. 61 Notice 2014-52, 2014-42 IRB 712, which essentially broadened the reach of Section 7874, said that Treasury and the IRS would issue Regulations to address certain transactions that are structured to avoid the purposes of Sections 7874 and 367 and certain post-inversion tax avoid - ance transactions. Notice 2014-52 also said that Treasury and the IRS planned to issue additional guidance to further limit (1) inversion transactions that are contrary to U.S.-based multinational companies. The Committee believes that corpo - Inversions demonstrate this cost rate inversion transactions are a symp - the purposes of Section 7874; and (2) the advantage in its purest form. By reor - tom of larger problems with our benefits of post-inversion ganizing to create an offshore parent current uncompetitive system for tax - transactions. In Notice 2015-79, 2015-49 corporation in a no-tax , ing U.S.-based global businesses and IRB 775, issued further guidance—much a U.S.-based group can reduce its tax are also indicative of the unfair advan - more aggressive rules—to address trans - liability significantly without any real tages that our tax laws convey to for - actions that are structured to avoid Sec - changes in its business operations eign ownership. The bill addresses the 62 and without negatively affecting its underlying problems with the U.S. tion 7874. At the time of writing this access to capital markets. system of taxing U.S.-based global article, IRS and Treasury had issued Pro - businesses and contains provisions to posed and Temporary Regulations that In 2004, Congress introduced impor - remove the incentives for entering into further limit inversions. 63 Notwithstand - tant statutory legislation (Section 7874) inversion transactions. Imposing full ing the numerous attempts by the IRS and that would diminish a U.S. corporation’s U.S. tax on gains of companies under - Treasury to curtail inversions, under the taking an inversion transaction is one ability to reincorporate in a foreign juris - such provision that helps to remove right set of facts, inversion transactions diction to obtain tax benefits. In a 2004 the incentive to enter into an inversion continue. Further guidance, or even con - Committee Report, 59 the House said: transaction. 60 gressional action, is expected.

to recognize taxable gain when it distributes an generally applied to acquisitions completed on or Section 7874 appreciated asset to its shareholder. after June 9, 2009. TD 9453, 74 Fed. Reg. 27920, 57 These were proposed in 1995 and made final in 2009-2 CB 114. In June 2012, the IRS issued final An inversion will typically occur when (1) 1996. TD 8638, 1996-1 CB 85; TD 8702, 1997- Regulations on whether a foreign corporation was a foreign corporation directly or indirect - 1 CB 92. treated as a surrogate foreign corporation. TD 58 ly acquires substantially all of the proper - Note 50, supra . 959, June 7, 2012. Notice 2014-52, 2014-42 IRB 59 712, strives to make inversions more difficult by H. Rep’t No. 108-548, 108th Cong., 2d Sess., ties held directly or indirectly by a U.S. strengthening the rules under Section 7874 and 64 part 1, at 1 (2004) (“2004 Committee Report”). corporation; (2) following the acquisi - 60 limiting the ability of companies to repatriate off - H. Rep’t No. 108-755, 108th Cong., 2d Sess. shore earnings tax free. See “Treasury and IRS tion, the former shareholders of the U.S. 561 (2004) (“Conference Report”) (P.L. 108-357, Respond to Inversions,” PwC In & Out , 25 JOIT corporation own at least 60% of the stock October 22, 2004 ). 11 (December 2014). 61 62 (by vote or value) of the foreign corpora - In June 2006, Temporary Regulations under Sec - See PwC, “Notice 2015-79 Provides Further Inver - tion 7874 were issued on the treatment of a for - sion Limitation,” 27 JOIT 44 (February 2016). 0242 tion by reason of holding stock in the U.S. eign corporation as a surrogate foreign 63 65 corporation. TD 9265, 2006-2 CB 1. In July 2006, TD 9761, REG-135734-14, April 4, 2016. See corporation; and (3) following the Notice 2006-70, 2006-2 CB 252, modified the PwC, “Temp. Regs. Further Restrict Inver - acquisition, neither the foreign corpora - effective date in the 2006 Temporary Regulations. sions,” 27 JOIT xx (June 2016). 64 tion nor its expanded affiliated group has Reg. 601.601(d)(2)(ii)(b). In June 2009, the 2006 This rule does not apply to acquisitions that 66 Temporary Regulations were withdrawn and were completed before March 4, 2003. Sec - substantial business activities in the for - replaced with new Temporary Regulations, which tion 7874(a)(2)(B)(i). eign corporation’s country of incorpora -

ACCIDENTAL INVERSIONS l JUNE 2016 l JOURNAL OF INTERNATIONAL TAXATION 33 The simplest solution to accidental inversions would be to clarify that the inversion rules apply only for U.S. federal income tax purposes

tion, compared with the total worldwide becomes a subsidiary of a foreign cor - business activities of the foreign corpora - poration and the former shareholders of tion’s expanded affiliated group (collec - the U.S. corporation hold at least 80% tively, “Three Requirements”). 67 If an (by vote or value) of the foreign corpo - inversion occurs, for a ten-year period the ration by reason of holding stock in the expatriated entity will be subject to tax on U.S. corporation. While the Base Trans - its “inversion gain.” 68 Generally, this gain action will not trigger recognition of the relates to certain transfers of stock or inversion gain, it will deny the intended property of the expatriated entity and tax benefit by treating the foreign parent income from licenses of property by the corporation as a domestic corporation expatriated entity. 69 for all purposes of the Code. 76 A foreign corporation will forever be classified as a U.S. corporation after the acquisition if at least 80% of the stock Unintended Effect of Section 7874 (by vote or value) of the foreign corpo - As discussed above, the Base Transac - ration is held by former stockholders of tion involves a transfer by a non-U.S. the U.S. corporation by reason of hold - domiciliary of stock in a USRPHC to a triggers the inversion rules, and the own - ing stock in the U.S. corporation. 70 The foreign corporation in exchange for ership threshold requirement is met, the foreign corporation will also be treated stock in the foreign corporation. If struc - foreign corporation will be treated as a as a U.S. corporation for all purposes of tured and implemented properly, the U.S. corporation for all U.S. federal tax the Code (notwithstanding Sections Base Transaction qualifies for nonrecog - purposes. As a result, the non-U.S. domi - 7701(a)(4) and (5)). 71 However, the nition treatment under Section 351. ciliary is treated as owning stock in a inversion gain will not apply in this Moreover, Regulations under Section U.S. corporation (a U.S.-situs asset) instance. 72 897 specifically allow for nonrecognition rather than stock in a foreign corpora - Section 7874(a)(2)(B)(i) requires in this type of Section 351 exchange. tion (a foreign-situs asset). the acquisition of “substantially all” of Thus, if certain reporting requirements In light of these results, the exception the properties held by the domestic cor - are met, the Base Transaction is not tax - to taxation under the Section 897 Tem - poration. Under Treasury Regulations, able under Section 351 and FIRPTA. porary Regulations and withholding the acquisition of stock in a domestic Notwithstanding these otherwise corporation is treated as the acquisition favorable results, Section 7874 potential - 65 Section 7874(a)(2)(B)(ii). 66 of assets of the domestic corporation ly causes adverse U.S. federal estate and See Reg. 1.7874-3(b). The expanded affiliated group proportionate to the percentage of gift tax consequences because the Base will be considered to have substantial business stock acquired. 73 In contrast, the acqui - Transaction satisfies the Three Require - activities in the relevant foreign country after the acquisition when compared to the total business sition of stock of a foreign corporation ments described above. More specifical - activities of the expanded affiliated group only if, that owns, directly or indirectly, domes - ly, the foreign corporation indirectly subject to the disregarded items detailed below, each of the following three tests is satisfied: (1) the tic corporation stock is not an acquisi - acquires all of the properties held by the number of group employees based in the relevant tion of the properties held by a U.S. corporation; the nonresident alien foreign country is at least 25% of the total num - 74 ber of group employees on the applicable date, and domestic corporation. No guidance who directly owned the shares in the (ii) the employee compensation incurred with has been provided in Section 7874 or U.S. corporation now owns all of the respect to group employees based in the relevant the corresponding Regulations to deter - shares of the foreign corporation, which foreign country is at least 25% of the total employ - ee compensation incurred with respect to all group mine whether “substantially all” of the holds the stock of the U.S. corporation; employees during the testing period (the “Group assets of a U.S. target corporation have and, finally, neither the foreign corpora - Employees Test”); (2) the value of the group assets 75 located in the relevant foreign country is at least been acquired. tion nor any of its affiliated members sat - 25% of the total value of all group assets on the Although there are many variations isfy the substantial business activities applicable date (the “Group Assets Test”); and (3) of inversions, the Base Transaction is exception because they do not meet the the group income derived in the relevant foreign 77 country is at least 25% of the total group income included within the type of inversion Group Assets Test since the majority of during the testing period (the “Group Income Test”). 67 when, pursuant to a plan (or a series of their assets consist of U.S. real property Section 7874(a). 68 related transactions), a U.S. corporation interests. Because the Base Transaction Section 7874(d).

34 JOURNAL OF INTERNATIONAL TAXATION l JUNE 2016 l ACCIDENTAL INVERSIONS estate situated in the United States at the time of his death is subject to U.S. feder - al estate tax. 79 Section 2104(a) says that stock owned and held by a nonresident alien of the United States is deemed to be property within the United States if issued by a U.S. corporation. 80 Prior to the issuance of Section 7874, in the Base Transaction, when the non - resident alien non-U.S. domiciliary contributed his shares in the USRPHC to the foreign (parent) corporation in exchange for stock, these newly received shares were not part of his U.S. gross estate because they qualified as a for - eign-situs asset. 81 Section 7874 now under Section 1445 for certain Section corporation, which were then trans - modifies this result by treating the for - 351 transactions is practically useless if ferred to a foreign corporation. The IRS eign parent corporation a U.S. corpo - the goal is to achieve the U.S. estate and ruled that both transfers qualified for ration for all purposes of the Code. This gift tax protection that comes from hold - Section 351 nonrecognition treatment causes the share in the U.S. corporation ing shares in a foreign corporation. 78 and were not taxable under Section 897. to be treated as a U.S.-situs asset and The IRS dealt with the Base Trans - However, the IRS did not address may cause the shares to be subject to action in Ltr. Rul. 201032016 but it did whether Section 7874 applied to the U.S. federal estate tax. 82 Therefore, Sec - not address the applicability of the Sec - second transaction. tion 7874 effectively overrides the estate tion 7874 inversion rules. The ruling Overrides of estate tax situs rules tax rules on situs categorization. involved a nonresident alien’s transfer for stock in foreign corporations. As No exception to Section 7874. of shares in two U.S. corporations that discussed above, only the portion of a Unfortunately, no exception to Section qualified as USRPHCs to a U.S. parent non-U.S. domiciliary decedent’s gross 7874 exists for the Base Transaction. For example, certain internal group restruc - 69 76 turings do not result in an inversion Id. Joint Comm. on Tax’n, DESCRIPTION OF THE 70 Section 7874(b). “TAX TECHNICAL CORRECTIONS ACT OF 2005” that is subject to the rules of Section 71 10 (July 21, 2005) (The provision clarifies that the See Conf. Rept. No. 108-755 (PL 108-357) p. 7874 that could result in the transferee inversion gain rule of Section 7874(a)(1) does not 346-47 (The provision denies the intended tax apply to an entity that is an expatriated entity with foreign corporation being treated as a benefits of this type of inversion by deeming respect to an entity that is treated as a domestic the top-tier foreign corporation to be a domes - U.S. corporation. corporation under Code section 7874(b).). tic corporation for all purposes of the Code.). 77 There are two requirements to qualify 72 Note 66, supra . Section 7874(a)(3). 78 as an internal group restructuring under 73 From a FIRPTA perspective, the Base Transac - Treas. Reg. § 1.7874-2(c). 74 tion should continue to qualify for nonrecogni - the Regulations: (1) before the acquisition, Treas. Reg. § 1.7874-2(c)(2). tion under Sections 351 and 897(e), as an 75 80% or more of the stock (by vote and val - H.R. Rep. No. 108-755, 108th Cong., 2d Sess., exchange of stock in a USRPHC for stock in a n.429 (2004) (“It is expected that the Treasury USRPHC should meet the “USRPI-for-USRPI” ue) or the capital and profits interest, of Secretary will issue regulations applying the term requirement. the domestic entity must have been held 79 ‘substantially all’ in this context and will not be Section 2103. 80 directly or indirectly by the corporation that bound in this regard by interpretations of the term See also Reg. 20.2104-1(a)(5). in other contexts under the Code.”). Several com - 81 is the common parent of the expanded See Reg. 20.2105-1(f). mentators have noted the numerous open ques - 82 affiliated group (“EAG”) after the acquisi - tions resulting from a lack of guidance on the It is possible, however, that a estate may meaning of “substantially all.” See, e.g., Peter H. alter this result. In TAM 9128001, Treasury cited tion; and (2) after the acquisition, 80% or Blessing, Targeting Business Entity Inversions: Article 9 of the U.S.- estate tax treaty: more of the stock (by vote and value) of Surrogation and Domestication, 34 Tax Mgm’t “Germany has the primary right to tax shares of the acquiring foreign corporation must be Int’l J. 3 (2005); Carl Dubert, Section 7874 Tempo - stock in a U.S. corporation which forms part of the rary Regulations: Treasury and IRS Wave Taxpay - estate of a decedent domiciled in…Germany.” held directly or indirectly by such com - 83 ers Through the Stoplight, J. Int’l Tax’n (2006). Reg. 1.7874-1(c). mon parent. 83 (Continued on page 63)

ACCIDENTAL INVERSIONS l JUNE 2016 l JOURNAL OF INTERNATIONAL TAXATION 35 Accidental Inversions Treasury to issue Regulations to ensure Assuming that the Base Transaction that certain transactions that are outside results in an inversion, clarifying Regu - (Continued from page 35) In the Base the intended scope of Section 7874 are lations would provide that the foreign Transaction, because the transferring not caught by the inversion rules. The corporation that now owns the U.S. cor - shareholder is an individual (or certain phrase “[t]he Secretary shall provide poration will be treated as a U.S. corpo - trusts), the internal group restructur - such regulations as are necessary to car - ration for U.S. federal tax income ing exception does not apply and the ry out this section” should be construed purposes only. Thus, while the foreign Base Transaction results in the stock of to mean that Treasury must ensure that corporation would be viewed as a U.S. the foreign corporation received in the Section 7874 is carried out properly by corporation for U.S. federal income tax transaction being treated as a stock in a not applying to transactions that are out - purposes, it would still be viewed as a for - domestic corporation for all purposes side the intended scope of Section 7874. eign corporation for U.S. federal gift and of the Code. Finally, as mentioned above, one of estate tax purposes. Further, the shares of the key reasons for the anti-inversion the foreign corporation received in the rules was to prevent “income shifting” by Base Transaction would be treated as a Solutions to Exempt large corporations. 86 This type of abuse foreign-situs asset for U.S. federal estate Base Transaction From is virtually impossible in the Base Trans - and gift tax purposes. Finally, if the Base Anti-Inversion Rules action scenario because any income gen - Transaction results in the foreign corpo - The legislative history of Section 7874 erated by the underlying U.S. real estate ration being treated as a U.S. corporation indicates clearly that the anti-inversion would be U.S.-source income and sub - for federal income tax purposes, no coor - rules were intended to apply to multina - ject to U.S. federal income tax, regardless dinating Regulations would be necessary tional companies with global operations of the overlying ownership. “Earnings under FIRPTA, as Temp. Reg. 1.897- looking to redomicile in a more income stripping” was the other motivating fac - 6T(a)(1) already covers a foreign person’s tax-efficient jurisdiction. Nowhere does tor behind the anti-inversion rules. 87 The transfer of a USRPI to a U.S. corporation the legislative history indicate that the act of a non-U.S. individual transferring in an exchange that otherwise qualifies anti-inversion rules were meant to apply shares of an existing domestic corpora - for nonrecognition under Section 351. 88 to the Base Transaction. After all, the tion owning U.S. real estate to a newly Closely held business exception. The anti-inversion rules focus primarily on formed foreign corporation in exchange legislative history of Section 7874 says abuses at the U.S. corporate level, not the for shares of the foreign corporation does that the inversion rules were designed to shareholder level. When the Section 7874 not, in itself, result in earnings stripping. combat the expatriations of “U.S.-based rules deprive an individual of an intend - It would require additional transactions multinational groups” that relocate their ed U.S. federal estate tax benefit, 84 they to rise to such a level of abuse. headquarters offshore. Specifically, the clearly violate the underlying intent of Limit application of Section 7874 to inversion rules originated out of the relo - 85 the inversion rules. U.S. federal income tax. The simplest cations of several large multinational To preserve the intended purpose of solution to the accidental inversion businesses (such as McDermott and the inversion rules, Congress, Treasury, would be to clarify that the inversion Helen of Troy, discussed above) that or the IRS should create a special carve- rules apply only for U.S. federal income manufactured goods or provided tech - out in the inversion rules that would tax purposes. If Section 7874 truly was nical, managerial, or skilled services. The exempt transactions like the Base Trans - intended to prevent abuse by multina - legislative history of Section 7874 does action from Section 7874. Section tional corporations and U.S.-based glob - not show that the inversion rules were 7874(g) gives the Secretary of the Treas - al businesses, Section 7874(b) should be intended to apply to closely held family ury the ability to “provide such regula - narrowed to only U.S. federal income tax businesses. Thus, another proposal tions as are necessary to carry out and not include U.S. federal estate and would be to provide a carve-out excep - [Section 7874].” While this subsection gift taxes. While a statutory change is tion under the inversion rules for close - appears to have been designed to prevent unlikely, Regulations could clarify that ly held corporations. Under such an the avoidance of the inversion rules by Section 7874(b) was not intended to exception, if the acquiring foreign cor - granting the Treasury the ability to cause foreign corporations to be treated poration in a transaction that otherwise enforce the inversion rules through reg - as U.S. corporations for purposes of U.S. qualifies as an inversion is closely held, ulatory authority, it should also allow federal estate and gift taxes. the foreign corporation would continue to be treated as a foreign corporation and not subject to Section 7874(b) or other - 84 86 Notwithstanding the application of Section See note 49, supra . wise treated as an expatriated entity 87 7874 to cause foreign corporation stock to be See note 50, supra . treated as U.S. corporation stock, it appears 88 under Section 7874(a). See Section 897(e); Temp. Reg. 1.897-6T(a)(1). that a decedent may still be entitled to exclude 89 This exception should provide sever - such stock from his estate if he qualifies for See Section 1361(b)(1). 90 al safeguards to prevent abuse. First, the benefits of an applicable U.S. estate tax treaty. See, e.g., Notices 2014-52 and 2015-79 (both See note 82, supra . addressing non-ordinary course distributions in exception could provide a cap on the 85 See generally Preliminary Report, supra note 50. relation to a potential inversion transaction). number of shareholders who own the

ACCIDENTAL INVERSIONS l JUNE 2016 l JOURNAL OF INTERNATIONAL TAXATION 63 acquiring foreign corporation, similar to the total number of shareholders on its Finally, this exception could contain the limitation on the number of share - tax return, which is akin to line I of Form an anti-abuse safeguard, similar to the holders that can own a “small business 1120S (U.S. Income Tax Return for an S rule in Reg. 1.701-2(b) in the context of corporation” (S corporation). 89 For Corporation). partnerships, which allows the IRS to example, the exception could provide Second, the exception could provide a recast a transaction if the intent of the that Section 7874 does not apply to a for - dollar threshold based on the FMV of the exception was abused. For instance, an eign corporation’s acquisition of stock in acquiring foreign corporation (and relat - anti-abuse rule would apply when an a U.S. corporation (or U.S. partnership) ed persons of such corporation) immedi - acquiring corporation uses nominees if, immediately after the transaction, the ately after the transfer. Even at reasonably to avoid the shareholder limit discussed foreign corporation is owned by 100 or high dollar thresholds, this type of excep - above or to circumvent the dollar fewer individuals (or certain trusts). This tion would not apply to large U.S. multi - threshold requirement. type of exception clearly would not apply national corporations seeking to invert. IRS consent (private letter ruling). to most U.S.-based multinational groups, Also, this rule would prevent a situation Another solution would be for Treasury and certainly would not apply to U.S. where a multi-billion dollar corporation to issue Regulations that give the IRS dis - publicly traded corporations seeking to owned by a small number of individuals cretion to exempt certain transfers from invert. Thus, such a regulatory exception attempted to use the closely held excep - Section 7874 if, on the taxpayers’ request, would be within the intended scope of tion to invert. To determine an appropri - they can prove that the transaction is Section 7874. This exception could be ate dollar threshold and overall comfort outside the intended scope of Section administered by having the closely held level, Treasury could review historical 7874. For example, if the shareholders of corporation file an annual form with the market values of companies that have the acquiring foreign corporation that IRS listing its total shareholders. Alterna - inverted and compare the projected rev - otherwise is subject to Section 7874(b) tively, the closely held corporation could enue streams from enforcing and impos - can prove that the principal purpose of be required to check a box on its U.S. tax ing the anti-inversion rules on closely the inversion is U.S. estate tax planning, return representing that it is under the held corporations against the interests of the IRS could exempt the transaction requisite shareholder limit, or simply list administrative convenience. from the application of Section 7874 through case-by-case letter rulings. The letter ruling route, as opposed to issuing additional guidance, might also be preferable because it would allow Treas - ury to avoid creating rules that lead to results that sometimes are inappropriate or unintended. 90

Conclusion Congress likely never considered U.S. federal estate and gift tax planning when adopting Section 7874. The Base Trans - action is simply not the type of transac - tion that Congress sought to prevent with Section 7874. Thus, the simplest way to prevent the Base Transaction from being caught within the overly broad language of Section 7874(b) would be to clarify that the foreign cor - poration will be treated as a U.S. corpo - ration for U.S. federal income tax purposes only. Finally, under Section 7874(g), Treasury should have the authority to exempt certain transactions, much like it has with respect to certain internal group restructurings. Such reg - ulatory guidance could be structured in several ways, as discussed above, provid - ed any regulations issued are within the intended scope of Section 7874. G

64 JOURNAL OF INTERNATIONAL TAXATION l JUNE 2016 l ACCIDENTAL INVERSIONS