Temporary Regulations Offer Bright-Line Test for Corporate Inversions

Internal Revenue Code (I.R.C.) Section 7874 regulates corporate and partnership inversions. An “inversion” occurs when an entity elevates a subsidiary in a low-tax jurisdiction (e.g., Bermuda) to a parent position, inverting the previous affiliation and becoming a subsidiary of the foreign-headquartered entity. By relocating one’s headquarters to a foreign jurisdiction, an entity shields its foreign-source income from the United States’ worldwide taxation regime.

Under Section 7874, when the former U.S. parent’s shareholders own in excess of 80% (by vote or value) of the new foreign entity’s stock, the IRS only respects the inversion if the foreign entity and its expanded affiliated group have “substantial business activities” in the foreign country. Otherwise, the IRS will continue to treat the company or partnership as a U.S. entity and tax it as such.

On June 7, 2012, the IRS and Treasury Department issued temporary regulations (T.D. 9592) establishing a bright-line rule for the substantial business activities exception. Under the new temporary regulations at Reg. § 1.7874-3T, an entity’s expanded affiliated group will have substantial business activities in the foreign country of incorporation if all of the following are located or derived in that foreign country:

  • 25% of the group’s employees (by headcount and compensation during the twelve-month period preceding the inversion);
  • 25% of the group’s active assets (tangible personal property and real property used or held in the active conduct of a trade or business; property the group rents is assigned a value equal to eight times its annual rent);
  • 25% of the group’s gross income from unrelated customers and in the ordinary course of business.

Under the 2012 temporary regulations, if one or more members of the expanded affiliated group hold, in the aggregate, more than 50% (by value) of the interests in a partnership, that partnership’s items shall be taken into account in the calculations above.

Potential inverters should be aware that even if they satisfy the above requirements, other tax rules (I.R.C. Section 367, net operating loss and foreign tax credit carryover suspension, etc.) continue to apply.

Please contact Michael Wiesner of Royse Law Firm, PC, at mwiesner@rroyselaw.com, if you would like to discuss the contents of this article.

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Roger Royse

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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