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The IRS has made good on its promise to quickly finalize the first of the two sets of temporary regulations issued under §7874 of the Code.

Briefly, §7874 applies if, pursuant to a plan: (1) a foreign corporation acquires, directly or indirectly, substantially all of the properties held directly or indirectly by a U.S. corporation; (2) the acquiring foreign corporation or any affiliated company (based on a greater-than-50% common ownership) does not have substantial business activities in the country in which the foreign corporation is organized; and (3) immediately after the transaction, former shareholders of the domestic corporation own at least 60% of the voting power or value of the stock of the foreign corporation by reason of holding stock in the domestic corporation. The stock ownership test disregards stock held by members of the expanded affiliated group (EAG) which includes the foreign corporation (for this purpose, affiliated being defined as more than 50% ownership).

If former shareholders hold at least 60% (but less than 80%) of the stock of the foreign corporation, a special tax regime applies for a 10-year period pursuant to which the U.S. company is restricted from using certain tax attributes to offset income realized on the transfer of stock or properties, including by way of license, as a part of the inversion transaction or to a foreign related person. If the former shareholders own 80% or more of the stock, the foreign acquiring corporation is treated for all tax purposes as a U.S. corporation.

It became clear early on that many internal restructurings and many acquisitions would be caught by the breadth of the statute. The following example illustrates the point: P, which owns 100% of S, transfers the stock of S to a foreign corporation taking back 100% of the stock of the foreign corporation. Because of the EAG rule, the stock of the foreign corporation held by P is disregarded in both the denominator and numerator of the required percentage test used to determine the level of shareholder ownership after the exchange so that there is no inversion. Suppose, instead, that P owns 90% of S and individual (or corporation) A owns 10% and the transaction proceeds with the two shareholders taking back 90% and 10%, respectively, of the stock of the foreign corporation. Under the EAG rule, the stock of P is disregarded (in both the numerator and the denominator of the fraction used to determine the requisite shareholder ownership level) while A is left owning, not 10% (below the 60% test for inversions), but 100%, 10/10 = 100%, well above the 80% test. This results in an inversion assuming all the other elements of the inversion test are met.

Recognizing the “unintended” consequences of the EAG rule, the IRS issued temporary regulations to provide relief in the case of certain internal restructurings and certain acquisitions. These regulations have now been finalized with little substantive change except that they've been tightened and slightly liberalized. However, the regulations are significant in the relief that they do not provide and for the warnings of further anti-abuse regulations to come.

The final regulations state the general rule that stock owned by one or more members of the EAG is excluded from both the numerator and the denominator of the fraction which is used to calculate the stock ownership percentages. This is especially designed to capture so-called “hook stock.”

Similar to the temporary regulations, the final regulations provide for two escape valves relating to internal restructurings and transactions in which a loss of control results. In these cases, while the stock held by members of the EAG is not counted in the numerator of the calculation, the stock is counted in the denominator.

Thus, in the case of internal restructurings, the rule now is that if the common parent of the EAG owns (by vote and value), directly or indirectly, 80% of the domestic entity before the acquisition and 80% of the foreign acquiring corporation, directly or indirectly, after the transaction, the stock will nonetheless be counted in the denominator (although not in the numerator). The examples in the final regulations track, for the most part, those contained in the temporary regulations.

Second, if the internal restructuring results in a loss of control, i.e., if the former shareholders do not hold, in the aggregate, directly or indirectly, more than 50% of the stock (by vote and value) of any member of the EAG, the stock held by any member of the EAG will be included in the denominator (although not in the numerator).

Examples similar to the temporary regulations are provided although the last example of the temporary regulations is conspicuously absent. That example demonstrates how many internal restructurings can still be adversely affected by §7874. In that example, C corporation and D corporation, each owning 50% of the capital and profits interest in a Delaware LLC, transfer their interests to a foreign corporation, each in exchange for a 50% interest. Because neither shareholder owns more than 50% of the foreign corporation, the basic EAG rule does not apply and neither C's nor D's shareholdings is excluded in applying the relevant stock ownership percentage test. As a result, the former shareholders own 100% of the foreign corporation and §7874 is implicated.

It's not clear why the example was dropped unless one thinks the answer is so obvious. I think nothing is obvious in the realm of §7874.

So, while the final regulations have not dramatically changed the temporary regulations, they do make clear in the Preamble that “plain vanilla” preferred stock, i.e., preferred stock that lacks voting rights and liquidation premiums and which is not convertible into common stock, will not be excluded and will be included in both the numerator and denominator of the calculation.

The private sector had earlier argued that, since the EAG definition does not include this kind of stock, it should also be ignored in the calculation for determining whether the required 80% or 60% tests are met. The IRS rejected this argument on the theory that the congressional intent was not to exclude preferred stock from the calculation although it was clear that they meant to do so in defining the EAG rule. Moreover, the IRS refused to consider inclusion of preferred stock in the definition of the EAG on the theory that it may facilitate the avoidance of the rules regarding EAGs.

And, now, the warnings. The IRS enumerated three areas in which it would issue regulations aimed at curbing abuses. Remember that in its issuance of the -2T Temporary Regulations the IRS dealt with the use of publicly-traded partnerships as a mechanism to avoid §7874 and it also issued warnings about the use of partnerships, generally, as a means by which to avoid §7874. Here are a few IRS designated areas which build upon that momentum.

In the first, the IRS said it is aware of positions being taken in title 11 or similar cases that foreign acquisitions of domestic entities in which the creditors become shareholders of the domestic entity do not run afoul of the 80% or 60% tests since the creditors were not shareholders who receive their interests in the foreign acquiring corporation by reason of having held stock in the acquired domestic entity.

The IRS maintains that the shareholders going forward are receiving their shares by reason of having held stock in the domestic entity since the creditors, in substance, are the equity owners of the acquired domestic entity at the time of the title 11 or similar case. The IRS warns that it is considering issuing regulations, under its authority to treat certain instruments as stock or to treat stock as not stock, pursuant to which such creditors would be treated as former shareholders of the domestic entity and that the stock issued by the foreign acquiring corporation would be treated as held by reason of holding stock in the domestic entity.

It seems to me that the statutory authority for the IRS to treat various instruments as stock may not necessarily contemplate viewing creditors in an emerging bankruptcy as stockholders. Warrants, options, contracts to acquire stock, and convertible debt instruments all share the same indicia of instruments that contemplate, at the outset, the right of a holder to become a stockholder. As a technical matter, that is not necessarily the case of a creditor who, because of an impending title 11 proceeding, all of a sudden becomes one in substance.

Second, the IRS acknowledged its awareness of transactions in which two or more domestic entities with approximately the same value are acquired pursuant to an overall plan with the position maintained by taxpayers that the percentage calculation is applied separately to each domestic entity with the result being that neither group of transferors is considered to own more than 50% even though, in the aggregate, the two groups of shareholders own 100% of the foreign acquiring corporation. Again, the IRS is considering issuing regulations to clarify that references to a “domestic corporation” will mean “one or more domestic corporations” where the properties of such corporation are acquired, directly or indirectly, pursuant to the same overall plan.

At first blush, this seems compelling but, admittedly, from a technical perspective, there is no question that each transferor group gives the other a 50% interest in its respective domestic entity. So, there is a difference between this fact pattern and what each transferor group could have done on its own. On the other hand, it's not hard to see how some abusive situations could arise.

Finally, the IRS stated that it is aware of taxpayers attempting to avoid the clutches of §7874 through the use of intervening partnerships. The example cited is one in which a foreign acquiring corporation issues new shares to a newly-established domestic partnership in exchange for a 99% interest in the partnership. The shares transferred to the partnership represent 70% of the outstanding stock of the foreign acquiring corporation. An affiliate of the foreign acquiring corporation transfers cash or other property to the partnership for the remaining 1% of the partnership.

When all is said and done, the position maintained by the taxpayers, according to the IRS, is that §7874 is not implicated even though, in substance, the foreign acquiring corporation acquires 100% of the domestic corporation and the former shareholders, through their 99% interest in the domestic partnership, hold more than 60% of the stock of the foreign acquiring corporation by reason of having held stock in the domestic corporation.

According to the IRS, the taxpayer's argument centers around the fact that the partnership is treated as an entity, rather than as an aggregate of its partners, and, as such, the ownership fraction is zero because none of the foreign acquiring corporation stock held by the partnership was held by former shareholders of the domestic corporation.

Once again, the IRS is considering issuing regulations to clarify that the exchange of an interest in a domestic entity for an interest in a partnership will be treated as an exchange of the interest in the domestic entity for a pro-rata share of the assets of the partnership.

This may not necessarily be an inappropriate response. However, given the fact that we are all over the lot in the treatment of partnerships as an entity or as an aggregate of its partners, it would be real nice if the IRS issued a coherent set of rules affecting partnerships rather than deal with these issues on an ad hoc basis.

This commentary also will appear in the August 8, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, and Davis, 919 T.M., Outbound Transfers Under Section 367(a), and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.