Friday, April 30, 2010
Jefferson P. VanderWolk (Faculty of Law, Chinese University of Hong Kong) has posted Inversions Under Section 7874 of the Internal Revenue Code: Flawed Legislation, Flawed Guidance, 30 Nw. J. Int'l L. & Bus. ___ (2010), on SSRN. Here is the abstract:
The section applies to two categories of inversions involving a limited change of ownership and the use of a new foreign parent corporation in a country where the group does not have substantial business activities. In one category, the group’s ownership does not change by more than 20 percent (disregarding any change due to a public offering related to the inversion). In such cases, the statute eliminates any US tax benefit from the transaction by treating the foreign parent as a US corporation for all purposes of the Internal Revenue Code. In the second category are inversions in which the group’s ownership changes by more than 20 percent but no more than 40 percent. In these cases, the statute respects the new parent company’s foreign status, but preserves US taxing rights over the group’s accrued gains up to the time of the inversion and limits the group’s ability to erode the US tax base through related party transactions. The statute does not apply to inversions where either the group has substantial business activities in the country of the foreign parent, or the change of ownership exceeds 40 percent.
The Obama Administration’s international corporate tax proposals would, if enacted, be likely to increase the US tax costs of many multinational groups that are owned by a US entity. One possible response by the managers or owners of such a group would be to restructure the group via an inversion transaction, so that the group would have a foreign corporate parent instead of a US parent entity. To discourage inversions, Congress enacted section 7874 of the Internal Revenue Code as part of the American Jobs Creation Act of 2004.
Section 7874 is complex. Its language immediately raised a number of issues requiring guidance from the IRS and Treasury in order to prevent absurd results. The statute also contains unclear terms, creating a need for regulatory guidance. In addition, the statute empowered the IRS and Treasury to write regulations “to prevent the avoidance of the purposes” of the section. This power has been exercised several times. The IRS and Treasury have adopted an overly restrictive interpretation of section 7874 in certain respects, with the result that certain inversions that ought not to be subject to the statute may be treated as being within its scope.
Part 1 of this article introduces the statute and discusses its legislative history. Part 2 explains in more detail how the statute works. Part 3 critically discusses particular guidance issued in 2009 relating to the ownership-change determination required by the statute. Part 4 discusses the statutory test of substantial business activities, the regulatory guidance on its application, and the implications of the subsequent elimination of much of that guidance. Part 5 discusses inversions from a policy perspective, within the context of the broader US international tax regime. Part 6 contains concluding observations.
The article concludes that the language and legislative history of section 7874 do not support recent guidance regarding the ownership-change tests. There is no indication that Congress intended to have the new foreign parent corporation treated as a domestic corporation in a case in which the owners of the group effectively transfer more than 20 percent of their equity interest to new investors via a private placement of stock in the new foreign parent corporation. Moreover, regarding the business-activities test of section 7874, the elimination of previous guidance, combined with the no-ruling position of the IRS, means that many inversions could not be undertaken with any idea of whether or not section 7874 would apply. The IRS and Treasury need to publish new and helpful guidance regarding the level of business activity in the foreign country of incorporation that will be considered “substantial” when compared to the total business activities of the group. From a policy perspective, the article advocates the partial or total repeal of section 7874 as part of a larger revision of the US international tax regime.