Inversion Notice 2015-79, summarized in an earlier blog post, arguably imports a special business purpose requirement into the current inversion regime, further constraining tax inversions and post-inversion restructuring.  An earlier blog post discussed section 2.02 of the Notice, but section 2.03 may also be of great significance.

Section 2.03 “clarifies” the existing rules of Treas. Temp. Reg. § 1.7874-4T by providing that nonqualified property includes business property if it is transferred with a principal purpose of avoiding the purposes of the anti-inversion rules. Stock of the foreign acquiring corporation (“FA”) exchanged for nonqualified property of a foreign entity is considered “disqualified stock” that is not included in the ownership fraction, thus increasing the likelihood that the fraction will reach the dangerous 80 percent threshold.

Section 2.03 modifies Example 2 of Treas. Temp. Reg. § 1.7874-4T(j) to illustrate the point. In the current Example, partnership PRS transfers marketable securities to foreign company FT in exchange for all FT’s stock. PRS then transfers the FT stock to FA in exchange for 25 shares of FA stock. The sole individual owner of the domestic target DT transfers all of DT’s shares to FA in exchange for 75 shares of FA stock. The FT stock is considered nonqualified property, and therefore the 25 shares of FA stock are disqualified stock and the ownership fraction is 75/75.

One might think that result occurred because the marketable securities are nonqualified property and “stuffing” nonqualified property into FT ought to make the FT stock nonqualified property as well (even if the FT stock is not itself marketable), but that apparently was not the intended rationale of the Example. Section 2.03(b) of the Notice modifies the Example by (i) redefining PRS as a foreign partnership, and (ii) having PRS transfer business assets directly to FA, rather than indirectly through FT. Because the facts state that the transfer was made with “a principal purpose of avoiding the purposes of section 7874,” the FA stock issued to PRS for the business assets is considered to be disqualified stock and the ownership fraction is 75/75.

This Example appears to be inching towards imposing a special business purpose requirement for inversions. Previously, it had been thought by most commentators that determination of whether the transaction is an inversion transaction depends on compliance with the mechanical rules. The disqualified stock rules simply protect the mechanical rules from abuse.  For example, stuffing passive assets to alter a critical ratio test seems to be a form of abuse that should be addressed. But under the facts of the Example, business assets are contributed “with a principal purpose of avoiding the purposes of section 7874.”

What could rebut such an assertion? If the contributed business assets meaningfully alters the way that the combined company conducts business, that would seem to be a rebuttal. The Preamble to the -4T regulations states: “section 7874 is intended to curtail inversion transactions that ‘permit corporations and other entities to continue to conduct business in the same manner as they did prior to the inversion.’ S. Rep. No. 192, 108th Cong., 1st. Sess. 142 (2003); Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress (JCS-5-05) (May 2005), at 343.” However, the Preamble also states: “[T]he determination of whether stock of the foreign acquiring corporation transferred in exchange for nonqualified property is disqualified stock is made without regard to the use of the nonqualified property.”

Even putting aside this latter confusing statement, the Example appears to import an additional qualitative test from the legislative history: Does the contribution of the foreign business assets meaningfully alter the way the newly combined company does business? Based upon the Example, advisors may need to show that the application of this test to the business operations of the combined company results in an affirmative answer to the question.

Inversion Notice 2015-79 restricts the location of the new foreign parent company, further constraining tax inversions.

As discussed in an earlier blog post, sections 2.02(a) and 2.02(b) of Notice 2015-79 will, in most cases, require that the new foreign parent in any inversion be organized and tax resident in the country of the primary foreign target. These rules will tend to favor inversions to countries where the foreign target is already organized and tax resident – a typical scenario where the foreign target has itself inverted (although not the only applicable acquisition scenario).

However, this is the exact scenario in the Pfizer-Allergan inversion merger. Pfizer is inverting to Ireland. Allegan was acquired in 2015 by a U.S. company, Activis, that had inverted into Ireland in 2013 in its acquisition of a Bermudian company, Warner Chilcott. Warner Chilcott became a Bermudian company in 2006 when it was taken private. Its assets had been acquired in 1996 by an Irish company (Nale Laboratories), which changed its name to Warner Chillcott and was then acquired by a Northern Ireland company (Galen, which also changed its name to Warner Chillcott).

If section 2.02(b) was in place in 2013, it is likely that Activis could not have inverted into Ireland by acquiring Warner Chillcott, which was then a Bermudian company.

“New Pfizer” is the child of a series of inversions and foreign acquisitions stretching back some 20 years. Is Treasury’s next step going to be to devise restrictions specifically targeted to these types of “serial inversions?” This could prove challenging, as there are numerous possible fact patterns that would need to be addressed. However, as more U.S. companies, and larger ones, invert, the perceived need of Treasury – and eventually of Congress – to take action will increase exponentially. For example, Pfizer reported in 2014 around $74 billion in earnings permanently reinvested outside the U.S., and may have up to the same amount of foreign earnings not reported as permanently reinvested outside the U.S.

The stakes are huge. However, it appears that Pfizer will not be affected by the current inversion legislation, as its shareholders will own only around 56 percent of the new combined company, well short of the triggering 60 percent threshold under current law.

Notwithstanding that section 2.02 will not affect the Pfizer transaction, these restrictions will place  significant limits on future inversions, and may also turn out to be extremely effective in conjunction with other proposed provisions.  For example, suppose the new Model Treaty limitation on withholding on payments from expatriated entities is added to the U.S.-Ireland tax treaty.

Inversion Notice 2015-79 bootstraps on previous guidance to further constrain tax inversions and post-inversion restructuring.

On November 19, 2015, the Department of the Treasury and the IRS issued Notice 2015-79 (the “Notice”). Interpreting previous guidance, namely Notice 2015-52 and Temp. Reg. § 1.7874-4T, the Notice announces the future issuance of regulations that will provide the following:

1. 2.02(a). An expanded affiliated group (“EAG”) cannot have substantial business activities in the country in which the foreign acquiring company (“FA”) is created or organized (when compared to the EAG’s total business activities) unless FA is subject to tax as a resident of the relevant foreign country.
2. 2.02(b). Certain stock of FA will be disregarded in cases where the new foreign parent is resident in a country other than that of the primary foreign target. The disregarded stock is not included in the ownership fraction, thus increasing the likelihood that the fraction will reach the dangerous 80 percent threshold.
3. 2.03(b). “Clarification” that nonqualified property includes business property if it is transferred with a principal purpose of avoiding the purposes of the anti-inversion rules. Stock of FA exchanged for nonqualified property of a foreign entity is considered “disqualified stock” that is not included in the ownership fraction, thus increasing the likelihood that the fraction will reach the dangerous 80 percent threshold.
4. 3.01(b). Inversion gain (that can not be offset by tax attributes for the “applicable period” of 10 years) includes income from indirect transfers or licenses of property through a CFC, such as certain post-inversion subpart F income.
5. 3.02(b). An exchanging shareholder must recognize all of the gain realized during the applicable period from the exchange of stock of a CFC (or of a lower-tier CFC) if the exchange substantially dilutes (or terminates) the interest of a U.S. shareholder in the CFC. The purpose of this rule is to capture the tax on any unrealized appreciation in the value of the CFC (in excess of the tax on E&P currently provided under section 1248).
6. 4.01(b). Active insurance assets will be excluded from the definition of foreign group nonqualified property, whether owned by a foreign entity or by a domestic entity subject to tax as an insurance company under subchapter L.
7. 4.02(b). An exception to the rules designed to prevent the pre-inversion “skinny down” of the domestic expatiating entity, where the former shareholders hold only a de minimis (less than 5 percent by vote and value) ongoing interest in FA or other member of its EAG.
8. 4.03(b). Clarification that implementation of the “small dilution” exception, to the rule designed to prevent the post-inversion decontrol and dilution of ownership of CFCs, should be applied using the percentage rather than the amount of CFC stock.

Effective dates: These rules are generally effective for acquisitions completed on or after November 19, 2015. However, 4, 5, & 8 are only effective for transactions also completed on or after September 22, 2014 (the date of Notice 2015-52). In addition, 6 & 7 are taxpayer-favorable provisions that may be elected for acquisitions completed before November 19, 2015.