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.