*The concepts discussed in this blog are complex and require careful consideration to ensure compliance with Australian and US tax laws. Unless otherwise stated, all monetary references are to US dollar amounts, and all legislative references are to the Australian Income Tax Assessment Act (ITAA) 1997 and to the United States’ Internal Revenue Code (IRC).
Continuing on from the prior weeks’ blogs Mergers & Acquisitions: Interposing an Australian Holding Company – Part 1: Scrip for Scrip in a Cross-Border Context and Mergers & Acquisitions: Interposing an Australian Holding Company – Part 2: the US Corporate Reorganization Rules, this week we consider the application of the US anti-avoidance rules in the context of interposing an Australian holding company (AU HoldCo) to hold the equity interests in US Inc., with the stockholders of US Inc. exchanging their interests in US Inc. for equivalent interests in AU HoldCo:
The US nonrecognition rules may not apply where a reorganization results in the transfer of property to a foreign corporation (IRS publication Outbound Transfers of Property to Foreign Corporation – IRC 367 Overview 09/08/2014). Of particular relevance in this context are IRC sections 367 and 7874 discussed in our previous blog Restructuring your US operations – Part 3: Anti-avoidance rules in the Internal Revenue Code.
In this week’s blog, we examine these rules in the specific context of an exchange of shares.
IRC section 367
As noted in Part 2, the exchange could satisfy IRC sections 354 and 361.
IRC section 367(a)(1) applies in relation to an exchange described in sections 332, 351, 354, 356, or 361 such that the foreign corporation is not for the purposes of determining the extent to which the gain shall be recognized, be considered to be a corporation, thereby requiring the US transferor (US Inc.) to recognize the gain in the property transferred (shares in AU Pty Ltd) to the foreign corporation (AU HoldCo). Exceptions to this rule include:
- a transfer of stock or securities of a foreign corporation which is a party to the reorganization (IRC section 367(a)(2)). While there is an indirect transfer of foreign corporation stock (AU Pty Ltd) to AU HoldCo through US Inc. shares, it is doubtful that AU Pty Ltd would satisfy the additional requirement of being a “party to the reorganization” as the section 368(b) definition of that term only extends to the exchanging companies, or a company that controls the acquiring company; and
- a section 361 reorganization where the transferor corporation is controlled by more than five domestic corporations, with members of an affiliated group being treated as one corporation (IRC section 367(a)(4)). IRC 1504 defines “affiliated group” as one or more chains of includible corporations connected through stock ownership with a common parent, with at least 80% of the stock (by voting power and value) being owned by the parent or by another corporation in the chain.
If ownership of US Inc. does not satisfy the domestic corporation rule for application of IRC 361, then in order for section 367 not to apply in this case, the following would be required:
- an IRC section 354 reorganization – exchange of stock or securities;
- the transfer of stock or securities of a foreign corporation which is a party to the reorganization (IRC section 367(a)(2)); and
- satisfaction of the Treasury Regulations in relation to the COI, COBE and business purposes tests (discussed in Part 2).
This could occur, for example, if AU HoldCo acquires US Inc. stock and US Inc. stockholders acquire AU HoldCo shares so that there is a transfer of a foreign company’s stock. However, the business purpose test in the Treasury Regulations would need to be satisfied – what is the value that AU HoldCo would bring to the group justify a business purpose? What business or assets would AU HoldCo bring to enhance the business of the US Inc. / AU Pty Ltd structure? This is fundamental to overcoming the section 367 exclusion.
IRC section 7874 anti-inversion rules
Section 367 does not apply if section 7874 applies (Reg. 1.7874-2(j)(3)).
As AU HoldCo is an Australian (“foreign”) corporation, section 7874 must be considered as the exchange would result in a US corporation’s (US Inc.’s) shares or assets being placed under a new foreign holding company (AU HoldCo).
If section 7874 applies, the taxable income of the “expatriated entity” (US Inc, the domestic corporation with respect to which a foreign corporation is a “surrogate foreign corporation” under IRC section 7874 (a)(2)(A)((i)) would include the “inversion gain” from the exchange (IRC section 7874 (a)(1)).
Section 7874 would apply to treat an inverted foreign corporation (AU HoldCo) as a “surrogate foreign corporation” that is classified as a domestic corporation for U.S. income tax purposes, if:
- AU HoldCo acquires substantially all of the properties of a domestic corporation (US Inc.). If AU HoldCo was specifically formed for the purpose of making the acquisition, it would be treated as a domestic corporation from its inception (Reg. 1.7874-2(j)); and
- the “shareholder continuity” test is satisfied by the shareholders of US Inc. holding 80% or more (by vote or value) of the stock in AU HoldCo after the exchange, due to its prior equity interest in US Inc.
Substantial Business Activities Exception
AU HoldCo would not be treated as a surrogate foreign corporation if it has, directly or through its “expanded affiliated group” (EAG) (as defined in IRC section 1504), substantial business activities (SBA) within its jurisdiction of organization (Australia).
The Treasury Regulations in relation to the SBA exception are strict and in order to qualify for the SBA exception, AU HoldCo (or its EAG) must meet each of the following three tests (Reg. 1.7874-3):
- Group employees test: The number of group employees based in Australia must be at least 25% of the total number of all group employees on the “applicable date” (the date of the exchange or the last day of the month immediately preceding the exchange) and the employee compensation incurred with respect to group employees in Australia must be at least 25% of the total employee compensation (wages, salaries, deferred compensation, employee benefits and employer payroll taxes) incurred with respect to all group employees during the “testing period” (being the one-year period preceding the Exchange). Whether individuals are considered “employees” for the purposes of this test would be determined under US federal income tax principles and Australian tax laws.
- Group assets test: The value of the group assets (tangible personal property or real property owned or rented by members of the EAG and used or held for use in the active conduct of a trade or business by the EAG) located in Australia must be at least 25% of the total value of all EAG assets on the Exchange date.
- Group income test: The EAG’s income derived in Australia (i.e. gross income from transactions occurring in the ordinary course of business with customers that are not related persons, and who are located in Australia) must be at least 25% of the total EAG income during the testing period. Group income must be determined under US federal income tax principles or as reflected in the relevant financial statements, prepared in accordance with US Generally Accepted Accounting Principles or International Financial Reporting Standards.
The Regulations also contain anti-abuse provisions designed to ignore the transfers of assets, employees, or income that are part of a plan with “a principal purpose” of avoiding section 7874.
If the anti-inversion rules apply, AU HoldCo would be subject to US Federal corporate tax, withholding tax (at 30% on dividends paid to its shareholders), and filing and reporting requirements.
Subject to consideration of the global effective tax rate of the flow of funds to stockholders, an exchange as proposed should only be considered if:
- the group can satisfy the SBA test for the purposes of IRC section 7874, with at least 25% of its employees and 25% of its assets being located in Australia and 25% of its income being derived from Australia; and
- if section 7874 does not apply and section 367 is relevant, only if:
- the transferor corporation is controlled by more than five domestic corporations;
- there is a transfer of stock or securities of a foreign corporation which is a party to the reorganization; and
- the Treasury Regulations in relation to the COI, COBE and business purposes tests can be satisfied.
This blog is part of a 3 part series comprising:
Mergers & Acquisitions: Interposing an Australian Holding Company – Part 3: the US Anti-Inversion Rules
For more information on US-Australia cross-border M&A, please contact:
Head, US-Australia Tax Desk