Corporate Expatriation Transactions: IRS and Treasury Issue Regulations on the “Substantial Business Activities” Exception and Finalize Regulations on Surrogate Foreign Corporations Under Section 7874

Sullivan & Cromwell LLP - June 13, 2012
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On June 7, 2012, the IRS and the Treasury Department issued temporary and proposed regulations (the “Regulations”) that provide for an exclusive bright-line rule to determine when a foreign corporation or publicly traded foreign partnership will be covered by the “substantial business activities” exception to the definition of a “surrogate foreign corporation.” If not so covered, the foreign corporation will be subject to U.S. tax on the “inversion gain” recognized in the next ten years, notwithstanding any contrary tax treaty provision. The Regulations are an apparent response to a number of recent transactions in which U.S. corporations, in connection with acquisitions of foreign corporations, expatriated to Ireland or Switzerland. The Regulations generally apply to acquisitions completed on or after June 7, 2012, but grandfather transactions completed after that date which are described in SEC filings or subject to a binding agreement before that date.

In contrast to prior IRS guidance, the Regulations eliminate the possibility of satisfying the exception on the basis of the facts-and-circumstances approach and significantly narrow the circumstances in which the substantial business activity requirement may be met. Under the Regulations, an “expanded affiliated group” will have substantial business activities in a foreign country only if at least 25% of the group’s employees (both by head count and compensation), gross tangible assets and gross income are located or derived in the foreign country (compared with a 10% safe harbor, since repealed, contained in the temporary regulations promulgated in 2006).

The Regulations also provide that a partnership’s employees, assets and gross income may be taken into account in the substantial business activities test only if one or more members of the group holds, in the aggregate, more than 50% (by value) of the interests in the partnership. If the 50% ownership threshold is met, then all (and not only a proportionate share) of the items of the partnership may be taken into account for purposes of the test.

On the same date, the IRS finalized regulations on other aspects relating to when a foreign corporation would be treated as a “surrogate foreign corporation” under Section 7874.