M&A Tax Considerations for Buyers and Sellers When ...

M&A Tax Considerations for Buyers and Sellers When Negotiating, Structuring, and Pricing Deals

Presented by: Roger Royse Pamela Fuller

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Tax Considerations for Buyers and Sellers when Negotiating, Structuring, and Pricing Deals

Roger Royse & Pamela A. Fuller

Royse Law Firm, PC

[email protected]

[email protected]

www.rroyselaw.com

IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication, including any attachment to this communication, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to any other person any transaction or matter addressed herein.

Tax Cuts & Jobs Act Changes

• The Tax Cuts & Jobs Act (TCJA) considerations for M&A.

• Changed the rates for Domestic Corporations. • Corporate tax rates were permanently lowed from 35% to 21%.

• New bonus depreciation rules incentivize asset deals

• Limits Corporate NOLs to 80% of TI

• Limited the allowability of interest deductions. • Interest deduction limitation no longer based debt-to-equity ratio.

• Interest is now limited to 30% of an approximation of EBIDTA (EBIT after 2021).

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Changes in Corporate Rates

• Changed the rates for Domestic Corporations. • Corporate tax rates were permanently lowed from 35% to 21%.

• US corporate valuations increased

• Asset sales more attractive

• Corporate double federal tax rate is 21% plus 20% dividend rate plus 3.8% NIIT (39.8%)

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Tax Cuts & Jobs Act Changes

• 100% bonus depreciation for “qualified property” placed into service by the taxpayer after September 27, 2017 (no cap).

• Qualified property is generally acquired tangible depreciable property, under 167(a), and 263A property with a recovery period longer than 10 years (includes films, sound recordings, video tape, book, etc.)

• Cannot be acquired from related parties, members of the same control group, or property with a transferred basis.

• General phase out begins for property placed into service in 2024 with an 80% allowable deduction,

• This phase out continues at a 20% reduction per year until a complete phase out of bonus depreciation for property placed into service in 2028.

• Section 179 deduction was increased to $1,000,000 from $500,000.

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Bonus Depreciation and Sec 179

• Incentivizes asset purchases

• Higher value to allocations to depreciable and 179 property

5

Interest Deductions

• Interest deduction limitation no longer based debt-to-equity ratio.

• Interest is now limited to 30% of an approximation of EBIDTA (EBIT after 2021).

• Less leveraged deals

• Interest expense carryforwards

• Gain from assets sales may free up interest expense

6



NOL Limitation

• Corporate NOLs arising in a taxable year after 2017 can offset up to 80% of current year taxable income

• No NOL carry-back, but unlimited carry-forwards

7

Self Created Intangibles

• After 2017, certain intangible assets can no longer be treated as capital gain assets

• Either (1) created by the taxpayer or (2) acquired from the creating taxpayer in a carryover basis acquisition :

• Patents

• Inventions

• Models and designs (whether or not they are patented)

• Secret formulas or processes

• Places pressure on allocation schedules

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Effect of the TCJA

• Asset deals are less costly to seller due to decreased rates

• Buyer will allocate more to tangible property for bonus and additional depreciation

• NOLs not as useful

• Leverage discouraged

• Allocation away from self created intangibles

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Corporations with NOL’s in a low interest environment

• Section 382 restricts the ability of a “loss corporation” to claim NOLs generated before the sale against income earned after the sale if there has been an “ownership change.”

• A “loss corporation” includes a corporation with an NOL carryover

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Section 382 – Ownership Change

• An ownership change occurs if the percentage of stock owned by 1 or more 5 percent shareholders increases by more than 50 percent during a 3 year period.

• The NOL limitation for any year after an ownership change is equal to the value of target immediately prior to the change, multiplied by the long-term tax-exempt rate

• Approximately 2.5% as of early 2016. Was 1.96% in early 2018. At 2.20% for March 2019 Rev. Rul. 2019-07 Table 3

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Modeling the Tax Aspects

• Suppose Target has NOLs

• In an asset sale, • Target has two levels of tax, maybe be able to soak up some gain with NOLS (now limited)

• Buyer takes a fair market value basis in assets, much of which will be amortizable over 15 years

• In a stock sale, • Seller has one level of tax

• Buyer does not obtain a fair market value basis in assets but does have potential to use Target’s NOLs at the rate of 2% of value of Target per year

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SAFEs, SAFTs and Tokens

• A SAFE is a security that converts into shares in a future equity issuance, much like convertible debt but with no interest accrual and no unconditional repayment obligation.

• A SAFT is a security that converts into future tokens to be issued in an initial coin offering (ICO).

• A Token is a digital asset based on distributed ledger technology that may represent a claim to equity, products or services

• Security tokens can be asset backed tokens or digitized stock

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Treatment as Stock

• IRS defines stock as a permanent interest in the corporation’s equity, i.e. its earnings and or underlying assets

₋ Tracking Stock

₋ Preferred stock

₋ Non qualified preferred

• Debt – debt v. equity ₋ Form of obligation Principle

₋ Debt equity ratio Interest

₋ Intent Management rights

₋ Subordination Credit worthiness

• Partnership Interests ₋ de facto partnerships

₋ analogy to non compensatory partnership options

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Stock Rights – Newer Investment Types

• Increasingly, alternative equity derivatives are being used to invest, but their tax status is often uncertain

• This table discusses likely tax treatments

Tax Treatment Note Alternatives (SAFEs, KISSes)

Mandatorily Convertible Debt

Potential Tax Treatment as

Equity?

Like penny warrant, could be deemed exercised from day one depending on certainty of exercise.

If the conversion occurs fairly soon and is certain, and its performance in the debt/equity factors, there is a chance it could be classified as preferred equity.

Potential Tax Treatment as

Warrant?

Probably the best analogy; SAFEs and KISSes are essentially investment stock options exercisable on certain events, rather than at certain times.

Low; the distinction between convertible debt and stock rights under §1223(5) are generally respected.

Potential Tax Treatment as Convertible

Debt?

Low; the distinction between convertible debt and stock rights under §1223(5) are generally respected.

If conversion reasonably far into future and federal tax indicia of debt are generally positive, a likely outcome.

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TYPE A REORGANIZATIONS – SECTION 368(a)(1)(A) STATUTORY MERGER

Target Acquiror

Shareholders

• Statutory Merger – 2 or more corporations combined and only one survives (Rev. Rul. 2000-5)

• Requires strict compliance with statute

• Target can be foreign; Reg. 1.368-2(b)(1)(ii)

• No “substantially all” requirement

• No “solely for voting stock” requirement

Requirements:

• Necessary Continuity of Interest (40%)

• Business Purpose

• Continuity of Business Enterprise

• Plan of Reorganization

• Net Value

Tax Effect:

• Shareholders – Gain recognized to the extent of boot

• Target – No gain recognition

• Acquiror takes Target’s basis in assets plus gain recognized by Shareholders

• Busted Merger – taxable asset sale followed by liquidation

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CONTINUITY OF INTEREST

• IRS – 50% Safe Harbor, Rev. Proc. 77-37

• IRS – 40% in Reg. 1.368-1T(e)(2)(v), example (1)

• John A. Nelson – 38% Stock

• Miller v. CIR – 25% Stock

• Kass v. CIR – 16% Stock is Insufficient

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Tax Language

The parties acknowledge and agree that for United States federal and state income tax purposes this SAFE is, and at all times has been, intended to be characterized as stock, and more particularly as common stock for purposes of Sections 304, 305, 306, 354, 368, 1036 and 1202 of the Internal Revenue Code of 1986, as amended. Accordingly, the parties agree to treat this Safe consistent with the foregoing intent for all United States federal and state income tax purposes (including, without limitation, on their respective tax returns or other informational statements).

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TRIANGULAR OR SUBSIDIARY MERGERS

Target Acquiror

Merger Sub

Acquiror Target

Merger Sub

1. Forward Subsidiary Merger

2. Reverse Subsidiary Merger

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Section 368(a)(2)(D) Forward Triangular Merger

• A statutory merger of Target into Merger Sub (at least 80% owned by Merger Sub)

• Substantially all of Target’s assets acquired by Merger Sub

• Would have been a good Type A merger if Target had merged into Merger Sub

Target Acquiror

Target Shareholders

80%

Merger Sub

Tax Consequences • Merger Sub takes Target’s

basis in assets increased by gain recognized by Target

• Acquiror takes “drop down” basis in stock of Merger Sub (same as asset basis)

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Target Acquiror

80%

Merger Sub

Section 368(a)(2)(E) Reverse Triangular Merger

• Merger of Merger Sub into Target where • (i) Target shareholders surrender control (80% of voting and nonvoting classes of stock) for

Acquiror voting stock and

• (ii) Target holds substantially all the assets of Target and Merger Sub

• Shareholder loan issues

Tax Consequences • Non-taxable to Target and carryover

basis • No gain to Acquiror and Merger Sub

under Sections 1032 and 361 • No gain to Target shareholders except

to the extent of boot • Acquiror’s basis in Target stock

generally is the asset basis, but Acquiror can choose to take Target shareholders basis in stock (if it is also a B)

• If transaction is also a 351, Acquiror can use Target shareholders’ basis plus gain

Target Shareholders

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Double Merger

Acquiror

Target Shareholders

Step 2: A-type Forward Merger Step 1: Reverse Triangular Merger

Target Acquiror

Merger Sub

80%

Merger Sub Target+Sub

Merger Sub Survives

Target Shareholders

Tax Benefit: A taxable reverse merger has just one tax on the shareholders, while a taxable forward merger has two taxes (one on shareholders and one on corporation). Intended that entire transaction be a tax-free A-type merger (where 20% boot limitation does not exist). Pairing the two reduces the risk of incurring the corporate level tax in the event the entire transaction is not treated as an A-type merger.

REV. RUL. 2001-46

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Double Merger – Wholly Owned LLC

Acquiror

Target Shareholders

Step 2: A-type Forward Merger Step 1: Reverse Triangular Merger

Target Acquiror

Merger Sub

80%

LLC Target+Sub

Merger LLC Survives

Target Shareholders

REV. RUL. 2001-46

Second step is merger into LLC under Reg 1.368-2(b)(1) (good forward merger)

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280G GOLDEN PARACHUTE RULES

20% excise tax and loss of deduction on Excess Parachute Payment • “Excess Parachute Payment” means the amount by which the Parachute Payment exceeds the Base

Amount • “Parachute Payment” means a payment, the present value of which, exceeds three times the Base

Amount • “Base Amount” means the average annual compensation for past 5 years • Must be paid to a disqualified individual (meaning employee, officer, shareholder, or highly

compensated individual) • As compensation, AND • Contingent on a change in control (50% change ownership or effective control, or ownership change in

a substantial portion of the company’s assets)

Reduce Excess for reasonable compensation Exclude reasonable compensation for future services Exception for small business corporation and non publicly traded corporation

that has 75% uninterested shareholder approval Withholding requirement

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280G – OTHER ISSUES

• Non-Publicly Traded Stock • Approval of 75% of shareholders after adequate disclosure

• Vote determines the right of the shareholder to the payment

• Ignore shares held by persons receiving the payment

• Reduction for Excess (299% of payments)

• Reduction for Reasonable Compensation

• Reduction for Future Services

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PERSONAL GOODWILL

• Key questions: (1) Who owns the goodwill (individual or company)? And (2) Was that goodwill ever transferred?

• Key case: • Martin Ice Cream – the court held that customer relationships and distribution lists were an asset of the

shareholder because they were never transferred to the company (the business began as a sole proprietorship and then part of the business was specifically transferred to a new company)

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PERSONAL GOODWILL

• Issues: • Is a buy/sell non-compete sufficient to satisfy the right to future services?

• What does the scope of the non-compete need to be? (geographic area, time, etc.)

• Is a fiduciary obligation not to compete sufficient?

• Is a non-solicitation and/or non-use of trade secrets provision sufficient?

• Best practice = shareholders should sell their “personal goodwill” separate from the stock/asset sale

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PERSONAL GOODWILL CASES

• Estate of Franklin Z. Adell v. Comm’r (Tax Court 2014) • Case about the treatment of the goodwill provided by the son of decedent’s company

• The son did not transfer his goodwill through an employment or noncompete agreement

• The Court held that the IRS’s value for the son’s goodwill was not high enough

• Bross Trucking, Inc. – goodwill may be transferred to a company via an employment contract if that employment contract grants the company a right to future services (e.g., through a non-compete provision)

• Note: non-compete provisions are generally invalid in California absent the sale of a business

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PERSONAL GOODWILL CASES

• Kennedy v. Comm’r (Tax Court 2010) • Kennedy sold his corporation; 25% of the purchase price was payment for consulting services and 75%

was payment for Kennedy’s goodwill • The Court held that the identification of personal goodwill is not enough to conclude that the goodwill was

sold • The Court found the payments to Kennedy were consideration for services because the contractual allocation

did not genuinely reflect the relative value of his customer relationships compared to the value of the his ongoing personal services

• Solomon v. Comm’r (Tax Court 2008) • Solomon sold its corporate division; the purchase agreement included a customer list and a covenant

not to compete • Nothing in the agreement made reference to the sale of personal goodwill and the acquiring party continued

to do business under its own name • The Court held that the proceeds paid directly to the shareholders were actually attributable to their covenant

not to compete rather than for a customer list or personal goodwill

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Qualified Small Business Stock (QSBS)

• Benefits • Reduced federal income tax for non-corporate stockholders on capital gains from QSBS held for more

than five years

• Gain exclusion is limited to greater of $10 million or 10x the taxpayer’s aggregate adjusted bases in the stock

• Potential to roll QSBS proceeds into new QSBS and tack holding period

• Eligibility • Stock in a C-corporation originally issued to the taxpayer after August 10, 1993 in exchange for money

or property (not stock) or as compensation for services

• Corporation is a “qualified small business”

• Original issuance exceptions • Acquired on conversion of other stock in the same corporation

• Certain carryover basis transactions

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QSBS ISSUE FOR CASH FREE STOCK SALES

• Target companies may be acquired on a cash free/debt free basis, however this often necessitates a cash dividend to shareholders immediately prior to the sale

• During negotiations, both Acquiror and Target shareholders typically treat this dividend as part of the acquisition price, however the form of the transaction is a dividend

• This pre-sale dividend can create problems for shareholders’ QSBS relief: • Under the QSBS rules, the maximum taxable gain considered available for relief is the higher of $10

million or ten times stock basis

• If the dividend payment is treated as a pre-sale distribution then it will reduce the basis of the stock and may therefore reduce the amount of gain available for QSBS relief

• Taxpayer may choose to file on the basis that the dividend is, in substance, part of the sale proceeds, however this could be subject to challenge by the tax authorities

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ROLLOVER OF GAIN INTO QUALIFIED OPPORTUNITY ZONE FUND

• Within 180 days after the sale of stock or real estate, the capital gain (not tax basis) may be invested in a Qualified Opportunity Zone Fund

• Capital gain deferred until the earlier of the date of sale or 12/31/2026

• 10% of the gain is forgiven for investment held for at least 5 years

• Another 5% of the gain is forgiven for investment held for at least 7 years

• No capital gain on the post reinvestment appreciation after 10 years

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EARN OUT PROVISIONS

• Bridge a valuation gap between seller and buyer • Additional financing option • Payment/tax deferral • Reduce risk of overpaying

• Earn outs usually based on • Financial Targets

• Earnings before interest, tax, depreciation and amortization (EBITDA); Revenue; Net income; Earnings per share

• Non-Financial Targets • Regulatory approval; Increase in customer base/sales;

Product development milestones

• Key Considerations: Terms, time period, payout structure, security for payments,

allocation of control of the acquired business, level of support (if any) committed

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EARN-OUTS TAX AND BOOK TREATMENT

Fair value of contingent earn-out is recorded as a contingent liability by the acquirer at acquisition => increases book goodwill. Earn-out not recognized for tax purposes until the amount is fixed or determinable => book basis but no tax basis at acquisition

Taxable asset acquisition (tax deductible goodwill): Two approaches to account difference at acquisition:

o Earn-out is treated as separate deductible item for tax book purposes:

- Acquisition: no tax basis = gives rise to a deferred tax asset (DTA)

- Over time: contingent payments result in book income or expense and the earn out liability is treated as non-taxable or non-deductible temporary difference which change the associated DTA

- Settlement: goodwill additional tax and additional tax amortization. DTA is reduced over amortization period but the amortization would need to be allocated between goodwill and other tax goodwill.

o Earn-out liability is treated as if its amount was settled at acquisition for tax purpose:

- Acquisition: tax basis is equal to book basis

- Over time: amortization of tax goodwill creates a deferred tax liability (DTL). Subsequent adjustments then affect the earn-out liability and create DTA or DTL because pretax adjustments to earn-out liability that are not measurements period adjustments are treated do not result in adjustments to book goodwill (ASC 805). DTA or DTL is then combined with DTL driven by tax amortization.

- Settlement: goodwill additional tax basis and additional tax amortization

Non-Taxable stock acquisition (non tax deductible goodwill): the initial basis of the shares (outside stock basis) is the purchase price of the stock. Additional goodwill related to earn-out liability does not result in additional tax basis for goodwill or outside stock basis. When subsequent payments are over and earn-out liability is settled there is no immediate tax effect but later adjustments can affect the tax rate.

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CONTINGENT PAYMENTS AND EARN-OUTS

• Distinguish Equity vs. Debt

• 3 Issues • (1) allocation between interest and sales proceeds;

• (2) timing of realization of sales proceeds; and

• (3) timing of basis recovery

• Interest • 1.1275-4(b)

• Contingent payment debt for cash or publicly traded property – use non-contingent bond method; projected non-contingent and contingent payments

• 1.1275-4(c) • Contingent debt instrument issued for non-publicly traded property – bifurcate into non-contingent

debt instrument and contingent debt instrument; contingent payment treated as principal based on present value, excess is interest

• Buyer’s basis is non-contingent portion plus contingent payments treated as principal

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Partnership Structure with Profits Interest

Target

Hold Co, LLC

Target Shareholders

100%

100% 100%

Merger

$$

Merger Co

Acquiror

Hold Co, LLC

Target Shareholders

100%

Issuance of unvested profits

interest

Acquiror

Target, LLC

Acquisition Structure: Post Acquisition:

Target converts to wholly-owned LLC - treated as a tax-free liquidation into Hold Co, LLC if a single member LLC

100% less profits interest

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S CORPORATIONS AND 338(h)(10)

T (S Corp) Acquiror

Merger Sub

Target Shareholders

• Character difference – ordinary income assets

• California – 1.5% tax on S corporations

• New York – gain from 338(h)(10) sale of New York S corporation is New York-source income

• All Target shareholders must consent on Form 8023

• Deemed 338 election for subsidiaries

• 1374 – BIG Tax • Minority shareholders in rollover • Hidden tax in liquidation or

deemed liquidation in installment sale.

• 3.8% NIIT Tax

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S CORP 338(h)(10) ELECTION AND

453B(h) BASIS ALLOCATION ISSUE

• Gain to Shareholders in year of sale: $1 million x 80% = $800,000; A/B of Shareholder = $1.8 million • No 331 liquidation: $1 million cash decreases A/B by $1 million to $800,000; $800,000 A/B in Note = $3.2 million

gain • 331 liquidation – apportion basis: $1.8 million basis apportioned $360,000 to cash and $1,440,000 to Note; Gain

in cash of $640,000 and gain in note of $2,560,000 for a total of $3.2 million gain (GP % on liquidation is 64%) • Defer cash portion and include in installment obligation: gain on liquidation equal to zero; Shareholder A/B in

note of $1 million; profit % is 80%

Target Acquiror

$1 million cash $4 million 453 Note

Stock Sale

$1 million basis

Cash - $1 million / $1 million A/B Assets - $4 million / zero A/B

Reg. 1.338(h)(10) – 1(e) Example 10

Shareholders

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S CORP NO 338(h)(10) ELECTION – DISAPPEARING BASIS

T (S Corp) Acquiror

Merger Sub

T Shareholders

Carryover Basis

Liquidate Target into Merger Sub or check the

box Q-Sub

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Alternative to Section 338(h)(10) S Corp Investment/Acquisition Using LLC

• Target S Corp shareholders form new S Corporation Holding Company

• Target S Corp shareholders contribute their Target stock to the new holding company which immediately elects QSub status

• Target converts to limited liability company and distributes retained assets & liabilities

Steps 1 & 2

S Corporation Holding Company

Target S Corp (QSub)

Target S Corp

Shareholders

Retained Assets and Liabilities

Target LLC

LLC Conversion

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S CORP INVESTMENT STRUCTURE

Holdings, Inc. (S Corp)

Target, Inc. (QSSS)

T Shareholders

Step One:


Target, LLC (QSSS)

Step Two:

T Shareholders


Target, LLC (QSSS)

T Shareholders

Step Three:

Investor

$$

Membership interest

Step One: Shareholders of Target, Inc. transfer all Target, Inc. stock to Holdings, Inc. in exchange for Holdings, Inc. stock. Holdings, Inc. makes an S election and Target, Inc. elects to be treated as a qualified subchapter S subsidiary (QSSS). Step Two: Target, Inc. converts to an LLC for state law purposes (Target, LLC). Step Three: Investor purchases a membership interest in Target, LLC from Holdings, Inc.

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Section 336(e)

Acquiror

Shareholder $

Target Stock

$

$ Assets

Assets

= Actual Component

= Deemed Component

Acquiror Shareholder

Target Target 3rd Party

Basic Model (for 80% stock sales): Target is treated as selling all of its assets to an unrelated person while owned by its former shareholders and then reacquiring same upon acquisition by Acquiror.

Section 336(e) does not apply to sales to a “related person.” The attribution rules could give rise to an unexpected “related person” situation where the seller acquires at least 5% of the acquiring partnership as part of the transaction. For example, where an investment partnership acquires a target and provides a modest partnership interest to the selling shareholders.

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SECTION 336(E) DETAILS Section 336(e) Basic Model

• Similar to h-10 but can be a non corporate buyer or a distribution

• 336(e) election is made by Seller and “old” Target: they must enter into a binding, written agreement

• “Old” Target is treated as selling all of its assets to an unrelated fictional person while owned by Seller (shareholders) for an amount equal to the “aggregate deemed asset disposition price” (ADADP) which is the sum of the grossed-up amount realized on the disposition (sale, exchange or distribution) plus the liabilities of “old” Target

• “New” Target is treated as acquiring all of the assets from an unrelated fictional person

• After the deemed asset disposition, but before the close of the disposition date, while owned by Seller, “old” Target is treated as transferring to seller all of the consideration deemed received from “new” Target, generally in complete liquidation of “old” Target

• “Old” Target shall recognize all of the gains and losses realized on the deemed asset disposition

• Seller does not recognize gain or loss on the disposition of target stock

• “New” Target is treated as a new corporation for federal income tax purposes but remains liable for the tax liabilities of “old” Target

• Step up in the tax basis of the “old” Target’s assets to fair market value.

• No effect upon a purchaser

• No effect upon minority shareholders, or shareholders other than seller, except in the case of S corporation targets

• For dispositions involving distributions, losses on deemed sales of assets are disallowed to the extent of the net loss, if any, recognized by Target

Tax Consequences

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International Tax Aspects

of Structuring M&A



Provisions of the 2017 TCJA that Significantly Altered Cross-Border M&A Stakes

Move to Partial “Territorial Regime”

Lower US Corporate Tax Rate

Broader US Corporate Tax Base for US Shldrs of foreign subs

TCJA Drastically Changes How Foreign Subsidiary Income

of US Corporations is Taxed

BEFORE 2017 US Tax Act

General Rule: United States generally taxes US corporations on a “worldwide” basis—i.e., US corporations taxed currently on both US-source income and foreign source income they receive. (Contrast with a pure “territorial jurisdiction,” which taxes its resident corporations only on income earned within its borders—not on foreign-source dividends and other foreign income ).

Policy for Worldwide (“Residence-Based”) System: Belief that capital is allocated more efficiently when investors’ choices about where to invest are not distorted by tax considerations. Economists believe it is more efficient if investments are made on the basis of pure economic fundamentals.

Deferral “Privilege” Exception: If a FOREIGN corporate Sub (of US corporate parent- as per diagram) earns foreign-source income, US corporate tax is not imposed on the foreign Sub’s income unless and until it is repatriated to the US—in an actual or deemed dividend. (Indefinite tax deferral is tantamount to a complete tax exemption due to time-value of money.)

Policy Rationale: US-owned foreign Subs need a “level playing field” to compete and should not have to pay both foreign and US taxes when their competitors do not. Thus, U.S. tax deferral is allowed so long as the foreign Sub can be viewed as truly competing in an active trade/business in its relevant market abroad. However, to the extent the foreign Sub receives income that is either “passive” or looks like “conduit income” (i.e., earned through an low-tax branch/tax haven), the deferral “privilege” ends w/respect to that income, which is then taxed currently to its US shareholder(s) under one of several statutory anti-abuse regimes. Rationale: Foreign Sub is just there for tax advantages—not to compete in a foreign trade/business (i.e., “capital import neutrality” policy objective no longer being served).

Foreign Tax Credits: The corporate income taxes imposed by U.S. upon actual or deemed repatriation of a foreign Sub’s E&P may generally be offset with the foreign taxes already paid on that E&P via a tax credit (to extent it eliminates double juridical taxation).

US C-Corp

Foreign Corp

U.S.

Foreign Jurisdiction

Foreign-source income

Dividend

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TCJA Drastically Changes How Foreign Subsidiary Income of US Corporations is Taxed:

No More Deferral—Sub’s E&P is either taxed currently or exempted

AFTER 2017 US Tax Act

General Rule: United States still generally taxes its US corporations on a “worldwide” basis—but at a much lower rate—i.e., 21% (down from 35%). However, the corporate tax base is broader with more foreign Subs’ E&P subject to US tax. Also, there is some foreign-source income that is completely exempt from U.S. corporate taxation . Thus, new system is still a “hybrid system” exhibiting attributes of both a residence-based AND territorial system.

“Deferral Privilege” Exception is formally eliminated: Now, all income of a foreign subsidiary owned by a U.S. corporation will be either:

Taxed currently by US (either under one of the pre-existing anti-abuse regimes (PFIC or expanded Subpart F ) OR under the new very broad category of §951A “GILTI” income (Global Intangible Low-Taxed Income), which functions as a minimum tax , which can reach a foreign Sub’s income even if it’s not passive or conduit income; OR

EXEMPT from U.S. corporate taxation (forever).

Three categories of foreign-source income of foreign Subs are now EXEMPT . But these may not amount to much due to the breadth of the new GILTI minimum tax. They include:

1. CFC’s earnings attributable to the 10% notional return in the GILTI regime (QBAI), which qualifies for the § 245A DRD when repatriated:

2. Income of 10% corporate “US Shareholders” of foreign Subs that do not qualify as CFCs (but do qualify as “specified foreign corporations” and so get the § 245A DRD); and

3. Pre-1987 E&P accumulated by foreign Subs, but only to extent of the pro rata share owned by 10% U.S. CORPORATE shareholders, since the §965 Transition Tax does not apply to those earnings and the §245A DRD applies when repatriated.

In Sum: U.S. still has a “hybrid system” –i.e., part Residence-based (perhaps more so now) and part Territorial. Despite its new territorial attributes, the purview of US corporate tax is probably greatly expanded… but at a much LOWER rate—21% (vs. the former 35% ).

US C-Corp

Foreign Corp

U.S.

Foreign Jurisdiction

Foreign-source income

Dividend

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Overview of U.S. Code Provisions

Governing

Cross-Border Reorganizations

IRC § 367



IRC § 367 - General Overview

• In general, Section 367, when it applies, turns “off” the non-recognition provisions that usually govern tax-free corporate reorganizations, and taxes the shareholders.

• Section 367(a): applies to Outbound tax-deferred reorgs. Applies to outbound transfers of property by U.S. person to a foreign corporation in any transaction to which § § 332, 351, 354, 356, or 361 applies, and turns OFF these non-recognition provisions with respect to built-in gains unless an exception applies, imposing a shareholder-level tax on the gains inherent in the property transferred (as though the property were sold).

• Section 367(b): applies to Inbound reorgs, Inbound § 332 LQs, and foreign-to-foreign reorgs.

• Section 367(d): applies to outbound transfers of “intangibles” by a U.S. person to foreign corporation in an exchange to which § § 351 or 361 would otherwise apply. Treats the intangible property as though it were licensed to the foreign corporation for a deemed royalty stream “commensurate with the income” generated by the intangible. (Thus, 367(d) inserts § 482 transfer-pricing principles.)

• Section 367(e): applies to outbound spin-offs (to which § 355 would otherwise apply) and to outbound liquidations.

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IRC § 367(a)

Outbound Cross-Border Reorganizations

• § 367(a)(1) – General Rule: “If, in connection with any exchange described in section 332, 351, 354, 356, or 361 , a US person transfers property to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be treated as a corporation.”

• General rule is one of taxation unless an exception applies.

• If the transaction does not qualify as a “reorg” under 368, then 367 does not apply (transfer is treated as a sale, which might yield a better result—e.g., installment sale treatment under § 453A).

• Exceptions to Gen. Rule of § 367(a)(1):

• § 367(a)(2): Outbound transfers of stock/securities in a foreign corporation, if that foreign corporation is a “party to the reorg” (and unless an exception in the regs applies)

• Outbound transfers of domestic stock: Regulations provide that generally, gain is recognized unless:

• No more than 50% of stock of foreign Acquiror received by US transferors,

• No more than 50% of stock of foreign Acquiror owned after the transfer by US “control group” (i.e., officers or directors or 5% Target shareholders)

• Gain Recognition Agreement ("GRA") is entered into by 5% US transferee shareholders

• 36 month active trade-or-business test is met,

• No intent to substantially dispose of or discontinue such trade or business,

• FMV of the assets of transferee must be at least equal to the FMV of the US target, and

• Tax reporting obligations are met

• § 367(a)(3) – (Repealed by 2017 TCJA) Transfers of property for use in the foreign transferee corp’s active trade or business.

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TCJA Repealed the Foreign Trade/Business Exception of § 367(a)(3)

and Added a new “Recapture” Rule for Foreign Branch Losses –New § 91

• Repeal of § 367(a)(3): Prior to its repeal, subsection (a)(3) provided an exception to the general recognition rule of §367(a)(1) for asset transfers if the assets were used in the active conduct of a trade or business outside the U.S.

• Because of its repeal, all outbound transfers of tangible property (in what would otherwise qualify as an outbound reorg) are subject to tax under § 367(a(1) at the shareholder level.

• Tax may now be recognized in any outbound asset reorg or on the incorporation of a foreign branch.

• New § 91 – Foreign Branch Loss Recapture: § 91 applies if a U.S. corp transfers substantially all of the assets of a foreign branch to a “specified 10 % owned foreign corp(defined in §245A) w/respect to which it is a “US shrldr” after transfer.

• The U.S. corporation must include in gross income the “transferred loss amount” with respect to such transfer, which is any excess of:

• Deductible losses incurred by the foreign branch after Dec. 31, 2017, and before the transfer, over

• Taxable income of the branch for a tax year after the year in which the loss was incurred and through the close of the year of the transfer, plus any amount recognized under § 904(f)(3) on the transfer.

• The transferred loss amount is generally reduced by the amount of gain recognized by the taxpayer on the transfer.

• Recaptured loss amounts are treated as U.S. source income.

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IRC § 367(d)

Treatment of Intangibles

• § 367(d)(1): “Except as provided in the regulations…if a US person transfers intangible property to a foreign corporation in an exchange described in §351 or § 361,

• (A) subsection (a) does not apply to the transfer and • (B) provisions of 367(d) apply instead.

• § 367(d)(2): Treats outbound transfer of intangible property as though it were sold for a stream of contingent payments—contingent on the productivity of use of the property over its useful life.

• “The amounts taken into account shall be treated as “commensurate with the income attributable to the intangible.”

• Treated as a royalty stream that IRS has the right to adjust under transfer pricing principles and transfer pricing regulations applicable to intangibles.

• What if the intangible is “sold” outright? Can an outright sale avoid the stream of deemed royalties (which is phantom income)m, and also “fix” the value on the date of the putative sale—perhaps locking in a lower value before it appreciates?

• If it is a controlled transaction under § 482, the IRS still has the power to adjust the amount of the royalties in order to prevent the evasion of taxes and to “clearly reflect income.” And, with respect to controlled transactions involving intangibles, the transfer or license must be “commensurate with the income attributable to the intangible.” See § 482 (last sentence).

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IRC § 367(d)

Treatment of Intangibles ( continued – 1)

• The TCJA revised the definition of intangible property in § 936(h)(3)(B), which was incorporate by reference in §367(d)(1), and thus applicable to outbound transfers of intangible property under § 367(d).

• Under prior law, §936(h)(3)(B) defined intangible property as any: • patent, invention, formula, process, design, pattern, or know-how;

• copyright, literary, musical, or artistic composition;

• trademark, trade name, or brand name; • franchise, license, or contract;

• method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or

• any similar item, which has substantial value independent of the services of any individual.

• Missing from the definition was: “foreign goodwill, going concern value, and workforce in place.” • Taxpayers would routinely argue that the legislative history of § 367(d) indicated that Congress did not think these

intangibles should be subject to § 367(a) because their value was ostensibly created outside the U.S. Taxpayers would also argue that if subject to § 367, they should fall under the general rule of 367(a), and thus be eligible for the exception for assets transferred for use in the foreign corporation’s active trade/business (i.e., prior to that exception’s repeal).

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IRC § 367(d)

Treatment of Intangibles (continued – 2)

• As revised, the definition of intangible property now includes “any goodwill, going concern value, or workforce in place (including its composition and terms and conditions (contractual or otherwise) of its employment).”

• Thus, Congress, in the TCJA, ended the longtime argument; these types of intangible are now clearly subject to § 367(d) deemed royalty treatment rather than § 367(a).

• The revised definition of intangible property is now set forth in § 367(d)(4). And, §936 was repealed in the Consolidated Appropriations Act, 2018 (P.L. 115-141).

• The TCJA also removed “any similar item” in the old definition, replacing it with a more specific catch-all phrase: “any other item the value or potential value of which is not attributable to tangible property or the services of any individual.”

• New grant of strong regulatory authority in § 367(d)(2)(D): an amendment permit Secretary to write regulations and require valuation of intangible property transfers on an aggregate basis or on the basis of realistic alternatives.

• Thus the TCJA confirms the authority of the IRS to require certain valuation methods be applied to intangible property..

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IRC § 367(a) and (d)

Planning for Outbound Transfers of Tangible and Intangible Assets

• § 367 now results in income or gain recognition on all outbound transfers of tangible and intangible property.

• But if transferor is a US C-Corp, tax is imposed at a reduced corporate rate of 21%.

• FDII deduction under § 250? If the assets transferred are for “foreign use,” the §367(a) gain or a §367(d) deemed royalty inclusion could be considered “foreign derived intangible income” (FDII) and thus eligible for a deduction under §250 that could further reduce the rate to 13.125%.

• Issue as to “related party” • “Foreign Use” requirement • “Sale” requirement • Foreign Branch Income Exception • Foreign tax treatment of the transfer (basis step-up on the

sale, greater amortization dds) • Also, consider deductibility of actual or deemed royalty

payments by (or US depreciation/amortization dd of) FS in its home jurisdiction.

• Impact on the GILTI calculation

• Assume that USP incorporates its foreign branch, FS, turning it into a corporate sub. USP is deemed to transfer its branch assets to a “foreign corporation”, thus triggering § 367(a) and (d).

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USP

FS Foreign

Sub

USP transfers tangible and intangible assets to FS

IRC § 250 – FDII Overview

The deduction for “foreign derived intangible income”

• New deduction for U.S. corporations for foreign-derived intangible income (FDII) reduces the U.S. tax rate on income from certain export sales and licenses and services provided to persons outside the United States.

• The current FDII deduction is 37.5%, which produces a 13.125% ETR (the deduction is reduced to 21.875% starting in 2026 for an ETR of 16.406%).

• In general, income is included in the computation of FDII if it is derived from (1) sales of property to any foreign person for foreign use, or (2) services provided to any foreign person or with respect to foreign property.

• The computation of FDII excludes certain types of income, including “foreign branch income,” which is defined in §904(d)(2)(J) as business profits attributable to one or more qualified business units in one or more foreign countries.

• The amount eligible for the FDII deduction is reduced by a fixed 10% return on tangible property.

• The FDII deduction is subject to a taxable income limitation.

• FDII Proposed Regs issued on March 4, 2019, delineating many of the requirements.

• Assume that USP incorporates its foreign branch, FS, turning it into a corporate sub. USP is deemed to transfer its branch assets to a “foreign corporation”, thus triggering § 367(a) and (d).

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USP

FS Foreign

Sub

USP transfers tangible and intangible assets to FS



IRC § 250 – FDII Overview (continued)

• “Foreign” use means any use, consumption, or disposition that is not within the United States.

• “Sale” of property includes any lease, license, exchange, or other disposition.

• Related Party Transactions: If property is sold to a related party who is not a U.S. person, the sale is not treated as for a foreign use unless the property is ultimately sold by a related party, or used by a related party in connection with property that is sold or the provision of services, to another person who is an unrelated party who is not a U.S. person, and the taxpayer establishes to the satisfaction of the Secretary that such property is for a foreign use.

• A sale of property is treated as a sale of each of the components thereof.

• If a service is provided to a related party who is not located in the US, taxpayer must establish that the service is not substantially similar to services provided by such related party to persons located within US.

• “Related party” defined by reference to § 1504(a) affiliated group, using a lower 50% threshold and including foreign corps & insurance companies. Any person (other than a corporation) is treated as a member of the affiliated group if the person is controlled by members of the group (including any entity treated as a member of the group by reason of this sentence) or controls any member.

• “Control” is determined under the rules of § 954(d)(3) (definition of “related person” for Subpart F).

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IRC § 367(b)

Inbound Reorgs & Inbound LQs, Foreign-to-Foreign • Underlying Tax Policy Concern of § 367(b) enunciated in Preamble to 1991 Proposed Regs: US shareholders should not

be allowed to repatriate the earnings and basis of their foreign corporation (which enjoyed deferral) without the imposition of US tax.

• § 367(b)’s policy with respect to Inbound Reorgs: The rules are based on principle that a “domestic acquiror of the foreign corporation’s assets should not succeed to the basis and other attributes of the foreign corporation except to the extent that the U.S. tax jurisdiction has taken account of the U.S. person’s share of the E&P that gave rise to those attributes.”

• Foreign-to-foreign transactions: § 367(b) protects the “1248 taint.” If a CFC is de-controlled in a foreign-foreign reorg, the US shareholder has to recognized a deemed dividend equal to the “1248 amount” as defined.

• Code § 367(b): General rule is no taxation unless provided otherwise in the regulations.

• § 367(b) regulations generally operated to prevent the avoidance of US tax by: • Taxing E&P of foreign subsidiaries in inbound § 381 transactions; and • Preserving such E&P, or accelerating the inclusion of dividend income, in connection with dispositions of stock in

foreign-to-foreign reorganizations.

• The § 367(b) rules can impose tax in the form of a deemed dividend equal to either the “all E&P amount” or the “§ 1248 amount”—two different measures of the foreign corporation’s E&P depending on the transaction and the underlying policy concern (e.g., de-control of a CFC without taxation generally triggers the § 1248 amount as a deemed dividend).

• The deemed dividend recognized under § 367(b) is treated as a “dividend” for all US tax purposes.

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IRC § 367(b)

Are purposes underlying § 367(b) and Regs now MOOT?

• What purpose do the § 367(b) regulations continue to serve under current law?

• Under the TCJA:

• Pre-TCJA earnings are taxed under the § 965 deemed repatriation rules.

• No more corporate tax deferral as CFC earnings are subject to current tax under Subpart F or the GILTI rules in § 951A.

• All other CFC earnings generally are exempt from US tax, as § 245A generally provides US corporate shrs with a 100% dividends-received deduction (DRD) on repatriation.

• § 1248(j) treats the § 1248 amount on the sale of stock as a dividend that qualifies for tax-free treatment under § 245A.

• § 964(e) provides for essentially the same treatment to a selling CFC upon a sale by an upper-tier CFC of stock in a lower-tier CFC.

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Foreign Sub

IRC § 367(b)

Planning for Inbound Asset Transfers in light of § 245A Assumed Facts:

• USP contributes the stock of FS to Newco U.S., after which FS elects to be treated as a disregarded entity for U.S. tax purposes. The transactions should qualify as an inbound “F” reorganization.

• Alternatively, FS elects to be a disregarded entity and is deemed to liquidate directly into USP in a section 332 transaction.

Analysis:

• Pre-TCJA: transaction would generally result in USP including the ”all E&P amount“ with respect to its FS stock in gross income as a dividend (generally, the E&P of FS attributable to the stock held by USP).

• Post-TCJA: Any “all E&P amount” dividend should be eligible for the DRD under §245A and effectively exempt from U.S. tax.

• The result would be the same in a foreign-to-foreign reorganization that resulted in the inclusion of dividend income equal to USP’s “§1248 amount” in the stock of FS (i.e., such amount would be exempt from U.S. tax under §245A).

• Don’t forget about possible impact on the BEAT tax; cf. § 311 distribution of assets from FS to USP.

(1) USP contributes FS stock to NewCo.

(2) FS elects to be treated as a disregarded entity, resulting in a deemed liquidation.

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USP

NewCo US

Foreign Sub

Foreign Sub

FS liquidates into US NewCo



JOINT VENTURE STRUCTURES

LLC

US & Foreign Assets

US Company Foreign

Company

• Section 367 Issues

• Disguised Sale ?

• Effect of assumed liabilities

• Possible application of § 721(c) if LLC is treated as a partnership…

• § 721(c) was enacted as a corollary to § 367(a)

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The U.S.

Anti-Corporate-Inversion

Rules

IRC §7874



IRC § 7874: Aimed at “corporate expatriations”

• U.S. Congress enacted IRC §7874 in 2004, and has been broadening the purview of its application in recent years with regulatory amendments.

• Senate Report states §7874 is aimed at domestic entities reincorporating offshore with little presence in the foreign acquiring corporation’s country of incorporation (i.e, the home country)…and with business operations conducted in the same manner as before the inversion.

• IRC § 367(a) imposes tax only at the U.S. shareholder level, and failed to stop several waves of high-profile corporate inversions.

• Nothing seemed to work to stop U.S. multinational companies from wanting to effectively reincorporate abroad.

• § 7874 focuses on ownership of the new foreign parent by the historic shareholders of the “inverted” domestic entity—both for purposes of its application and its effects.

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IRC 7874 – High Level Overview

• Anti-Inversion Rules – tax outbound reorganization and/or tax foreign Acquiror as a U.S. taxpayer; Code § 7874

• If ownership of former U.S. Target shareholders in foreign Acquiror is 80% or more; foreign Acquiror is treated as a U.S. company

• If ownership continuity is between 60-80%; foreign Acquiror is NOT treated as a U.S. company, but U.S. tax attributes cannot be used to offset gains

• 20% excise tax on stock-based compensation upon certain corporate inversion transactions

• § 7874 exception available for companies with “substantial business activities” in the foreign jurisdiction which exist when:

• (1) The number of employees and the amount of employee compensation in the foreign jurisdiction is at least 25% of the number of employees and amount of employee compensation in the total group;

• (2) The value of group assets (only tangible property held for use in the trade or business) located in the foreign jurisdiction is at least 25% of the total group assets; and

• (3) The income derived from the foreign jurisdiction is at least 25% of the group income

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What is a Corporate Inversion?

Simple paradigm structure BEFORE inversion

Ireland Co. US Co.

Foreign Sub

SHs SHs

US Co. Stock

UK Co. Stock

• Shareholders of US Co. exchange their stock for stock in Ireland Co.

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What is a Corporate Inversion?

Paradigm Structure AFTER the Inversion

Ireland Co.

US Co.

Foreign Sub

US SH

SHs Ireland

Focus on ownership of NFP by historic US shrlds

• IRC § 7874 requires that the former US Co. shareholders cannot own 80% or more (value or vote) of Ireland Co.—the “New Foreign Parent” (NFP).

• Otherwise, Ireland Co. (the NFP) will be treated as a U.S. CORPORATION for all U.S. federal tax purposes – a tax disaster (making all the U.S. tax planning obsolete, and also possibly creating double juridical taxation depending on the facts).

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Historical Incentives to Invert

(1) Earnings Stripping

Ireland Co.

US Co.

Foreign Sub

US SH

Ireland

SH

Note

• Earnings Stripping has been a main driver for corporate expatriations

• US MNCs have exploited opportunity to “strip-out” earnings from U.S. corp tax free through tax deductions for interest, royalties paid, etc. with little or no tax incurred on receipt by the related party.

• After 1 year, US Co. distributes a note to Ireland Co., creating the opportunity for earnings stripping with reduced withholding tax on the distribution under the US-Ireland treaty.

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(2) Access Foreign Cash without US Tax Cont.

• Before Notice 2014-52, the foreign acquiror and the former US Co. shareholders could gain access to foreign earnings in Foreign Sub through UK Co. via a “hopscotch” loan.

UK Co.

US Co.

Foreign Sub

US SH

UK SH

“Hopscotch” Loan

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(2) Access Foreign Cash without US Tax – (Plenty of it!)

• Since 1960, globalization has caused U.S. multinationals to derive an increasingly greater percentage of their profits from foreign subsidiaries.

• About $2.1 trillion

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(3) Protect Future Foreign Earnings from U.S. Tax

•High U.S. combined statutory corporate income tax rate

•Earnings of foreign subsidiaries of a U.S. multinational are subject to US tax upon repatriation if not before (e.g., subpart F)

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• The foreign acquirer could acquire foreign businesses, make strategic investments abroad, or organically expand its foreign operations without facing U.S. corporate tax on future earnings or trapping foreign earnings under the U.S.

• Inverted U.S. MNCs found ways to migrate their foreign subs so that they were newly situated under the new foreign parent—and thus further removed from the purview of the U.S. income tax net (subject to Subpart F anti-deferral regime).

Ireland Co.

US Co.

Foreign Sub

US SH

Ireland SH

Foreign

(3) Protect Future Foreign Earnings from U.S. Tax

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How Have Inversions Been Executed?

Simplistic Paradigm Structure BEFORE Inversion

U.S. Co. (i.e., “Domestic Entity” or “DE”) and Foreign Co. (FC) seek to combine under FC or a new foreign holding company—the “Foreign Acquiror” (“FA”).

DE SHs

DE (U.S.)

Foreign Subs

(CFCs)

FC SHs

FC

FC Subs (non-CFCs)

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How Have Inversions Typically Been Executed?

Resulting Structure AFTER Inversion

• Here a new foreign entity is formed by contributions of both DE and FC.

• Another variety involves DE becoming a sub of New Foreign Parent (NFP) in a “self inversion”

Legacy DE SHs

DE (U.S.)

Foreign Subs

(CFCs)

Legacy FC SHs

FC

FC Subs (non-CFCs)

New Foreign Parent

(NFP)

< 80% > 20%

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Paradigm inverting merger (BEFORE)

Inversions have often been structured as mergers, where substantially all the assets of the U.S. Target are transferred to a U.S. affiliate of the new Foreign Parent in exchange for Foreign Parent’s stock, which is distributed up to the U.S. Target’s shareholders in a liquidating distribution of the U.S. Target.

DE SHs

DE (U.S. Target)

U.S. Sub 2

U.S.

Sub 1

FC SHs

FA

(Foreign Parent)

U.S.

Affiliate

Merger

Foreign Parent Shares

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Paradigm inverting merger (After)

After the merger, the U.S. group has effectively been moved under the new Foreign Parent.

DE SHs

DE (U.S. Target)

U.S. Sub 2

U.S.

Sub 1

FC SHs

FA

(Foreign Parent)

U.S.

Affiliate

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Summary of Key U.S. Restrictions on Corporate Inversions

• Code § 367(a), and § 367 regulations impose tax at U.S. shareholder level. (But these rules did not stop waves of inversions)

• Tax Code §7874 (2004 HIRE Act)—the purview of which has been expanded multiple times by regulation in cat & mouse game between Gov’t and US MNCs. (Slowed down inversions for a while.)

• IRS Notice 2014-52: expanded §7874 guidance to cover transactions after 9/22/2014, impacting calculation of the numerator and denominator in the critical continuity-of-ownership fraction –(key 60% & 80% thresholds)

• IRS Notice 2015-79: Tightened rules and expanded reach of §7874

• Anti-Inversion Regs – 1.7874-1, et seq. (Final & Temp. as of Jan. 2017) implement rules described in the two Notices, and add new ones, including: “serial acquiror rule,” “multi-step acquisition rule,” modifications to SBA test & “spinversion” rules. 2017 Technical Changes.

• §385 Regs (Final as of 10/2016) to Recharacterize “Debt” as “Equity” and vice versa. (Rules attempt to remove earnings stripping incentive for inversions- but rules are very broad)

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IRC § 7874

Overview of fundamental statutory 60% and 80% tests

IRC § 7874(a)(2)(B) provides, in its pertinent part, that if pursuant to a plan or series of

related transactions:

(i) a foreign corporation (“FC”) acquires, directly or indirectly, substantially all of the properties held directly or indirectly by a domestic corporation, or substantially all the properties constituting a trade or business of a domestic partnership,

(ii) after the acquisition at least 60 percent of the stock (by vote or value) of FC is held by former shareholders or partners of the domestic entity (“DE”) by reason of their former ownership of DE, and

(iii) after the acquisition, FC’s “expanded affiliated group” (“EAG”) fails to meet the so-called substantial business activities test(which test works as an overall exception to §7874,

then FC will be treated as a “surrogate foreign corporation” and consequently any “inversion gain” will be fully taxable from the date the acquisition begins until ten years after its completion, with only limited offset by losses and tax credits.

[Note: The above is paraphrased from §7874 and emphasis of key statutory terms is supplied.]

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Overview of statutory 60% and 80% tests (Cont.)

• Section 7874(b) further provides that “notwithstanding §7701(a)(4) (defining “domestic” corporation or partnership) IF conditions (i) and (iii) of § 7874(a)(2)(B) are met and at least 80 percent of the stock of FC (by vote or value) is held by former owners of DE by reason of such historic ownership, the FC will be treated as a domestic US corporation for all federal tax purposes.

• The consequences described in subsections (a) and (b) of § 7874 do not apply, however, if the EAG satisfies the “substantial business activities” test.

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§ 7874: Key Operational Rules and Definitions

• Plan or series of related transactions: This is statutory language, but term is left undefined in the Code. Sec. 7874(c)(3) provides that “a plan” is deemed to exist for acquisitions of substantially all of the assets during the 4-year period beginning 2 years before the ownership requirements are met. (But Caution - See Temp. Reg. § 1.7874-8T – “Serial Acquisitions” rule could apply even where no “plan” is found under the facts and circumstances, or within the 4-year statutory presumption period.)

• Substantially All. Undefined in Code. But legislative history states Treasury expects to issue regulations, and is not be bound by interpretations in other contexts (like Subch. C). Subch. C reorg definition is likely to be used as analogous authority.

• Facts & Circumstances or Threshold Percentage? • Gross Assets? Net Assets? Business Assets?

• Stock of the surrogate foreign corporation “held by”: Note that test is not necessarily the stock “received” by historic shldrs of the domestic entity, but rather the stock “held” or owned by them by reason of their ownership in the domestic entity. Attribution rules.

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§ 7874: Key Rules & Definitions (cont…)

• Inversion Gain: Defined in §7874(d)(3). With respect to “60/<80” transactions, § 7874(a)(1) provides that the “taxable income of the expatriated entity for any taxable year” within the 10 year period following the expatriation (the “applicable period”) can be no less than the “inversion gain.” Inversion gain is primarily any gain realized by the expatriated entity that is related to the transaction (including §78) plus any gains realized by related tax planning occurring during the applicable period. The term includes gains realized by reason of a direct or indirect transfer of stock or other properties, or by reason of a license of any property--either as part of the acquisition described in §7874(a)(2)(B)(i), or, for non-inventory property, after such acquisition if the transfer or license is to a specified related person. Importantly, the use of certain tax attributes, such as NOLs and tax credits, to offset inversion gain is greatly limited. See §7874(e)(1).

• Expatriated Entity: Domestic target (corporation or partnership) for which FA is a “surrogate foreign corporation” and any U.S. person related under §§267(b), 707(b)(1) to the domestic target. This term is relevant to measuring “substantial business activities” in the SBA test.

• Expanded Affiliated Group [EAG]: Use §1504 affiliated group rules, but without regard to §1504(b)(3) and substituting > 50% vote and value instead of 80%. (This term is relevant to measuring “substantial business activities”.)

• Applicable Period: Defined in § 7874(d)(2) as the period beginning on the first date properties are acquired in the acquisition described in § 7874(a)(2)(B)(i), and ending on the date which is 10 years after the last date properties are acquired as part of such acquisition.

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Snapshot of Key § 7874 Rules

KEY TEST of IRC § 7874: • If historic Shldrs of US Corp receive > 50% of New Foreign Parent: Deal is generally taxable to U.S. Shrlds of

the U.S. Corp under §367.

• If historic Shldrs of U.S. Corp own at least 60%, but < 80% of NFP: Restrictions are imposed on the inverting U.S. Corp, but NFP is respected for U.S. tax purposes as a foreign (non-U.S.) corporation. However, U.S. Corporate group is taxed on “inversion gain” (as defined).

• If historic Shldrs own 80% or more of NFP: Then NFP will be treated as a U.S. corporation for U.S. TAX purposes (even though it remains a foreign corporation for other legal purposes) -- a tax disaster! (U.S. tax planning is rendered meaningless; multiple juridical taxation could now be a real risk).

==================================================================== • Because the SBA test is so difficult to meet, the key focus has been on the amount of stock the former shareholders

of US Corp OWN in New Foreign Parent (NFP) after the transaction (by reason of their prior ownership in U.S. corp) and the resulting ownership fraction—i.e., 50%, 60%, or 80% of NFP.

• NOTE: Current IRS Regulations are aimed at how this ownership threshold is measured. When the new rules are applied, it can move historic ownership from approx. 55% historic /45%) to say 61% historic/39% --making §7874 applicable!

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Illustration of 80% and 60% Tests of § 7874

• If, after transaction, historic Shldrs of US Co. own 80% or more (by vote or value) of Ireland Co., Ireland Co. will be treated as a U.S. corporation for U.S. tax purposes – a terrible result. (All tax planning failed; there is also a risk of multiple international taxation.)

• If, after transaction, historic shldrs of US Co own at least 60% but < 80%, then Ireland Co. is respected as a foreign corporation, but the U.S. Co. group is taxed on “inversion gain.”

Ireland Co.

US Co.

Foreign Subs

US SHs

SHs

-- 80% or > -- 60% to 79%

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“Substantial Business Activities” Test

• § 7874(b)(2)(iii): If the “expanded affiliated group” (EAG), including the foreign acquiring corp, has “substantial business activities” in the same country where the foreign acquiring corp is created or organized, as compared to the total business activities of the EAG, then the foreign corp is not treated as a “surrogate foreign corp” (and the rules of §7874 do not apply to the transaction).

• Original 2006 SBA Regs: had facts-and-circumstances test and a 10% bright-line safe harbor (requiring at least 10% of tangible assets, employees, compensation, and third party revenues to be in FC’s jurisdiction)..

• July 2012 Regs: imposed a 25% bright-line test as the exclusive SBA test.

• Notice 2015-79: announced requirement that foreign acquiring corporation also be subject to tax as a “tax resident” in the foreign country of its creation or organization in order to meet SBA test.

• Reg. §1.7874-3T(b)(4): implemented the “subject-to-tax as a tax resident” rule of Notice 2015-79, and did not alter the 25% test of the existing regulations. (Result: can no longer arbitrage residency –i.e., having tax residency in a different, more advantageous treaty country that looks to place of “mngmt & control” while §7874 uses “place of incorporation” as corporate residency test.)

SBA is the Big Exception to § 7874, but Difficult to Meet

83

“Substantial Business Activities” Test (Cont. -2)

Meeting the “taxable foreign parent” rule of Reg. §1.7874-3 (originally issued as Temp. Reg – 6/3/2015): • The SBA test will be satisfied only if at least 25% of the

EAG’s “group” employees, group assets and group income are located or derived in the foreign acquiring corporation’s country of incorporation. (Look to EAG’s financial statements for purposes of determining the amount of items of income that are taken into account rather than for the purpose of identifying the members of the EAG. See §1.7874-3(d)(10)

• Reg. §1.7874-3(b)(4) now requires that the foreign acquiring corporation also be a tax resident in the foreign country of its creation or organization.

AND

Tax Resident

UST

(US)

FA

(Country X)

F2

(Country Y)

F1

(Country X)

- At least 25% of employees

- At least 25% of group assets

- At least 25% of group income;

84



Ownership Rules modifying the Numerator of the Ownership Fraction

Non-Ordinary Course Distributions NOCD – Basic Rules of -10 (final as of 1/13/2017))

• Reg. §1.7874-10 treats former owners of the U.S. target as receiving additional value (not vote) in stock of the foreign acquiring corporation when the U.S. target has made NOCDs.

• Requires excess distributions made by a U.S. target to be “added back” to the value of the U.S. target for purposes of calculating the ownership fraction (but not SBA).

- Excess of total distributions in each look- back year over 110% of the average amount of distributions in the thirty-six month period preceding the start of each look-back “year”.

- 36-month look-back period from closing date divided into three look-back “years”.

UST

(US)

Shareholders A

Shareholders B

<70% >30%

FT

(Country X)

Excess

Distributions

are “added

back”

<85% >15%

FA

(Country X)

Ownership Percentage

After Adding NOCDs

15 %

85


Year 1 Year 2 Year 3

Look-Back Period

DHP for LBY 1

DHP for LBY 2

DHP for LBY 3

Steps to determining the amount of NOCD with closing due date of Date X:

1. Identify look-back period.

2. Divide the look-back period into 12 month look-back years (LBYs).

3. Identify the distribution history period (DHP) for each look-back year.

4. Calculate the NOCD threshold for each look-back year.

5. Calculate, for each look-back year, the excess, if any, of all distributions made during the look-back year over the NOCD threshold for the look-back year. Such excess amounts constitute NOCDs.

Non-Ordinary Course Distributions

86




NOCD rule under § 367(a)

• For purposes of determining whether a foreign acquiring corporation is substantial in relation to a U.S. target corporation, Reg. §1.367(a)-3 (now final) provides that the value of the U.S. target company includes the aggregate amount of NOCDs made by the U.S. target company, subject to application of a de minimis rule.

• In this regard, NOCDs and the de minimis exception are calculated in the same manner as provided under Temp. Reg. §1.7874-10T (final as of 1/13/2017)

Non-Ordinary Course Distributions

87

Subsequent Transfers – General Rule


General Rule

• Foreign acquiring corporation stock received by a former corporate owner of a domestic target that is subsequently transferred will not be treated as held by a member of the EAG.

• The transferred stock will be included in the numerator and the denominator of the ownership fraction.

Exceptions:

• U.S.-parented groups; and

• Foreign-parented groups.

FA

USP

US

Target

S/H

UST

Step 2:

USP spins

FA

Step 1: USP

transfers UST

to FA

UST

88



Passive Assets/Cash Box Rules

Ownership Rules modifying the Denominator of the Ownership Fraction

• Reg. §1.7874-7T (now final as of 1/13/2017) disregards stock of a foreign acquiring corporation for purposes of calculating ownership continuity if the value of such stock is predominantly (i.e., more than 50%) attributable to certain passive assets (the “passive assets rule”).

• Includes an exception in the case of de minimis ownership continuity.

89

Anti-Stuffing Rules

Ownership Rules modifying the Denominator of the Ownership Fraction

General Rule

•Section 7874(c)(2)(B) provides that stock of a foreign acquiring corporation sold in a public offering related to the acquisition of a U.S. target is excluded from the denominator of the ownership fraction.

•Reg. §1.7874-4T (now final) further excludes certain “disqualified stock” from the denominator of the ownership fraction.

•Defines “avoidance property” as any property (other than specified nonqualified property) acquired with a principal purpose of avoiding 7874, regardless of whether the transaction involves an indirect transfer of specified nonqualified property.

Public

DT

(US)

75% 25%

Treas. Reg. §1.7874-4T(j), Example 3

PRS

(Country X)

PRS Properties

FA

(Country Y)

PRS Properties

Contributed

DT stock in

exchange for

FA stock

Contributed

PRS

properties in

exchange for

FA stock

90



End of Corporate Tax Deferral and Expansion of Subpart F

- Expanded purview of CFC Rules

- New Tax on “GILTI” – New § 951A

- One-time “Transition Tax” – New § 965

Expanded Purview of Subpart F’s CFC Rules Post-TCJA

Six ways the 2017 Act broadened Subpart F’s application

1. § 951(b) definition of “US shareholder” was broadened to include a value test -(after TCJA, the test for “US shldr” is a US person owning at least 10% of EITHER vote OR 10% of value of a foreign corporation (directly, indirectly through foreign entities, or constructively through modified § 318 attribution rules).

2. Amended § 951(b) to provide that the new definition of “U.S. shareholder” applies “for purposes of this title,” – (i.e., Title 26—the whole U.S. Internal Revenue Code)—instead of just for purposes of Subpart F as under pre-TCJA law.

3. Repealed IRC § 958(b)(4), which had (prior to repeal) turned-off the downward stock attribution rules of § 318(a)(3)(A) through (C) for purposes of imputing stock owned by a foreign person to a US person (in identifying US shldrs and CFCs).

4. Eliminated from § 951’s income inclusion rule the requirement that a foreign corporation must be a CFC for at least “an uninterrupted period of 30 days” during any taxable year in order for a US shldr to be taxed. (Now a foreign corporation need only be a CFC for 1 day.)

5. Added a broad new category of income to Subpart F—i.e., § 951A “Global Intangible Low Taxed Income” (GILTI). Although § 951A GILTI is not technically within § 952’s definition of “Subpart F Income,” GILTI is part of Subpart F, and GILTI’s application thresholds are basically the same (i.e., only “US shlders” in a “CFC” are taxed on GILTI inclusions, as that new residual category is defined).

6. Added , to very end of Subpart F, new § 965 --“Treatment of deferred foreign income upon transition to participation exemption system of taxation” (i.e., the “Transition Tax”)

92



Expanded Reach of Subpart F- CFC Rules Post-TCJA

Basically, when does Subpart F regime apply?

• Subpart F regime can potentially apply whenever there is a “controlled foreign corporation” (CFC).

• CFC is defined in § 958(a) as “any foreign corporation if > 50% of the total voting power OR > 50% of total value is owned by 10% “US shareholders” on any 1 day.

• For purposes of identifying “US shldrs” and testing for “CFC” status, stock ownership can be direct, indirect through foreign entities, or constructive. (Attribution rules of § 318 are incorporated by reference in Subpart F, but with modifications.)

• Beware of control premiums and value discounts (“drag along” & “tag along” rights)

• With respect to voting power, courts have looked to power to control board of directors. See Framatome v. Cir. 118 TC (2002) (because the veto powers and supermajority requirements prevented US shldr from exercising powers over Japanese corp ordinarily exercised by a domestic board of directors, US shareholder did not have > 50% voting power. Court relied on Alumax v. Cir., 109 TC 133 (1997), aff’d 11th Cir.

Foreign Corp = CFC

Foreign Corp

US P/S or LLC

US Individual

45% value; 45 vote

35% value; 35% vote

20% vote & value

Foreign Corp is a “CFC” because the “US shareholders” (i.e., the US LLC and the US individual together own > 50% of the vote (and here, also 55% of the value). IF US individual owned only 5%, then there would be no CFC.

93


“US shareholder” definition broadened to include US persons who own 10% of vote OR VALUE

• “US shareholder” was historically defined in § 951(b) as a “US person” that owns at least 10% of the foreign corporation’s VOTING stock . VALUE WAS IGNORED.

• The 2017 Tax Act amended § 951(b) to add a value test….so that a U.S. shareholder is now defined as any “US person” that owns (directly, indirectly, or constructively) at least 10 % of foreign corp’s voting stock OR 10 % of foreign corp’s VALUE.

• Value test is likely to import all the judicial and administrative IRS authority regarding control premiums, minority discounts, and in some instances, “drag-along” and “tag along” rights, valuation of beneficial ownership—making process of identifying “US shldrs” in complex family trust and/or corporate arrangement more complex.

• Effective date of new “US shldr” definition is prospective: Applies to CFC tax years beginning after 12/31/2017,and for taxable years of US shldrs in which or with which the CFC’s year ends. Sec. 14214(b), TCJA.

• “US person” includes US citizens, US residents, US C- corp, S Corps, partnerships formed in the US, Estates taxable in the U.S., and non-foreign trust

• For § 951(b) purposes (defining “US Shareholder”), stock ownership has always been computed, and continues to be computed, using the “direct” and “indirect through foreign entities” of § 958(a) AND the constructive attribution rules of § 958(b) (which incorporate § 318, but modifies them in significant ways)

• Although constructive ownership rules are used to identify “US shareholders” and “CFCs,” income is included in proportion to each US shldr’s direct and/or indirect ownership only! US shldrs are never subject to tax based on shares they own only constructively. See flush language of § 958,and confirmed in House Report and 2018 Notices.

• § 965: While constructive ownership can cause § 965 to apply, only the E&P of foreign corporations attributable to shares actually owned (directly and indirect) are deemed repatriated.

• § 951A: While constructive ownership can cause § 951A to apply, inclusion is based on shares of the CFC owned directly and indirectly (not constructively).

94




“US shareholder” broadened to include 10% of vote OR VALUE • PRE- TCJA law: “US shareholder” defined as a US person owning

stock representing 10% or more of the total voting power of all stock of the foreign corporation. § 951(b). (Ownership could be direct, indirect, or constructive.)

• Thus, a US person holding nonvoting preferred shares representing 10% of the VALUE was not treated as a “US shlder.” That US person could not be counted for purposes of determining whether a foreign corporation was a CFC. And, if it was a CFC, such shldr would not be subject to US taxation under Subpart F.

• POST-TCJA Law: TCJA expanded definition of “US shareholder” to include a US person owning shares representing 10% or more of the VALUE of all shares of the foreign corporation (regardless of the shareholder’s voting power).

• RIGHT: US individual qualifies as a “US shareholder” of the Foreign Corp because she owns stock representing at least 10% of the foreign corporation’s value.

• But IF the value of US individual’s shares is only 9% of the Foreign Corp’s total value, then US individual is not a “US shareholder” and her shares can not be counted to determine if Foreign Corp is a CFC. (Note that she also only owns 9% of vote.)

• Here, value of US individual’s shares is critical. If the value of her shares is only 9%, then Foreign Corp is not a CFC because US LLC does not own > 50% of vote or value. IF US individual’s shares can be counted (because she has at least 10% of total value, then her ownership counts, and together US LLC and US individual own shares totaling > 50% of the total value of Foreign Corp.

Foreign Corp

US individual

Voting Common • 9 % vote • 6% value

Nonvoting Preferred

• 4% value of ForCorp

US LLC Voting Common • 41 % vote • 41% value

Foreign persons

95


§ 958 (a) & (b): different rules and different purposes

§ 958 contains the ownership “attribution” rules for determining stock ownership. Subsections (a) and (b) serve different purposes, and contain distinct rules.

§ 958(a)(1) and (2): Gen. Rule: For purposes of Subpart F (other than § 960(a)(1)), stock owned means—

• stock owned directly (§ 958(a)(1)), and

• Stock owned indirectly through foreign entities, including a foreign corporation, foreign partnership, foreign trust, or foreign estate. § 958(a)(2). (Do not attribute up through domestic entities.)

• US shlds are taxed only on their direct and indirect ownership as determined under §958(a)(1) & (2)—not on their constructive ownership.

• § 958(b) defines “constructive ownership” of stock, for purposes of identifying a

• “US shareholder” defined in § 951(b);

• “CFC” defined in § 957;

• “related person” as defined in § 954(d)(3); and

• US shldr(s) that has “invested in US property” under through domestic corporations, pursuant to §956(c)(2).

• § 958(b) expressly incorporates the § 318(a) attribution rules, but modifies them.

96



BEFORE the 2017 TCJA: How did § 958(b) modify the § 318(a) attribution rules?

PRE – TCJA:

Section 958(b): Constructive attribution rules, for purposes of Subpart F, incorporate the attribution rules of § 318, but modify them as follows:

1) NO NRA to US individual stock attribution: In applying § 318(a)(1)(A), no stock of a non-resident alien is to be attributed to a US citizen or a US resident alien for purposes of making the US individual a “US shareholder” or § 954(d)(3) “related person” or identifying a CFC;

2) Upward Attribution (i.e., up TO owners of entities from the entities): In applying §318(a)(2)(A) – (C), if a partnership, estate, trust, or corporation owns, directly or indirectly, more than 50 % of the total combined voting power of all classes of stock entitled to vote of a corporation, it shall be considered as owning ALL the stock entitled to vote. (Policy: effective control is assumed.)

3) In applying § 318(a)(2)(C), the phrase “10 percent” shall be substituted for the phrase “50 percent” used in subparagraph (C).

4) Downward Attribution rules of 318(a)(3)(A) –(C) are turned OFF: Such rules can never be applied so as attribute stock owned by a foreign person to a US person (e.g., to make the US person a US shareholder).

97


Repealed § 958(b)(4)’s limit on downward attribution

• The 2017 Act repealed IRC § 958(b)(4)…..RETROACTIVELY.

• This change is applicable to the last year of the foreign corporation that begins before Jan. 1, 2018 (and the taxable years of its US shareholders that end with or within the CFC’s taxable year). This means that for calendar year taxpayers, the repeal of § 958(b)(4) applies retroactively—i.e., to taxable years ending in 2017.

• Before its deletion from the US Tax Code, § 958(b)(4) provided:

“ Subparagraphs (A), (B), and (C) of Section 318(a)(3) shall not be applied so as to consider a United States person as owning stock which is owned by a person who is not a United States person.”

– § 318(a)(3)(A) provides for downward attribution of stock ownership TO partnerships and estates . (The partnership/estate is treated as owning whatever the partner or estate owns.)

– § 318(a)(3)(B) provides for downward attribution of stock ownership TO trusts (exception for “remote contingent interests” in which case there is no downward attribution to the trust).

– § 318(a)(3)(C) provides for downward attribution of stock ownership TO corporations:

“If 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such corporation shall be considered as

owning the stock owned, directly or indirectly, by or for such person.” *

* Note that the relevant threshold under § 318(a)(3)(C) is “AT LEAST 50%” of the value…

98



Repeal of § 958(b)(4) – Myriad Collateral Effects: “Pop-Up CFCs” & real, substantive Subpart F tax exposure

Foreign Parent (Non- CFC)

US Shareholder Foreign

Shareholders 10% vote or value 90%

Foreign Sub 1 Foreign Sub 2 Foreign Sub 3 US Sub

Borrower Guarantor Guarantor Guarantor

318(a)(3)(C): For Co owns at least 50% of US Sub by value…

• Prior to the TCJA, Foreign Subs 1, 2 and 3 were not CFCs

• Because Foreign Parent Co owns US Sub stock w/at least 50% total value, § 318(a)(3)(C) is triggered. Thus, ALL the stock owned by Foreign Parent is treated as owned by US Sub-

-making US Sub both a § 951(b) “US shlr” and Foreign Subs 1, 2, and 3 “CFCs.”

• US Sub not taxed on constructive ownership (which is all it owns in this diagram).

• BUT the 10% US shlder (at the top) owns 10% of the CFC indirectly (through Foreign Corps) and thus IS taxed on its pro rata share of all Subpart F earnings of Foreign Subs 1, 2, 3.

Also, the indirect US Shldr could also have tax under §§ 956 (Earnings invested in US Property); §951A (GILTI; § 965 Transition Tax (even though none of the foreign corps are

“controlled” directly or indirectly by US shs.

• Here, advisors should review income and earnings of each CFC. Also, need to review loan documentation requiring guarantees (because under of § 956 Investment in US Property, any CFC guarantee of a U.S. obligation could trigger a deemed dividend).

99

Congress’ Repeal of § 958(b)(4):

Myriad Collateral Damage – (intended or not?)

• The TCJA repealed a limitation on downward attribution of stock ownership to an entity from its owner

• This change applies beginning in the last taxable year of a foreign corporation that begins before Jan. 1, 2018 (and the taxable years of its US shlders that end with or within the corporation’s taxable year). This means that for calendar year taxpayers, the repeal of § 958(b)(4) applies retroactively—i.e., to taxable years ending in 2017.

• This is not just an outbound issue for U.S. shareholders.

• Without the old restriction of § 958(b)(4), a U.S. sub of a foreign parent company may be considered a U.S. shareholder of a non-U.S. sister subsidiary of the foreign parent.

• Myriad Implications of this repeal, which were likely NOT intended by Congress: • If foreign parent has a 10% direct or indirect U.S. direct or indirect shareholder (not constructive) such shareholder could have

Subpart F, §951A GILTI, IRC § 956, or other “phantom” income (not within the scope of the post-inversion decontrol-of-CFC transactions;

• Foreign investors in U.S. corporations may cause their non-U.S. subsidiaries to become CFCs; • Qualification for U.S. portfolio interest exemption for withholding may be implicated (i.e., lost! -- the foreign corporate recipient

of the US-source “portfolio interest” cannot qualify for the exemption if it is a CFC receiving interest from a related person). • Will often wreak havoc with PFIC/CFC overlap rules. • Happily may cause the PFIC rules to not apply with respect to new § 951(b) “US shareholders” • May cause § 1248 to apply, triggering “dividends” that qualify for the new § 245A DRD.

100



Effect of repeal of § 954(b)(4):

Obligation to file IRS Form 5471

• Repeal of § 958(b)(4) dramatically increases the number of US shareholders who are now required to file Form 5471.

• IRC § 6038: If any foreign corporation is treated as a CFC for any purpose under subpart F, the Secretary of Treasury may require any US person treated as a US shareholder (or officer or director) of such corporation to file an information return on Form 5471, providing information about the entity.

• IRS Form 5471, entitled “Information Return of US Persons with respect to Certain Foreign Corporations” is normally required to be filed with the US shareholder’s tax return. The US persons required to file, and the extent of the information they are required to provide on Form 5471, varied based on the person’s filing “category” (e.g., Category 2, 3, 4, or 5.)

• Under Category 5, a Form 5471 is required to be filed for each CFC with respect to which the US person is a “US shareholder.” (Form 5471 Instructions).

• Stiff Penalties for Failure to Timely File Form 5471: $10,000 for each annual accounting period (for each missing Form 5471). If any failure continues for more than 90 days after the day on which the Secretary mails notice of such failure to the United States person, such person shall pay [increased penalties] not exceeding $50,000 (for each foreign corp for which a Form 5471 was due). IRC § 6038(c).

• Failure to file a Form 5471 can also result in decreased foreign tax credits. IRC § 6038(c).

• Repeal of 958(b)(4), as well as expanded definition of “US shareholder” dramatically increases the number of CFCs and US shldrs, and therefore the obligation to file Forms 5471 (many being obligated with respect to their 2017 taxable years). But see “group filing exception” below.

• Fairness Concerns: US shldrs and US subs could get hit with substantial penalties for not reporting on the operations of foreign corporations over which they have no control and from which they will never be entitled to receive income (because their ownership is only constructive). The “Category 5” filing obligation can apply even when a US shldr is not otherwise subject to tax under subpart F.

101

Increased Obligation to file IRS Form 5471:

Notice 2018-13 provides limited relief

• General Rule: Notice 2018-13 provides limited relief for “constructive US shldrs” from obligation to file a Form 5471 but only with respect to “constructive” CFCs

• Specifically, in section 5.02 of the Notice (and echoed in Preamble or the Proposed 965 Regs) IRS announced its intent to “amend the Instructions for Form 5471 to provide an exception from Category 5 filing for a US person that is a US shareholder with respect to a CFC if:

(1) “no US shareholder (including such US person) owns, within the meaning of §958(a), stock (directly or indirectly) in such CFC, and

(2) the foreign corporation is a CFC solely because such US person is considered to own the stock of the CFC owned by a foreign person under § 318(a)(3).”

• Thus, a very limited exception! Basically, it is a “but for” test. If the foreign corp would not be a CFC but for the constructive ownership of the US shareholder (who owns no stock directly or indirectly), then a Form 5471 may not need to be filed. Also, it appears from language in the Notice, that no other US shareholder may hold ANY stock directly or indirectly. So…use caution when trying to fit within this narrow exception.

• Group filing exception to filing Form 5471: To alleviate redundant filings, a joint ownership exception generally allows one U.S. person to file a joint 5471 on behalf of other persons required to file the same information for the same CFC. Example: Only one Form 5471 for a CFC may need to be filed by a consolidated group even when there multiple Category 5 US shldrs due to expanded § 958(b) constructive ownership rules.

• When a U.S. person files a Form 5471 on behalf of a person that is not in its consolidated return group, the person relying on the exception must attach to its return a statement that identifies the filer and provides certain other information.

• Look for updated Instructions to Form 5471. Anticipate more guidance on Form 5471 filing obligations from IRS.

102



Repeal of § 958(b)(4):

Increased exposure to § 951(a), as well as § 956, § 951A GILTI, and § 965 Transition Tax

• Not only can classification of the foreign sub as a CFC under § 318(a)(3)(C) increase exposure to taxation under § 951(a) (Foreign Personal Holding Company Income, Foreign Base Company Sale & Services Income and other categories of § 951(a) “Subpart F Income,” it can also trigger the application of many other tax provisions in the Code. For example:

• § 956 Earning Invested in U.S. Property: Where a foreign corp suddenly becomes a “CFC,” many types of transactions can be characterized as “deemed repatriations” under § 956 (e.g., loans, pledges of stock).

• GILTI Exposure under § 951A: applies to §951(b) “US shareholder” of a “CFC,” using the same exact same definitions and ownership thresholds. But as under § 951(a), § 951A GILTI tax is computed on with respect to shares actually owned (i.e., directly and indirectly).

• § 965 Transition Tax: The mandatory repatriation rules of 965 apply to “US shareholders” of “specified foreign corporations” (SPF) that have post-1986 E&P that was not previously taxed (or repatriated). A SPF is defined as a CFC or any foreign corporation that has at least one domestic C-Corp that is a § 951(b).

• §245A participation exemption: The DRD is denied with respect to “hybrid dividends” in certain tiered CFC structures.

• Many other provisions can be triggered, even though the underlying policy reasons for the application of those provisions is often not present.

103

Repeal of §958(b)(4):

Impact on application of §965 Transition Tax

• US Sub directly owns 9% of Foreign Sub, and, under revised section § 958(b), constructively owns the remaining 91% of Foreign Sub as a result of “downward attribution” of Foreign Parent’s ownership of Foreign Sub. US Sub is treated as wholly owning Foreign Sub, and Foreign Sub is an SFC for purposes of § 965.

• Thus, US Sub would have to include in income its pro rata share of Foreign Sub’s post-86 E&P under the mandatory repatriation rules of §965, although the amount of the inclusion would be based solely on its direct and indirect ownership (9%) of Foreign Sub, and only take into account E&P earned by Foreign Sub during periods Foreign Sub qualified as an “SFC.”

• FTCs: foreign income taxes paid or accrued by Foreign Sub would not be attributed to US Sub’s mandatory repatriation inclusion because US Sub owns < 10% of Foreign Sub’s voting stock (as determined under the relevant rules).

Foreign Parent

US Sub

Foreign Sub

100%

91% 9%

104



Repeal of § 958(b)(4) – Collateral Effects:

Could Disqualify Foreign Corporate Recipient

from Eligibility for US Portfolio Interest Exemption • A CFC cannot qualify for the all important US Portfolio

Interest Exemption if it received interest from a “related person.” § 881(c)(3)(C).

• Excluded from the definition of “portfolio interest” is interest “received by a CFC from a related person” (within meaning of §864(d)(4)/ § 267(b), (f).

• Because TCJA repealed §958(b)(4), the downward attribution rules of §318(a)(3) are no longer “turned off,” and are operative beginning with foreign corporation’s tax years beginning before 12/31/2018.

• Because Foreign Partnership owns at least 50% of the value in US Portfolio Corporate Fund, such Fund is deemed to own all the stock that Foreign P/S owns. (Same rule would apply if F-1 owned at 50% of the value). Therefore, under §318(a)(2), US Portfolio Fund constructively owns 60% of F-2, making it a “US shldr” and making F-2 a CFC.

• Suddenly, F-2 (a CFC) cannot qualify for the US Portfolio interest exemption because F-2 is a CFC receiving the interest from a “related person” within the meaning of §267(b), (f)

• A lot of restructuring has been (or must be) done to get around this sudden loss of the US Portfolio Interest Exemption…(lost retroactively for taxable year beginning before 2018).

F-1

US Portfolio

FUND F-2

loan

Interest payments (often

exempted from US 30% withholding tax if they qualify as “portfolio interest”)

P/S owns 55% of US Portfolio Fund

Foreign P/S

60%

F-1

105

Repeal of § 958(b)(4) – Collateral Effects:

Could wreak havoc with PFIC/CFC overlap rules

• TCJA’s removal of § 958(b)(4) from the Internal Revenue Code will cause some PFICs to become “CFCs” and subject to CFC rules, instead of the dreaded PFIC rules. (A “good thing” usually…)

• § 1297(d): a foreign corporation that is a CFC as to any U.S. inclusion shareholder cannot be a PFIC. Many may find this is a happy consequence of the repeal of §958(b)(4) since it may help some avoid the horrid PFIC rules. (Some may have even tried to qualify for the CFC regime instead of the PFIC regime but failed. Application of 318(a)(3) can help in that instance.)

• Eligibility for §245A Deduction. Dividends from a PFIC do not qualify for the §245A deduction, but dividends from a CFC do. (Thus, where repeal of §958(b)(4) causes a foreign corp that would have been a PFIC to become a CFC, a US shlder that is a “corporation” will be allowed the deduction.

• Pop-Up PFICs: A foreign corporation can be a PFIC with respect to non 951(b) shldrs (owning < 10%) and a CFC with respect to § 951(b) shldrs. Under §1297(e)(2), if the foreign corporation is a CFC (and not publicly traded), it is required to apply the PFIC asset test of §1297(a)(2) by reference to the adjusted basis, rather the fair market value, of its assets. This will often cause the corporation to be treated as a PFIC when it would not have otherwise qualified had the FMV test applied.

• PFIC Parent, CFC Sub. Recall the simplest example of a “faux CFC” (i.e., foreign sub of a foreign parent that happens to own a US sub). Although the results in such a case might merely be annoying, like having to file Form 5471, there is a possibility that foreign parent in such a case might be a PFIC as to some U.S. shareholders, with very strange results since a PFIC would then own a “faux CFC.” *

• * See K. Blanchard, Top Ten Reasons to Limit 958(b)(4) Repeal, 47:6 TAX MNGMT, INT’L J. (2018)

106




• More unintended consequences of § 958(b)(4)’s repeal (a non-exclusive list)

• Qualifying for the 245A Participation Exemption: US shareholder that sells stock in a “faux CFC” may have a §1248 “dividend” that can qualify for the §245A DRD. (“A good thing.”)

• Basis bump-ups and more PTI: Inclusions of any extra Subpart F and/or GILTI income can give rise to positive basis adjustments under §961 and create PTI for purposes of §959 and §965. (“A good thing.”)

• Portfolio Interest Exemption: Section 881(c)(3)(C) and §881(c)(5) limit the availability of the US Portfolio Interest Exemption as applied to interest paid to CFCs by “related persons.” Clearly, the policy underlying these restrictions is not implicated in the case of a faux CFC.

• Expatriations: §877 provides punitive tax rules for US citizens or long-term green card holders who expatriate. §877(d)(1)(C) and §877(d)(4) punish expatriates who own or form CFCs (apparently including these “faux CFCs” that pop-up due to the repeal of § 958(b)(4).

• Subpart F Insurance Income. Repeal of § 958(b)(4) makes it easier to create income under § 953, which was already sweepingly broad. A US tax-exempt org may be subject to the UBIT (Unrelated Business Income Tax) if it is a shareholder of a faux CFC that has insurance income. §512(b)(17).

• Downward E&P adjustments under § 312(m). § 312(m) prohibits a downward adjustment to E&P of a foreign corporation that pays interest on an obligation that fails to meet the registration requirements of §163(f). This punitive rule does not apply to a foreign corporation that is not a CFC and does not have a tax-avoidance purpose. However, if a foreign corporation is a CFC, it will be subject to the punitive rule, regardless of its purpose.

• International Shipping & Aircraft Income. § 883 generally exempts income earned by foreign corps from intern’l ships and aircraft so long as the foreign corp is not “treaty shopping” and resides in a country granting US carriers an similar exemption. § 883(c)(2) turns off the treaty shopping restriction for CFCs.

107

Expanded Reach of Subpart F- CFC Rules Post-TCJA Repeal of “uninterrupted 30-day ownership” test

• PRE- TCJA: Income earned by a foreign corporation that would otherwise qualify as Subpart F income of a CFC was not subject to U.S. tax if the foreign corporation was not a “CFC” for an uninterrupted period of at least 30 days. § 951(a).

– Example: Assume a foreign corporation with one class of stock and a December 31st year end met qualified as a “CFC” during its last month because a US person acquired more than 50% of its stock on Dec. 3rd. Because the foreign corporation would not have qualified as a CFC for an uninterrupted period of 30 days during its taxable year, the US shareholder will not have any inclusion under 951(a) for the year of the acquisition.

• TCJA repealed this 30-day rule. Sec. 14215(a), TCJA.

• POST-TCJA: Now, a US shldr will be taxed on its pro rata share of Subpart F income even if the foreign corporation qualifies as a “CFC” for only ONE DAY, provided the US owns the CFC on the last day of the CFC’s tax year.

• New rule is effective prospectively: Repeal of the 30-day rule is effective for tax years of foreign corporations beginning after December 31, 2017, and taxable years of U.S. Shareholders in which or with which those taxable years of a foreign corporation end.

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https://www.bloomberglaw.com/product/tax/bc/W1siRG9jdW1lbnQiLCIvcHJvZHVjdC90YXgvZG9jdW1lbnQvWDdUOVRPVTAwMDAwMDA_ZG9jX2lkPVg3VDlUT1UwMDAwMDAwJmRvY190eXBlPUxBV19SRVBPUlRTJnJlbW92ZV9qcz1mYWxzZSJdXQ--f546a29010a819f4ad47d1cdb13dee763b4f8f2f/document/1?citation=26 usc 881(c)(3)(c)&summary=yes



New § 951A

“Global Intangible Low Taxed Income” (GILTI)

Basic M&A Planning Considerations

New § 951A Global Intangible Low Taxed Income - “GILTI”

• New “GILTI” tax under § 951A: Although not technically a new category of Subpart F income, new §951A taxes “US shs” of a CFC on a sweeping new

basis, functioning as sort of a residual “minimum tax.”

• Specifically, new § 951A imposes US tax on 10% (or greater) US shldrs (as defined in amended § 951(b)) on “tested income” of their CFCs.

• ‘Tested income’’ is: all gross income, less allocable expenses, other than income already taxed as (i) ECI, (ii) Subpart F income, (iii) income excluded from Subpart F by virtue of the high-taxed “kick out” exception, (iv) dividends from §954(d)(3) “related persons,” and (v) any foreign oil & gas extraction income. (Thus, tested income is likely to comprise a large portion of the operating income of many CFCs.)

• GILTI may be taxed at a lower 10.5% rate (lower than capital gains of C Corps): “US shldrs” (10%) that are “C -Corporations,” can deduct 50% of their GILTI inclusions under new § 250, which can result in a rate of approximately 10.5% .

• Foreign Tax Credits: As with Subpart F income or actual repatriation under pre-TCJA law, an indirect FTC is available on GILTI for foreign income taxes imposed at the CFC level on its tested income. § 960(d). However, all foreign taxes on GILTI income can get no more than an 80% FTC (20% is disallowed), and placed in a separate § 904 FTC basket with no carrybacks/carryforwards. Thus, obtaining full utilization of the FTCs associated with GILTI will be more difficult that under prior law. See discussion of “Affirmative Subpart F Planning” below.

• GILTI inclusion = CFCs’ “net tested income” (measured at shldr level and less losses in the same tested income category) that exceeds a fictional deemed return on investment which is basically 10% of a CFC’s aggregate tax basis in tangible property used by the CFC in producing tested income. §951A(d)(1). This type of income that can be exempted is based on QBAI (“qualified business asset investment”). This sliver of QBAI—the notional net deemed 10% return on tangible assets– is essentially never subject to US tax, even when actually repatriated.

110



New § 951A GILTI kills the “Check & Sell (Assets) Deals

Assumed facts:

• U.S. parent, Dover, owns CFC1 (Dover UK), which owns CFC 2, the foreign target.

• Dover U.K contracts to sell Target STOCK to Foreign Buyer. The gain on the stock sale is likely to be “foreign personal holding company income” under Sec. 954(c) and thus taxable under Subpart F. When Dover realizes this, it makes a retroactive Check-the-Box election (after the sale closes!!) to treat the Target as a tax transparent entity for U.S. tax purposes. This election causes (1) a deemed liquidation of the Target, and (2) a deemed sale of its ASSETS (even though the stock is what is actually being sold , and the UK sees it as a stock sale.)

• Under pre-TCJA law, a deemed sale of CFC2’s assets used in its trade or business generally escapes Subpart F income (due to an exception for sales of active trade/business assets).

• But post-TCJA, even though the deemed asset sale escapes immediate taxation under Subpart F, the gain will likely constitute “tested income” for GILTI purposes.

• Thus, the U.S. parent would include the gain from the deemed sale of assets in GILTI. (Check-and-Sell deal’s benefits are nullified.)

See Dover v. Commissioner, 122 TC 324 (2004).

Dover makes a retroactive Check-the-Box Election to be treated as selling assets (not stock) for US tax purposes

Dover

U.S.

Dover

U.K

(CFC-1)

Foreign

Target

(CFC-2)

Foreign

Buyer

(1) Dover

agrees to

sell

Target’s

STOCK

(2)

Deemed liquidation,

as a result of check-

the-box election.

Thus, actual stock

sale is treated as a

deemed sale of

ASSETS for US tax

purposes.

111

§ 951A – M&A strategy: Consider planning “into” Subpart F to avoid GILTI

• To the extent a CFC’s income is included as “Subpart F income,” it cannot be GILTI income (by definition)

• Advantages of Subpart F income (as compared to GILTI)

– “Excess foreign tax credits” can be utilized (with a 10-year carry forward). Unused GILTI FTCs cannot be carried back or forward to other years (they are just lost)

– Foreign tax credits associated with Subpart F income are not stuck in the “GILTI FTC basket” but can be cross-credited against other “general basket income, and are otherwise subject to the 10-year carryforward.

• Alternatively, elect the “high tax exception” to Subpart F under § 954(b)(4).

• How to get a “true territorial” result ?

– Take advantage of the “High Tax Exception”: Taxpayers may elect to exclude income from Subpart F IF the income is subject to a foreign tax rate of > 90% of the maximum US rate (i.e., > 18.9%). §954(b)(4); Regs. §1.954-1(d).

– Income excluded under the Subpart F “High Tax Kick-out Exception” is NOT subject to EITHER Subpart F or GILTI. § 951A(c)(2)(A)(i)(III).

– Thus, the income will enjoy DEFERRAL from U.S. taxation….AND it is eligible for the “participation exemption” (i.e., the 100% DRD) under new §245A !

• Section 904(b)(4) may apply to any allocable shareholder – level expenses.

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§ 951A – M&A strategy: Comparing US statutory tax rates & limits on FTC utilization

§245A DRD

§951(a) Subpart F

§951A GILTI

Foreign branch

§956 Invest US property

§250 FDII

Non-FDII

Effective rates (%)

0 21 10.5 21 21 13.125 21

Foreign tax credits (%)

None 100% 80% 100% 100% 100% 100%

FTC Carryforward

None 10-yrs None 10-yrs 10-yrs 10-yrs 10-yrs

Other Creates exempt income/ partially exempt asset

For corps, PTI generally means little 245A

GL or passive

Separate Basket

Separate Basket

Converts Exempt Income

Multiple year FTCs?

Most income U.S. source – no FTCs

Most income U.S. source – no FTCs

Avoid/ get in FDII

Offshore Onshore

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Some Post 2017-Tax Act Strategies to consider Using the Check-the-Box Election

• Consider converting the U.S. investor making an investment abroad into a a C-Corporation if it will have CFCs (But caution: election could trigger tax under §7874 and/or § 367(a) or (d) (now almost impossible to transfer intangibles outside US without tax due to amendments to § 367).

• Consider “planning into” Subpart F. (Why??? --to avoid GILTI as the results under GILTI could be worse, due to foreign tax credit limitations, despite lower, preferential tax rate! It is easy to plan into Subpart F – e.g., create a branch to have services performed outside the CFC’s cy of incorporation.)

• Check-the-box to flow-through status to combine QBAI in a chain of CFCd where one CFC is an “income CFC” and another is a “loss CFC” (more QBAI means less GILTI exposure)

• Check-and-Sell Transactions (Remember, tax stakes are changed because a §1248 “dividend” is eligible for the § 245A DRD.

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Qualifying for the Lower GILTI rate & the

new § 245A 100% DRD • Unless a partnership elects to be treated as a

C corporation for U.S. tax purposes (and therefore subject to multiple levels of taxation), the reduced rate on GILTI inclusions may be unavailable to its partners.

• U.S. investors may find that a domestic C corporation blocker may be a more efficient holding structure for investments in CFCs.

Tax- Exempt

Blocker (US)

CFC

US Foreign

Fund

115

New § 951A

GILTI – Key M&A Take Aways

• M&A Take Away: Although “tested income” is likely to comprise a big percentage of many CFC’s operating income, GILTI can only be earned by a CFC—not a 10/50 corporation. Thus, in disposing of a foreign corporation, this may raise planning opportunities (could dispose of shares or assets in a 10/50 corporation without triggering GILTI).

• M&A Take Away: Although modeling and running the numbers will usually be needed in more complex transactions, there are a few rules of thumb on when it may be wise to “plan into” GILTI and when to avoid GILTI:

– Avoid if US shareholder of the CFC is NOT a C Corporation (and cannot become one, or cannot make a Sec. 962 election). Reason: cannot qualify for the 50% deduction under §250, so could have a LOT of phantom income at full marginal rates (not 10.5% rate). Also, may want to avoid GILTI if US shareholder has a lot of excess foreign tax credits.

– Maybe “plan into” GILTI (or don’t fear it if) the CFCs in question own a lot of tangible, depreciable trade-and-biz assets, which can generate a lot of QBAI (qualified business asset investment), which is exempt from U.S. tax, even when repatriated.

• M&A Take Away: Deemed asset sales, even if the gain is exempted from Subpart F, are likely to produce more total gain in the form of GILTI under new § 951A. This factor will greatly impact both “check-& -sell-assets” transactions and §338(g) deemed asset sales—both of which formerly often escaped current US taxation when T was a CFC due to exceptions for sales of T/Biz assets in Subpart F Regs.)

• M&A Take-Away: However, because GILTI is often taxed to corporate US shareholders at effective rates as low as 10.5%, GILTI can effectively reduce the overall tax to the Seller depending on the facts.

116



New Due Diligence Items

• Introduced Section 965 Liabilities • One-time toll on foreign income of foreign subsidiaries of U.S taxpayers.

• 8% (cash) or 15.5% (non cash) depending on cash position of foreign corporation.

• Many companies elected to pay the liability in annual installments over eight years.

• 10% Shareholders of calendar year foreign corps incurred tax on 12/31/2017

• Potentially indefinite deferral rules for S corps

• Changes to constructive ownership rules of CFC’s subject a potentially large number of corporations to this liability.

117

Acquiring or Selling/Disposing of a U.S.-owned foreign

subsidiary:

Tax Considerations



- Overview of Stakes -

Stock Deal or Assets Deal? Taxable (or tax-deferred)?

Under U.S. tax law, there are 4 principal ways to acquire a target company:

• Taxable purchase of target corp’s stock

• Taxable purchase of target’s corp’s assets

• “Tax free” acquisition of stock in a qualified corporate reorganization exchange

• “Tax free” acquisition of assets in a qualified corporate reorganization exchange

In any M&A analysis of a desired acquisition, there are at least 2 fundamental threshold TAX questions that need to be asked up, front apart from the overall business objectives of the client:

(1) Should it be an “assets deal” or “stock deal”?

(2) Should US tax be deferred (if that’s possible), or does client want the transaction to be regarded as currently recognized for US tax purposes?

Section 338 election--including the basic §338(g) election and the more popular §338(h)(10) election--involve acquisitions that are currently “recognized” for US tax purposes—i.e., “taxable”—not just realized, but “tax deferred” through the mechanism of a carry-over tax basis to the Acquiror. § § 362(b), 334(b). If the acquisition is taxable, the Acquiror generally gets a “cost basis.” § 1012.

119

- Overview of Stakes -

Purchaser’s Basic Business & Tax Considerations

• From business, legal, and administrative perspective, the purchaser (“P”) of a corporate business often prefers buying a corporation’s STOCK rather than assets because

– A stock purchase is much easier to accomplish

– A stock purchase usually avoids disruption of Target’s contractual & other relationships regarding the assets (e.g., leases).

• But from tax perspective, a corporate P often prefers to buy T’s assets because, among many factors:

– P can obtain a higher “cost” basis in assets, which is valuable due to present value of depreciation/amortization deductions. And, post 2017 TCJA, a higher depreciable basis in tangible assets provides a QBAI cushion against imposition of the new GILTI tax under § 951A…(see in-depth analysis of this and other factors, with examples below)

• In general: If certain requirements are met, a § 338 election affords a corporate P the business & legal convenience of a stock purchase, but with the tax benefits of an asset purchase by allowing the P to elect to treat the stock purchase as an asset purchase for federal income tax purposes.

120



The § 338(g) Election Mechanism (p.1)

• A corporation that purchases at least 80%, by vote and value, of the stock of a Target corporation (excluding certain nonvoting preferred) within a 12-month period (i.e., a “qualified stock purchase” or “QSP”) can elect irrevocably to treat the stock purchase as an asset acquisition.

• Deemed Asset Sale: If the § 338(g) election is made, the Target Corp (“Old T”) is treated (for tax purposes only) as if it sold all of its assets to itself (i.e., “New Target”) at the close of the first day on which the Purchaser has acquired 80% of Old Target's stock (i.e., the “acquisition date”).

• The Target is then treated as a new corporation (i.e., “New T”), unrelated to Old T, that purchases, on the day after the “acquisition date,” Old T’s assets at a price that reflects the price paid for T’s stock, adjusted for the Target's liabilities and other items.

• Stepped Up Asset Basis: Thus, a principal effect of this deemed asset sale is that New Target's acquires an aggregate basis in its assets that is “stepped up” (or down) under §1012 to the FMV price that the unrelated Purchaser actually paid for Old Target's stock (adjusted for assumed liabilities and other items).

• Allocation of Basis Required: New T is required to allocate the deemed purchase price among its assets according to a prescribed “residual method” under IRC §1060, which can get complicated… (Must compute “adjusted grossed Up Basis”).

• Old Target’s tax attributes are extinguished, and New Target starts a new life with a clean slate of tax attributes. (Note that PTI accounts are wiped clean in a 338(g) election, which may not be good for Purchaser if there were huge PTI accounts.)

121


• Price for Purchaser’s Stepped Up Asset Basis: Two levels of tax recognized transactions:

(1) the stock sale is taxable (indeed, it is required to be a “qualified stock PURCHASE”), and

(2) the deemed asset sale is fully recognized for US tax purposes.

• The deemed asset sale is treated as though it were a fully taxable transaction to the Target Corporation, although the gains may be offset by Target’s tax attributes (e.g., NOLs). (Deemed asset sale not visible to the foreign jurisdiction...which prior to 2010 Hire Act created opportunity to hype FTCs. But see § 901(m)).

• Thus, unless a § 338(h)(10) election is made (and § 338(h)(10) election is NEVER available for a non-US target) the price for New T’s basis step-up is a doubly tax recognized transaction: one level of tax incurred by S on the sale of the Target stock and another level or tax Old T’s deemed sale of its assets.

• Why can’t parties elect § 338(h)(10) for a foreign target? Because a §338(h)(1)election can only be made if Target is:

(i) a domestic corporation that is a subsidiary member of a consolidated group,

(ii) a domestic corporation that is a subsidiary member of an affiliated group not filing a consolidated return, or

(iii) an S corporation (as defined in § 1361). Reg. §1.338(h)(10)-1(c)(1).

122




• Which party is really bearing the US Tax Burden of a § 338(g) Election?? (It depends…but new provisions of TCJA are likely to create more gain…)

• If T is a CFC, Old Target’s deemed asset sale often qualify for exceptions to Subpart F income—for example, the exception to § 954(c) “Foreign Personal Holding Company Income” set forth in Reg. §1.954-2(e)(3) for depreciable T/biz assets. (Need to also test under § 954(d) for FBC Sales income.) And this is why § 338(g) elections and “Check & Sell” transactions were often used prior to the 2017 TCJA.

• But after the 2017 TCJA, the deemed asset sale will likely give rise to GILTI income--i.e., more actual GAIN even if Subpart F inclusions are avoided. GILTI income is currently recognized to §951(b) “US Shldrs”) under new § 951A…with other ramifications analyzed below.

• Seller is responsible for any tax liability arising from the stock sale. The deemed asset sale triggered in a § 338(g) election occurs on the “acquisition date,” and any tax liability resulting from the deemed asset sale is Old Target's (Old T’s) liability (i.e., from the US tax perspective…Obviously, the deemed asset sale is not recognized for foreign law purposes!)

• But, absent contractual provisions to the contrary, the US income tax liability resulting from the deemed fictional asset sale could be borne economically by Purchaser because it is the owner of New Target and New T inherits Old T's tax liabilities.

• NOTE: the Purchaser makes the § 338(g) unilaterally, and yet it can have a huge effect on the Seller (who may never have agreed to it)! Thus, it is very important for parties (especially Seller who doesn’t have the power under the Code to make the 338(g) election unilaterally) to have contractual provisions in the M&A documents, and on the M&A checklist. Parties need to agree on whether the §388(g) election will be made…

123

§ 338(g) Mechanism - (p.4)

• Purchasing Corp must make a “qualified stock purchase” (QSP), defined as transaction (or series of transactions) where 1 corp acquires by “purchase” 80% control of Target’s stock during the 12-month “acquisition period.”

• 80% control means at least 80% voting power and value

• Share acquisitions may be over 12 months, but must be by “purchase” (thus excluding shares acquired by gift, inheritance, tax-free reorgs, and certain related-person transfers, etc.).

• Purchaser must be a corporation, and cannot be an individual or a partnership.

• However, neither Purchasing Corp nor Target need be US corporations. See IRS Chief Counsel Advice 2007-006.

• Purchasing Corp. may elect s338(g) unilaterally without the consent of the Seller or Target (unless contractually bound to get consent, which should always be on Seller’s M&A checklist).

• Deadline: Must elect no later than 15th day of 9th month beginning after the month in which the “acquisition date” occurs (which is the day within the 12-month period on which 80% control was acquired. (Example:

• The § 338(g) election is irrevocable.

• Procedure for late § 338 elections.

Non-US Target Corp.

Non-US Shrhldrs

Cash

Target Stock

Purchaser US Corp.

Appreciated Assets (Value > a/b)

124



§ 338(g) Election – Historical Evolution of how a Stock Sale came to be treated as a Deemed Asset Sale

• Pre 1954 Tax Act: US Courts applied an elusive “intent standard.”

• 1950 seminal case (no longer the law): Kimbell-Diamond Milling Co. v. CIR, 14 T.C. 74 (1950), affd. 287 F.2d 718 (5th Cir. 1951). Milling company (KD) purchased stock of a another milling company (“target” or “T”) after its own plant was destroyed by fire. KD argued it should acquire a carryover basis in T’s assets, since it bought T’s stock. IRS argued transaction should be treated, in substance, as an asset deal—with KD getting only a “cost basis” in the assets equal to what it paid for the stock. Tax Court agreed with IRS, finding KD’s sole intent was to acquire T’s assets (KD liquidated T 3 days after stock purchase). HELD: KD (Buyer) should be treated as directly acquiring T’s assets as the stock purchase was merely a transitory step in the asset acquisition. Thus, KD must take “cost basis” in the assets equal to what it paid for T’s stock.

• Kimbell-Diamond doctrine codified in 1954 as (former) §334(b)(2) in 1954 Tax Act to replace elusive “intent test” with ostensibly more “objective test.” Thus, old §334(b)(2) allowed a Parent Corp to step up basis of its sub’s assets if Parent (a) acquired at least 80% of the Sub’s stock in fully taxable purchase during a 12-month period and (b) caused Sub to liquidate pursuant to a plan of LQ adopted w/in 2 yrs of purchase. Sub recognized gain on LQ as if it had sold its assets, and its tax attributes were extinguished. Purchaser was treated as if it purchased assets—taking a cost basis approximately equal to what it paid for the T stock (rather than a transferred basis, which usually results from a complete liquidation of controlled T Sub). Old § 334(b)(2) was criticized as being very complex w/pitfalls.

• 1982: § 338 (election) enacted (with policy goal of simplification) allowing Purchasing Corp to ELECT to treat certain 80% stock purchases as asset purchases, in order to allow Purchasing Corp to take a higher, depreciable tax basis in those assets…(if certain requirements were met, which were borrowed from KD doctrine).

125

§ 338(g) Election Historical Evolution (Cont’d)

• Originally, § 338(g) election triggered only ONE level of tax: Between 1982 and 1986, §338 functioned in the context of the Gen. Utilities doctrine, as codified by (former) §337. Under old §337, a corp generally recognized no gain or loss on sale of its assets after adopting a Plan of Liquidation.

• Nonrecognition was subject to certain exceptions, the most significant of which were depreciation recapture under §1245 and §1250 and investment tax credit recapture.

• Thus, until General Utilities repeal in the 1986 Act, a sale of a target's assets followed by a LQ of Target generally resulted in only ONE level of federal income tax—i.e., the tax incurred by T shldrs on their exchange of their shares for LQ proceeds (plus target-level recapture income).

• Combined effect of §338(g) election in context of old 337 meant that Purchaser could acquire a §1012 step-up in T’s asset bases, at cost of a single layer of fed income tax imposed on T’s shldrs.

• Repeal of Gen Utilities doctrine in 1986 Act radically altered the impact of §338 and introduced distortions, particularly in the consistency rules.

• After 1986 Act, §338 meant double taxation (absent a §338(h)(10) election), and so 338(g) elections generally became undesirable in purely domestic context. § 338(h)(10) elections became the common tool planning tool in domestic context.

• But § 388(g) elections were and are still viable in cross-border context—in purchases of foreign corporations (CFCs). Recall that § 338(h)(10) cannot be elected where the Target is foreign.

• In a 338(g) election, neither Purchasing Corp nor Target need be US corporations—both can be foreign. See IRS Chief Counsel Advice 2007-006.

126



Mechanics of Electing § 338(g) – Must have a “QSP”

• P must make a QSP: Purchasing Corp must make a “qualified stock purchase” defined as transaction (or series of transactions) where 1 corp acquires by “purchase” 80% control of Target’s stock during the 12-month “acquisition period.”

• 80% control means at least 80% voting power and value

• Share acquisitions may be over 12 months, but must be by “purchase” (thus excluding shares acquired by gift, inheritance, tax-free reorgs, and certain related-person transfers, etc.).

• Purchaser must be a corporation, and cannot be an individual or a partnership.

• However, neither Purchasing Corp nor Target need be US corporations. See IRS Chief Counsel Advice 2007-006.

• Purchasing Corp. may elect s338(g) unilaterally without the consent of the Seller or Target (unless contractually bound to get consent, which should always be on Seller’s M&A checklist).

• Deadline: Must elect no later than 15th day of 9th month beginning after the month in which the “acquisition date” occurs (which is the day within the 12-month period on which 80% control was acquired.

• Use IRS Form 8023 to make the § 338(g) election.

• The § 338(g) election is irrevocable.

• § 9100 Relief for LATE § 338 elections: Rev. Proc. 2003-33 provides that in accordance with § 301.9100-3, an extension of 12 months from the date of discovery of the failure to file a timely § 338 election is automatically granted to any person described therein.

Non-US Target Corp.

Non-US Shrhldrs

Cash

Target Stock

US Purchaser

Corp.

Appreciated Assets (Value> tax basis)

127

New TCJA provisions & factors in the § 338(g) analysis

• New lower 21% US corporate tax rate: For post-2017 tax years, the top federal corporate income tax rate was lowered 14 points.

• New “GILTI” tax under § 951A: Although not technically a new category of Subpart F income, it taxes “US shs” of CFC on a sweeping new basis, functioning as sort of a residual “minimum tax.” Specifically, new § 951A imposes US tax on 10% (or greater) US shldrs (as defined in amended § 951(b)) on “tested income” of their CFCs.

• § 902 Indirect Credit Repealed: Prior to its repeal, § 902 allowed US Shs of CFCs that received an “dividend” to credit the foreign taxes paid on the CFC’s earnings out of which the dividend was paid (or deemed paid). Deemed “dividends” under 1248 were also allowed a § 902 indirect credit. The § 902 credit was replaced by the § 245A DRD. The indirect § 960 FTC (for Subpart F deemed divs) was retained, but amended.

• New § 245A - a limited “participation exemption”: “US shareholders” (as defined in 951(b)) that are C Corps, can deduct 100% of “dividends” received from their CFCs or “specified foreign corporations” is a one-year holding period is satisfied. (HP is 1year within the 2-yr period surrounding ex-dividend date). A “specified foreign corp” is defined as any foreign corporation that has at least one 10% corporate shlder that would qualify as a § 951(b) shldr if the foreign corporation were a CFC.

• § 245A can be material factor for CFCs with large amounts of exempt QBAI. (Indeed, § 245A can work as an incentive for Purchasers to get higher-bases depreciable tangible assets that generate QBAI, because that sliver of notional income can be repatriated tax free.

• Because the § 245A DRD is available to Corporate shareholders (owning at least 10%) of so-called 10/50 corporations, and such non-CFCs cannot generate GILTI, a greater percentage of such 10/50 corporations’ earnings may be eligible for the § 245A DRD.

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New 2017 Tax Act provisions & considerations (cont’d)

• § 1248 retained: Under §1248, gain on the Sale/Exchg stock of a foreign corporation (FC)--whether or not a CFC at time of sale--by a person who was a 10% U.S. shldr” at any time during the preceding 5 years while the FC was a CFC, is recharacterized as a dividend to the extent of the post-1962 accumulated E&P of the FC “attributable” to such stock and only for periods during which the 10% US shldr held the stock while the FC was a CFC. The E&P so computed is called “the 1248 amount” in the Regs.

– Prior to elimination of the Capital Gains preference for corporations in 1986, § 1248 functioned as an anti-abuse provision to prevent Tps from turning capital gains into OI.

– After 1986, and before the 2017 Tax Act, § 1248 was used as a vehicle to bring up indirect foreign tax credits under § 902.

• New § 1248(j): “In the case of a sale or exchange by a domestic corporation of stock in a foreign corporation held for 1 year or more, any amount received by a domestic corporation…treated as a dividend by reason of this section shall [be eligible] for the section 245A [100% DRD].”

• New § 964(e): It extends the 100% DRD of 245A to sales of lower-tier CFC stock by upper-tier CFCs where the application of 1248 and 964(e) results in a deemed dividend. (Prior to the 2017 Act, this CFC-to CFC dividend would have been excluded under 954(c)(6).) The HP requirements for 245A DRD apply, so CFC-to-CFC dividends may result in Subpart F income.

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Results of CFC purchase WITHOUT a §338(g) Election

Assume a US shareholder is selling its interest in a CFC ---

Results with NO § 338(g) Election: Gain recognized by a US corporation on its sale of CFC stock is recharacterized as a dividend under §1248 to the extent of the previously

untaxed post-1962 E&P of the CFC and its subs (i.e., the “§ 1248 amount”).

• The § 1248 “dividend” is eligible” for the 100% DRD under new § 245A (holding period requirement must be satisfied).

• Any remaining capital gain is subject to a 21% tax rate.

• Taxable year of Target does not close for US tax purposes.

• Thus, a domestic Purchaser (rather than the Seller) generally is subject to tax on any Subpart F income and GILTI of the CFC for the entire year of sale, but reduced by the amount of current year earnings treated as a dividend distributed to Seller, including any amount recharacterized as a dividend under § 1248.

130



Results of CFC purchase WITH a §338(g) Election

Assume a US shareholder is selling its interest in a CFC ---

Results WITH a § 338(g) Election: • Target CFC is deemed to sell its all its assets to New Target. Old T recognizes any gain (and losses) resulting from the deemed asset sale.

• If Seller is a US corporation, the CFC Target’s gain on non-trade/bizs may be Subpart F income; any other gains would likely be “tested income” for GILTI purposes and taxed at 10.5%.

• CFC Target’s tax year closes.

• Target’s Subpart F income and GILTI through the date of sale is includible in gross income of the US Seller (rather than the Buyer), absent contractual provisions to the contrary.

• Basis-bump up for purposes of actual stock sale: US seller will also be taxed on any gains realized on the sale of the CFC-Target’s stock, with the basis of such stock first increased for the amount of any inclusions under Subpart F and GILTI for the year--including the Subpart F and GILTI income generated by the deemed asset sale.

• Subject to holding period requirements, the stock gain will be recharacterized as a deductible dividend under sections §1248 and § 245A to the extent of the CFC’s post-1962 accumulated untaxed E&P (i.e., the “1248 amount” that are not Subpart F income or tested income), as well as earnings arising from gain on the deemed sale of assets that are not subject to Subpart F or GILTI.

131

Purchaser Considerations in Deciding whether to Elect § 338(g)

Potential Advantages (and possible disadvantages) to Purchaser of Electing § 338(g): • Advantage -- Complete Elimination of Target’s tax attributes: (This factor can actually cut both ways.)

• On one hand, because the historic E&P accounts are wiped clean, P is able to calculate more easily (and cheaply) the character of future distributions.

• P need not rely on historic financial records to determine source & character of pre-acquisition earnings and amounts of foreign taxes paid in pre-acquisition years.

• P is also not at risk for audit adjustments for pre-closing periods if election is made. Further, a clean tax attribute slate removes need for cumbersome computations of accounting adjustments needed to convert statutory retained earnings of foreign T to US GAAP as required by 1.964-1(b)(1), and to convert US GAAP retained earnings to accumulated E&P.

• Disadvantage - Complete Elimination of Target’s tax attributes:

• The elimination of historic E&P pursuant to a §338 election can prevents P from receiving distributions of PTI free of tax (unless the 245A DRD is available).

• If FT becomes a CFC at a time when it already had an “investment in US property,” P’s § 338(g) election would destroy any benefit from § 956(b)(2).

• The “1248 amount” account of New T is eliminated if there is a 338(g) election. Thus, if P later decides to sell New Target, there will be much less/no post-1962 accumulated 1248 E&P to be characterized as a “dividend” eligible for the 100% DRD under §245A.

132




Potential Advantages (and possible disadvantages) to Purchaser of Electing § 338(g): • Basis Step-up in Assets of New Target: (This can cut both ways too.)

• The step-up gives Purchaser of FT greater depreciation/amortization deductions for U.S. tax purposes, and reduced gain on assets sold post-acquisition. (FT’s future income and E&P for U.S. tax purposes are reduced, which also reduces FT's E&P for dividend and FTC purposes. Although this has the effect of reducing future subpart F inclusions, FT will likely still be subject to GILTI.

• Having a higher depreciable asset basis provides more QBAI, and thus a cushion against the imposition of GILTI due to having a higher net deemed tangible income return.

• But if FT pays little or no foreign tax on its future earnings, P has less dividend income should FT ever distribute earnings. If, however, the FT pays foreign tax at a high rate, then a §338 election could increase the FT’s excess FTCs because the basis step-up is not likely to be effective under the tax laws of countries in which the target operates. (This mismatch increases the effective rate of foreign tax paid by the foreign target relative to its E&P for U.S. tax purposes. Prior to enactment of §901(m), the increase in the effective foreign tax rate could generate excess FTCs when earnings were distributed or deemed distributed. Since 2010, §901(m) restricts the prior FTC benefit of making a §338(g) election for a foreign target, although in many circumstances it may remain beneficial.

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Potential Advantages (and possible disadvantages) to Purchaser of Electing § 338(g): • Election may facilitate Post-Acquisition Restructuring: A § 338(g) election made for a first-tier CFC would increase the basis in that

Target CFC’s assets—i.e., its bases in its own subsidiaries. In one fact pattern, Foreign T owned a US corp, the stock basis of which was stepped up to FMV with a § 338(g) election. This enables New Foreign Target to sell the domestic sub’s stock up the ownership chain free of gain that would otherwise apply. See. Rev. Rul. 74-605.

• Election may impair Post-Acquisition Transactions: Because a § 338(g) election eliminates the accumulated E&P and §1238 amount accounts, PTI may not be able to be distributed tax-free to the US shareholder.

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US individual Seller of CFC with and without a § 338(g) Election

With NO § 338(g) Election:

• Seller A has a § 1248 dividend for any E&P, which is taxed as a “qualified dividend” assuming conditions are satisfied (15%).

• The § 245A DRD is not available because A is not a US C Corporation.

• Residual tax is “capital gain” taxed at 23.8% (20% + 3.8% net investment tax rate)

With § 338(g) Election: Drastic difference!

• Seller has GILTI income on Target CFC’s deemed asset sale, but the 50% deduction under § 250 is not available for individuals (nor for funds or pass-through entities).

• Seller has GILTI inclusion, which gives Seller a stock basis bump-up, so she has less gain on the stock sale, which would have been taxed at preferable capital gain rates (23.8%).

• Effect of 338(g) election: Converts capital gains into ordinary income, taxable at 40.8 % (i.e., 37% + 3.8%)

• Individuals and pass-through Sellers will usually want contractual protections to prevent Purchaser from electing § 338(g) (regardless of whether Purchaser is US or foreign).

US Individual

“A”

Target CFC

Purchaser

A sells 100% of CFC stock in QSP

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§ 338 Election Scenarios – (Cheat Sheet) (1) Domestic corporate seller and Purchaser and Target

• § 338(g) election: Usually not done unless the target had net operating losses (NOLs) because it does not make sense to pay tax today for depreciation on the same amount to be deducted tomorrow; the gain falls on the buyer’s side in a one day year of target, although the target generally can use its historic NOLs. However, now the buyer (new target, the next day) may expense part of the purchase price. Depending on the amount of expensing and the portion of the gain currently taxed, the election might make sense for the buyer.

• § 338(h)(10) election: Usually done unless the asset gain is much greater than the seller’s stock gain. Expensing the benefit will fall on the buyer ’s side and make the election more favorable.

(2) U.S. corporation sells U.S. sub to a foreign corporation

• § 338(g) election: Same as (1) above.

• § 338(h)(10) election: Same as (1) above.

(3) U.S. corporation sells stock of a controlled foreign corporation (CFC) to a U.S. corporation

• § 338(g) election: Deemed asset sale can produce Subpart F income and global intangible low-taxed income (GILTI), which will be taxable to the seller as if the CFC’s year closed on the day of the deemed sale. That inclusion will increase the seller’s stock basis and create previously taxed income (PTI) for the seller, and the seller will recognize stock sale gain, Section 1248 will apply, and the dividend created will be eligible for a 245A dividends received deduction (DRD).

• § 338(h)(10) election: N/A§

• No § 338 election: Section § 1248 gain and dividend created will be eligible for a § 245A DRD; seller will not have Subpart F or GILTI inclusion for the year because the CFC year will not close on sale.

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§ 338 Election Scenarios – (Cheat Sheet continued) (4) U.S. corporation sells stock of CFC to a foreign purchaser

• § 338(g) election: Deemed asset sale can produce Subpart F income and GILTI, which will be taxable to the seller as if the CFC’s year closed on the day of the deemed sale. That inclusion will increase the seller’s stock basis and create PTI, the seller will recognize stock sale gain, and Section 1248 will apply and 245A will apply to the dividend.

• § 338(h)(10) election: N/A

• No § 338 election: Section 1248 gain, 245A will apply to dividend; seller will have Subpart F or GILTI inclusion for the year because the CFC year will close on sale unless the foreign buyer has U.S. subs and CFC status continues.

(5) Foreign corporation sells U.S. sub to a U.S. corporation

• § 338(g) election: Same as (1) above.

• § 338(h)(10) election: N/A

(6) Foreign corporation sells foreign sub to a U.S. corporation

• § 338(g) election: I f the target was not a CFC, the deemed asset sale cannot produce Subpart F income and GILTI; if it was a CFC, those income items would not be taxable except to the target’s U.S. shareholder.

• § 338(h)(10) election: N/A

(7) CFC sells CFC

• Section 338(g) election: U.S. shareholder of the seller CFC will include Subpart F income and GILTI generated by deemed asset sale.

• 338(h)(10) election: N/A

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Current Restrictions on

Hybrid Arrangements

After

2017 US Tax Act and Other Countries’

Implementation of BEPS Action 2



The Perceived Abuse in Hybrid Arrangements

• Hybrid arrangements, such as those involving hybrid entities or hybrid instruments are viewed as abusive because their use can erode the tax bases of both jurisdictions involved in a transaction.

• A “hybrid entity” is one that is viewed as tax transparent in one country, but as a separate corporate taxpayer in another country. The use of hybrid entities can result in income that is not taxed in any country because, for example, each country views the item as not being received by a person taxable within its own jurisdiction or, alternatively, the item is eligible for some beneficial treatment.

• A “hybrid instrument” can result in an income deduction in the country viewing the instrument as “debt” and in no income inclusion (or beneficial treatment) in the country that treats the same payment as “equity.”

• Hybrid arrangements typically involve:

• A payment in one country where the payor resides, with no corresponding income inclusion where the recipient resides (or a favorable rate of taxation). This is called “Deduction—No Inclusion” (“D/NI”) in BEPS speak)

• A double deduction for the same expense. This is called “Double Deduction” (“DD”) in BEPS speak); OR

• Multiple claims of foreign tax credit relief for the same foreign tax paid. 139

Classic Example of Hybrid Instrument

• Assumed Facts:

• F-Co contributes money to US Sub, in exchange for a an instrument, which is in legal “form” under the laws of F-Co’s country, a contribution in exchange for US Sub’s stock.

• Country F views the F-Co as holding “equity” in US Sub.

• The U.S. views the same transaction, in substance, as a “debt instrument” creating a debtor-creditor relationship, and “loan” for tax purposes.

• Because at least two countries relevant to the transaction view the instrument inconsistently, it is a “hybrid instrument.”

• Absent special rules, the U.S would allow US Sub to deduct the “interest” payments on its U.S. tax return.

• At the same time, because Country F views the payments as “dividends” on equity, Country F would (absent special rules) allow F-Co to exempt them under any available special tax regime (e.g., a repatriation deduction or credit).

• Thus, the payments result in deductions in one jurisdiction (the U.S.), with no taxation of the full amounts in the country where the recipient resides. (i.e., “Deduction-No Inclusion” or “D/NI” in BEPS speak.)

• Traditionally, the U.S. has had no “bright-line” test for distinguishing “debt” from “equity,” but has applied substance-over-form principles. Unlike the U.S., many other countries look to the legal form of the instrument to determine its tax treatment, resulting in myriad opportunities for creating hybrid instruments and tax arbitrage.

F-Co

US Sub

Payments are “interest in US; “dividends” in Country F

F-Co invests in US Sub as “shareholder” under F’s law; but “creditor” in US

140



Example of Hybrid Entity

Spanish Financing Structure –

“Sociedad Colectiva”

• Assume Netherlands views the SC (a Sociedad Colectiva) as tax transparent—i.e., a disregarded branch.

• Assume Spain treats the SC as a corporate taxpayer—i.e., a regarded entity for tax purposes.

• The SC is a “hybrid entity” because the two countries relevant to the transaction classify the SC differently for tax purposes.

• Result:

• Netherlands does not tax NL on the receipt of interest because it views NL as having made a loan to itself.

• Under Spanish tax law, SC may deduct the interest it pays against the income of its tax group formed by SC and the ETVE (75% participation exemption). In addition, there may no w/h tax or (a preferential rate) under the Netherlands-Spain treaty.

• The payment is deductible from income in Spain, but not included in income of the recipient the Residence country– resulting in a “deduction—no inclusion” (“DD/NI” in BEPS speak).

• Results under EU law—ATAD II? EU Parent-Sub Directive ?

SC is a Hybrid Entity

NL

Spanish SC

ETVE/OpCo

Loan Interest payments

141

Common Hybrid Structures- #1 Traditional Use of Hybrids to Disregard Loan (and avoid Subpart F income – may not work anymore!)

• Assume U.S. views U.S. Parent and Entity A in Country X as tax opaque corporations.

• Assume U.S. views Entity B in Country Y as a tax transparent “disregarded entity” (or branch of its corporate parent in Country X).

• Assume Country X views Entity A as a tax opaque corporation.

• Assume Country Y views Entity B as a tax opaque corporation—not merely a branch of Entity A.

• Conclusion: B is a “regular hybrid” entity because the U.S. views it as disregarded entity (branch) while another relevant jurisdiction (Country Y) views B inconsistently as a corporation.

• Tax Result ? For purposes of Subpart F, U.S. disregards the A-B loan because it sees it as a transaction occurring purely within Foreign Corp A.

• Meanwhile, Country X allows A to deduct the interest payments (reducing its Entity’s A’s E&P, which could be taxed at a high rate), and Country Y imposes little or no tax on the receipt of the interest payments.

• Isn’t this is the kind of income shifting that is supposed to be targeted by Subpart F. See IRS Notice 98-11 (Ex. 2), but withdrawn by Notice 98-35.

Loan Interest

US Parent Corp.

Foreign Entity A

(Country X)

Foreign Entity B (Country Y – a

tax haven)

142



Common Hybrid Structures- #2 Using Hybrids to Fit within “Same Country Exception” to IRC § 954(c) – (Foreign Base Company Income)

Loan

Interest

• Assume same facts except U.S. views U.S. Parent and Entities A and C in Country X as tax opaque corporations.

• U.S. views Entity B in Country Y as a tax transparent “disregarded entity” (or branch of its corporate parent in Country X).

• Country X views Entity A as a tax opaque corporation.

• Country Y views Entity B as a tax opaque corporation—not merely a branch of Entity A.

• Conclusion: B is a “regular hybrid” entity because the U.S. views it as disregarded entity (branch) while other relevant jurisdictions (Countries X and Y) view B inconsistently as a corporation.

• Tax Result ? For Subpart F purposes, U.S. views the B-C loan as occurring between Entity C and Entity A (Not B) because U.S. seems B as a mere branch of Entity A. Thus, because the U.S. views the interest payments as received by a 954(d)(3) “related person” to Entity C, but because both CFCs are organized in the same country, the payments are not 954(c) FBCI—i.e., within an exception to Subpart F income!

• Meanwhile, Country X allows C to deduct the interest payments (reducing Entity’s C’s E&P, which could be taxed at a high rate), and Country Y, which sees B as a corporation, imposes little or no tax on the receipt of the interest payments.

• Thus, earnings are being stripped out of CFC C, without any inclusion under Subpart F, and very little or not tax imposed on the income anywhere. See IRS Notice 98-11 (Ex. 1), but withdrawn by Notice 98-35. See also the OECD BEPS- Action 2 Hybrid Arrangements; U.K. Hybrid Mismatch Rules (effective 1/1/2017).

US Parent Corp.

Foreign Entity A

(Country X)

Foreign Entity B

(Country Y – a tax haven)

Foreign Entity C

(Country X)

143

Nails in the “Hybrid Coffin” Escalating Limits on Hybrid Arrangements in Last 20 Years

A. IRC § 894 and Reg. § 1.894-1(d)(2)(ii) – Domestic law limits tax benefits of arrangements using domestic reverse hybrids

B. IRS Notice 98-11, but soon withdrawn by Notice 98-35.

C. U.S. Model Tax Treaty (going back to at the 1996 US Model Treaty): U.S. negotiating position has been to ensure that treaty benefits are limited when “fiscally transparent entities” are used to achieve double non-taxation. Stricter and broader anti-hybrid provisions in 2016 US Model Tax Treaty.

D. OECD’s Partnership Report of 1999 – “The Application of the OECD Model Tax Convention to Partnerships”

E. OECD/G20’s “BEPS” initiative – (Base Erosion Profit Shifting report, Action 2 “Neutralising the Effects of Hybrid Mismatch Arrangements”

1. Oct. 2015: Final Report on Action 2 issued (expands on Sept. 2014 Interim Report)

2. Aug. 22, 2016: “Branch Mismatch Structures” discussion draft released (detailed )

3. OECD recommends changes to domestic law and OECD Model Tax Treaty.

4. OECD’s Multilateral Instrument signed (containing anti-hybrid provisions)

F. “Fruit of BEPS”: Implementation of Action 2 in an increasing number of countries’ domestic law (and EU)

G. EU’s Anti-Tax-Abuse Directive (ATA Directive), Article 9 (ATAD I and ATAD II) and EU’s Amendment to Parent-Sub Directive

H. Unilateral limits imposed by other countries (independent from OECD’s BEPS): UK’s “Hybrid Mismatch Rules” effective Jan. 1, 2017 (BREXIT?); Netherlands; Germany; France; Australian proposal

I. USA: Obama Proposals; 2016 Model Tax Treaty restrictions; US Congress asked to fix “hybrid problem,” and

finally, in 2017, US Congress enacts IRC § 267A (GOP Senate’s provision was enacted--very similar to Obama proposal!) 144



New IRC § 267A (Pub. L. 115–97, title I, § 14222(a), Dec. 22, 2017, 131 Stat. 2219.)

• § 267A disallows U.S. tax deductions for any “disqualified related party amount,” which is interest and royalties paid or accrued to a “related party” in a “hybrid transaction,” or paid to or by a “hybrid entity.” §267A(a).

• “Related party” for § 267A purposes is defined by reference to “related person” in § 954(d)(3) (substituting the payor for the CFC). Thus, related party includes an individual, corporation, partnership, trust or estate that controls, is controlled by, the payor, or where both payor and recipient of the interest or royalty are “controlled” by same person(s). Control means >50% ownership (by vote or value). Ownership can be direct, indirect, or constructive through labyrinthine attribution rules. See § 958(a), (b). (And, consider the scope of application given repeal of § 958(b)(4)).

• “Hybrid Transaction” defined broadly as “any transaction, series of transactions, agreement, or instrument one of more payments of which are treated as interest or royalties” for U.S. tax purposes and which are not so treated for purposes of the tax law of the recipient’s foreign country. (E.g., Otherwise deductible interest payments that are considered dividends, subject to preferential treatment like participation exemption for foreign tax purposes.)

• “Hybrid Entity” is an entity treated as fiscally transparent in the U.S., but not for purposes of the tax law of the foreign country where the recipient is resident, or vice versa.

• “Disqualified Related Party Amount” is any interest or royalty paid or accrued to the extent that the payment:

-- Is not included in the income of the related foreign party under the tax law of the country in which the related party is resident or subject to tax OR

-- The related party will (also) be allowed a deduction with respect to the amount under the tax law of the foreign country

-- Exception: to extent such payment is included in income of a US shareholder under § 951(a) (Subpart F).

• § 267A(e) grants IRS/ Treasury Dept. broad regulatory authority to write rules carrying out purposes of § 267A(a), including its application to conduit arrangements, branches, structured transactions, and for treating a “tax preference” as an “income exclusion” if the preference reduces the applicable statutory rate by 25%. Regs may also provide exceptions where an interest payment or royalty is taxed in a third country, or in cases that do not present a risk of tax base erosion.

• Observation: As drafted, and in the absence of liberalizing regulations, § 267A may literally disallow interest and royalty payments in common “Check-the-Box” structures involving eligible entities—e.g., payments to a related GmbH and Co. KG, viewed as tax transparent by Germany, but which could be treated as an opaque corporation for U.S. tax purposes.

145

How new § 267A targets “Hybrid” Finance Structures: “Repos” “Repo” Financing of Canadian acquisition of US Subsidiary

CanCo

US HoldCo

US OpCos

US Target

Bank

Bank Loan $$

“Sale” of Sub preferred shares” to Canco w/forward contract, requiring US HoldCo to repurchase them from CanCo at fixed price w/time-value-of money component. (“Hybrid instrument” due to conflicting debt-equity classifications)

Assumed Facts: CanCo borrows from 3rd party bank, using loan proceeds to “purchase” US

HoldCo common stock. US HoldCo contributes the cash to US OpCos for common and preferred, and then “sells” the preferred Sub shares to Canco, but simultaneously enters into a forward contract to “repurchase” them on fixed date (or on demand) at fixed price + interest component. US OpCos use proceeds of subscription to acquire US Target.

US Tax Results (PRE 2017 Tax Act): If properly structured, and although in form a share

“purchase,” US views the sale & “repurchase” as a “secured loan” in substance, with CanCo merely holding title to the preferred shares as collateral. Thus, when US Opcos pay dividends to Canco on the preferred “repo shares” Canco holds, US has (in past) allowed those interest payments to be deducted against income of US consolidated group.

Canadian Tax Results: Canada sees the arrangement as “equity.” Thus, dividends paid to

Canco on the repo shares of the OpCos (or on HoldCo’s common) are dividends out of “exempt surplus” (because derived in active US business) and not taxed to Canco. No FTC available in Canada for the 5% W/H tax on any dividends from Holdco. However, no US W/H tax on the dividends on the repo shares (as they are recharacterized as “interest” in the US).

US Result under new IRC §267A: To the extent that the interest payments qualify as

“disqualified related party amounts” § 267A will DENY the interest deductions since paid to a related foreign party, resident in a foreign jurisdiction where such payments are not taxed as income. Effective date: Taxable years beginning after 12/31/2017. (Note that the interest is not “recharacterized” as equity. If the controversial US Debt-Equity regulations under § 385 apply, debt issuances of a US obligor to a related party could be recharacterized as “stock per se” for all US income tax purposes. The § 385 Regulations have not been withdrawn.)

Cascading share subscriptions to US Subs-- “purchases” in form. US Group files consolidated tax return.

146



Structures that new IRC § 267A does not target

§ 267A , as drafted, apparently does not disallow the double deduction in this case because there is no “related party.” But other countries’ “hybrid mismatch rules” may apply. Does the grant of regulatory authority in §267A (e ) givethe U.S. Treasury latitude to address this structure in Regs? (i.e., imputing some kind of “related foreign party”?)

Assumed Facts: Countries A and B classify B-Co inconsistently for tax purposes. Country A views B-Co as a tax transparent branch; Country B views Bco as opaque.

Thus, B Co is a hybrid entity.

Country A deducts the interest payments made by its transparent foreign branch.

B-Co, as borrower, also deducts the same interest payments to on its Country B tax return. (Alternatively, such deductions in B-Co may increase the B Co’s losses, which may offset profits under a tax consolidation regime.

If Country B is the United States, § 267A will not disallow the interest deductions because they are not being made to a “related [foreign] party.” (If Country A is the United States, the US dual consolidated loss rules will generally disallow any net loss of the B-Co group.)

Still, but for a special rule, a “double deduction” would result (“double dip” or double deduction –”DD” in BEPS speak).

Note: Obama proposal would have denied interest or royalty deductions arising from certain hybrid arrangements involving unrelated parties in appropriate circumstances, such as structured transactions.

BEPS Action 2: • Primary rule: to the extent a payment gives rise to a DD outcome, deny the deduction at

the parent level • Defensive rule: If A-Co Parent takes the deduction, then the tax law in Country B should

deny the deduction at payor level (i.e., in Country B).

147

OECD’s BEPS Action 2: Neutralizing the Effects of Hybrid Mismatch Arrangements”

• The 2015 Report on Action 2 makes recommendations for domestic legal rules to neutralize “mismatches” in tax outcomes that arise in respect of “hybrid mismatch arrangements” (HMA)

• “Hybrid Mismatch Arrangement” (HMA): “exploit differences in the tax treatment of an entity or instrument under the laws of two or more tax jurisdictions to achieve double non-taxation, including long-term deferral.

• Action 2 addresses inconsistencies caused both by hybrid entities and hybrid instruments.

• With respect to hybrid entities, Action 2 targets payments made by or to a hybrid entity that give rise to one of three types of mismatches:

a. deduction / no inclusion (D/NI) outcomes, where the payment is deductible under the rules of the payer jurisdiction but not included in the ordinary income of the payee;

b. double deduction (DD) outcomes, where the payment triggers two deductions in respect of the same payment; and

c. indirect deduction / no inclusion (indirect D/NI) outcomes, where the income from a deductible payment is set-off by the payee against a deduction under a hybrid mismatch arrangement.

148



OECD’s Recommended “Fix”: Adopt “Primary” and “Defensive” Rules

In the Deduction/No Inclusion (“D/NI”) situation:

• Primary rule: to the extent a payment gives rise to a D/NI outcome, domestic law should deny a deduction for such payment in the payer’s jurisdiction

• Defensive rule: But if such deduction is not denied (or taken anyway), domestic law should require such payment to be included as ordinary income in the payee jurisdiction

• Recommended Application: D/NI rule applies to (i) related party or control group transactions and (ii) structured arrangements

• Recommendation: Participation exemption and similar dividend relief should not apply to the payee if payment is deductible by the payer, whether or not parties are related. (However, if the payment is treated as “tax exempt” income in and of itself in payee jurisdiction, that will not create a D/NI situation. See Interim Report 9/2014.

• In the Double Deduction (“DD”) situation:

• Primary rule: to the extent a payment gives rise to a DD outcome, deny the deduction at the parent level

• Defensive rule: deny the deduction at the payer level

• Application: DD rule has broader application 149

EU Directive (ATAD 2) now addresses hybrid mismatches with 3rd (non-EU) countries

• May 2017: Council of European Union adopted a directive amending the original “Anti-Tax Avoidance Directive” (ATAD). This “ATAD 2” extends scope of ATAD to hybrid mismatches involving non-EU countries.

• ATAD 2 sets minimum rules that neutralize hybrid mismatches, where at least one of the parties involved is a corporate taxpayer in an EU Member State.

• In addition to expanding the territorial scope of the ATAD to third countries, ATAD 2 also expands the scope to address

• hybrid permanent establishment (PE) mismatches, hybrid transfers, imported mismatches,

• reverse hybrid mismatches and dual resident mismatches.

• ATAD 2 explicitly states that Member States should use the applicable explanations and examples outlined in Action 2 of the OECD’s BEPS reports as a source of illustration or interpretation to the extent that they are consistent with the provisions of the ATAD 2 and EU Law.

• Deadline for implementation by Member States: Jan. 1, 2020 (to transpose the Directive into national laws and regulations) and Jan. 1, 2022 for the implementation of reverse hybrid mismatches).

• Implications: expected to have a significant effect on tax planning by multinational companies operating in the EU.

• AND the “MULTILATERAL INSTRUMENT: An historic multilateral tax treaty (explicitly binding) signed by 68 countries in June 2017, as result of OECD’s BEPS initiative) also includes anti-hybrid mismatch rules—most of which were opted into by the signatory countries.

150



§ 245A DRD (repatriation DRD) is disallowed if payment constitutes a “Hybrid Dividend”

• § 245A(e): DRD is not available for hybrid dividends paid by CFC to a US shareholder

• Hybrid dividends also do not qualify for any FTC on the E&P being distributed, or a deduction for taxes imposed on such dividend

• “Hybrid dividend” defined: a dividend to which § 245A would apply, and for which the CFC receives a deduction “or other tax benefit” for foreign tax purposes

• Unlike § 267A (see above), US tax treatment at payor level is not relevant for §245A

• § 245A is relevant only after PTI account has been distributed including for current year (since PTI is not taxable when distributed).

• Hybrid dividend received by one CFC from another CFC with common corporate US shareholder is treated as subpart F income (taxable at 21% rate) “notwithstanding any other provision of this title” (so apparently overrides § 954(c)(6)!)

• New § 245A includes grant of regulatory authority (awaiting guidance from Treasury)

Check-the-Box Elections for Foreign Subs Pamela A. Fuller, Esq.

Tully Rinckey - Royse Law Firm 151

Planning Point: Avoid “hybrid entities” (and instruments) to prevent disallowance of the § 245A DRD !!

USP

Low-Tax CFC 1

Straight Loan

CFC 2

Interest PECS/ORA or Straight Loan With DE

USCo

CFC 1

DRE

The §245A repatriation DRD would be disallowed in this situation because the dividend is a “hybrid dividend”

If CFC 2 deducts the interest in its (pink) jurisdiction, and there is no inclusion in CFC-1’s jurisdiction (gree), would a dividend paid out of that interest income be a “hybrid dividend” disqualified for the § 245A DRD by 245A(e)?

152



Dispositions by Foreign Partners of

Interests in Partnerships engaged

in a US trade or business

New IRC §864(c)(8) and §1446(f)

Foreign Partner’s Disposition of Interest in a Partnership w/a US Trade/Biz: BACKGROUND

Non-US Partner

P/S

US Trade/Biz #2 (ECI assets)

US Trade/ Biz #1 (no ECI).

Partner

3rd Party Buyer

Sale of P/S Interest

US Group

Issue: To what extent, if any, should Foreign Partner’s sale proceeds be treated as ECI (taxable in US) or as capital gain (generally not taxable in US)?

• Rev. Rule 91-32: IRS rules that a foreign partner

who sells an interest in a P/S is subject to US taxation if that P/S is engaged in a US trade/biz through a US office, to the extent the gain is attributable to property of the P/S which was used to produce “effectively connected income” (ECI).

– Many US taxpayers tried to ignore this Revenue Ruling, arguing any gain should be capital gain—not taxable in US.

– Obama Administration, in its proposed budget, recommended codifying Rev. Rul. 91-32 and adding a withholding obligation.

• Grecian Magnesite v. CIR, 149 T.C. (2017): US Tax Court rejected Rev. Rule 91-32, holding that gain or loss recognized by a foreign partner disposing of a P/S interest is generally not considered ECI (or effectively connected loss) with respect to any US trade/biz that partnership may be conducting.

• New IRC § 864(c)(8): Enacted as part of the 2017

TCJA. Treats as ECI the foreign partner’s “distributive share of the amount of gain (or loss) which would have been ECI if the partnership entity has sold all of its assets at FMV just prior to the foreign partner’s disposition (but reduced for any gain already subject to the FRPTA regime).

– § 864(c)(8) effectively reverses the result obtained in Grecian Magnesite court opinion, issued earlier in the year 2017.

154



IRC § 864(c)(8) – What it does

• Reverses holding in Grecian Magnesite (retroactively to November 27, 2017), so that foreign partners will be taxed on the sale/exchange of their interests in partnerships (US or foreign) that are conducting a trade or business in the United States.

• § 864(c)(8)(A) provides: Notwithstanding any other provision of subtitle A (Income Taxes) of the Code, gain or loss of a nonresident alien individual or foreign corporation from the sale, exchange, or other disposition of a "directly or indirectly”* held partnership interest shall be treated as effectively connected to the extent that such gain or loss does not exceed the gain or loss such person would have recognized as effectively connected gain or loss had the partnership sold all of its assets at their fair market value as of the date of the transfer.

• * Applies to tiered P/S structures: Conference Report makes clear that interests in a partnership that holds ECI assets, and that is held by a partner indirectly through other partnerships, is subject to new 864(c)(8). the provision.

• Tax recognition of the outside gain the foreign partner realizes on sale its partnership interest is limited to the disposing partner’s share of gain inherent in any ECI assets held by the partnership. ECI gain and loss is apparently netted to arrive at net ECI gain or net ECI loss.

• Coordination with the FRPTA rules to avoid double taxation: Subpar. (C) of §864(c)(8) provides that the amount of gain or loss on the sale, exchange or other disposition of the partnership interest that is treated as ECI under subparagraph (A) shall be reduced by the amount of gain or loss on such disposition that is treated as effectively connected under §897 (i.e., the FIRPTA rules).

• The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) authorizes the US to tax foreign persons on dispositions of “U.S. real property interests.” When a foreign person disposes of a U.S. real property interest in a sale, exchange, or transactions that normally would be a non-recognition transactions, FIRPTA treats such gains as “effectively connected income” (ECI), and imposes withholding obligations under § 1445.

• § 864(c)(8)(E) grants regulatory authority to Treasury to promulgate Regs or other appropriate guidance for the applying § 864(c)(8), including with respect to various corporate non-recognition provisions.

• Example: If a P/S interest is contributed by a non-US partner to a corporation, should the non-recognition rule of §351 be turned off? Section 864(c)(8) does not purport to override any non-recognition provisions.

155

IRC § 864(c)(8) – What it says (c)(8) Gain or loss of foreign persons from sale or exchange of certain partnership interests

(A) In general . Notwithstanding any other provision of this subtitle, if a nonresident alien individual or foreign corporation owns, directly or indirectly, an interest in a partnership which is engaged in any trade or business within the United States, gain or loss on the sale or exchange of all (or any portion of) such interest shall be treated as effectively connected with the conduct of such trade or business to the extent such gain or loss does not exceed the amount determined under subparagraph (B).

(B) Amount treated as effectively connected . The amount determined under this subparagraph with respect to any partnership interest sold or exchanged—

(i) in the case of any gain on the sale or exchange of the partnership interest, is— (I) the portion of the partner’s distributive share of the amount of gain which would have been effectively connected with the conduct of a

trade or business within the United States if the partnership had sold all of its assets at their fair market value as of the date of the sale or exchange of such interest, or

(II) zero if no gain on such deemed sale would have been so effectively connected, and

(ii) in the case of any loss on the sale or exchange of the partnership interest, is—

(I) the portion of the partner’s distributive share of the amount of loss on the deemed sale described in clause (i)(I) which would have been so effectively connected, or

(II) zero if no loss on such deemed sale would be have been so effectively connected.

For purposes of this subparagraph, a partner’s distributive share of gain or loss on the deemed sale shall be determined in the same manner as such partner’s distributive share of the non-separately stated taxable income or loss of such partnership.

(C) Coordination with United States real property interests. If a partnership described in subparagraph (A) holds any United States real property interest (as defined in section 897(c)) at the time of the sale or exchange of the partnership interest, then the gain or loss treated as effectively connected income under subparagraph (A) shall be reduced by the amount so treated with respect to such United States real property interest under section 897.

(D) Sale or exchange. For purposes of this paragraph, the term “sale or exchange” means any sale, exchange, or other disposition.

(E) Secretarial authority. The Secretary shall prescribe such regulations or other guidance as the Secretary determines appropriate for the application of this paragraph, including with respect to exchanges described in section 332, 351, 354, 355, 356, or 361.

156



New §1446(f) Transferee Withholding

• As part of the 2017 US Tax Act, Congress also enacted a new withholding requirement—IRC section 1446(f).

• Section 1446(f) provides that, if the portion of the gain (if any) on a disposition of an interest in a partnership would be treated under § 864(c)(8) as income effectively connected with the conduct of a trade or business within the U.S. ("ECI"), the transferee of the partnership interest [i.e., Buyer] must withhold tax equal to 10% of the amount realized on the disposition.

• The withholding is applied to the entire “amount realized” as determined under §1001(b), and does appear to be limited to ECI on the deemed sale of the partnership’s ECI assets. Regulatory authority is granted to provide for reduced withholding in some situations. See new Notice 2018-29 (below).

• If transferee fails to withhold on the “amount realized,” partnership is required to withhold on distributions to the transferee partner in the amount the transferee failed to withhold (plus interest). But see Notice 2018-29.

• Different effective dates: Although § 864(c)(8) applies to dispositions of partnership interests occurring on or after November 27, 2017, §1446(f) applies only to dispositions occurring after Dec. 31, 2017.

• IRS Notice 2018-8: Suspends, temporarily, application of 1446(f) withholding to dispositions of interests in publicly traded partnerships (PTPs), and promises that future guidance (Regs) will be prospective and will include transition rules to allow sufficient time to prepare systems and processes for compliance with the new W/H requirements. (IRS later announced in Notice 2018-29 that this suspension does not apply to non-publicly traded partnerships, which are to generally follow the withholding procedures under § 1445, applicable to FIRPTA.)

157

IRS Notice 2018-29:

• Notice 2018-29 provides guidance with respect to the new withholding provision IRC §1446(f), enacted in connection with new § 864(c)(8). Although it does not suspend the W/H requirement for non-publicly traded partnerships, it provides helpful rules and a few safe harbors.

• Notice directs transferees to apply § 1445 principles and forms for reporting and paying withholding tax until specific guidance and forms are issued under § 1446(f). (See, e.g., § Reg. 1.1445-1(c).)

• Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests • Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests. • Include statement "Section 1446(f)(1) withholding" at the top of relevant forms; enter amount subject to withholding under §

1446(f)(1) on line 5b of Part I of Form 8288 and on line 3 of Form 8288-A. Enter the amount actually withheld on line 6 of Part I of Form 8288 and on line 2 of Form 8288-A. At this time, the IRS will not issue W/H certificates under section 1446(f)(3).

• Provides interim guidance on how to determine liabilities in calculating the “amount realized” (implementing Crane & Tufts, and IRC § 752)

• In a few situations, withholding is limited to amounts of cash and property transferred (e.g., where most of amount realized is debt relief).

• Provides guidance on coordinating withholding rules of § 1446(f) with FIRPTA’s withholding regime (FIRPTA does not generally exempt non-recognition transactions, while § 864(c)(8) apparently does.)

• Provides guidance on application of withholding in the context of tiered partnerships

• Provides guidance on partnership’s backup withholding on distributions to the new transferee partner.

• Provides guidance on complete redemptions of a foreign partner’s P/S interest.

158



IRS Notice 2018-29 (cont.)

• Notice provides LIMITED EXCEPTIONS from duty to withhold (which may be temporary).

• Notice provides that pending further guidance, Transferee of P/S interest is NOT required to withhold in any of the following circumstances:

• Transferor furnishes affidavit to transferee signed under penalty of perjury, that it/she/he is not a “foreign person” and transferor has no reason to believe otherwise;

• Transferee receives a certification, signed under penalties of perjury by transferor with a US TIN, that transfer of P/S interest will result in zero realized gain;

• 1st de minimis rule: Transferee receives a certification that Transferor’s allocable share of ECI was < 25 % of its distributive share of income for each of the three prior taxable years in which Transferor was a partner (for the entire year). A transferor that did not have a distributive share of income in any of its three immediately prior taxable years during which the partnership had ECI cannot provide this certification. A transferee is not relieved from withholding if it has actual knowledge that the certification is false. When a partnership is a transferee by reason of making a distribution, this rule does not apply. Notice says these thresholds will be reduced when further guidance is issued.

• 2nd de minimis rule – ECI would be < 25% of total gain on the deemed sale: Transferee receives a certification from the P/S stating that if the P/S had sold all its assets at their FMV, amount of gain that would have been effectively connected with a US Trade/Biz would be < 25% of the total gain. (May be difficult to get P/S to cooperate.) Notice says the < 25% threshold will be reduced in forthcoming Regs.

• Non-Recognition Transactions: Until further guidance is issued, Notice provides that Transferee is not required to withhold 10% of the amount realized on a transfer in which the Transferor is not required to recognized any gain or loss by reason of a non-recognition provision. (E.g., § 351 incorporating transactions.)

159

Example: Foreign Partner’s Disposition of Interest in Partnership with a US Trade/Biz

Facts:

Foreign Co. sells its 30% interest in US P/S to an unrelated party on Feb. 14, 2018, realizing a $450 gain. Is any of it subject to US tax as “ECI”?

Analysis:

• Under §864(c)(8), For Co’s $450 realized gain is treated as income “effectively connected with the conduct of a US trade/business to extent such gain does not exceed its distributive share of gain that would be ECI had the P/S sold all of its assets at FMV as of date of sale/exchange of such interest (but reduced by real property gains that would already be separately taxed as ECI under the FIRPTA regime).

• Hypothetical sale of all of P/S’s assets would result in $600 US Real Property gain, and $300 ECI gain in personal property assets, for a total of $900 ECI gain. (NOTE: FIRPTA gains are treated as ECI under that tax law.)

• § 864(c)(8) provides that the amount treated as ECI in the hypothetical asset sale is reduced by the amount that would already be taxed as ECI under the § 896(g) of the FIRPTA regime—here $600.

• Thus, 30% of the inherent $600 FIRPTA gain (i.e., $180) is allowed to first offset For Co.’s OUTSIDE gain on the sale of its P/S interest--($450 realized gain less $180 = $270. How much of the remaining outside gain is treated as ECI to For Co?

• For Co.’s 30% distributive share of the $900 total ECI gains = $270. That $270, representing For Co’s share of total ECI gain is also offset by 30% of the FIRPTA gain: ($270 - $180 =$90).

• Thus, under § 864(c), $90 of For. Co.’s realized gain on the sale of its P/S interest is treated as ECI—and taxed in the U.S. (This makes sense as $90 equals For Co.'s 30% distributive share of the ECI gains on the personal property held by the P/S , which assets are effectively connected with a US Trade or Business.)

Non-US P/S

US Trade/Biz

For Co. Non-US

3rd party Non-US

70% 30%

US

For Co. 1 SELLS its 30% P/S interest for $500

For Co.’s 30% P/S Interest FMV $600 Basis $150

US Real Property Personal ECI Property FMV $1000 FMV $1000 Basis $ 400 Basis $ 700

160



Example: Foreign Partner’s Disposition of Interest in Partnership with a US Trade/Biz (Continued)

Facts:

Foreign Co. sells its 30% interest in US P/S to an unrelated party on Feb. 14, 2018, realizing a $450 gain. Is any of it subject to US tax as “ECI”?

Analysis of Transferee Withholding Obligation under new § 1446(f) and Notice 2018-29:

• §1446(f) became effective Jan. 1, 2018, and it applies to this sale of For Co’s P/S interest which occurred on Feb. 14, 2018.

• Section 10 of Notice 2018-29 provides that if a transferee is required to withhold on an “amount realized” under § 1446(e)(5), or Reg. § 1.1445-11T(d), only FIRPTA withholding applies.

• However, there is no FIRPTA withholding in this example because the P/S assets are not 90% US Real Property Interests and cash. Thus, withholding under new 1446(f) conceivably applies to the ENTIRE amount realized—i.e., 10% w/h X $600 = $60.

Non-US P/S

US Trade/Biz

For Co. Non-US

3rd party Non-US

70% 30%

US

For Co. 1 SELLS its 30% P/S interest for $500

For Co.’s 30% P/S Interest FMV $600 Basis $150

US Real Property Personal ECI Property FMV $1000 FMV $1000 Basis $ 400 Basis $ 700

161

Base Erosion Anti-Abuse Tax “BEAT”

New IRC § 59A



Overview of BEAT

• IRC § 59A – official name in Code: “Tax on base erosion payments of taxpayers with substantial gross receipts”

• § 59A(a): “There is hereby imposed on each applicable taxpayer for any taxable year a tax equal to the base erosion minimum tax amount for the taxable year. Such tax shall be in addition to any other tax imposed by this subtitle.”

• Intended as disincentive to large corporate taxpayers (US or foreign) to “erode” the US tax base by making deductible payments (e.g., interest, royalties) to “related” foreign (non-US) persons.

• Applies only to Large Corporations (US or Foreign) earning annual average gross receipts of at least $500MM and with a “base erosion percentage” of at least 3% (2% for certain banks) during the 3-year period immediately preceding the taxable year.

• If BEAT applies, it is a minimum tax imposed in addition to the TP’s other tax liability (not in lieu of).

• Annual Test: Large corporate taxpayers must test for BEAT liability every year.

163

Overview of BEAT continued…

• The BEAT can apply to large US corporations (other than a RIC, REIT, or S-Corp) and to large foreign corporations with a US branch(es) or a US affiliate(s)

• Special aggregation rules apply to determine if two conjunctive application prerequisites are met: (1) whether the $500M average-annual-gross-receipts threshold is satisfied; and (2) whether the “base erosion percentage” is at least 3% (2% for certain banks)

• IF the two-part application test is met, then BEAT imposes a minimum federal income tax (in addition to the corporate TP’s regular tax liability) of:

• 5% of “modified taxable income” for TY 2018 • 10% for TYs 2019-2025 • 12% for TYs 2026 and beyond • BEAT rate is 1% higher for certain financial groups (banks/broker-dealers)

• § 59A(f) – Grants IRS broad regulatory authority as necessary and appropriate to prevent avoidance of §59A’s purposes

• Little or no effect on US State Corporate Tax Bases: Because the BEAT is a new federal corporate tax on a base that is distinct from the corporate income tax base, it presumably does not impact the determination of the US corporate income tax base that serves as the starting point for determining many U.S. states’ corporate income tax returns.

• Most commentators expect that no (or very few) states will pass tax laws to conform conforming state tax laws to IRC § 59A BEAT.

164



Base Erosion and Anti-Abuse Tax

• Base Erosion and Anti-Abuse Tax (BEAT) • Tax on deductible payments from domestic corporations and branches to foreign affiliates.

• Only applicable to corporations with $500 million in annual sales.

• Exclusions for: • Cost of goods sold,

• Certain payments for services representing cost reimbursement with no mark up,

• Certain payments pursuant to derivatives that are marked to market for tax purposes,

• Payments that are subject to U.S. withholding tax.

• No exclusion for interest or other payments in connection with financial transactions other than derivatives.

• May effect the use of shareholder debt to finance acquisitions of U.S. businesses by Foreign Multinationals.

• Incentive to stay below $500 million or spin off divisions

165

BEAT’s Policy and Seeming Inconsistency with Treaty Obligations

• Dual Congressional Purpose: (1) Anti-Base-Erosion and (2) a Minimum Tax: Because the BEAT appears to impose tax on payments that are already taxed as Subpart F income and Effectively Connected Income (ECI), it also functions as a “minimum tax”—not just an anti-earning stripping mechanism.

• To increase international competitiveness of US companies: The BEAT arguably serves this objective by reducing base erosion opportunities that have previously allowed foreign-controlled US corps to operate in USA at lower effective tax rates than their US competitors.

• See Unified Framework for Fixing Our Broken Tax Code (Sept. 27, 2017), https://www.treasury.gov/press-center/press-releases/Documents/Tax-Framework.pdf

• US-tax-base erosion by foreign-controlled US corps had caused US businesses to be more valuable on an after-tax basis to a foreign acquiror than to a US acquiror-- a principal incentive for US corporate inversions.

• Caveat: While the BEAT reduces base-eroding opportunities, it also inhibits the full deductibility of payments, which is arguably inconsistent with the international “arm’s length standard” for transfer pricing. Thus, BEAT could conflict with existing APAs and accepted transfer pricing principles, established by the OECD.

• Violates US Tax Treaty and Trade Treaty Commitments? BEAT is arguably not consistent with: • Art. 24 (5), Non-Discrimination, US Model Tax Treaty (2016) • Art. 7, attribution of profits to a US permanent establishment • Art. 23, double tax relief • Art. 25, Mutual Agreement Procedure • Could also conflict with existing APAs (advance pricing agreements); WTO Trade - GAT and GATS

166



IRC § 59A - Key Definitions and Terms of Art

• A simple way to think about BEAT’s application is to focus on its two-part application test in § 59A. In general, the BEAT will apply if:

1. An “applicable taxpayer” makes “base eroding tax payments” to a “related foreign person,” but

2. Only to extent the tentative BEAT tax liability exceeds TP’s regular tax liability.

• Thus, in determining whether any large corporate taxpayer has a BEAT liability, the following must be identified and/or computed:

• “Applicable Taxpayer” - defined in § 59A(e) (note the aggregation rules in par. (3))

• “Base Erosion Minimum Tax Amount” - This is essentially the BEAT, defined in § 59A(b) by reference to:

• “Modified Taxable Income” - defined in 59A(c)(1) by reference to: • “Base Erosion Tax Benefit” - defined in § 59A(c)(2)

• “Base Erosion Tax Payment” - defined in § 59A(d)(1)

• “Base Erosion Percentage” - defined in § 59A(d)(1)

• “Related Party” - defined in § 59A(g) (incorporates definitions in §§ 267(b), 707(b)(1) and 482)

• “Foreign Person” - defined in § 59A(f)

167

BEAT only applies to “Applicable Taxpayers”

• § 59A(e): “Applicable taxpayer” means, with respect to any taxable year, a taxpayer— • (1)(A): that is a corporation (foreign or US but not a RIC, REIT, or S-Corp); • (1)(B): has average annual “gross receipts” of at least $500M for the 3-yr period ending with the preceding tax year; AND • (1)(C): has a “bare erosion percentage” for the taxable year of 3% or higher (2 % for certain banks and financial institutions).

• Aggregation Rules apply only for purposes of: • Determining whether the $500M avg. annual gross receipts test is met, and • Determining whether the 3% “base erosion percentage” threshold is met (2% for certain financial institutions) • §59A(e)(3) treats all members of an aggregated group as one person, but only for purposes of (1) testing whether the $500M avg.

gross receipts threshold is met, and (2) whether the base erosion percentage is at least 3% (2% for certain financial institutions). • The BEAT aggregation rule refers to the “single employer rule” of § 52(a), which in turn incorporates the controlled group rules of

§1563(a), but substituting “more than 50 percent” for “at least 80 percent” where it appears in §1563(a)(1). • Although §1563(b)(2)(B) generally excludes “foreign corporations” from the definition of “controlled group,” new §59A(e)(3) turns

off that exclusion. Thus, US companies that are owned > 50% by a foreign corporation are treated as one person for purposes of applying the $500M gross receipts test and the “base erosion percentage.”

• §59A(e)(2): For non-US corporations, “gross receipts” includes only those used to determine ECI under § 864(c). • RESULT: count only gross receipts of any US controlled group, together with any ECI of the foreign parented group, to test

whether group has $500M gross receipts. • Drafting error? If statute were applied literally, all intergroup payments could be ignored—both inbound and outbound.

Arguably, payments to US group members and to US branches by foreign group members should be ignored in calculating the single employer group for purposes of the BEAT because they are obviously not base eroding. (This issue is likely to be clarified in forthcoming Treasury regulations.)

168



BEAT – Aggregation does not apply in calculating

BEAT tax liability:

• Calculation of actual BEAT liability appears to be done on an entity-by-entity filing basis—not on the basis of a controlled group as defined in the BEAT aggregation rules.

• Tax attributes used in calculating the actual BEAT liability—e.g., NOLs, various tax credits—are calculated on a “taxpayer” basis.

• Thus, US corporations filing a consolidated return (as a single TP) calculate their BEAT liability on a consolidated basis as a consolidated federal taxpayer; corporate taxpayers not filing consolidated calculate their BEAT liability on a stand-alone basis.

• Effect on Non-US “Inbound Groups”: Such groups must aggregate the US gross receipts and tax deductions of all their > 50%-owned US subs (as well as any tax transparent US branches of non-US members of their § 59A(e)(3) aggregated/controlled group) to determine whether BEAT will apply to any subsidiary.

169

BEAT Aggregation Rules – Illustration

Foreign

Parent

US Parent #1

Foreign Sub

US Parent #2

US Sub

Foreign Sub

100%

80%

100%

100%

100%

Foreign Sub

100%

Foreign Sub

20%

US Branch

IRC §59A(e)(3)

aggregation rule treats

all corporations (US or

foreign) that are

members of the same

aggregated group (as

defined) as one person

for two purposes only:

(1) to determine

whether the $500M

gross receipts test is

met, and (2) whether

the base erosion

percentage is 3% (2%

for financial

institutions).

Count gross receipts of

foreign members, but

only to extent of their

gross receipts related to

effectively connected

income (ECI).

Implicit Rule in 59A: For purposes of actually calculating

the BEAT liability, do NOT apply the aggregation rules of

§59A(e)(3). Rather, look to “taxpayer filer” status—i.e., US

consolidated groups calculate their BEAT liability on a

consolidated basis. Stand alone, non-consolidated entities

calculate their BEAT liability separately.

US Parent #3

US Sub

50%

100%

10%

Foreign Sub

170



BEAT’s Application in the Partnership Context

• § 59A is silent on its application to partnerships: Looking only at statute, intended treatment is unclear, and will depend on forthcoming guidance from Treasury and the IRS, which may be retroactive.

• Guidance may be retroactive

• Calculation of $500M gross receipts threshold, base erosion payments, and base erosion percentage are all likely to be affected by how payments by, to, and through partnerships are viewed (i.e., whether the payments are viewed as being paid to/by the entity itself, or to/by its partners).

• Seems rational that Treasury’s administrative guidance will take position that BEAT applies at the partner level (i.e., applying aggregate-of-partners approach, as opposed to “entity” approach)

• In absence of guidance, note that § 59A treats a partnership as a “person” both in defining “foreign person” (§ 59A(f)) and “related party” (§ 59A(g)).

• If BEAT applies at partner level, TPs might try to manipulate BEAT’s application through “special allocations” of items to avoid § 59A’s application thresholds and character of payments, but §704(b) requires such allocations to have “substantial economic effect” apart from their tax consequences. So, §704(b) should be able to police potential abuse.

171

Forthcoming regulations might take an aggregate approach, testing for BEAT’s application at the partner level

• zz • zz

Payments by P/S likely to be

treated as deducted at partner

level. (So, each partner would be

tested for “applicable taxpayer”

status.)

Payments to a US P/S with foreign partners may be treated as paid to the partners for §59A purposes; thus, could be “base erosion payments” w/in BEAT.

• zz

US FC US US US FC FC

US FP

US

US $$ $$ $$

Payment to foreign P/S with

only US partners is not likely to

be treated as payment to a

foreign person under §59A…so

outside of BEAT.

172



Overview of BEAT Calculation

• Step one: Determine if there is an “Applicable TP” not within either 1 of 2 safeharbors—i.e., < $500M three-year annual gross receipts OR has a “base erosion percentage” of < 3%. (If annual gross receipts are > $500M, then must analyze other tests to see if BEAT applies.)

• Step Two: Determine “Base Erosion Percentage” under § 59A(c)(4) (i.e., “Base Erosion Tax Benefits” divided by Total Deductions for the year, other than §172 NOL dd; §245A participation dd; §250 dds for GILTI/FDII; and dds not treated as “base erosion payments” because they are either “qualified derivative paymts” or within services cost method safe harbor of Reg. § 1.482-9).

• If Base Erosion Percentage is < 3%, stop--because BEAT does not apply. (The base erosion percentage must be < 2% for certain financials to escape BEAT.)

• Step Three: Determine “Modified Taxable Income” (i.e., Taxable income + “Base Erosion Tax Benefits” + [Base Erosion % x NOL dd for the tested year])

• Step Four: Calculate the § 59A(c)(4) floor, which is TP’s “Regular Tax Liability” (§ 26(b)) reduced by all allowable credits for the taxable year (TY) other than the R&E credits, and 80% of the allowable §38 credits. (NOTE: Huge debate before TCJA was signed because in draft statute, the §38 “general business credit” was drafted to reduce “regular tax liability” in BEAT calculation, meaning the laundry list of various credits listed in §38(b) would, in effect, increase a TP’s BEAT liability, many of those credits relate to politically sensitive industries (e.g.., alternative energy, low income housing). Note: FTCs are subtracted to compute “Regular Tax Liability”—WHY?

• Step Five: Determine BEAT Liability for the year. BASIC FORMULA:

“Base Erosion Minimum Tax Amount” = Excess of [Modified Taxable Income X 10%*] OVER [21% rate X TP’s Net US Tax liability, less the “allowable tax credits” (but disregarding R&E credit and 80% of TP’s applicable § 38 credit)].

• * Substitute 5% of modified taxable income for TY 2018; 10% for TYs 2019-2025, 12% for TYs 2026 & beyond

• Step Six: Determine TP’s Total US Corporate Income Tax Liability (i.e., [TP’s regular tax liability minus credits] + BEAT Liability)

• This is an annual test.

173

Identifying “Base Erosion Payments” for BEAT purposes

• § 59A(d)(1) defines “Base Erosion Payment” as “any amount paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer and with respect to which a deduction is allowable under this chapter.”

• Base Erosion Payments may include: • Royalties

• Interest (Ordering rule: interest disallowed under new §163(j) is allocated first to payments that are “unrelated” for BEAT purposes, thus increasing chances that the payment will be a base eroding payment and added back to “modified taxable income”).

• Payments for acquisition of depreciable or amortizable property acquired from a foreign related person (property must generate depreciation/amortization dds).

• Payments for services (But note exception for some intercompany services at cost)

• Insurance Premiums or other consideration for any reinsurance payments (§§803(a)(1)(B), 832(b)(4)(A)).

174



“Bare Erosion Payments” do NOT include:

• Payments that reduce “gross receipts” (e.g., payments included in “cost of goods sold” of inventory (COGS) rather than being deductible, unless the recipient foreign affiliate is a post -11/9/2017 inverted company, or a member of such entity’s “expanded affiliated group” as defined in § 7874.

• Payments to the extent they are already subject to the US 30% withholding tax under §871 or §881. Example: If a royalty payment is eligible for a treaty-reduced W/H tax of 5% (instead of US 30% statutory rate), then 5/6ths of the actual royalty payment is treated as a base erosion payment because the royalty is subject to only 1/6th of the US 30% W/H tax. Cf., treatment of Subpt F Income & ECI, which are not exempt from BEAT.

• “Qualified Derivative Payments” (as defined in § 59A(h)(2)) • Taxpayer under mark-to-market; treats gain or loss as “ordinary”; and treats character of all items w/respect to payment pursuant

to the derivative as “ordinary.” Exceptions for split derivatives.

• Intercompany services payments eligible for “services cost method” in Reg. §1.482-9(b) (but determined without regard to either any “mark-up” or requirement that such services not contribute significantly to the fundamental risks of the business.

• Rev. Proc. 2007-13 lists 101 qualifying services assumed to be low-value; • Activities excluded from the Reg. §1.482-9 safe harbor (which could thus be base erosion service payments for BEAT purposes)

include: mftg, production, reselling, distribution services, sales agency, commissionaire, R&D/R&E, engineering, scientific, financial transactions (including guarantees).

• Activities likely to be “covered services” w/in Reg. §1.482-9 safe harbor include: services not specifically “excluded” and for which adequate books/records are maintained. These are often “support services” common across the taxpayer’s industry sectors, and which do not have a significant mark-up component, such as data entry, recruiting, credit analysis, data verification, legal services, and other common support services.

175

“Foreign Person” and “Related Party” are broadly

defined in BEAT

• For § 59A BEAT purposes, a “foreign person” may be a corporation, partnership, or other entity. • §59A(f) defines “foreign person” by reference to § 6038A(c)(3), to include entities that are not US domestic

entities

• For § 59A BEAT purposes, “related party” means, with respect to any applicable taxpayer, • (A): any 25-percent owner of the taxpayer (vote or value);

• (B): any person that is related to either the taxpayer or to any 25-percent owner of the taxpayer within the meaning of §§267(b) or 707(b)(1) (generally a >50% control standard); and

• (C): “any other person who is related (within the meaning of section 482 to the taxpayer.” • Thus, § 59A provides a very broad standard for related party. Under § 482, the IRS may determine that two parties are “related” by

virtue of them “acting in concert” or having a common purpose, even if there one party owns no equity in the other.

• Some commentators have interpreted § 59A as imposing a 25% “related” threshold, but not clear from the statute whether 25% ownership is the intended threshold in all cases because such interpretation would make (B) superfluous. “Any 25% owner” is not defined, and could be limited to direct 25% owners).

• § 318 attribution rules apply for purposes of the first two prongs: • “10 percent” is substituted for “50 percent” in § 318(a)(2)(C) (i.e., attribution threshold from a corp to a SH).

176



BEAT Calculation – Basic Example

Assumed Facts for US Group:

• Avg. annual gross receipts 2016 through 2019 is > $500M

• 2019 Taxable Income = $100M

• $5M Tax Credits (with $2M = R&D credits)

• “Related Person” payments:

• $35M interest paid to Non-US parent by US Group (Assume $5M is limited under new §163(j))

• $85M royalties to Foreign IP-Co

• $5M shared services fees paid by US Group to Non-US Parent (qualifying for Services Cost Method (SCM) under Reg. § 1.482-9, no mark-up)

• $10M service fee paid to CFC (not SCM eligible)

• Total deductible expenses = $625 M

• Assume Non-US Parent and IP-Co are US tax treaty eligible and no there is no US Group depreciation or amortization in connection w/property acquired from a foreign related person in post-2017 period.

Inbound Licensing Structure

IP-Co (Non-US)

Non-US Parent

US Group

CFC

$85M royalties paid by US group to IP-Co

License

Sales to 3rd party customers

$10M service fee (not SMC eligible)

$35M interest & $5M service fee (§ 482 SCM eligible)

177

BEAT Calculation – Basic Example (continued)

• Step One: $500M annual avg. gross receipts test is met. (Given facts assume that…so this safe harbor is flunked)

• Step Two: Determine “Base Erosion Percentage.”(Here, it’s 20%)

Deductions attributable to “base erosion paymts”

All deductions for year (other than §172 NOL, §245A, §250 GILTI/FDII, etc.)

$30M + $85M + $10M $625M EQUALS 20 %, which is > 3% (So, this test also flunked.)

• Step Three: Determine “Modified Taxable Income”

MTI = Taxable income + base erosion benefits

MTI = $100M + $125 = $225M

• Step Four: Calculate TP’s “Regular Tax Liability” but REDUCED by all allowable credits other than R&E credits and 80% of §38 credits, etc. (i.e., the floor described in §59A(b)(1)(B)).

21% rate X Taxable Income LESS regular tax credits (other than R&D, etc.)

$21M LESS ($5M credits - $2M R&D Credit) = $18M Floor

• Step Five: Determine BEAT liability for TY. 10%(MTI) – TP’s Regular Tax Liability less credits (i.e., subtract the “floor” described in 59A(b)(1)(B))

10% ($225M) - $18M Floor = $4.5M BEAT Liability

• Step Six: TP’s Total US Corporate Tax = Regular Tax Liability (less credits) + BEAT Liability

[($100M TI x 21% US corporate tax rate) -$5M credits] + $4.5M BEAT = $20.5M

178



Strategies to Manage BEAT Exposure

• Modeling, monitoring, and specific BEAT “management” will be needed to stay under the 3% “base erosion percentage” (which operates as a cliff) (2% for certain financial institutions)

• Statutory requirement (§59A(b)) that certain credits be subtracted in calculating the BEAT can easily result in a low “regular tax liability” which offsets “Modified Taxable Income” in the BEAT calculation.

• Possible strategies: • Financings: Refinance intercompany debt into third-party loans

• Manufacturers: Evaluate whether certain payments could be included in COGS (or structure them that way—e.g., Think about whether royalties paid for distribution could be restructure so that they become production costs of the inventory; marketing costs v. internal costs that reduce gross receipts)

• Services: • Find payments eligible for the “services cost method” under Reg. §1.482-9 (exception to base erosion payment)

• Distinguish cost-based services from cost reimbursements

• Replace global services contracts (US general contractor, foreign subcontractors) with local contracts to eliminate payments from US affiliates to related foreign persons

179

Procurement Transaction - § 59A BEAT Implications

Assumed Facts:

• USP purchases finished goods from unrelated Chinese clothing manufacturer

• USP relies on a Hong Kong affiliate to procure the goods from third-party mftrs in China.

• USP pays HK Sub a “procurement fee,” which UPS deducts from its gross income.

The §59A BEAT Issue:

The procurement fees, otherwise deductible, are being paid to a foreign “related person” under § 59A and thus could be “base erosion payments” for BEAT purposes if USP’s avg annual aggregated gross receipts > $500M and its “base erosion % > 3%.

Alternative Structure?

Revise contract with HK Co., making it a “buy-sell” procurement arrangement, rather than fee-based. This would effectively replace the deductible BEAT payment with a non-deductible “cost” item for the inventory, thus reducing USP’s gross receipts (and thus, outside of BEAT definition of “base erosion payment”).

Caveats and Considerations:

• Practical & legal ability to amend the contract

• Transfer pricing (would TP Regs require comp for giving up valuable contract?)

• Customs & Trade: Must compare customs cost of importing from related HK affiliate to non-related China corp.

• Subpart F. HK Co is a CFC, and would have §954(d)(1) FBC “sales income” unless an exception (K-mftg ?) applies. If not Subpart F income, would it be GILTI?

• BEAT’s grant of regulatory authority to US Treasury to write anti-avoidance rules for the BEAT?

USP, Inc.

HK Sourcing Subsidiary

(CFC)

China Mnftr.

Sales of inventory to USP

Procurement fees paid by USP under a procurement contract

180



Cost Sharing Payments - § 59A BEAT Implications

Assumed Facts:

• USP is a technology company, incorporated in the US as a C-Corp.

• USP has a cost-sharing agreement (CSA) with an Irish subsidiary, which provides that IP rights are split geographically—i.e., US IP to be exploited by USP and non-US IP to be exploited by Ireland Co.

• USP’s “reasonably anticipated benefits” (RAB) = 50%; Ireland Co’s RAB = 50%.

• Another Sub, Dutch Co., performs R&D for USP’s group. Under terms of the original billing arrangement, Ireland Co. makes payments to USP for its 50% RAB. Then USP compensates Dutch Co. for 100% of Dutch Co’s R&D services.

The § 59A BEAT Issue: The entire service fee paid by USP to Dutch Co. could be a “base erosion payment” for §59A BEAT purposes (outside of service cost method safe harbor) ,assuming such paymt is otherwise deductible and assuming USP’s avg annual aggregated gross receipts for past 3 years > $500M and its “base erosion % > 3%.

Alternative Structure ? Revise billing procedures to have Dutch Co. directly bill Ireland Co. for 100% its R&D services so that USP is

no longer making that outbound payment for those costs to a related foreign person. USP will then have to make a CSA payment to Ireland Co. based on USP’s RAB. Although that CSA payment may be a “base erosion payment,” it will likely be less than the prior payment to Dutch Co. Under the new arrangement, “base erosion payments” within purview of the BEAT would be reduced.

Caveats and Considerations:

• Practical costs of amending billing procedures

• Transfer pricing? (Also, BEPS considerations for this structure—location of DEMPE functions…)

• Congress’ grant of regulatory authority in §59A to US Treasury to write anti-avoidance rules for the BEAT? Should this “fix” be a prohibited BEAT avoidance technique under forthcoming Regs?

USP, Inc.

Ireland Co.

Dutch Co. (R&D)

Originally, USP pays all Dutch Co’s contract R&D costs, deducting them.

Under revised arrangement, Ireland Co. pays Dutch Co. for all its R&D services.

Under revised arrangement, USP makes CSA payments to Ireland Co.

181

BEAT - New Reporting Requirements and Penalties

• The 2017 Tax Act amended §6038--the current reporting regime for 25%-foreign-owned corporations, IRS Form 5472--by adding new subsection (b)(2) imposing additional reporting requirements related to the BEAT.

• The additional reporting require TPs to disclose info necessary to determine: • Base erosion payments;

• Base erosion tax benefits; and

• Base erosion minimum tax amount for the taxable year.

• The IRS is expected to guidance on the new reporting requirements.

• Penalties for failure to report this information have been increased from $10,000 to $25,000 per form, with $25k penalties accruing every 30 days after failure to report for 90-day period and after official notification.

• See §6038A (d). There is a “reasonable cause” exception for such failures.

182



Insolvent and Distressed Corporations

Insolvent and Distressed Corporations

• No Net Value

• Limitations on Utilizing NOLs under Section 382

• Tax Attributes

• Cancellation of Indebtedness Income

184



NET VALUE RULES

• 2005 Proposed Regulation 1.368-1(b)(1): Exchange of no net value (liabilities exceed value) does not qualify as a reorganization

• Example: Acquiror owns all of the stock of both Merger Sub and Target. Target has assets with FMV of $100 and liabilities of $160, all of which are owed to B. Target transfers all of its assets to S in exchange for the assumption of Target’s liabilities, and Target dissolves. The obligation to B is outstanding immediately after the transfer. Acquiror receives nothing in exchange for its Target stock.

• Explanation: Under paragraph (f)(2)(i) of the Reg, Target does not surrender net value because the FMV of the property transferred by Target ($100) does not exceed the sum of the amount of liabilities of Target assumed by Merger Sub in connection with the exchange ($160). Therefore, under paragraph (f) of the Reg., there is no exchange of net value. See Prop. Reg. 1.368-1(f)(5) Example 3.

• Alabama Asphalt

185

NO-NET-VALUE EXCHANGES

• Even though the IRS withdrew their proposed regulation, REG-163314-03, in July of 2017, there are still potential issues with reorganizations involving the exchange of an insolvent subsidiary.

• The proposed regulation set out to clarify variances in the tax authorities approach to nonrecognition of exchanges involving insolvent subsidiaries.

• The proposed regulation set out rules stating that in order for nonrecognition rules of Chapter C to apply there must be net value in both the surrender and receipt of the exchange.

• Tax authorities still are odds with exchanges involving the transfer of insolvent subsidiaries. • Insolvent companies may not be able to make distributions to shareholders in a liquidation and this would fail

section 332 causing recognition of gain or loss to a parent liquidating an insolvent subsidiary. H. G. Hill Stores, Inc. v. Commissioner, 44 B.T.A. 1182 (1941).

• The transfer of an insolvent subsidiary is generally not attributable to the stock interest of the parent if debtor interests are superior to shareholder interests. And as such, the transfer of an insolvent subsidiary is deemed a transfer made in satisfaction of indebtedness and not a reorganization under section 368. Rev. Rul. 59-296.

• However, Norman Scott, Inc. v. Commissioner, 48 T.C. 598 (1967), held that nothing in section 368(a)(1)(A) prevented an insolvent subsidiary from merging into a sister company in a statutory merger.

186



Section 382 – In General

• the U.S. has rules that prevent trafficking in losses.

• Section 382 restricts the ability of a “loss corporation” to claim NOLs generated before the sale against income earned after the sale if there has been an “ownership change.”

• A “loss corporation” means any corporation: 1. entitled to use an NOL carryover, or

2. that incurs an NOL during the year in which an ownership change occurs, or

3. that has a net unrealized built-in loss.

187

Section 382 – In General

• Section 382 is a highly complex provision which reflects taxpayers’ persistent efforts to circumvent it.

• There are two principal considerations in determining whether Section 382 will limit NOLs: 1. whether an ownership change as occurred, and

2. the value of the target at the time of the sale.

188




• An ownership change occurs if the percentage of stock owned by 1 or more 5 percent shareholders increases by more than 50 percent during a 3 year period.

• The NOL limitation for any year after an ownership change is equal to the value of target immediately prior to the change, multiplied by the long-term tax-exempt rate (approximately 2.5% as of early 2016).

189


• ownership changes can be complicated if fluctuations in stock ownership: • Occur over time,

• occur indirectly, or

• occur in bankruptcy.

• Section 382 has special rules for each of these circumstances with extensive regulations.

190



Section 382(l) – Bankruptcy Exception

• Section 382(l)(5) provides an exception to the general loss limitation rules in recognition of the fact that, by the time a company is in bankruptcy it is often the creditors, rather than the shareholders, who are the economic owners.

• It is not uncommon for the court to approve a plan under which shares of stock held by historic shareholders are cancelled without consideration, and new shares are issued to the company’s creditors.

191


• Under Section 382(l)(5), a loss corporation’s pre change NOLs will not be limited after an ownership change if:

• the corporation is (immediately prior to the ownership change) under the jurisdiction of the court in a title 11 or similar case, and

• the shareholders and qualified creditors of the loss corporation (determined immediately prior to the ownership change) own (after the ownership change as a result of being shareholders or creditors) at least 50% of the stock of the corporation.

• Stock transferred to a creditor shall be taken into account only if: • the stock is transferred in satisfaction of the debt, and

• the debt was held by the creditor for at least 18 months

192




• If the target transaction occurred in the context of a bankruptcy then an ownership change would not occur and target’s NOLs would not be limited.

• Without Section 382(l)(5), the pre-change NOLs would be limited by virtue of the fact that creditors are now shareholders (assuming they own at least 50% of the loss corporation).

• a “qualified creditor” receives the target stock in satisfaction of its debt and it has been a lender for more than 18 months.

193

Section 382(l) – Bankruptcy Exception Consequences

• Section 382(l)(5) comes at a price. Due to potentially harsh consequences, loss corporations may elect out of this treatment if the benefit of no NOL limitation is outweighed by the following.

• The two main consequences are: • A subsequent ownership change within 2 years will cause elimination of the NOLs, and

• There is a “toll charge” for certain interest payments to creditors who are becoming shareholders in the bankruptcy.

194



Section 382(l) – Bankruptcy Exception When To

Elect Out

• Second Ownership Change: A loss corporation and its advisors need to seriously consider the possibility of another ownership change within 2 years. If this is possible, the corporation is at risk of losing the ability to claim all its NOLs—a complete forfeiture.

• Toll Charge: In exchange for offsetting post-change income with pre-change NOLs, the corporation must pay a price by reducing its NOLs. Since debt is being converted to equity, interest paid on the debt during the 3 year period prior to the ownership change is disallowed thereby reducing the amount of NOLs. This may be very significant for borrowers with significant debt.

195

Section 382 – Valuation of Loss Corporation

• As a result of target’s ownership change, its NOLs will be limited.

• Under the general loss limitation rules, the value of the loss corporation is determined immediately prior to the ownership change.

• Since valuation drives the amount of the limitation, taxpayers want the value of the loss corporation to be as high as possible. The statute and the regulations contain provisions to prevent the artificial inflation of a loss corporation’s value (e.g., anti-stuffing rules).

196



Section 382 – Valuation of Loss Corporation

• Valuation of the loss corporation is inherently factual, unless the loss corporation is a public company. Taxpayers can use appraisals or asset valuations to determine value.

• For purposes of 382, the relevant value is the fair market value of the stock immediately prior to the ownership change.

• Assuming a $10 million valuation, the NOL limitation would be $250,000 per year ($10 million multiplied by the long-term tax-exempt rate of 2.5%). With a $50 million NOL, it would take 200 years to fully use the losses.

197

Section 382 – Valuation of Loss Corporation Electing Out of the Bankruptcy Exception

• As discussed above, special rules apply to loss corporations in bankruptcy. If target were in bankruptcy and elected not to have the provisions of Section 382(l)(5) apply because of the adverse impact, then target would fall back under the general rules of Section 382 with one principal exception.

• Section 382(l)(6) provides that the value of target is increased by the surrender or cancellation by a creditor of any claims against the company. The effect of this provision is to increase the limitation allowing the use of more NOLs in future tax years.

198



Section 382 – Valuation of Loss Corporation Electing Out of the Bankruptcy Exception

• If Section 382(l)(6) were to apply to target, then the value would increase by the amount of debt cancelled in the transaction.

199

Cancellation of Indebtedness

• On the conversion of debt to equity, target is treated as satisfying the debt with an amount of money equal to the fair market value of the stock issued. Code Section 108(e)(8).

• The debt that is not satisfied is treated as cancellation of indebtedness (“COD”) income.

200



Measuring target’s COD

• Generally, COD income is realized at the time the debt is satisfied for less than its principal amount.

• COD income is equal to the difference between the amount due under the obligation and the amount paid by the debtor.

201

Can COD Income be Excluded?

COD can be excluded from income in certain cases:

• Discharge in bankruptcy (regardless of the extent of Borrower’s insolvency). Code Sections 108(a)(1)(A) and 108(d)(2).

• Discharge when Borrower is insolvent (but only to the extent of insolvency). Code Sections 108(a)(1)(B) and 108(a)(3).

• “Qualified farm indebtedness.” Code Sections 108(a)(1)(C) and 108(g).

• For borrower other than a C corporation, “qualified real property business indebtedness” (QRPBI). Code Sections 108(a)(1)(D) and 108(c).

• Qualified principal residence indebtedness (QPRI) discharged before 2017 (or subject to an arrangement entered into and evidenced in writing before Jan. 1, 2017). Code Sections 108(a)(1)(E) and 108(h).

202



When Is COD Excluded from Income?

• The insolvency and bankruptcy exceptions are the exceptions most often used in a debt workout.

• The bankruptcy exception applies to all COD income.

• The insolvency exception applies only to the extent of target’s insolvency.

• If the insolvency and bankruptcy exceptions don’t help, the exception for qualified real property business indebtedness (QRPBI) may be useful (for taxpayers other than C corporations).

203

Insolvency and Bankruptcy Exceptions

• if target is not in bankruptcy, it could only exclude some or all of the COD from income if it were insolvent.

• Insolvency is defined as the excess of liabilities over the fair market value of assets, as determined immediately before the COD. Code Section 108(d)(3).

• In a bankruptcy, the COD income is excluded regardless of the debtor’s solvency.

204



Reduction of “Tax Attributes”

• If target could avoid COD income through the insolvency or bankruptcy exceptions, then it must reduce valuable “tax attributes” to the extent of excluded COD. Section 108(b).

• Recall that if target is in bankruptcy and avoids the loss limitation rules, then it must reduce its NOLs under the “toll charge” provision. Avoiding COD income would require a further reduction of target’s tax attributes.

• Tax attributes include NOLs, credits, capital losses, carryovers of losses, and basis.

205

Reduction of “Tax Attributes”

• Complex rules on the order in which attributes are reduced, but Borrower does have a limited amount of choice about the order in which attributes are reduced.

• If the taxpayer chooses, it may elect to forgo the standard reduction provisions and reduce the basis in its depreciable assets first.

• This election may be made, for instance, if the taxpayer has assets it expects to maintain for a period of time and if its NOLs may soon expire and it could potentially utilize them.

206



MENLO PARK

149 Commonwealth Drive,

Suite 1001

Menlo Park, CA 94025

SANTA MONICA

520 Broadway

Suite 200

Santa Monica, CA 90401

SAN FRANCISCO

135 Main Street

12th Floor

San Francisco, CA 94105

Menlo Park Office: 650-813-9700

CONTACT US

www.rroyselaw.com

@RoyseLaw

ORANGE COUNTY

135 S. State College Blvd

Suite 200

Brea, CA 92821

207

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