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May 10, 2016

2016-Issue 14 – Just when you thought it was safe to go back in the water, on April 4, 2016, the IRS and Treasury released proposed and temporary regulations attacking corporate inversion transactions with an even bigger bite than expected. The first to fall victim to the new rules was the Pfizer-Allergan deal. In its press release issued on April 6, 2016, Pfizer announced that the merger agreement was terminated by mutual agreement of the companies. Pfizer indicated that the decision was “driven by the actions announced by the U.S. Department of Treasury on April 4, 2016.” Undoubtedly, the statement amassed strong sentiment in boardrooms and living rooms, as the aggregate deal value of $160 billion garnered investors a 30 percent premium based on Pfizer’s and Allergan’s unaffected share prices as of October 28, 2015 (the deal announced in November 2015). One could only imagine the view on Wall Street as various investment bankers and advisers said farewell to an estimated $200 million of success-based deal fees. Allergan’s chief executive, Brent Saunders, was not shy about voicing his opinion when he was quoted by the Wall Street Journal as saying the new regulations are “un-American” and “capricious” and “the rules are focused on the wrong thing: Our government should be focused on making America competitive on a global stage, not building a wall locking companies into an uncompetitive tax situation.”

Some may quip, what’s all the fuss about? Didn’t the IRS and Treasury put taxpayers on notice of these impending regulations in 2014 and 2015? The answer to that is yes and NO! True, the IRS and Treasury announced the intention to issue regulations aimed at further curbing corporate inversions in Notice 2014-52 (released on September 22, 2014) and Notice 2015-79 (released on November 19, 2015), but new rules were added to the temporary regulations issued on April 4, 2016, that were not in the prior notices. The new rules generally apply to transactions completed on or after April 4, 2016. Thus, although the Pfizer-Allergan deal was signed in November 2015 (after the notices were issued), the new rules would have applied to that deal because it did not close before April 4, 2016. Some have called this unfair and just plain wrong. However you feel about the IRS and Treasury’s actions, it’s clear the temporary regulations have affected significant deals and will change the landscape for future transactions.

While the temporary regulations also address and implement the rules described in Notices 2014-52 and 2015-79, this edition of Tax Advisor Weekly focuses on the “new additions” that were not part of the notices — specifically, the multi-step acquisition rule under Temp. Treas. Reg. 1.7874-2T and multiple domestic entity acquisitions rules under Temp. Treas. Reg. 1.7874-8T. But first, a little background on Section 7874.

Section 7874 General Rules:
Under Section 7874, a foreign corporation is treated as a “surrogate foreign corporation” if three conditions are satisfied:

i. The foreign acquiring corporation acquires, directly or indirectly, substantially all the properties held directly or indirectly by a domestic corporation (domestic entity acquisition);

ii. After the domestic entity acquisition, at least 60 percent of the stock of the foreign acquiring corporation is held by the former domestic entity shareholders by reason of holding stock in the domestic entity (ownership percentage); and

iii. After the domestic entity acquisition, the expanded affiliated group (EAG as defined in Section 7874(c)(1)) does not have substantial business activities in the country in which the foreign acquiring corporation is organized.

If any one of the three requirements above is not satisfied, Section 7874 simply does not apply. If the requirements are met, the tax treatment to the foreign acquiring corporation and the EAG differ depending on the ownership percentage.

Hotel California Rule: If the former domestic entity shareholders own 80 percent or more of the surrogate foreign corporation, that entity is treated as though it is a domestic entity and is subject to U.S. taxation — forever. For those of you who may be fans of the band the Eagles, my West Coast colleagues and I affectionately refer to this aspect of Section 7874 as the Hotel California Rule because, as the song goes, you can check out any time you like, but you can never leave.

Inversion Gain Rule: If the ownership percentage falls between 60 and 79 percent, the foreign surrogate corporation is respected as a foreign corporation but the taxable income of the domestic entity includes any inversion gain recognized during the 10-year period following the domestic entity acquisition. Inversion gain includes gain recognized from the transfer of stock or properties of the domestic corporation, including income from a license of property, and such income or gain cannot be offset by any net operating loss carryovers the domestic corporation may have. Similarly, the tax on the inversion gain may not be offset by tax credits.

Background on the New Rules
The multi-step acquisition rules and multiple domestic acquisition rules introduced in the temporary regulations affect the application of the ownership percentage test described above and in effect alter the stock included or excluded in computing the ownership percentage. This is noteworthy because most of the recent inversions, including the Pfizer-Allergan deal, relied on the ownership percentage test to fall below the 80 percent, or 60 percent, threshold (depending on the deal). Thus, it’s not hard to see why many folks believe these rules came out in direct response to and were perhaps aimed at blowing up the Pfizer-Allergan deal.

Multi-Step Acquisition Rules
The current regulations provide guidance on the types of transactions that constitute a domestic entity acquisition. Treas. Reg. 1.7874-2(c)(2) provides that a foreign corporation’s acquisition of stock of another foreign corporation that in turn owns either stock in a domestic corporation or a partnership interest in a domestic entity is not considered an indirect acquisition of the properties held by the domestic entity. Because the domestic entity had a foreign parent before the acquisition, the acquisition of the domestic entity’s foreign parent generally does not give rise to the policy concerns that motivated Congress to enact Section 7874. That said, in the preamble to the temporary regulations, the IRS and Treasury indicate that policy concerns do arise where multiple acquisitions occur in which a foreign corporation engages in a domestic entity acquisition that does not result in the foreign acquiring corporation being treated as a domestic corporation (either because the ownership percentage is less than 80 percent or the foreign corporation and its EAG satisfy the substantial activities prong of the three-prong test described above) and the foreign corporation is itself acquired by another foreign corporation. Because the second deal involves a foreign corporation acquiring another foreign corporation, taxpayers could cite Treas. Reg. 1.7874-2(c)(2) to avoid having the second deal being subject to Section 7874. The IRS and Treasury posit that in certain circumstances this position is contrary to the purpose of Section 7874. To address this concern, the temporary regulations introduce a multi-step acquisition rule that treats a foreign corporation (F2) that directly or indirectly acquires substantially all of the properties of another foreign corporation (F1) as a domestic entity acquisition to the extent that F2’s acquisition of F1 occurs as part of a plan in which F1 acquires directly or indirectly substantially all the properties of a domestic entity. The rules then compute the ownership percentage by treating the stock of F2 received by former F1 shareholders in the second transaction as if it was stock received by reason of holding stock in a domestic entity. Confused? The temporary regulations provide the following example:

A owns all of the stock of DC1, a domestic corporation. B owns all of the stock of F1, a foreign corporation subject to tax in Country X. F1 acquires all of the properties of DC1 in a Section 368(a)(1)(D) reorganization (“Acquisition 1”) and as a result, A owns 70 shares in F1 and B owns 30 shares in F1. Pursuant to a plan that includes the DC1 acquisition, F2, a newly formed foreign corporation subject to tax in Country X, acquires all of the stock of F1 solely in exchange for 100 newly issued shares of F2 stock (“Acquisition 2”). As a result of the acquisition, A owns 70 shares of F2 and B owns 30 shares of F2 and F2 owns 100 shares (all of the stock) of F1, which in turn owns DC1.

Result: Acquisition 1 constitutes a domestic entity acquisition but F1 is respected as a foreign corporation because A owns less than 80 percent of F1. Because the F2 Acquisition occurs pursuant to the same overall plan as the F1 Acquisition, F2 is treated as indirectly acquiring substantially all the properties of DC1. Therefore, Acquisition 2 must also be tested under Section 7874(b). The 70 shares of F2 stock received by A in exchange for A’s F1 stock are included in both the numerator and denominator of the ownership fraction test.

Although F2 would also be respected as a foreign corporation (i.e., because A owns less than 80 percent of F2), DC1’s taxable income would include any inversion gain recognized during the 10-year period following Acquisition 2.

The temporary regulations do not provide any guidance as to what constitutes a plan, nor do the rules provide any safe harbors (e.g., a presumption that no plan existed if the acquisitions occur more than one year apart). This leaves taxpayers with the potentially burdensome task of proving a negative with no helpful guidance.

Multiple Domestic Acquisitions Rule: We’re Going to Need a Bigger Boat
In the preamble to the temporary regulations, the IRS and Treasury express concern that a single foreign acquiring corporation may avoid the application of Section 7874 by completing multiple domestic entity acquisitions over a relatively short period of time under circumstances where any one acquisition on its own would not run afoul of the ownership percentage test. Specifically, the IRS and Treasury note that the value of the foreign acquiring corporation increases to the extent it issues stock in a domestic entity acquisition, such that with each subsequent domestic entity acquisition, the foreign corporation grows larger and larger by value, eventually enabling it to acquire an even larger domestic corporation.

Does this fact pattern sound familiar? Recall that the Pfizer-Allergan deal would have been valued at approximately $160 billion. The Pfizer-Allergan deal signed in November 2015. On March 17, 2015, Actavis PLC (which was later renamed to Allergan PLC) completed its acquisition of Allergan in a domestic entity acquisition with an aggregate deal value of approximately $70 billion. In July 2014, Actavis PLC acquired Forest Labs, also a domestic entity, in a cash and stock deal valued at $25 billion. Both of these deals increased the value of Actavis PLC. The completion of the Allergan deal increased Actavis PLC’s market capitalization to approximately $147 billion. And then, along comes Pfizer. Absent the introduction of the multiple acquisition rule, the ownership percentage held by the Pfizer shareholders in the resulting Pfizer-Allergan would have been less than 80 percent.

To address such policy concerns and, in effect, address the Pfizer-Allergan deal, the temporary regulations impose rules that exclude from the denominator of the ownership percentage test foreign acquiring corporation stock attributable to certain domestic acquisitions occurring within a 36-month period ending on the signing date of the relevant domestic entity acquisition. The temporary regulations set forth a three-step process to identify and quantify excluded shares as follows:

i. Identify and calculate the total number of foreign acquiring corporation shares issued in prior domestic acquisitions (irrespective of whether the prior deal fell below the 60 percent ownership percentage) (“excludable shares”);

ii. Adjust the total number of excludable shares for any redemptions (occurring after the close of the prior deal but before the completion of the current relevant domestic acquisition) that are attributable to the excludable shares; and

iii. Multiply the total number of excludable shares, as adjusted for redemptions, by the fair market value per share as of the completion of the relevant domestic acquisition.

This math exercise needs to be repeated for each domestic acquisition that occurs within 36 months of the signing of the relevant domestic acquisition. The sum of all the excludable shares is then excluded from the denominator of the ownership percentage fraction.

For other brave swimmers who may still venture into the water, it’s important to note that this three-prong test has a rather harsh bite, as appreciation in the foreign acquiring stock that may have nothing to do with prior domestic acquisitions is not adjusted out. Thus, a foreign acquiring corporation that has stock appreciation attributable to its own pre-acquisition business growth is pulled into the math equation. The net result is that a successful foreign business that decides to expand into U.S. markets through acquisitions may find itself in the unpleasant position of itself becoming a domestic corporation.

Alvarez & Marsal Taxand Says:
While the temporary regulations issued on April 4, 2016, certainly affected Pfizer, the inversion transaction is not completely dead. Inversions can still be completed, but the potential pricing and mix of cash and equity will likely change. A domestic company is free to “invert” through an all-cash deal and can still invert through cash and stock deals, but the gymnastics to do so become trickier.

The bottom line is that as long as the United States employs a worldwide system of corporate income taxation (unlike virtually all of its trading partners / competitors, which employ a territorial system) and retains uncompetitive corporate tax rates of 35 percent, many U.S. multinational companies will continue to consider inversion transactions, and many (such as the publicly announced Mitel-Polycom deal on April 15, 2016) will remain undeterred by the actions of the IRS and Treasury. 

For More Information

Kristina Dautrich Reynolds
Managing Director, Washington DC
+1 202 688 4222

Albert Liguori 
Managing Director, New York
+1 212 763 1638

Ken Brewer
Senior Advisor, Miami
+1 781 248 4332

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisers who are free from audit-based conflicts of interest and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the United States and serves the United Kingdom from its base in London.

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