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For many years,the most common structure for non-U.S.individuals1 to hold U.S. business assets,such as U.S. real estate, has been to holdsuch assets directly under a U.S. corpora-tion and then to have the shares of the U.S.corporation owned by a foreign corpora-tion. If implemented properly, this struc-ture protects the non-U.S. individual fromU.S. federal estate and gift tax, and alsoallows the non-U.S. individual to controlthe timing of shareholder-level tax on div-idend distributions. Since the introduc-tion of Section 7874 in 2004, however, if

not implemented properly, this structurecould result in an “inversion” that wouldresult in the foreign corporation beingtreated as a U.S. corporation, for all pur-poses of the Code. In that case, the non-U.S. individual would not be protectedfrom U.S. federal estate tax. Given thatnon-U.S. domiciliaries2 have only a$60,000 exemption on the value of theirU.S.-situs assets includable in their grossestate, structures such as the onedescribed above, if they result in an inver-sion, would have disastrous U.S. federalestate tax consequences to the non-U.S.domiciliary on death.

This article will discuss one varia-tion of the “inversion” transaction,which involves the transfer of shares bynon-U.S. individuals of an existing U.S.Subchapter C corporation owning U.S.real estate to a newly formed foreigncorporation in exchange for shares ofthe foreign corporation (“Share Inver-sion”). It then describes the effect of theShare Inversion and associated anti-inversion rules on the recipient foreigncorporation and its non-U.S. individ-ual owners. This transaction will bereferred to as the “Base Transaction”throughout this article.

Accidental

InversionInversion

The transfer of shares by non-U.S. individuals of

an existing U.S. corporation owning U.S. real estate

to a newly formed foreign corporation in exchange

for shares of the foreign corporation can have

disastrous U.S. estate tax consequences for

the non-U.S. domiciliary on death.

ROBERT H. MOORE AND MICHAEL J. BRUNO

When Intended Estate Planning Results in an

Summary of U.S. Federal Tax RulesTo fully appreciate the inversion rules’impact on the Base Transaction, follow-ing is a brief description of certain termsused throughout this article and thebasic U.S. federal income, estate, and gifttax rules that apply to individuals.For U.S. federal income tax purpos-

es, “U.S. person” includes U.S. corpora-tions3 and individuals who are eitherU.S. citizens, U.S. green card holders, orconsidered to be substantially presentin the United States.4 Nonresidentaliens and foreign corporations (“for-eign persons”) are not considered U.S.persons.5 U.S. persons are subject toU.S. federal income taxation on theirentire worldwide income, regardless ofthe source of the income. In contrast,foreign persons are subject to U.S. fed-eral income tax on only certain types of“U.S.-source” income. For these pur-poses, U.S.-source income generallyincludes (1) income effectively connect-ed to a U.S. trade or business, includinggains from the sale of U.S. real proper-ty (ECI)6; and (2) certain types of pas-sive income from U.S. sources that arenot derived from a U.S. trade or busi-ness, such as dividends, rents, and inter-est (“FDAP (fixed or determinableannual or periodical) income”).7

Unlike the U.S. federal income tax, theU.S. federal estate and gift taxes areapplied based on an individual’s citizen-ship or domicile (instead of residence).U.S. citizens and U.S. domiciliaries8 aresubject to the U.S. federal estate and gifttax on the fair market value (FMV) oftheir worldwide assets (wherever locat-ed throughout the world) that they trans-fer during life or at death.9 On the otherhand, individuals who are neither U.S.citizens nor considered domiciled in theUnited States are subject to U.S. federal

estate or gift tax only on the FMV of theirownership interest in certain U.S.-situsassets transferred during life or on death.U.S. citizens and U.S. domiciliaries arecurrently entitled to a $5,450,000 millionlifetime exemption (adjusted for infla-tion);10 however, a non-U.S. domiciliaryis permitted to generally exclude only thefirst $60,000 of his taxable U.S.-situsproperty from the calculation of his U.S.federal estate tax. No similar exemptionfrom U.S. federal gift tax exists for non-U.S. domiciliaries.Noncitizens who are not considered

domiciled in the United States are sub-ject to U.S. federal estate or gift tax onlyon the value of their ownership interestsin certain U.S.-situs assets transferredduring their lifetime or on death. Proper-ty that is considered U.S.-situs propertyfor estate and gift tax purposes variesdepending on the type of property trans-ferred. Some assets are considered U.S.

situs for U.S. federal estate tax purposesbut not for U.S. federal gift tax purpos-es, whereas other assets are consideredU.S. situs for both estate and gift tax pur-poses. Shares of stock in U.S. corpora-tions are U.S.-situs property for U.S.federal estate tax, but not for U.S. federalgift tax purposes.11 In contrast, certainassets are considered U.S. situs for bothU.S. federal estate and gift tax purposes.These assets include interests in realproperty located in the United States.12

On the other hand, a non-U.S. domicil-iary is not subject to U.S. federal estate orgift tax on his interests in foreign situsproperty. Shares of stock in foreign cor-porations are considered foreign-situsproperty, and thus, not subject to U.S.federal estate or gift tax.13

For many foreign individual in-vestors, the most important U.S. tax con-sideration when considering an in-vestment in the United States is how to

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ROBERT H. MOORE is a partner, and MICHAEL J.BRUNO is an associate, in Baker & McKenzie LLP’s TaxPractice Group.

avoid the U.S. federal estate and gift tax-es. This is primarily because non-U.S.domiciliaries are allowed to exclude onlythe first $60,000 in value of U.S.-situsassets from their U.S. estates. Thus, mostnon-U.S. domciliaries seek to hold theirU.S.-situs assets, such as U.S. real estate,under a foreign corporation,14 as sharesin a foreign corporation are explicitlyexcluded from the definition of U.S.-situs assets. Further, foreign individualsoften prefer to have their U.S. invest-ments held directly by domestic entities,such as U.S. corporations, as domesticentities typically have an easier timeconducting business in the United Statesand, where the U.S. branch profits taxmight apply to a foreign corporationengaged in business in the United States,holding U.S. business assets under adomestic corporation also allows a non-U.S. investor to control the timing ofshareholder-level taxation that applies todividend distributions.

Base TransactionA non-U.S. individual owns stock in aU.S. corporation, which primarily ownsinterests in real estate located in theUnited States. In this case, the U.S. cor-poration qualifies as a U.S. real proper-ty holding corporation (USRPHC) forpurposes of the Foreign Investment inReal Property Tax Act of 198015 (FIRP-TA), which is discussed below.The optimal U.S. tax structure to hold

this U.S. real estate should avoid U.S.transfer tax exposure (gift, estate, andgeneration skipping transfer tax) for thenon-U.S. individual and his future estate.Thus, the non-U.S. domiciliary may forma foreign corporation to hold the USR-PHC stock (and possibly other U.S.assets) because stock in a foreign corpo-ration is not included in the non-U.S.domiciliary’s U.S. gross estate and is notsubject to U.S. federal estate or gift tax.16

To accomplish the estate and gift taxplanning goal, the non-U.S. domiciliarywould then contribute the shares of theUSRPHC to the foreign corporation.This “Base Transaction” is permittedunder FIRPTA and, until 2004, success-fully converted what otherwise was aU.S.-situs asset (stock in the USRPHC)to a foreign-situs asset (stock in the for-eign corporation).17 Section 7874, how-ever, causes the Base Transaction to resultin potentially disastrous U.S. estate andgift tax exposures, as discussed below.18

Overview of FIRPTAThis section reviews the legislative his-tory of FIRPTA and analyzes the oper-ation of the FIRPTA rules that areprimarily in Sections 897 and 1445. Itis clear that FIRPTA was intended toaddress only U.S. federal “income” taxconsequences of real property gains,rather than U.S. federal estate or gift taxconsequences associated with owningU.S. real property.

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1Section 7701(b)(1)(B).

2Reg. 25.2501-1(b); see also Estate of Jack, 54Fed. Cl. Ct. 590 (2002).

3Section 7701(a)(4).

4Sections 7701(a)(30), (b)(1)(A).

5Sections 7701(a)(5), 7701(b)(1)(B).

6Section 871.

7See Section 871(a)(1)(A). FDAP income typical-ly is subject to a flat 30% withholding tax rate(absent an applicable U.S. income tax treaty),without allocable deductions, depending on thetype of U.S.-source income.

8See note 2, supra.

9See Sections 2501 (gift tax) and 2001 (estatetax).

10See Rev. Proc. 2015-53, 2015-44 IRB 615.

11See Section 2104 (estate), Reg. 20.2104-1(a)(1).

12See Reg. 20.2104-1(a)(1).

13Section 2104(a); Regs. 20.2104-1(a)(5),20.2105-1(f).

14See Reg. 20.2105-1(f).

15Omnibus Reconciliation Act of 1980, P.L. 96-499, 94 Stat. 2599, 2682 (December 5, 1980).

16However, the foreign corporation may be disre-garded if it appears that it is merely acting asa holding company for the nonresident alien’sshares in the USRPHC, or its corporate formal-

ities are ignored. See Swan Est., 247 F.2d 144(CA-2, 1957); Fillman, 355 F.2d 632 (Ct. Cl.,1966).

17See Notice 2006-46, 2006-1 CB 1044.

18The same issue can arise if an interest in adomestic partnership is transferred to a foreigncorporation. However, we will only address thetransfer of stock in a U.S. corporation for pur-poses of this article.

19H. Rep’t No. 96-1167 at 530, reprinted in 1980-2 CB 530, 534.

20Id. at 534, 571.

21See Petkun, “The Foreign Investment in RealProperty Act of 1980,” 1 Penn St. Int’l L. Rev.11, 12-13 (1982).

22See Reiner, “Foreign Investment in U.S. RealEstate: Proposals for Taxing Gains,” 6 Int’l. TaxJ. 138, 138-39 (1979).

23See Jimmy Carter, “Agricultural Foreign Invest-ment Disclosure Act of 1978 Statement onSigning S. 3384 Into Law,” American Presiden-cy Project (October 14, 1978), www.presidency.ucsb.edu/ws/?pid=29989.

24A separate piece of legislation passed tospecifically address the unfair treatment andeconomic risks to U.S. farmers was the Agricul-tural Foreign Investment Disclosure Act of1978, which required disclose of transfers byforeign persons of U.S. agricultural real prop-erty. 7 U.S.C. sections 3501-3508.

For many foreign individualinvestors, the most importantU.S. tax consideration is avoidingU.S. federal estate and gift taxes

Legislative history. Before the enact-ment of FIRPTA, a foreign person’s U.S.-source real estate gains were generally nottaxable in the United States unless the realproperty was held in connection with aU.S. trade or business.19 Sometimes, evenwhen the real property was connected toa U.S. trade or business, the foreign per-son would circumvent U.S. federal taxexposures by putting the U.S. real proper-ty in a holding corporation. Then, whenthe foreign person wanted to sell its inter-est in the underlying real property, ratherthan having the holding corporation sellthe real property directly, the foreign per-son would sell its shares in the holdingcorporation, and the resulting gain fromthe sale was not taxable in the UnitedStates.20 Foreign persons were also ableto avoid U.S. tax on U.S.-source real estategains by using the Section 453 installmentsale method rules, which enabled them todefer principal payments into years whenthe foreign person was not engaged in aU.S. trade or business, and thereby notsubject the payment to tax in the UnitedStates.21 Aside from the potential taxabuses, the unfair advantage of foreignpersons over U.S. persons in the U.S. realestate market also had a significant effecton the U.S. agriculture industry. Specifi-cally, foreign investment22was causing theprice of U.S. farm land to soar, which putsmaller U.S. farmers out of businessbecause they could no longer competewith rising market prices.23

In response to these abuses andbecause it was essential to establish equi-ty of tax treatment in U.S. real propertybetween foreign and U.S. persons24,Congress enacted FIRPTA,25 as modi-fied by the Economic Recovery Tax Actof 1981 and the Tax Reform Act of 1984,which made a foreign person’s U.S. realestate gains taxable, as if automaticallyeffectively connected to a U.S. trade orbusiness of the foreign investor.26 FIRP-TA added Section 897, which contains

detailed rules on the taxation of a for-eign person’s investment in U.S. realproperty interests. The Tax Reform Actof 1984 added Section 1445, which cre-ated a withholding mechanism toenforce the tax owed under Section 897and resolve collection and filing issuesunder prior law.27

Application of FIRPTA rules. FIRP-TA, as codified principally in Sections897 and 1445, governs the taxation ofdispositions of United States real prop-erty interests (USRPIs) by foreign per-sons. Section 897(a) generally requiresgain or loss from the disposition of aUSRPI by a foreign person to be takeninto account as if (1) the foreign person

were engaged in a trade or businesswithin the United States during the taxyear, and (2) the gain or loss were effec-tively connected with that trade or busi-ness.28As a result, recognized net gainsgenerally are subject to U.S. federalincome tax at graduated rates.29

“USRPI” generally means an interest(other than an interest solely as a credi-tor) (1) in real property located in theUnited States or the Virgin Islands, or (2)in a U.S. corporation that is (or, duringthe five-year period preceding the dis-position of the interest, was) a USR-PHC.30 In general, a U.S. corporation isa USRPHC if the FMV of the corpora-tion’s USRPIs is at least 50% of the aggre-

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25See note 13, supra.

26See Staff of the Joint Committee on Taxation,98th Cong., 2d Sess., General Explanation ofthe Revenue Provisions of the Deficit Reduc-tion Act of 1984, 406 (Committee Print 1984);Senate Finance Committee Print No. 96-37,96th Cong. at 8 (1980), accompanying S. 2939,Revenue Reconciliation Act of 1980.

27See Committee Print 1984, supra note 26.

28Section 897(a)(1). Gain or loss from the dispo-sition of a USRPI is determined under the gen-eral rules in Section 1001. Reg. 1.897-1(h).

29See Sections 871(b), 882(a)(1).

30Section 897(c)(1)(A); Reg. 1.897-1(c)(1). Seealso Regs. 1.897-1(b), 1.897-1(d); Section897(c)(1)(A)(ii).

31Section 897(c)(2); Reg. 1.897-2(b)(1).

32Section 1445(a).

33Id. See also Reg. 1.1445-1(g)(5). On December18, 2015, Congress passed the Protecting Amer-icans from Tax Hikes Act of 2015 (“PATH Act”),which increased the FIRPTA withholding tax to15%, effective for dispositions occurring 60 daysafter the date of enactment of the Act.

34See Sections 1445(e), 1446.

35See Regs. 1.1445-2(d)(2), 1.1445-5(b)(2). Seealso Section 897(e) and Temp. Reg. 1.897-6T.

36Section 897(e)(1).

37Section 897(e)(3); Temp. Reg. 1.897-6T(a)(2).

38Temp. Reg. 1.897-6T(a)(1). See also Section897(e)(2)(A).

39Temp. Reg. 1.897-6T(a)(1).

40See Temp. Regs. 1.897-6T(a)(1), 1.897-5T(d)(1)(iii).This requirement is suspended when (1) thetransfer otherwise qualifies in its entirety fornonrecognition treatment under Temp. Reg.1.897-6T; (2) the transferor does not have any

gate FMV of its (1) USRPIs, (2) interestsin real property located outside the Unit-ed States, and (3) other assets used orheld for use in a trade or business.31

To enforce the substantive tax rulesin Section 897, Section 1445 imposes ona transferee (i.e., the buyer) the obliga-tion to withhold when (1) the transferorof the property is a foreign person, and(2) the property transferred is a USR-PI.32When withholding is required, thetransferee of the USRPI generally mustdeduct and withhold 15% of the amountrealized by the transferor;33 however,special withholding rules may apply incertain situations.34 In addition, anexception to the withholding require-

ment may apply when a taxpayer dispos-es of a USRPI in an exchange that qual-ifies for nonrecognition treatment.35

If a USRPI is disposed of in a transac-tion that otherwise would be governedby a nonrecognition provision, Section897(e) says that the nonrecognition pro-vision will apply for purposes of Section897 only if the USRPI is exchanged foran interest, the sale of which would besubject to U.S. federal income tax.36 Forpurposes of this rule, a nonrecognitionprovision is any Code provision underwhich gain or loss will not be recognizedif the requirements of that provision aremet (e.g., Section 351).37

The Regulations restate the generalrule in Section 897(e) using slightly dif-ferent terminology.38 They say that in atransaction in which gain is realized, anonrecognition provision will apply onlyto the extent that the transferred USRPIis exchanged for another USRPI, which,immediately after the exchange, wouldbe subject to U.S. taxation on its dispo-sition (“USRPI for USRPI exception”).39

The Regulations add that, to qualifyfor nonrecognit ion treatment, thetransferor of the USRPI generally mustfile a U.S. federal income tax return forthe year in which the transfer occursand attach a statement that includescertain required information.40 Forexample, if a foreign person contributeda USRPI to a U.S. corporation, whichqualified as a USRPHC immediatelythereafter, and received shares in theU.S. corporation in the exchange, thetransfer generally would qualify fornonrecognition treatment if certainreporting obligations are satisfied.As discussed above, to prevent poten-

tial abuses, FIRPTA generally denies theapplication of nonrecognition provi-sions except in limited cases. For exam-ple, a foreign person may make a tax-freeexchange of a USRPI only if a taxableUSRPI is received in exchange.41

Notwithstanding the USRPI-for-USRPI exception, the Temporary Regu-lations under Section 897(e) provide anexception that allows for nonrecogni-tion treatment in certain foreign-to-for-eign exchanges of USRPIs. Specifically,this exception provides for nonrecog-nition treatment if a foreign personexchanges stock in a USRPHC in threetypes of transactions: 1. A Type D or Type F reorganizationexchange between foreign corpo-rations (and their foreign share-holders).42

2. A Type C reorganization betweenforeign corporations if the transfer-or’s shareholders also own morethan 50% of the transferee.43

3. A Section 351 transfer (or a Type Breorganization exchange) of USR-PHC stock to a foreign corporationand immediately after the exchangeall of the outstanding stock of thetransferee corporation is owned bythe same nonresident alien individ-uals and foreign corporations thatimmediately before the exchangeowned the stock of the USRPHC.44

The exception under the TemporaryRegulations further requires that (1) thetransferee’s subsequent disposition ofthe transferred USPRI be subject to U.S.federal income tax;45 (2) certain filingrequirements are satisfied;46 and (3)one of “five conditions” in Temp. Reg.1.897-6T(b)(2) exists.47

Notice 2006-46. In Notice 2006-46,2006-1 CB 1044, the IRS and Treasurydetermined that the five conditions inTemp. Reg. 1.897-6T(b)(2) were nolonger necessary and declared that finalRegulations would eliminate these con-ditions. Taxpayers may rely on theguidance in Notice 2006-46 until finalRegulations are issued and, therefore,do not have to satisfy one of the fivecondit ions in Temp. Reg. 1.897-6T(b)(2).

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other ECI for the year in which the transferoccurs; and (3) a notice of nonrecognition is filedfor the transfer pursuant to Reg. 1.1445-2(d)(2).Notice 89-57, 1989-1 CB 698.

41Temp. Reg. 1.897-6T.

42Temp. Reg. 1.897-6T(b)(1)(i).

43Temp. Reg. 1.897-6T(b)(1)(ii).

44Temp. Reg. 1.897-6T(b)(1)(iii).

45See also Temp. Reg. 1.897-5T(d)(1).

46See also Temp. Reg. 1.897-5T(d)(1)(iii).

47See Temp. Reg. 1.897-6T(b)(1).

48Congressional Research Service, “Firms ThatIncorporate Abroad for Tax Purposes: Corpo-rate Inversions and Expatriation (updatedMarch 5, 2010).

49Joint Committee on Taxation, Background andDescription of Present-Law Rules and Propos-als Relating to Corporate Inversion Transactions(JCX-52-02, June 5, 2002), pages 3-4.

Nowhere does the legislative historyindicate that the anti-inversionrules were meant to apply to the Base Transaction

Overview of Anti-Inversion RulesThe U.S. government48 has recognizedthat inversions provide tax savings in twosignificant ways. First, an inversion mayreduce U.S. tax on foreign-source incomeby effectively shifting income away froma U.S. corporation to its related foreigncorporations (“income shifting”). In turn,this potentially achieves pure territorialtax treatment for the group, rather thanworldwide income treatment.49 Second,an inversion may reduce U.S. tax throughearnings stripping with foreign related-party debt (or similar transactions),where a U.S. subsidiary pays interest to itsforeign parent and the interest may thenbe deductible for U.S. federal tax purpos-es (“earnings stripping”).50 In light ofthese abuses, the U.S. government hasissued numerous anti-inversion rulesover the past 20 years to prevent U.S.multinational corporations from relocat-ing their domicile to foreign jurisdictions.

Legislative history. The history of theinversion transaction dates back to twonotable corporate inversions that tookplace over 20 years ago.51The first was the1982 inversion of McDermott Inc., aDelaware corporation (“McDermott”),where McDermott Inc. shareholderstransferred their shares to its whollyowned foreign subsidiary, McDermottInternational, Inc. (“McDermott Interna-tional”) in exchange for cash and sharesin McDermott International pursuant toa reorganization plan. The IRS arguedthat the former McDermott shareholderswere taxable under Section 30452 on thetransfers of their McDermott stock inexchange for stock in McDermott Inter-national. However, the courts disagreedwith the IRS and found that because“stock” did not constitute “property”within the meaning of Section 317, Sec-tion 304 did not apply to their stock-for-stock exchange. In response to theinversion, the IRS issued Section 1248(i),which requires a U.S. corporate parent of

a controlled foreign corporation to rec-ognize gain equal to the Section 124853

dividend amount if a shareholder of theU.S. corporate parent exchanges stock ofthe U.S. corporate parent for stock of aforeign corporation.54

The second inversion involved the1994 inversion of Helen of Troy Limited,a U.S. cosmetic company that redomi-ciled in Bermuda in a transaction thatwas tax free for its shareholders.55 Inresponse to this inversion, the IRS said inNotice 94-93, 1994-2 CB 563, that inalliance with Treasury, it would introduceguidance on the consequences of inver-sion transactions because they were con-cerned that, depending on the facts andcircumstances, an inversion transactionmay create losses improperly or permitthe avoidance of income or gain in cir-cumvention of the repeal of the GeneralUtilities56 doctrine or other applicablerules. The IRS soon enacted new Regula-tions under Section 367.57

In 2002, Treasury released a prelimi-nary report on the issues that arise fromthe reincorporation of U.S. multination-al companies in foreign countries (“Pre-liminary Report”).58 In a statementaccompanying the Preliminary Report,then Treasury Secretary Paul O’Neill said:

When we have a tax code that allowscompanies to cut their taxes on theirU.S. business by nominally movingtheir headquarters offshore, then weneed to do something to fix the taxcode. In addition, if the tax code disad-vantages U.S. companies competing inthe global marketplace, then we shouldaddress the anti-competitive provi-sions of the code. I don’t think anyonewants to wake up one morning to findevery U.S. company headquarteredoffshore because our tax code drovethem away and no one did anythingabout it. This is about competitivenessand complications in the tax code thatput U.S.-based companies out of stepwith their foreign competitors. We willwork with Congress to address theseimportant issues quickly.

The Preliminary Report defined aninversion as “a transaction through whichthe corporate structure of a U.S.-basedmultinational group is altered so that anew foreign corporation, typically locat-ed in a low or no tax country, replaces theexisting U.S. parent corporation as theparent of the corporate group.” The Pre-liminary Report said that inversiontransactions “implicate fundamentalissues of tax policy,” recognizing that:

The U.S. tax system can operate toprovide a cost advantage to foreign-based multinational companies over

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50Office of Tax Policy, Department of the Treasury,Corporate Inversion Transactions: Tax PolicyImplications 11-14 (2002).

51Bhada, 892 F.2d 39 (CA-6, 1990), aff’g 89 TC 959(1987); Caamano, 879 F.2d 156 (CA-5, 1990),aff’g 89 TC 959 (1987); see also CongressionalResearch Service, Ways and Means Commit-tee Democrats, “A Spike in Corporate Inver-sions” (undated), www.bloombergview.com/quicktake/tax-inversion.

52Under Section 304(a)(1), if one or more personsare in control of each of two corporations andone of the corporations acquires stock in theother from a controlling person in return forproperty, the property paid for the stock is treat-ed as a distribution in redemption of the acquir-ing corporation’s stock. The tax treatment of theredemption is subject to Section 302 to deter-mine whether it is treated as an exchange or asa distribution of property under Section 301.

53Section 1248 recharacterizes gains from thesale of stock as dividends to the extent of theearnings and profits attributable to the stock.

54H. Rep’t No. 104-586, 104th Cong., 2d Sess.156 (P.L. 104-188, August 20, 1996).

55See Helen of Troy Ltd., Prospectus/Proxy State-ment (January 5 1994); Joint Committee on Tax-ation, Present Law and Selected Policy Issues inthe U.S. Taxation of Cross-Border Income (JCX-51-15, March 16, 2015); Mohan, “The Erosion ofthe States’ Tax Base—A Whopper of a Problem?An Examination of Possible Solutions to Corpo-rate Inversions,” Weekly State Tax Rep’t: NewsArchive (Bloomberg BNA), October 10, 2014).

56The General Utilities doctrine permitted a cor-poration to distribute appreciated assets to itsshareholders without recognizing gain under cer-tain circumstances. See General Utilities andOperating Co., 296 U.S. 200 (1935). After itsrepeal, a corporation ordinarily must be required

The exception to taxation under the Section 897Temp. Regs. and withholding under Section 1445 forcertain Section 351 transactions is practically useless

if the goal is U.S. estate and gift tax protection from holding shares in a foreign corporation

U.S.-based multinational companies.Inversions demonstrate this costadvantage in its purest form. By reor-ganizing to create an offshore parentcorporation in a no-tax jurisdiction,a U.S.-based group can reduce its taxliability significantly without any realchanges in its business operationsand without negatively affecting itsaccess to capital markets.

In 2004, Congress introduced impor-tant statutory legislation (Section 7874)that would diminish a U.S. corporation’sability to reincorporate in a foreign juris-diction to obtain tax benefits. In a 2004Committee Report,59 the House said:

The Committee believes that corpo-rate inversion transactions are a symp-tom of larger problems with ourcurrent uncompetitive system for tax-ing U.S.-based global businesses andare also indicative of the unfair advan-tages that our tax laws convey to for-eign ownership. The bill addresses theunderlying problems with the U.S.system of taxing U.S.-based globalbusinesses and contains provisions toremove the incentives for entering intoinversion transactions. Imposing fullU.S. tax on gains of companies under-taking an inversion transaction is onesuch provision that helps to removethe incentive to enter into an inversiontransaction.60

The 2004 Committee Report reiter-ated that the inversion rules were tar-geted at “U.S. based global businesses.”Since 2004, there have been numerous

Regulations, Rulings, and Notices on inver-sions.61Notice 2014-52, 2014-42 IRB 712,which essentially broadened the reach ofSection 7874, said that Treasury and theIRS would issue Regulations to addresscertain transactions that are structured toavoid the purposes of Sections 7874 and367 and certain post-inversion tax avoid-ance transactions. Notice 2014-52 also saidthat Treasury and the IRS planned to issueadditional guidance to further limit (1)inversion transactions that are contrary tothe purposes of Section 7874; and (2) thebenefits of post-inversion tax avoidancetransactions. In Notice 2015-79, 2015-49IRB 775, issued further guidance—muchmore aggressive rules—to address trans-actions that are structured to avoid Sec-tion 7874.62 At the time of writing thisarticle, IRS and Treasury had issued Pro-posed and Temporary Regulations thatfurther limit inversions.63 Notwithstand-ing the numerous attempts by the IRS andTreasury to curtail inversions, under theright set of facts, inversion transactionscontinue. Further guidance, or even con-gressional action, is expected.

Section 7874An inversion will typically occur when (1)a foreign corporation directly or indirect-ly acquires substantially all of the proper-ties held directly or indirectly by a U.S.corporation;64 (2) following the acquisi-tion, the former shareholders of the U.S.corporation own at least 60% of the stock(by vote or value) of the foreign corpora-tion by reason of holding stock in the U.S.corporation;65 and (3) following theacquisition, neither the foreign corpora-tion nor its expanded affiliated group hassubstantial business activities66 in the for-eign corporation’s country of incorpora-

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to recognize taxable gain when it distributes anappreciated asset to its shareholder.

57These were proposed in 1995 and made final in1996. TD 8638, 1996-1 CB 85; TD 8702, 1997-1 CB 92.

58Note 50, supra.

59H. Rep’t No. 108-548, 108th Cong., 2d Sess.,part 1, at 1 (2004) (“2004 Committee Report”).

60H. Rep’t No. 108-755, 108th Cong., 2d Sess.561 (2004) (“Conference Report”) (P.L. 108-357,October 22, 2004 ).

61In June 2006, Temporary Regulations under Sec-tion 7874 were issued on the treatment of a for-eign corporation as a surrogate foreigncorporation. TD 9265, 2006-2 CB 1. In July 2006,Notice 2006-70, 2006-2 CB 252, modified theeffective date in the 2006 Temporary Regulations.Reg. 601.601(d)(2)(ii)(b). In June 2009, the 2006Temporary Regulations were withdrawn andreplaced with new Temporary Regulations, which

generally applied to acquisitions completed on orafter June 9, 2009. TD 9453, 74 Fed. Reg. 27920,2009-2 CB 114. In June 2012, the IRS issued finalRegulations on whether a foreign corporation wastreated as a surrogate foreign corporation. TD959, June 7, 2012. Notice 2014-52, 2014-42 IRB712, strives to make inversions more difficult bystrengthening the rules under Section 7874 andlimiting the ability of companies to repatriate off-shore earnings tax free. See “Treasury and IRSRespond to Inversions,” PwC In & Out, 25 JOIT11 (December 2014).

62See PwC, “Notice 2015-79 Provides Further Inver-sion Limitation,” 27 JOIT 44 (February 2016). 0242

63TD 9761, REG-135734-14, April 4, 2016. SeePwC, “Temp. Regs. Further Restrict Inver-sions,” 27 JOIT xx (June 2016).

64This rule does not apply to acquisitions thatwere completed before March 4, 2003. Sec-tion 7874(a)(2)(B)(i).

tion, compared with the total worldwidebusiness activities of the foreign corpora-tion’s expanded affiliated group (collec-tively, “Three Requirements”).67 If aninversion occurs, for a ten-year period theexpatriated entity will be subject to tax onits “inversion gain.”68 Generally, this gainrelates to certain transfers of stock orproperty of the expatriated entity andincome from licenses of property by theexpatriated entity.69

A foreign corporation will forever beclassified as a U.S. corporation after theacquisition if at least 80% of the stock(by vote or value) of the foreign corpo-ration is held by former stockholders ofthe U.S. corporation by reason of hold-ing stock in the U.S. corporation.70 Theforeign corporation will also be treatedas a U.S. corporation for all purposes ofthe Code (notwithstanding Sections7701(a)(4) and (5)).71 However, theinversion gain will not apply in thisinstance.72

Section 7874(a)(2)(B)(i) requiresthe acquisition of “substantially all” ofthe properties held by the domestic cor-poration. Under Treasury Regulations,the acquisition of stock in a domesticcorporation is treated as the acquisitionof assets of the domestic corporationproportionate to the percentage ofstock acquired.73 In contrast, the acqui-sition of stock of a foreign corporationthat owns, directly or indirectly, domes-tic corporation stock is not an acquisi-t ion of the propert ies held by adomestic corporation.74 No guidancehas been provided in Section 7874 orthe corresponding Regulations to deter-mine whether “substantially all” of theassets of a U.S. target corporation havebeen acquired.75

Although there are many variationsof inversions, the Base Transaction isincluded within the type of inversionwhen, pursuant to a plan (or a series ofrelated transactions), a U.S. corporation

becomes a subsidiary of a foreign cor-poration and the former shareholders ofthe U.S. corporation hold at least 80%(by vote or value) of the foreign corpo-ration by reason of holding stock in theU.S. corporation. While the Base Trans-action will not trigger recognition of theinversion gain, it will deny the intendedtax benefit by treating the foreign parentcorporation as a domestic corporationfor all purposes of the Code.76

Unintended Effect of Section 7874As discussed above, the Base Transac-tion involves a transfer by a non-U.S.domiciliary of stock in a USRPHC to aforeign corporation in exchange forstock in the foreign corporation. If struc-tured and implemented properly, theBase Transaction qualifies for nonrecog-nition treatment under Section 351.Moreover, Regulations under Section897 specifically allow for nonrecognitionin this type of Section 351 exchange.Thus, if certain reporting requirementsare met, the Base Transaction is not tax-able under Section 351 and FIRPTA.Notwithstanding these otherwise

favorable results, Section 7874 potential-ly causes adverse U.S. federal estate andgift tax consequences because the BaseTransaction satisfies the Three Require-ments described above. More specifical-ly, the foreign corporation indirectlyacquires all of the properties held by theU.S. corporation; the nonresident alienwho directly owned the shares in theU.S. corporation now owns all of theshares of the foreign corporation, whichholds the stock of the U.S. corporation;and, finally, neither the foreign corpora-tion nor any of its affiliated members sat-isfy the substantial business activitiesexception because they do not meet theGroup Assets Test77 since the majority oftheir assets consist of U.S. real propertyinterests. Because the Base Transaction

triggers the inversion rules, and the own-ership threshold requirement is met, theforeign corporation will be treated as aU.S. corporation for all U.S. federal taxpurposes. As a result, the non-U.S. domi-ciliary is treated as owning stock in aU.S. corporation (a U.S.-situs asset)rather than stock in a foreign corpora-tion (a foreign-situs asset).In light of these results, the exception

to taxation under the Section 897 Tem-porary Regulations and withholding

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65Section 7874(a)(2)(B)(ii).

66See Reg. 1.7874-3(b). The expanded affiliated groupwill be considered to have substantial businessactivities in the relevant foreign country after theacquisition when compared to the total businessactivities of the expanded affiliated group only if,subject to the disregarded items detailed below,each of the following three tests is satisfied: (1) thenumber of group employees based in the relevantforeign country is at least 25% of the total num-ber of group employees on the applicable date, and(ii) the employee compensation incurred withrespect to group employees based in the relevantforeign country is at least 25% of the total employ-ee compensation incurred with respect to all groupemployees during the testing period (the “GroupEmployees Test”); (2) the value of the group assetslocated in the relevant foreign country is at least25% of the total value of all group assets on theapplicable date (the “Group Assets Test”); and (3)the group income derived in the relevant foreigncountry is at least 25% of the total group incomeduring the testing period (the “Group Income Test”).

67Section 7874(a).

68Section 7874(d).

The simplest solution to accidentalinversions would be to clarify thatthe inversion rules apply only forU.S. federal income tax purposes

under Section 1445 for certain Section351 transactions is practically useless ifthe goal is to achieve the U.S. estate andgift tax protection that comes from hold-ing shares in a foreign corporation.78

The IRS dealt with the Base Trans-action in Ltr. Rul. 201032016 but it didnot address the applicability of the Sec-tion 7874 inversion rules. The rulinginvolved a nonresident alien’s transferof shares in two U.S. corporations thatqualified as USRPHCs to a U.S. parent

corporation, which were then trans-ferred to a foreign corporation. The IRSruled that both transfers qualified forSection 351 nonrecognition treatmentand were not taxable under Section 897.However, the IRS did not addresswhether Section 7874 applied to thesecond transaction.

Overrides of estate tax situs rulesfor stock in foreign corporations. Asdiscussed above, only the portion of anon-U.S. domiciliary decedent’s gross

estate situated in the United States at thetime of his death is subject to U.S. feder-al estate tax.79 Section 2104(a) says thatstock owned and held by a nonresidentalien of the United States is deemed tobe property within the United States ifissued by a U.S. corporation.80

Prior to the issuance of Section 7874,in the Base Transaction, when the non-resident alien non-U.S. domiciliarycontributed his shares in the USRPHCto the foreign (parent) corporation inexchange for stock, these newly receivedshares were not part of his U.S. grossestate because they qualified as a for-eign-situs asset.81 Section 7874 nowmodifies this result by treating the for-eign parent corporation a U.S. corpo-ration for all purposes of the Code. Thiscauses the share in the U.S. corporationto be treated as a U.S.-situs asset andmay cause the shares to be subject toU.S. federal estate tax.82 Therefore, Sec-tion 7874 effectively overrides the estatetax rules on situs categorization.

No exception to Section 7874.Unfortunately, no exception to Section7874 exists for the Base Transaction. Forexample, certain internal group restruc-turings do not result in an inversionthat is subject to the rules of Section7874 that could result in the transfereeforeign corporation being treated as aU.S. corporation.There are two requirements to qualify

as an internal group restructuring underthe Regulations: (1) before the acquisition,80% or more of the stock (by vote and val-ue) or the capital and profits interest, ofthe domestic entity must have been helddirectly or indirectly by the corporation thatis the common parent of the expandedaffiliated group (“EAG”) after the acquisi-tion; and (2) after the acquisition, 80% ormore of the stock (by vote and value) ofthe acquiring foreign corporation must beheld directly or indirectly by such com-mon parent.83 (Continued on page 63)

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69Id.

70Section 7874(b).

71See Conf. Rept. No. 108-755 (PL 108-357) p.346-47 (The provision denies the intended taxbenefits of this type of inversion by deemingthe top-tier foreign corporation to be a domes-tic corporation for all purposes of the Code.).

72Section 7874(a)(3).

73Treas. Reg. § 1.7874-2(c).

74Treas. Reg. § 1.7874-2(c)(2).

75H.R. Rep. No. 108-755, 108th Cong., 2d Sess.,n.429 (2004) (“It is expected that the TreasurySecretary will issue regulations applying the term‘substantially all’ in this context and will not bebound in this regard by interpretations of the termin other contexts under the Code.”). Several com-mentators have noted the numerous open ques-tions resulting from a lack of guidance on themeaning of “substantially all.” See, e.g., Peter H.Blessing, Targeting Business Entity Inversions:Surrogation and Domestication, 34 Tax Mgm’tInt’l J. 3 (2005); Carl Dubert, Section 7874 Tempo-rary Regulations: Treasury and IRS Wave Taxpay-ers Through the Stoplight, J. Int’l Tax’n (2006).

76Joint Comm. on Tax’n, DESCRIPTION OF THE“TAX TECHNICAL CORRECTIONS ACT OF 2005”10 (July 21, 2005) (The provision clarifies that theinversion gain rule of Section 7874(a)(1) does notapply to an entity that is an expatriated entity withrespect to an entity that is treated as a domesticcorporation under Code section 7874(b).).

77Note 66, supra.

78From a FIRPTA perspective, the Base Transac-tion should continue to qualify for nonrecogni-tion under Sections 351 and 897(e), as anexchange of stock in a USRPHC for stock in aUSRPHC should meet the “USRPI-for-USRPI”requirement.

79Section 2103.

80See also Reg. 20.2104-1(a)(5).

81See Reg. 20.2105-1(f).

82It is possible, however, that a estate tax treaty mayalter this result. In TAM 9128001, Treasury citedArticle 9 of the U.S.-Germany estate tax treaty:“Germany has the primary right to tax shares ofstock in a U.S. corporation which forms part of theestate of a decedent domiciled in…Germany.”

83Reg. 1.7874-1(c).

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(Continued from page 35) In the BaseTransaction, because the transferringshareholder is an individual (or certaintrusts), the internal group restructur-ing exception does not apply and theBase Transaction results in the stock ofthe foreign corporation received in thetransaction being treated as a stock in adomestic corporation for all purposesof the Code.

Solutions to Exempt Base Transaction From Anti-Inversion RulesThe legislative history of Section 7874indicates clearly that the anti-inversionrules were intended to apply to multina-tional companies with global operationslooking to redomicile in a more incometax-efficient jurisdiction. Nowhere doesthe legislative history indicate that theanti-inversion rules were meant to applyto the Base Transaction. After all, theanti-inversion rules focus primarily onabuses at the U.S. corporate level, not theshareholder level. When the Section 7874rules deprive an individual of an intend-ed U.S. federal estate tax benefit,84 theyclearly violate the underlying intent ofthe inversion rules.85

To preserve the intended purpose ofthe inversion rules, Congress, Treasury,or the IRS should create a special carve-out in the inversion rules that wouldexempt transactions like the Base Trans-action from Section 7874. Section7874(g) gives the Secretary of the Treas-ury the ability to “provide such regula-tions as are necessary to carry out[Section 7874].” While this subsectionappears to have been designed to preventthe avoidance of the inversion rules bygranting the Treasury the ability toenforce the inversion rules through reg-ulatory authority, it should also allow

Treasury to issue Regulations to ensurethat certain transactions that are outsidethe intended scope of Section 7874 arenot caught by the inversion rules. Thephrase “[t]he Secretary shall providesuch regulations as are necessary to car-ry out this section” should be construedto mean that Treasury must ensure thatSection 7874 is carried out properly bynot applying to transactions that are out-side the intended scope of Section 7874.Finally, as mentioned above, one of

the key reasons for the anti-inversionrules was to prevent “income shifting” bylarge corporations.86 This type of abuseis virtually impossible in the Base Trans-action scenario because any income gen-erated by the underlying U.S. real estatewould be U.S.-source income and sub-ject to U.S. federal income tax, regardlessof the overlying ownership. “Earningsstripping” was the other motivating fac-tor behind the anti-inversion rules.87Theact of a non-U.S. individual transferringshares of an existing domestic corpora-tion owning U.S. real estate to a newlyformed foreign corporation in exchangefor shares of the foreign corporation doesnot, in itself, result in earnings stripping.It would require additional transactionsto rise to such a level of abuse.

Limit application of Section 7874 toU.S. federal income tax. The simplestsolution to the accidental inversionwould be to clarify that the inversionrules apply only for U.S. federal incometax purposes. If Section 7874 truly wasintended to prevent abuse by multina-tional corporations and U.S.-based glob-al businesses, Section 7874(b) should benarrowed to only U.S. federal income taxand not include U.S. federal estate andgift taxes. While a statutory change isunlikely, Regulations could clarify thatSection 7874(b) was not intended tocause foreign corporations to be treatedas U.S. corporations for purposes of U.S.federal estate and gift taxes.

Assuming that the Base Transactionresults in an inversion, clarifying Regu-lations would provide that the foreigncorporation that now owns the U.S. cor-poration will be treated as a U.S. corpo-ration for U.S. federal tax incomepurposes only. Thus, while the foreigncorporation would be viewed as a U.S.corporation for U.S. federal income taxpurposes, it would still be viewed as a for-eign corporation for U.S. federal gift andestate tax purposes. Further, the shares ofthe foreign corporation received in theBase Transaction would be treated as aforeign-situs asset for U.S. federal estateand gift tax purposes. Finally, if the BaseTransaction results in the foreign corpo-ration being treated as a U.S. corporationfor federal income tax purposes, no coor-dinating Regulations would be necessaryunder FIRPTA, as Temp. Reg. 1.897-6T(a)(1) already covers a foreign person’stransfer of a USRPI to a U.S. corporationin an exchange that otherwise qualifiesfor nonrecognition under Section 351.88

Closely held business exception. Thelegislative history of Section 7874 saysthat the inversion rules were designed tocombat the expatriations of “U.S.-basedmultinational groups” that relocate theirheadquarters offshore. Specifically, theinversion rules originated out of the relo-cations of several large multinationalbusinesses (such as McDermott andHelen of Troy, discussed above) thatmanufactured goods or provided tech-nical, managerial, or skilled services. Thelegislative history of Section 7874 doesnot show that the inversion rules wereintended to apply to closely held familybusinesses. Thus, another proposalwould be to provide a carve-out excep-tion under the inversion rules for close-ly held corporations. Under such anexception, if the acquiring foreign cor-poration in a transaction that otherwisequalifies as an inversion is closely held,the foreign corporation would continueto be treated as a foreign corporation andnot subject to Section 7874(b) or other-wise treated as an expatriated entityunder Section 7874(a).This exception should provide sever-

al safeguards to prevent abuse. First, theexception could provide a cap on thenumber of shareholders who own the

84Notwithstanding the application of Section7874 to cause foreign corporation stock to betreated as U.S. corporation stock, it appearsthat a decedent may still be entitled to excludesuch stock from his estate if he qualifies forbenefits of an applicable U.S. estate tax treaty.See note 82, supra.

85See generally Preliminary Report, supra note 50.

86See note 49, supra.

87See note 50, supra.

88See Section 897(e); Temp. Reg. 1.897-6T(a)(1).

89See Section 1361(b)(1).

90See, e.g., Notices 2014-52 and 2015-79 (bothaddressing non-ordinary course distributions inrelation to a potential inversion transaction).

Accidental Inversions

acquiring foreign corporation, similar tothe limitation on the number of share-holders that can own a “small businesscorporation” (S corporation).89 Forexample, the exception could providethat Section 7874 does not apply to a for-eign corporation’s acquisition of stock ina U.S. corporation (or U.S. partnership)if, immediately after the transaction, theforeign corporation is owned by 100 orfewer individuals (or certain trusts). Thistype of exception clearly would not applyto most U.S.-based multinational groups,and certainly would not apply to U.S.publicly traded corporations seeking toinvert. Thus, such a regulatory exceptionwould be within the intended scope ofSection 7874. This exception could beadministered by having the closely heldcorporation file an annual form with theIRS listing its total shareholders. Alterna-tively, the closely held corporation couldbe required to check a box on its U.S. taxreturn representing that it is under therequisite shareholder limit, or simply list

the total number of shareholders on itstax return, which is akin to line I of Form1120S (U.S. Income Tax Return for an SCorporation).Second, the exception could provide a

dollar threshold based on the FMV of theacquiring foreign corporation (and relat-ed persons of such corporation) immedi-ately after the transfer. Even at reasonablyhigh dollar thresholds, this type of excep-tion would not apply to large U.S. multi-national corporations seeking to invert.Also, this rule would prevent a situationwhere a multi-billion dollar corporationowned by a small number of individualsattempted to use the closely held excep-tion to invert. To determine an appropri-ate dollar threshold and overall comfortlevel, Treasury could review historicalmarket values of companies that haveinverted and compare the projected rev-enue streams from enforcing and impos-ing the anti-inversion rules on closelyheld corporations against the interests ofadministrative convenience.

Finally, this exception could containan anti-abuse safeguard, similar to therule in Reg. 1.701-2(b) in the context ofpartnerships, which allows the IRS torecast a transaction if the intent of theexception was abused. For instance, ananti-abuse rule would apply when anacquiring corporation uses nomineesto avoid the shareholder limit discussedabove or to circumvent the dollarthreshold requirement.

IRS consent (private letter ruling).Another solution would be for Treasuryto issue Regulations that give the IRS dis-cretion to exempt certain transfers fromSection 7874 if, on the taxpayers’ request,they can prove that the transaction isoutside the intended scope of Section7874. For example, if the shareholders ofthe acquiring foreign corporation thatotherwise is subject to Section 7874(b)can prove that the principal purpose ofthe inversion is U.S. estate tax planning,the IRS could exempt the transactionfrom the application of Section 7874through case-by-case letter rulings. Theletter ruling route, as opposed to issuingadditional guidance, might also bepreferable because it would allow Treas-ury to avoid creating rules that lead toresults that sometimes are inappropriateor unintended.90

ConclusionCongress likely never considered U.S.federal estate and gift tax planning whenadopting Section 7874. The Base Trans-action is simply not the type of transac-tion that Congress sought to preventwith Section 7874. Thus, the simplestway to prevent the Base Transactionfrom being caught within the overlybroad language of Section 7874(b)would be to clarify that the foreign cor-poration will be treated as a U.S. corpo-ration for U.S. federal income taxpurposes only. Finally, under Section7874(g), Treasury should have theauthority to exempt certain transactions,much like it has with respect to certaininternal group restructurings. Such reg-ulatory guidance could be structured inseveral ways, as discussed above, provid-ed any regulations issued are within theintended scope of Section 7874. �

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