The IRS issued temporary and proposed regs under Code section 7874 (Reg-112994-06, TD 9265) aimed at corporate inversion transactions in which a foreign entity replaces the US parent of a multinational corporate group. The rules, enacted as part of the American Jobs Creation Act in October 2004, have caused significant uncertainty for both US and Canadian practitioners engaged in structuring a wide variety of cross-border transactions, including reorganizations, acquisitions, and public offerings of both debt and stock in Canada. The new regs are Treasury's second round of guidance on the scope of the inversion rules (see "Corporate Inversions Update," Canadian Tax Highlights, April 2006) and offer welcome clarification, especially on (1) what constitutes an "indirect" acquisition of substantially all of the assets of a domestic corporation or partnership; and (2) what constitutes substantial business activities in the foreign parent company's home country. Anti-abuse provisions apply to the use of publicly traded foreign partnerships and options and similar interests to avoid the inversion regime.

Indirect acquisitions. An inversion may occur when a foreign corporation directly or indirectly acquires substantially all the assets of a US corporation or partnership and thereafter at least 60 percent of the forco's stock is held by the US entity's former shareholders. The technical language of the rules did not clearly indicate whether an inversion occurred on an indirect acquisition, such as when a Canco acquired stock of another Canco that owned a USco's stock. The new regs clarify that an acquisition of a foreign corporation that owns stock in a US corporation does not constitute an "indirect" acquisition of the USco under section 7874; the result is reasonable because the USco was foreign-owned before the acquisition, and thus the change in ownership at the foreign upper tier caused no adverse US tax consequences.

Substantial business activities. A legislative safe harbour exists if a Canadian acquiror's expanded affiliated group (EAG) has substantial business activities in Canada. (The ownership threshold of an affiliated group, defined in Code section 1504(a), is lowered to 50 percent, and foreign corporations are included.) Early indications suggested that the test for "substantial" business activities might be similar to modern limitation-on-benefits provisions in US tax treaties such as that with the Netherlands. The new regs take a different approach. Two tests determine whether the Canadian business activities are substantial in relation to the EAG's total business activities. (1) A facts-and-circumstances test considers such non-exclusive factors as operational activities involving property, employee head count and payroll in Canada, sales in Canada, management based in Canada, the residence of owners or investors in Canada, and the EAG's historical presence in Canada. In the absence of precedent applying this test, it is of little practical value in structuring current deals. (2) A more useful test provides a safe harbour in which the EAG is treated as having substantial business activities in Canada if (a) after the acquisition, the EAG employees based in Canada account for at least 10 percent, by head count and compensation, of total employees; (b) after the acquisition, the total value of EAG assets located in Canada represents at least 10 percent of the total value of its assets; and (c) during the 12 months ending on the last day of the accounting period in which the acquisition is completed, the EAG's sales in Canada account for at least 10 percent of its total sales. EAG assets are defined as tangible property used in the active conduct of a trade or business; the definition specifically excludes intangibles. This mechanical safe harbour test should provide much-needed certainty for practitioners structuring deals.

Anti-abuse provisions. The regs set out two structures perceived to be abusive. The legislation applies to surrogate foreign corporations, and the IRS was concerned that taxpayers might attempt to avoid the inversion rules by using a foreign partnership as the acquiring entity. The IRS says that it will treat a publicly traded foreign partnership as a foreign corporation, notwithstanding that the partnership meets the qualifying income exception to classification as a corporation under the "publicly traded partnership" rules. Thus, the inversion regime expressly applies to the numerous Canadian income fund deals structured as publicly traded partnerships for US tax purposes. The regs also provide that options, warrants, convertible debt, and similar interests in the Canadian acquiror held by a former shareholder of the expatriated US entity are treated as exercised to the extent that as a result of the exercise the 60 and 80 percent continued ownership thresholds are met. Practitioners using exchangeable shares and similar interests must count such interests in the inversion calculation.

Effective date. The new regs initially applied to acquisitions completed after June 5, 2006, but a July 28, 2006 IRS Notice (2006-70) rendered the regs inapplicable to situations in which a binding commitment to an acquisition that would result in an inversion was entered into before December 29, 2005 but was not completed by the June 6, 2006 cutoff. Acquisitions of options or similar interests, for example, falling within those dates are not counted in the inversion calculation.