The US corporate inversion tax rules enacted in 2004 affect a wide range of cross-border transactions, including Canadian income fund offerings coupled with acquisitions of US target companies, and transfers by Canadians of certain US-situs property to Canadian holdcos to avoid US estate tax. Three recent proposals clarify and modify these rules. (1) Temporary regulations issued December 27, 2005, effective March 4, 2003, clarify some important aspects of these new rules, particularly with respect to affiliate-owned stock, and they also provide a warning with respect to exchangeable share transactions. (2) Forthcoming additional regulations will clarify the "substantial business activities" exception and the application of the inversion rules to foreign partnerships. (3) Proposed legislation both tightens the inversion rules and provides relief to Canadian acquisitions of certain non-publicly traded US companies.

A corporate inversion may occur when a Canadian or other non-US entity acquires substantially all the equity interests or assets of a US corporation or partnership, and thereafter the target's former equity holders own at least 60 percent of the non-US acquiror's stock. (If they hold 80 percent or more, the non-US acquiror is treated as a domestic corporation.) The inversion rules do not apply if the non-US acquiror conducts substantial business activities in its home country. In determining whether the post-acquisition level of ownership is met, stock held by members of the expanded affiliated group (EAG) that includes the non-US acquiror and stock of the non-US acquiror sold in a public offering related to the acquisition is excluded. The latter exclusion is particularly important in structuring Canadian income fund offerings involving acquisitions of US targets.

1) New temporary regs primarily address stock held by members of the EAG, which is made up of the non-US acquiror and all companies connected to it by a chain of greater than 50 percent ownership. The regs seek to prevent the abuse of the affiliate-owned stock rule through the use of "hook stock" (stock of the non-US acquiror held by an entity in which it holds at least 50 percent of the stock, directly or indirectly): affiliate-owned stock is completely excluded from the fraction that determines the stock ownership percentage.

The regs also clarify that some legitimate internal group restructurings are outside the scope of the inversion rules--namely, certain transactions occurring as part of an internal group restructuring involving a US entity, and certain business acquisitions between unrelated parties where the former shareholders or partners of the US entity have a minority interest in the acquired properties after the acquisition. The preamble to the regs also hints at future guidance on at least eight additional inversion issues, and warns that the IRS may use its authority to issue anti-abuse regulations to address structures that it considers potentially abusive, including structures involving the use of exchangeable shares and intermediaries.

2) More recently, an IRS official, speaking at a Federal Bar Association meeting in Washington, acknowledged the broad authority to issue regs conferred by the statute, and indicated that forthcoming regulations will address how to determine whether an affiliated group has "substantial business activities" in its home country. It was suggested that the test may be modelled on the limitation-on-benefits article in many modern US tax treaties, such as that with the Netherlands. The official also indicated that new regs will prevent attempts to avoid the inversion rules by using a foreign partnership as the non-US acquiror: some taxpayers say that the rules' reference to "foreign entities" does not cover foreign partnerships, which are not taxable entities.

3) Legislation introduced in the US Senate in November 2005 proposed significant amendments to the inversion rules and is currently before the House and Senate conference committee. The proposals (a) make the rules retroactive to transactions completed after March 20, 2002 (currently March 4, 2003); (b) lower the threshold for inversions from 60 to 50 percent; (c) increase the potential accuracy-related and gross-valuation misstatement penalties for taxpayers related to the US target; (d) eliminate the generally applicable debt-equity threshold in applying the interest-stripping rules to taxpayers related to the US target; and (e) lower the threshold for excess interest expense from 50 to 25 percent. These changes may cast the net wider to catch more acquisitions of US companies by foreign entities. However, the proposal also excludes the acquisition of a US company if none of its stock was publicly traded at any time during the four years ending on the acquisition date--a welcome change for Canadian income fund offerings involving acquisitions of US companies.