IRS Revises ‘Foreign Corporation’ Definition

     WASHINGTON (CN) – The Internal Revenue Service has created a bright-line test to determine if foreign corporations that buy U.S. firms are really operating in their claimed home countries or just benefiting from preferential tax treatment.
     The IRS has adopted a temporary rule, describing the test, and has begun the usual rulemaking process with an identical proposed rule.
     In 2006, the IRS adopted temporary rules to fight so called inversion transactions where a U.S. corporation would create a new company in a tax haven, which then bought or exchanged all of the shares in the domestic corporation for shares in the foreign corporation.
     Under Section 7874 of the Internal Revenue Code, such companies are considered expatriated entities and the acquiring foreign entity is called a surrogate foreign corporation. Significant penalties are attached to the conversion of the domestic stock into foreign stock to discourage such transactions.
     Entities were considered foreign surrogates if, after acquisition, at least 60 percent of the stock in the foreign corporation was held by former shareholders of the domestic company and if the new entity did not have substantial business activity outside the United States.
     The new test defines substantial business activity as having 25 percent of the corporation’s employees, assets and income located or derived from a foreign country.
     The employees, assets and income of partners in the corporation are only included in the new threshold analysis if they own at least 50 percent of the corporation. This provision is to deter the creation of many small partnerships to hide control of the corporation.
     The IRS also adopted a final rule clarifying that the 60 percent stock threshold refers to voting control of the corporation and that options to purchase stock are included in the threshold if they were issued to avoid the restrictions of section 7874.
     This final rule also makes clear the IRS will treat creditor claims against insolvent domestic firms acquired by surrogate corporations, as stock in the domestic firm rather than as purchases of its assets.
     The temporary rule and the final rule apply to acquisitions completed on or after June 7, 2012. The proposed rule, if approved, would also apply to acquisitions made while the temporary rule was in effect.

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