New Entities Created in Bankruptcy Subject to the Section 7874 Inversion Rules
February 07, 2011Administrative Actions
A few days ago the Office of Chief Counsel (International) released an internal memorandum that addressed the potential application of the inversion rules of Section 7874 in bankruptcy. Section 7874 was enacted in 2004 as another tool to battle expatriation and the avoidance of U.S. tax. In most basic terms, the section provides that certain expatriated entities (foreign corporations that acquire U.S. corporations or partnerships and which are at least 60% owned by the former owners of the acquired U.S. entity and which do not have substantial business operations in their country of incorporation) will either have to recognize in the future any “inversion gain” as defined in Section 7874(d)(2) (essentially gain from the sale of properties acquired from the domestic entity), or, if the expatriated entity is at least 80% owned by the former owners of the domestic entity, the foreign corporation will be taxed as a U.S. corporation.
Chief Counsel had an issue with the following. In the bankruptcy plan of reorganization (aka “POR”), the debtor took the position that certain newly created foreign entities would not be subject to the Section 7874 inversion rules. Apparently, the debtor’s rationale for this position was not explained in the POR. As such, Chief Counsel advised that the agent follow up on this issue in future audits of the newly formed foreign entities.
What does this mean to investment funds? Private equity funds often provide funding to businesses that go through bankruptcy. The funding may take the form of debtor in possession (DIP) financing, secured debt or equity in the reorganized entity. Section 7874 and the rule discussed here may present an unexpected tax trap to a fund that has put new money into the company. The POR may call for a new foreign entity and could purport that the inversion rules do not apply (as in the POR that was discussed in the ruling) and the fund may go with this. However, if the IRS disagrees with this position, the investment fund runs the exposure of being invested in an entity that would be treated as a US entity for tax purposes, or that would have to recognize “inversion gain” in the future. One of the major differences between the taxation of domestic and foreign corporations is that a domestic corporation is taxed on its worldwide income whereas a foreign corporation is taxed on ECI or FDAPI which generally includes only U.S. source (with few minor exceptions). Thus, if the inversion rules apply, the U.S. Government has a clam to a larger chunk of the reorganized entity’s revenue, which in turn usually means less cash-flow to the fund.
The memorandum can be found on IRS’s website here, and is also copied below.