U.S. companies take "AIM" at the U.K. stock market.

For various business reasons, several U.S. companies have attempted to list their shares on the Alternative Investment Market (AIM) of the London Stock Exchange. The business reasons for listing U.S. company shares on a foreign stock exchange are beyond this item's scope; suffice it to say that the U.S. regulatory environment may have created interest in looking beyond its borders to other capital markets.

The listing of U.S. companies' shares on a foreign stock exchange may fall within the following pattern:

1. The U.S. shareholders transfer their shares of the operating companies to a U.S. holding company (USHoldco) in exchange for USHoldco shares. Such exchange will most likely qualify as tax free under Sec. 351. If so, neither the exchanging shareholders, nor the corporations whose shares are transferred or the transferee holding company, should recognize taxable income. This step is often required to simplify the transfer described in step #2 (below).

2. The shareholders transfer their USHoldco shares for shares in the foreign entity that will be listed on the foreign exchange. In the case of the AIM, the listed entity will be a public limited company (PLC). A PLC is a per se corporation for U.S. income tax purposes under the Sec. 7701 "check-the-box" rules; see Regs. Sec. 301.7701-2(b)(8)(i). 3. Shares of PLC are then offered for sale on the foreign exchange.

Most of the U.S. tax challenges arise in step #2. Two sets of rules may create a whole host of tax concerns for the U.S. shareholders. One set, under Sec. 367(a) and Regs. Sec. 1.367(a)-3(c), deals with the outbound transfer of U.S. corporations to foreign entities. The other rules are a recent creation under the American Jobs Creation Act of 2004--the Sec. 7874 anti-inversion rules.

In light of these two sets of tax rules on outbound transfers of shares, the situation described above presents two main U.S. income tax issues:

* Can the U.S. resident shareholders defer U.S. income tax that may result from the transfer of their ownership in USHoldco for shares in PLC?

* Can the transaction (which will result in PLC being the ultimate parent of the worldwide group) avoid the anti-inversion rules? If the anti-inversion rules apply to the proposed transfer of USHoldco's shares to PLC, PLC may be treated as a U.S. corporation, subject to U.S. income tax on its worldwide income.

Deferral under Sec. 367

It is possible for the U.S. shareholders to defer U.S. income tax on their transfer of shares of US-Holdco to PLC, if the following conditions are met:

Ownership limit: In general, Regs. Sec. 1.367(a)-3(c)(1)(i) bans the U.S. shareholders of USHoldco from acquiring or ending up with more than 50% of PLC's vote or value. In addition, under Regs. Sec. 1.367(a)-3(c)(1)(ii), U.S. persons who are officers or directors or who own at least 5% of PLC's vote or value cannot, in the aggregate, own more than 50% of PLC's vote or value immediately after the transaction.

GRA required: If a U.S. shareholder owns 5% or more of either PLC's vote or value, such shareholder must enter into a five-year gain recognition agreement (GILA) relating to USHoldco shares; see Regs. Sec. 1.367(a)-3(c)(1)(iii). The rules and consequences of entering into a GRA are found in Regs. Sec. 1.367(a)-8; for background on GRAs, see Gilbreath and Dubroff, Tax Clinic, "Effect of Certain Asset Reorgs. on Gain Recognition Agreements," TTA, January 2006, p. 15.

Foreign active trade or business test: In addition, PLC must be engaged in an active trade or business outside the U.S. The rules for this test, under Regs. Sec. 1.367(a)-3(c)(3), are very complex. In general, the active trade or business test will be met if PLC (or its 80%-owned foreign corporation or partnership (qualified subsidiary)) was engaged in an active business for a 36-month period preceding the transfer of USHoldco to PLC, and there is no plan to dispose of such business at the time of the transfer. It is common for a PLC planning to list its shares on the AIM to acquire an active U.K. company. The test should be met as long as the principal purpose for PLC's acquisition of the active U.K. company was not to satisfy the active trade or business test. Finally, PLC's fair market value (FMV) must at least equal USHoldco's FMV at the time of the transfer; see Regs. Sec. 1.367(a)-3(c)(3)(iii)(A).

Provided the above tests can be met, the transfer of the shares of the U.S. companies to PLC may be tax deferred. In addition, if more than 10% of USHoldco's shares are transferred by U.S. shareholders to PLC, then USHoldco is subject to information reporting requirements with respect to its U.S. income tax return in the year of transfer; see Regs. Sec. 1.367(a)-3(c)(6).

Avoidance of Anti-Inversion Rules

The anti-inversion rules, if applicable, may result in treating PLC as a U.S. corporation for U.S. income tax purposes. These rules will apply if the former shareholders (including nonresidents) of the U.S. companies receive at least 80% of the total PLC shares; see Sec. 7874(b). If the former shareholders of USHoldco receive 80% or more of PLC's shares in the exchange, PLC will be treated as a U.S. corporation and the transaction could be accomplished on a tax-deferred basis. However, PLC would be treated as a U.S. corporation, which would be undesirable. If the U.S. shareholders receive less than 60% of the PLC shares in the exchange, the anti-inversion rules will not apply.

If the U.S. shareholders receive 60% or more, but less than 80%, the anti-inversion rules will apply, and a special tax regime will apply to the inverted entity (i.e., USHoldco); see Sec. 7874(a)(2)(B)(ii). However, as long as PLC or its affiliates are engaged in substantial business activities within the U.K., the anti-inversion rules will not apply.

There is a bright-line test to determine substantial business activity under new Temp. Regs. Sec. 1.7874-2T(d)(2). It provides that at least 10% of the worldwide group's factors (asset values, gross income, payroll expense and headcount) must be located or take places in the foreign country (the U.K. in the above example). For purposes of the Sec. 367(a) rules, PLC or its subsidiary must have an active business outside the U.S. Under the anti-inversion rules, PLC must have an active business in the U.K.

Conclusion

The rules governing the transfer of shares of a U.S. company to a foreign entity are very complex. However, the transfer could be accomplished on a tax-deferred basis, if the existing USHoldco shareholders receive less than 50% of PLC's shares in the transfer. Also, the anti-inversion rules can be avoided completely if the former shareholders of the U.S. companies (including nonresident shareholders) own less than 60% of PLC after the transfer, or if PLC is engaged in a substantial business activity in the U.K.

FROM ROBERT VERZI, CPA, CHERRY, BEKAERT & HOLLAND, L.L.P., ATLANTA, GA