What Is Form 8635 and Who Is Required to File It?
Learn how corporations use Form 8635 to verify a substantial foreign business presence and determine the tax treatment following a corporate inversion.
A corporate inversion is a transaction where a U.S.-based corporation reincorporates in a foreign country, often to lower its tax obligations. After this transaction, U.S. tax law provides a test to assess whether the newly formed foreign entity has a genuine business presence in its new home country. This assessment prevents U.S. companies from using a foreign address to avoid taxes without having meaningful operations there. The outcome determines if the company will be treated as a U.S. corporation for tax purposes despite its foreign charter.
Who Is Subject to the Substantial Business Activities Test
The entity responsible for this analysis is the original U.S. corporation that underwent the inversion, referred to as the “expatriated entity” under the Internal Revenue Code. This company must be prepared to demonstrate its position to the IRS if it asserts that its new foreign parent should not be taxed as a U.S. corporation.
This obligation is triggered when the new foreign parent company seeks to qualify for the “substantial business activities” exception. This exception is a safe harbor that, if met, allows the foreign parent to be respected as a foreign corporation for U.S. tax purposes. Failure to meet this exception can result in the foreign parent being treated as a domestic U.S. corporation, negating the tax advantages of the inversion.
Information Required for the Substantial Business Activities Test
To satisfy the substantial business activities test, a company must gather specific data concerning its worldwide operations. The test is a quantitative measure of a company’s business presence in the new foreign country. It is conducted at the level of the “expanded affiliated group” (EAG), which includes the new foreign parent and all its controlled subsidiaries. The test requires that at least 25% of the group’s activities are based in the foreign country, measured across the following three categories:
- Employees: The company must calculate the number of its employees based in the foreign country and determine if that figure is at least 25% of its total employees worldwide. It must also calculate the total compensation paid to employees based in the foreign country and ensure it represents at least 25% of the total employee compensation for the entire EAG.
- Assets: The company must determine the value of its tangible assets, such as property, plant, and equipment, located within the foreign country. This amount must be at least 25% of the total value of all group assets worldwide. The valuation can be done using either the assets’ adjusted tax basis or their fair market value, but the method must be applied consistently.
- Income: The company must track the income derived from transactions in the foreign country. This figure must equal at least 25% of the total income generated by the EAG globally during the testing period. This calculation focuses on income from sales to unrelated customers in the ordinary course of business.
How to Report This Information
There is no specific, numbered IRS form designated for asserting that a company meets the substantial business activities exception. The expatriated entity must maintain all necessary records to demonstrate how it satisfies the 25% threshold for each of the three test components: employees, assets, and income. This documentation is necessary to support the company’s tax position in the event of an IRS inquiry.