8 minute read | January.30.2025
Orrick's UK Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other specialists. Our Band 1 ranked London TCG team successfully completed over 350 financings and tech M&A transactions in 2023 & 2024 totaling $5B+, and has dominated the European venture capital tech market for 35 quarters in a row (PitchBook, Q3 2024). View previous series instalments here.
From time to time, founders based outside the U.S. will form a U.S. holding company above their non-U.S. operating company in what is known as a “flip” transaction. Founders typically pursue a flip transaction to facilitate or attract investment by U.S.-based venture funds and investors. For these same reasons, non-U.S. founders sometimes begin operations with a U.S. holding company, even if the company’s activities are largely outside the U.S.
Occasionally, founders may wish to “flip-back” by creating a new non-U.S. holding company on top of a U.S. holding company. They typically do this at the request of non-U.S. investors who may be subject to restrictions on investing in companies organized outside their own country. Other times, founders respond to tax incentives under their domestic laws.
While a flip transaction into the U.S. is common and often tax-neutral, a flip-back transaction from the U.S. into another country is more complicated from a U.S. tax perspective and can have unintended consequences.
Here are key U.S. tax considerations to keep in mind when weighing a flip-back transaction.
Section 7874 of the U.S. tax code responded to corporate inversion transactions in which U.S. parent entities of multinational groups moved to jurisdictions outside the U.S. Under this rule, a non-U.S. company will be treated as a U.S. corporation for U.S. tax purposes if all of the following are met:
The first prong is almost always met since the non-U.S. holding company usually acquires all of the stock of the U.S. holding company. In a typical flip-back transaction, all the former shareholders of U.S. holding company (including holders of Simple Agreements for Future Equity, or SAFEs, which are generally treated as stock for U.S. tax purposes) exchange their stock or SAFEs for stock or SAFEs of the non-U.S. holding company, resulting in them owning 100% of the stock of the non-U.S. holding company for U.S. tax purposes.
Sometimes the former shareholders of the U.S. holding company own less than 80% of the non-U.S. holding company because the non-U.S. holding company is raising capital from new investors concurrently with the flip-back transaction. In those cases, stock issued for cash in an inversion transaction is disregarded for purposes of this test. As a result, in a flip-back transaction, often, the only feasible way for a non-U.S. holding company to avoid being treated as a U.S. corporation would be under the substantial business activities test.
For this test, the expanded affiliated group that includes a non-U.S. holding company (which should include the U.S. holding company and the operating company) will be considered to have substantial business activities in the country where the non-U.S. holding company is organized if each of the following conditions is met:
For startups that often have a fluid workforce in different countries, do not own much personal or real property and do not generate profits or even revenue (or generate revenue from customers in multiple countries), it may be difficult to demonstrate they meet each of the requirements. As a result, there is a real possibility that the non-U.S. holding company will be treated as a U.S. corporation for U.S. tax purposes.
If a non-U.S. holding company is treated as a U.S. corporation for U.S. tax purposes, all of its (and the U.S. holding company’s) worldwide income will remain subject to U.S. tax. In addition, all their non-U.S. subsidiaries’ income will remain subject to the U.S. anti-deferral tax regimes that may subject the income to U.S. tax even if no cash distributions are made to the U.S.
At the same time, the non-U.S. holding company would likely be subject to tax in its country of organization. As a result, the non-U.S. holding company would likely be treated as a dual tax resident and subject to double taxation. Many startups may not face an immediate cash tax impact if they are not generating profit and are not expected to do so in the near future. For profitable companies, the impact of double taxation is often mitigated partially, but not entirely, through foreign tax credits or other tax exemptions in their home jurisdiction.
Once a non-U.S. holding company is treated as a U.S. corporation for U.S. tax purposes, it will remain so indefinitely, and it may be difficult to predict the full impact of being a dual tax resident as the company evolves. In addition, being subject to two tax regimes will increase the company’s compliance burden and costs.
A non-U.S. holding company with dual tax resident status may face fundraising challenges with both U.S. and non-U.S. investors due to the uncertain tax treatment of their investment and the potential tax impact on the company. Additionally, potential acquirers are likely to discount the value of the company on account of the additional tax costs.
Despite the complexity of being a dual tax resident, there is still one benefit non-U.S. holding companies may enjoy from being treated as a U.S. corporation: as discussed further below, U.S. investors will receive more favorable tax treatment under certain U.S. international taxation rules than if the non-U.S. holding company was treated as a non-U.S. corporation for U.S. tax purposes.
If a non-U.S. holding company meets the substantial business activities test under Section 7874, it will not be treated as a U.S. corporation for U.S. tax purposes.
While this may be a better outcome for the company, it is likely to be more disadvantageous for its U.S. investors. A stock-for-stock exchange generally is a tax-deferred transaction for U.S. tax purposes, but that is not the case when stock of a U.S. company is exchanged for stock of a non-U.S. company, unless certain specific requirements are met (which are not likely to be met in the context of a flip-back transaction). As a result, if a non-U.S. holding company is not treated as a U.S. corporation under Section 7874, the flip-back transaction would likely be treated as a taxable exchange for U.S. shareholders, resulting in taxable gain or loss without the receipt of any cash.
In addition, while they already may have lost such benefits due to an earlier flip transaction, U.S. investors – current and future – will not qualify for qualified small business stock (QSBS) benefits as they will hold stock in a company that is treated as a non-U.S. corporation for U.S. tax purposes.
Furthermore, if a non-U.S. holding company is determined to be a “passive foreign investment company” or “controlled foreign corporation” under U.S. tax rules, U.S. investors may be subject to additional tax and reporting requirements. Therefore, if a non-U.S. holding company is treated as a non-U.S. corporation for U.S. tax purposes, it may have adverse tax consequences for U.S. investors both on the exchange and in the future. In contrast, if the non-U.S. holding company is treated as a U.S. corporation under the anti-inversion rules, these consequences would not arise as they are only relevant to stock of a non-U.S. corporation.
A flip-back transaction is often driven by non-U.S. investors’ concerns. However, it can have significant tax and non-tax impacts on the company and its other investors – immediately and in the future. A company should weigh the pros and cons of a flip-back transaction based on its circumstances, including the company’s investor composition, current and projected operations and fundraising needs.
It may be worth exploring alternative strategies to address non-U.S. investors’ concerns, such as by allowing them to invest directly in the operating company, invest in non-equity instruments or by making a “check-the-box” election on a non-U.S. holding company to treat it as tax transparent for U.S. tax purposes.
One may decide that, on balance, a flip-back transaction is the best course of action for the company, but the complexity and lasting impact of such a transaction warrant careful analysis beforehand.
If you are interested in learning more, contact SeoJung Park, Eric Wall or another member of the Orrick team.