With protectionist trends globally fueling a heightened focus on cross-border investments and acquisitions, investors and investees have to assess the application of overlapping regulatory regimes to their transactions. This article outlines some of the main areas of regulation that non-US investors seeking minority equity stakes in US companies, and the companies seeking such investments, should be aware of: CFIUS, export controls, sanctions, ownership reporting, and taxation. Key recent developments include:
- A previously popular approach to CFIUS investment restrictions, “springing rights,” under which foreign investors would typically immediately acquire a small, noncontrolling equity interest or nonvoting equity not subject to reporting and only obtain governance or information rights after receiving CFIUS approval, is no longer allowed for mandatory filings.
- Be prepared to go “up the chain” to understand the identity of all ultimate beneficial owners.
- Investment paired with a strategic collaboration or commercial transaction can additionally raise export controls issues, especially as the regulatory “garden wall” is changing over time in scope and height. Consider how to solve for now- or previously-permissible collaboration activities becoming restricted.
- Consider stipulating up front proxy governance mechanisms and an exit mechanism if an investor should become designated a sanctioned person.
- Investors should also be aware of regulatory developments around outbound investments (so-called “reverse CFIUS”) that have the potential to re-calibrate the US’ current approach to regulating such investment.
CFIUS
The main gatekeeper for inbound US investment is the Committee on Foreign Investment in the United States (CFIUS), an interagency body that monitors transactions that could raise national security risks. CFIUS has been particularly active recently, reviewing a record 440 filings in 2022 and requiring mitigation measures in 23% of notices. Other foreign investment regimes can be implicated where the US business provides telecommunication services (Federal Communications Commission licenses with the involvement of Team Telecom) or has a facility clearance to perform on classified contracts (Defense Counterintelligence and Security Agency).
CFIUS jurisdiction does not generally reach investment by non-US persons that are “solely for the purposes of a passive investment” and in which a non-US investor will acquire 10% or less of the outstanding voting interest in a US business. CFIUS has jurisdiction to review acquisitions of “control” by a non-US investor in a US business, with “control” broadly construed as the right to determine significant business decisions, including the right to veto matters beyond standard minority shareholder protections. In the case of non-control transactions, CFIUS has jurisdiction to review a transaction only if (1) a non-US person invests in a company involved in critical technology, critical infrastructure, or sensitive personal data (a “TID US business”), and (2) the non-US person (a) acquires at least one of the following: access to material nonpublic technical information, board membership or observer rights, or any involvement in substantive decision making (“Information and Governance Rights”), or (b) if a foreign government has a 49% interest in the non-US investor, the investor acquires a 25% voting interest.
A filing is mandatory only in two circumstances: first, if the transaction provides a non-US investor with “control” or Information and Governance Rights in a TID US business that produces, designs, tests, manufactures or develops one or more critical technologies that would require a license or other authorization under one of the US export control regimes in order to be exported to the investor; second, if a non-US investor obtains a 25% or more voting interest in a TID US business, and a foreign government (other than those of Australia, Canada, New Zealand, or the United Kingdom) holds a 49% or more voting interest in the non-US investor. The regulations define “critical technologies” as any that are (i) controlled under the International Traffic in Arms Regulations, (ii) included on the Commerce Control List of the Export Administration Regulations, aside from those controlled only for anti-terrorism reasons, (iii) subject to nuclear-related controls administered by the Nuclear Regulatory Commission and Department of Energy, (iv) select agents or toxins under US regulation or (v) designated as “emerging” and “foundational” technologies pursuant to The Export Control Reform Act of 2018. Failure to submit a mandatory filing could subject parties to a civil penalty of $250,000 or the value of the transaction, whichever is greater.
Outside of the mandatory filing regime, voluntary filings may be appropriate if the investor acquires over 10% and/or any Information and Governance Rights. In such situations, whether to file is a judgement case to be considered with competent CFIUS counsel. However, in an era when CFIUS calls in non-notified transactions on a regular basis, parties often lean towards pre-closing filings where there may be sensitive attributes to the transaction, either because of the nature of the US business or the national origin of the investor.
A previously popular approach used in financings, “springing rights,” in which investors would acquire equity and defer voting and other governance rights until receipt of CFIUS approval, is no longer allowed where the transaction is subject to a mandatory filing requirement, although it may be possible to use a springing rights construct with convertible debt instruments. Mandatory filings must be submitted a minimum of 30 days prior to the transfer of any equity interest.
In addition, during a review, CFIUS may request information regarding all directly or indirectly involved non-US investors, including limited partners in an investment fund. Common requests include names of non-US investors, their jurisdictions, and ultimate ownership percentages even if the parties have implemented agreements to limit disclosure of such information. Thus, investment funds and parties to transactions involving non-US investors should be prepared to understand the identity of all shareholders or risk encountering unanticipated CFIUS obstacles.
If CFIUS identifies national security issues in its review of a transaction, CFIUS can suspend, modify, or prevent the transaction from closing or impose certain obligations on the parties using a variety of mitigation measures, typically called National Security Agreements. Such mitigation measures can include establishing a corporate security committee, voting trust and other mechanisms to limit non-US influence, including the appointment of a US Government-approved security officer and/or member of the board of directors and requirements for security policies, annual reports, and independent audits. In the case of minority investments, parties may be able to avoid some of the more onerous forms of mitigation if they make arrangements to address CFIUS's concerns in key transactional documents and/or the target company's operational policies, but such arrangements are subject to negotiation on a case-by-case basis between the parties and CFIUS.
Export Controls
Non-US investors and their US investee companies also need to navigate US export controls, which restrict the extent to which a US company can share proprietary US technology, software as well as other items with non-US persons. These controls can apply not just post-investment but also during deal negotiations and regardless of the level of investment. US export controls can require licenses not just for physical shipments, but also electronic transfers/downloads (e.g. code repository access) and even through in-person or virtual written or spoken transmissions of technical data released to foreign persons in the US or abroad. Whether or not an export license is required depends on many factors, including the sensitivity of the particular technology/software, who it is being shared with (e.g. certain restricted party investors), where the investors are located/resident, what the technology/software will be used for (e.g. certain military-related, WMD proliferation, nuclear or other nefarious end uses or end users) and, in some cases, what other activities the investors or other recipients are separately engaged in (e.g. as military end users, the production or development of advanced node semiconductors, etc.) Thus, export controls create significant compliance issues for companies engaged in cross-border research, manufacturing or development of dual-use products—i.e. those products which can both be used for civilian and military purposes.
Such export control considerations can notably be relevant for investments that are paired with a strategic collaboration or commercial element. Care should be given to ensure that proprietary technologies and code are properly classified to identify potentially controlled technology and software, that sensitive, controlled technologies and software are appropriately firewalled from foreign investors through a robust technology control plan, and to structure strategic commercial partnerships with foreign investors carefully, including considering what would happen if the export controls landscape changes over time so that previously permissible collaboration activities become restricted.
Sanctions
Another trap for the unwary is US sanctions. These overlap to some extent with export controls, but focus more on “who and where” US companies deal with, regardless of the products or technologies involved. The US generally prohibits direct and indirect dealings by US persons with certain embargoed countries and certain “bad actors” (Specially Designated Nationals or “SDNs”) located around the world. SDNs are persons and entities who are either designated on lists issued by the Office of Foreign Assets Control (OFAC) at the US Department of the Treasury, as well as unlisted parties that are 50% or more owned by one or more such SDNs (OFAC also maintains lesser restrictions against other types of sanctioned parties.) SDNs are located around the world and can be sanctioned not just for affiliation with embargoed countries, but also for engaging in certain undesirable activities contrary to US national security and foreign policy, including terrorism, WMD proliferation, human rights abuses, drug trafficking, cyber-enabled activities, etc. These sanctions often have broad reaching impacts. For example, in 2020 the US sanctioned Huawei and its affiliates, preventing any semiconductors made with US equipment (a functional requirement in global semiconductor manufacturing) to be sold to Huawei.
US persons may face civil and criminal penalties for violations, including for entering into contracts signed by a blocked individual or for transferring funds to or from a blocked individual, providing services, issuing dividends, etc. Moreover, OFAC generally requires immediate compliance once a person has been added to a sanctions list. As a result, if an investor ends up on a sanctions list, it becomes nearly impossible to interact with such investor, including (in a Hotel California-like twist), taking actions to remove such investor from a company's capitalization table. Non-US investors can also be impacted as they may face “secondary sanctions risk” (e.g. a risk of designation themselves) for providing certain types of material support to sanctioned parties even if not “prohibited” as such, thus their appetite to remain invested in a company with sanctioned co-shareholders may be limited. Therefore, parties should consider stipulating upfront an exit mechanism if such investors become subject to sanctions.
Beneficial Ownership Reporting Under the CTA
Another consideration is heightened transparency requirements. Non-US investors making minority investments may also need to be disclosed under new beneficial ownership reporting to the US Treasury's Financial Criminal Enforcement Network (FinCEN). The federal Corporate Transparency Act (CTA) requires every corporation, limited liability company, limited partnership or comparable business operating in the United States not eligible for one of 23 statutory exemptions (a “Reporting Company”) to submit a confidential online electronic report— known as a Beneficial Ownership Information Report (“BOI Report”)—to FinCEN starting Jan. 1, 2024. The BOI Report form requires disclosure of basic identification information about each Reporting Company and about all individuals who are a Reporting Company's controlling “beneficial owners.” The CTA defines such “beneficial owners” as individuals: (A) with “direct or indirect” ownership or “control” of 25% or more of a company's equity interests; or (B) who “directly or indirectly exercise substantial control over” a Reporting Company. In the case of non-US investors, we frequently encounter investors with sensitivities regarding such disclosure, and if so, parties should structure any transactions accordingly, such as by lowering the ownership stake below the 25% threshold.
Tax Considerations for Non-US Investments
The tax consequences associated with various transactional arrangements often drive how non-US investors invest and whether they can invest at all. As comprehensive tax planning advice is beyond the scope of this article, the below represents a few common tax considerations:
- S-Corporations, which are a common form of organization for closely-held businesses in the US because they allow for pass-through taxation to shareholders, are not permitted to retain their status as an S-Corporation if they have non-US shareholders. Upon an investment from a non-US investor, the S-Corporation will become a traditional C corporation for US tax purposes, which causes many S-Corporations not to accept investments from non-US investors.
- Dividends from US companies to non-US investors are generally subject to withholding tax at a rate which could be as high as 30% but may be reduced by applicable tax treaties.
- Many US businesses are taxed as pass-through entities, including limited partnerships and limited liability companies (subject to such entities electing to be taxed as corporations). A non-US investor that invests in a pass-through entity that earns income “effectively connected” with a US trade or business (which includes most operating income) will be subject to filing US income tax returns to report the “effectively connected” income allocated to them. The US pass-through business will also have to withhold a portion of income allocated to the non-US investor and pay that withholding to US tax authorities, even if no distributions are made to the non-US investor.
- Sales of stock of a US corporation by a non-US investor are generally exempt from US capital gains tax unless the corporation holds substantial US real property. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) generally subjects the disposition of US real property interests by a non-US person to a withholding tax of 15%, subject to certain exceptions and/or adjustments.
Reverse CFIUS
Finally, Executive Order 14105 (EO), issued on Aug. 9, 2023, established a framework for regulating certain types of outbound investments by US persons in China and Chinese-owned companies in the semiconductor, quantum computing and artificial intelligence (AI) sectors. While the regulations implementing the EO are still being finalized, the regulations have the potential to impose new reporting requirements for outbound investment and prohibit US persons from investing in companies located in China, Hong Kong, or Macau that are engaged in activities relating to advanced semiconductors, quantum computing, and software incorporating AI that are designed to be exclusively, or primarily, used for military, government intelligence or mass surveillance purposes. These regulations are yet another development investors will need to monitor and consider as they structure their next investment.
Conclusion
In the last few years, the US government's approach to overseeing foreign direct investment has undergone changes that non-US investors cannot ignore if they want to close transactions on schedule. To increase chances of success, non-US investors would do well to familiarize themselves with the current foreign direct investment frameworks and work with their advisors to ensure their transactions are structured in a way to address the various tax, CFIUS and export control implications of foreign investment.
*Allison Stafford Powell, Rod Hunter, and Lane Morgan also contributed to this piece.
** Copyright 2024 Bloomberg Industry Group, Inc. (800-372-1033). Minority Interest, Major Impact: Considerations When Non-US Investors Invest in US Companies. Reproduced with permission.