This document contains temporary amendments to 26 CFR part 1 under section 7874 of the Internal Revenue Code (Code). Section 7874 provides rules for expatriated entities and their surrogate foreign corporations. An expatriated entity is defined in section 7874(a)(2)(A) as a domestic corporation or partnership with respect to which a foreign corporation is a surrogate foreign corporation, and also as any U.S. person related (within the meaning of section 267(b) or 707(b)(1)) to such domestic corporation or partnership.

A foreign corporation is treated as a surrogate foreign corporation under section 7874(a)(2)(B), if, pursuant to a plan or a series of related transactions: (i) the foreign corporation directly or indirectly acquires substantially all the properties held directly or indirectly by a domestic corporation, or substantially all the properties constituting a trade or business of a domestic partnership; (ii) after the acquisition at least 60 percent of the stock (by vote or value) of the foreign corporation is held by (in the case of an acquisition with respect to a domestic corporation) former shareholders of the domestic corporation by reason of holding stock in the domestic corporation, or (in the case of an acquisition with respect to a domestic partnership) by former partners of the domestic partnership by reason of holding a capital or profits interest in the domestic partnership (ownership percentage test); and (iii) the expanded affiliated group that includes the foreign corporation (EAG) does not have business activities in the foreign country in which the foreign corporation was created or organized that are substantial when compared to the total business activities of the EAG.Section 7874(c)(1) defines the term expanded affiliated group as an affiliated group defined in section 1504(a) but without regard to the exclusion of foreign corporations in section 1504(b)(3) and with a reduction of the 80 percent ownership threshold of section 1504(a) to a more-than-50 percent ownership threshold.

The tax treatment of expatriated entities and surrogate foreign corporations varies depending on the level of owner continuity. If the percentage of stock (by vote or value) in the surrogate foreign corporation held by former owners of the domestic entity, by reason of holding an interest in the domestic entity, is 80 percent or more, the surrogate foreign corporation is treated as a domestic corporation for all purposes of the Code. If such ownership percentage is 60 percent or more (but less than 80 percent), the surrogate foreign corporation is treated as a foreign corporation but certain income or gain required to be recognized by the expatriated entity under section 304, 311(b), 367, 1001, or any other applicable provision with respect to the transfer of property (other than inventory or similar property) or the license of property cannot be offset by net operating losses or credits (other than credits allowed under section 901). These measures generally apply from the first date properties are acquired pursuant to the plan through the end of the 10-year period following the completion of the acquisition.

Section 7874(c)(4) provides that transfers of properties or liabilities (including by contribution or distribution) are disregarded if such transfers are part of a plan a principal purpose of which is to avoid the purposes of the section.

The IRS and Treasury Department have broad authority to issue regulations under section 7874. Section 7874(c)(6) authorizes the Secretary of the Treasury to prescribe such regulations as may be appropriate to determine whether a corporation is a surrogate foreign corporation, including regulations to treat warrants, options, contracts to acquire stock, convertible debt interests, and other similar interests as stock, and to treat stock as not stock. In addition, under section 7874(g) the Secretary of the Treasury is authorized to provide regulations needed to carry out the section. Those regulations could include guidance providing adjustments to the application of the section as are necessary to prevent the avoidance of the section, including avoidance through the use of related persons, pass-through or other non-corporate entities, or other intermediaries.

The legislative history of section 7874 indicates that the section was intended to apply to so-called inversion transactions in which a U.S. parent corporation of a multinational corporate group is replaced by a foreign entity. See H.R. Conf. Rep. No. 108-755, 108^th Cong., 2d Sess., at 568 (Oct. 7, 2004). The Senate Finance Committee stated its belief “that inversion transactions resulting in a minimal presence in a foreign country of incorporation are a means of avoiding U.S. tax and should be curtailed.” S. Rep. No. 108-192, 108^th Cong., 1^st Sess., at 142 (Nov. 7, 2003). In particular, Congress believed that such transactions permit corporations and other entities to continue to conduct business in the same manner as they did prior to the inversion, but with the result that the group that includes the inverted entity avoids U.S. tax on foreign operations and may engage in earnings-stripping techniques to avoid U.S. tax on U.S. operations. See S. Rep. No. 108-192, at 142 (Nov. 7, 2003); see also Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108^th Congress, at 343 (May 2005).

The IRS and Treasury Department have issued temporary and proposed regulations under section 7874 relating to the application of section 7874(c)(2) (affiliated-owned stock rule), under which stock held by members of the expanded affiliate group that includes the acquiring foreign corporation (EAG) is not taken into account for purposes of the ownership percentage test of section 7874(a)(2)(B)(ii). See T.D. 9238, 2006-6 I.R.B. 408 (Feb. 6, 2006). Those regulations ensure that the affiliated-owned stock rule cannot be used to avoid the application of section 7874, through the use of hook stock or otherwise, to situations where that provision should apply. In addition, those regulations ensure that this test does not apply to certain transactions that are properly viewed as outside the scope of section 7874.

The temporary and proposed regulations provide guidance on the determination of whether a foreign entity is treated as a surrogate foreign corporation under section 7874(a)(2)(B) of the Code. In particular, the regulations address the indirect acquisition of properties, stock held by reason of holding an interest in a domestic entity, the substantial business activities of an EAG, prevention of the avoidance of section 7874 in certain circumstances, and certain effects of being treated as a domestic corporation under section 7874(b).

Section 7874 does not apply unless a foreign entity completes a direct or indirect acquisition of defined properties. The legislative history of the section indicates that Congress intended the acquisition of stock in a corporation to be considered an indirect acquisition of the properties held directly or indirectly by the corporation. See H.R. Conf. Rep. No. 108-755, 108^th Cong., 2d Sess., at 573 (Oct. 7, 2004) (“U.S. corporation becomes a subsidiary of a foreign incorporated entity or otherwise transfers substantially all of its properties”). The IRS and Treasury Department believe that guidance regarding the indirect acquisition of properties held directly or indirectly by a domestic corporation is needed to refine further the parameters of the provision’s scope.

The statute also applies to indirect acquisitions of properties constituting a trade or business of a domestic partnership. The IRS and Treasury Department are considering guidance regarding the application of this part of the statute, but are not issuing any such guidance at this time.

Section 7874 requires a determination of the amount of stock in the acquiring foreign entity that is held by former shareholders or partners of the domestic corporation or partnership “by reason of” their holding stock or a partnership interest in the domestic entity. The IRS and Treasury Department believe that guidance is needed as to how this determination is made in certain circumstances.

Section 7874 does not apply if the EAG has business activities in the foreign country in which, or under the laws of which, the acquiring foreign entity was created or organized that are substantial when compared to the total business activities of the EAG. The IRS and Treasury Department believe that Congress was concerned about transactions where the new foreign parent entity is incorporated in a country in which the EAG does not have a bona fide business presence that is meaningful in the context of the group’s overall business. See S. Rep. No. 108-192, 108^th Cong., 2d Sess., at 142 (Nov. 7, 2003) (The Committee believes that inversion transactions resulting in minimal presence in a foreign country of incorporation are a means of avoiding U.S. tax and should be curtailed.). The IRS and Treasury Department believe that guidance is necessary to ensure proper application of the substantial-business-activities rule.

The IRS and Treasury Department are aware of recent transactions in which taxpayers have attempted to avoid the application of section 7874 through the use of a foreign partnership. These transactions involve the acquisition of substantially all the properties of a domestic corporation or partnership by a foreign entity that is considered a foreign partnership for U.S. Federal income tax purposes, despite the fact that interests in the entity are (or will be) publicly traded on a securities exchange. Although a partnership is a flow-through entity for Federal income tax purposes, the substitution of a foreign partnership for a domestic corporation as the parent entity of a multinational group can create many of the same opportunities for U.S. tax avoidance that Congress sought to curtail by enacting section 7874 (namely, removal of foreign operations from U.S. taxing jurisdiction and the use of earnings-stripping techniques to reduce U.S. tax on income from domestic operations). Section 7874(g) is intended to provide authority to address these types of issues.

Under section 7704 of the Code, a publicly traded partnership is generally treated as a corporation for all purposes of the Code. Section 7704(c), however, generally provides an exception from corporate treatment if 90 percent or more of the partnership’s gross income for a taxable year consists of passive income such as dividends. This exception does not apply on a look-through basis in the case of payments from related parties, so the exception can be satisfied even if the underlying earnings from which the income is paid are not passive in nature. The legislative history of section 7704 indicates that the rationale for this exception was to preserve flow-through tax treatment where a partnership simply holds investments that the partners could have independently acquired, as opposed to business activities that would normally be conducted in corporate form and taxed at the entity level. See H.R. Rep. 100-391 (Oct. 26, 1987) at 1066-1067. In the case of a foreign eligible entity that acquires directly or indirectly substantially all the properties of a domestic corporation, or substantially all the properties constituting a trade or business of a domestic partnership, the rationale for the exception provided by section 7704(c) does not clearly apply.

The IRS and Treasury Department believe it is appropriate to exercise their regulatory authority under section 7874(g) to make adjustments to the application of the section to prevent avoidance of the purpose of the section through the use of certain non-corporate entities. In the absence of regulations making a relevant adjustment to the application of the section, a publicly traded foreign partnership that is not treated as a corporation under section 7704 arguably might not be treated as a surrogate foreign corporation under section 7874(a)(2)(B) on the grounds that the entity is considered a partnership rather than a corporation for Federal income tax purposes. The IRS and Treasury Department believe that it is contrary to the broad anti-abuse purposes of section 7874 for the provisions to be avoided in circumstances raising the same type of earnings stripping and other concerns simply by substituting a partnership for a corporation as the acquiring entity (often through the ease of a check the box election). To ensure that the purposes of section 7874 are not avoided in this manner, the regulations provide that a publicly traded foreign partnership that is not treated as a corporation under section 7704 will be treated as a foreign corporation for purposes of applying section 7874(a)(2)(B) to determine whether the acquiring foreign entity is a surrogate foreign corporation.

The IRS and Treasury Department are also concerned that taxpayers may attempt to avoid the purposes of section 7874 through the use of options and similar interests related to stock of the foreign acquirer. Congress foresaw the possibility of this type of avoidance and provided a specific grant of regulatory authority in this regard in section 7874(c)(6). The IRS and Treasury Department believe it is appropriate to exercise that authority at this time.

Under section 7874(b), a foreign corporation is treated for purposes of the Code as a domestic corporation if it would be a surrogate foreign corporation if the continuing ownership threshold of section 7874(a)(2)(B)(ii) were 80 percent rather than 60 percent. This “domestication” rule gives rise to certain issues relating to the application of other provisions of the Code. The IRS and Treasury Department believe that guidance on these issues is necessary to avoid uncertainty.

Commentators requested that specific guidance be provided regarding the application of section 7874 to acquisitions of stock, to clarify that such acquisitions are indirect acquisitions of the properties held by the corporation whose stock is acquired.

To this end, section 1.7874-2T(b) of the regulations provides that, for purposes of section 7874(a)(2)(B)(i), an acquisition by a foreign corporation of stock in a domestic corporation is considered to be an indirect acquisition of a proportionate amount of the properties held directly or indirectly by the domestic corporation. Further, the regulations provide that an acquisition by a foreign corporation of an interest in a partnership that holds stock in a domestic corporation is considered an indirect acquisition of a proportionate amount of the properties held directly or indirectly by the domestic corporation.

The regulations also provide that a foreign corporation’s acquisition of stock in a second foreign corporation is not considered an indirect acquisition by the first foreign corporation of any properties held by a domestic corporation or domestic partnership owned wholly or partly by the second foreign corporation. The IRS and Treasury Department believe that it was not Congress’s intent for section 7874 to apply to indirect acquisitions by foreign corporations of domestic entities that were already owned by a foreign corporation before the acquisition. See H.R. Conf. Rep. No. 108-755, 108^th Cong., 2d Sess., at 568 (Oct. 7, 2004).

Finally, the regulations provide that, in acquisitions in which a corporation (either domestic or foreign) which is under the control of a foreign corporation acquires the stock or assets of a domestic corporation in exchange for stock of the controlling foreign corporation, such foreign corporation will be considered to have made the acquisition of a proportionate amount of the domestic corporation’s stock or assets.

Section 1.7874-2T(c) of the regulations provides that, for purposes of section 7874(a)(2)(B)(ii), stock of the acquiring foreign entity that is received in exchange for stock of a domestic corporation, or in exchange for a capital or profits interest in a domestic partnership, is considered to be stock held by reason of holding stock in the domestic corporation or holding the interest in the domestic partnership, as the case may be. Moreover, the regulations provide that, where, in the same transaction or series of related transactions, other property is also contributed to the foreign entity in exchange for its stock, the amount of stock held by a former shareholder of the domestic corporation or former partner of the domestic partnership for section 7874 purposes is determined on the basis of the relative value of the property in exchange for which the foreign entity’s stock was issued. This rule is subject to the potential application of section 7874(c)(4), which requires that transfers be disregarded if they occur as part of a plan to avoid the purposes of section 7874.

The regulations also provide, for purposes of clarity, that the terms former shareholders and former partners mean any persons who held an ownership interest in the domestic entity before the acquisition, regardless of whether they continue to hold such an interest in the domestic entity after the acquisition.

The regulations provide both an all-facts-and-circumstances test and a bright-line safe harbor test of whether an EAG has substantial business activities in the acquiring foreign entity’s country of incorporation when compared to the total business activities of the EAG. The IRS and Treasury Department believe that this dual approach appropriately provides taxpayers with the certainty of an objective and clear safe harbor, while preserving the ability of a taxpayer to conclude, in a case that is not within the scope of the safe harbor, that section 7874 is not applicable to a foreign entity’s acquisition of the stock or assets of a domestic entity where, after the acquisition, the group has a meaningful and bona fide business presence in the relevant foreign country. This dual approach was also recommended by a commentator.

Section 1.7874-2T(d)(1) of the regulations provides, as a general rule, that the determination of whether the EAG has substantial business activities in the relevant foreign country, when compared to the total business activities of the EAG, will be based on an analysis of all the facts and circumstances of each case. The regulations set forth a non-exclusive list of factors to be considered in the analysis. The weight given to any factor will depend on the particular circumstances. The listed factors include, among other factors, the EAG’s local employee headcount and payroll, property, and sales; the EAG’s historical presence in the foreign country; its management activities in the country; and the strategic importance to the EAG as a whole of the business activities in that country.

The regulations state that the presence or absence of any factor, or any particular number of factors, in the list is not determinative, and that there is no minimum percentage of the group’s total employee headcount, payroll, assets, or sales that must be shown to be in the foreign country. Nevertheless, the determination of substantiality for this purpose must be made on the basis of a comparison to the total activities of the EAG, and the factors in the list must be evaluated accordingly.

Congress intended to prevent taxpayers from avoiding section 7874 through tax-motivated transfers of properties or liabilities, by providing in section 7874(c)(4) that such transfers shall be disregarded. Therefore, in analyzing the facts and circumstances to determine whether an EAG’s business activities in the relevant foreign country are substantial within the meaning of the statute, it is necessary to disregard any assets, liabilities or activities in the foreign country that were transferred pursuant to a plan a principal purpose of which was to avoid section 7874.

The regulations also provide that certain factors are not to be given weight in making the determination under the facts and circumstances test. These factors include any assets that are temporarily located in the foreign country for the purpose of avoiding the purposes of section 7874.

Although the list of factors to be disregarded does not include passive assets, the IRS and Treasury Department believe that the statutory phrase “business activities” ordinarily does not include passive investment activities and related income and assets. Investment assets may include intangible assets that have significant value but are not being exploited by any member of the EAG in the course of active business activities. In contrast, intangibles that are used in the course of active business operations by EAG members will normally be accorded due weight by the IRS in the application of the all-facts-and-circumstances test. In order to preserve a wide breadth for the all-facts-and-circumstances rule, investment assets and income have not been included in the list of factors to be given no weight, but it is expected that such passive assets and income normally would not be given any significant weight.

Section 1.7874-2T(d)(2) of the regulations sets forth an alternative, safe harbor test for determining whether, after the acquisition, an EAG has substantial business activities in the relevant foreign country, when compared to the total business activities of the EAG. The safe harbor test will only be satisfied by an EAG that has a substantial and bona fide business presence in the relevant foreign country. The IRS and Treasury Department intend, however, that even if the EAG does not satisfy the safe harbor test, it still may satisfy the facts and circumstances test of §1.7874-2T(d)(1). This safe harbor test is consistent with the approach suggested by a commentator.

The safe harbor test is satisfied if the EAG satisfies three conditions, relating to employees, assets, and sales. Under section 7874, the determination of whether an EAG’s business activities in the relevant foreign country are substantial when compared to the total business activities of the EAG is to be made “after the acquisition.” Given the practical difficulty of measuring the various business factors on dates other than the periodic dates during the year as of which an EAG’s management accounts are prepared, the regulations provide for the determination of group employees, assets, and sales during a twelve month testing period ending on the last day of the monthly or quarterly accounting period in which the completion of the acquisition occurs.Moreover, the determination of facts existing on that day for purposes of the safe harbor rule is subject to the application of section 7874(c)(4), under which any transfer is disregarded if made pursuant to a plan a principal purpose of which is to avoid the purposes of section 7874.

The first condition of the safe harbor rule is that, after the acquisition, the group employees based in the foreign country account for at least 10 percent (by headcount and compensation) of total group employees.

The term group employee is defined as a common law employee of one or more group members on a full time basis throughout the twelve-month testing period. An employee is considered to be based in a country only if the employee spent more time providing services in such country than in any other country throughout such twelve-month period.

The second condition is that, after the acquisition, the total value of the group assets located in the foreign country represents at least 10 percent of the total value of all group assets.

The term group assets is defined as tangible property used or held for use in the active conduct of a trade or business by a group member. An item of tangible personal property is considered to be located in a country only if such item was physically present in such country for more time than in any other country during the twelve-month testing period. Value is determined on a gross basis (that is, without reduction for liabilities) after the acquisition. Group assets acquired or transferred as part of a plan a principal purpose of which is to avoid the application of section 7874 are disregarded.

The IRS and Treasury Department specifically excluded intangible assets from the definition of group assets, even though intangibles may be used in the course of active business operations. The reason for excluding intangibles is that they frequently present difficult factual issues relating to their use, value, and location. Therefore, their inclusion in the definition of group assets for purposes of the safe harbor test would introduce a significant element of uncertainty in many cases as to the application of the safe harbor rule. Given that the purpose of the safe harbor rule is to provide a clear, bright-line test, it was decided that the definition of group assets should not include intangibles. This exclusion was also suggested by a commentator.

The third condition of the safe harbor rule is that, during the twelve-month testing period, the group sales made in the foreign country accounted for at least 10 percent of total group sales.

The term group sales is defined as sales by group members, measured by gross receipts from such sales. Group sales are considered to be made in a particular country only if the services, goods or other property transferred by those sales are sold for use, consumption or disposition in that country. The term “sales” includes sales of services and of the use of property as well as sales involving the transfer of title to personal property.

Consideration was given to the use of thresholds higher than the 10 percent figure used in the safe harbor rule. However, based on comments received, the IRS and Treasury Department believe that 10 percent is a reasonable threshold.

It has been brought to the attention of the IRS and Treasury Department that taxpayers are implementing structures (including partnership structures) that result in many of the same overall tax consequences as structures that Congress intended to be subject to section 7874, but are taking the position that these structures are not within the scope of section 7874. As a result, the IRS and Treasury Department have identified acquisitions by certain publicly traded foreign partnerships as a category of transactions requiring a special rule in order to prevent avoidance of the purposes of section 7874. Section 7874(g) provides broad regulatory authority to adjust the application of the section to prevent avoidance of the purposes of the section through the use of non-corporate entities. Commentators have also agreed that this authority exists. Accordingly, §1.7874-2T(e) provides that a publicly traded foreign partnership will be treated as a foreign corporation for purposes of applying section 7874(a)(2)(B) and §1.7874-2T to determine whether it is a surrogate foreign corporation.

The regulations define publicly traded foreign partnership for purposes of this rule as any foreign partnership that would, but for the application of section 7704(c), be treated as a corporation under section 7704 of the Code at any time during the two-year period following the partnership’s completion of an acquisition described in section 7874(a)(2)(B)(i). Under section 7704, a partnership is generally treated as a corporation if interests in the partnership are traded on an established securities market, or if interests in the partnership are readily tradable on a secondary market or the substantial equivalent. Section 7704(c) generally provides an exception for a publicly traded partnership where 90 percent or more of its gross income consists of qualifying income (which includes dividends from controlled subsidiaries).

If a publicly traded foreign partnership is within the scope of the regulations, the foreign partnership will be considered to be a foreign corporation, and if it meets the requirements of section 7874(c)(1), may be a member of the EAG, in determining whether it is a surrogate foreign corporation under section 7874(a)(2)(B). For purposes of applying the substantial business activities test of section 7874(a)(2)(B)(iii), the foreign partnership will be considered to be a corporation created or organized in, or under the laws of, the foreign country in which, or under the laws of which, the foreign partnership was created or organized. Moreover, interests in the foreign partnership will be treated as stock of such foreign corporation for purposes of applying the ownership percentage test of section 7874(a)(2)(B)(ii).

If the foreign partnership is considered a surrogate foreign corporation, and the ownership percentage under section 7874(a)(2)(B)(ii) is at least 80 percent, the foreign partnership will be treated under section 7874(b) as a domestic corporation for all purposes of the Code. A conversion rule is provided in the regulations to clarify the Federal income tax consequences of the deemed change from a foreign partnership to a domestic corporation.

In contrast, if the entity is considered a surrogate foreign corporation but the ownership percentage under section 7874(a)(2)(B)(ii) is at least 60 percent but less than 80 percent, the foreign entity will be a foreign partnership for all purposes of the Code, but section 7874(a)(1) will govern the Federal income tax treatment of the expatriated entity (that is, the domestic corporation or domestic partnership whose assets were acquired directly or indirectly by the foreign partnership, and any United States person who is related under sections 267(b) or 707(b)(1)).

Finally, if the publicly traded foreign partnership is not considered to be a surrogate foreign corporation, because the ownership percentage under section 7874(a)(2)(B)(ii) is less than 60 percent, because the EAG has substantial business activities in the country in which, or under the laws of which, the foreign partnership was created or organized, or otherwise, section 7874 will not apply to the foreign partnership, or to the domestic entity, the assets of which it directly or indirectly acquired, and the foreign partnership will continue to be classified as a foreign partnership for all purposes of the Code.

Section 1.7874-2T(e) applies equally to foreign entities that are considered partnerships under both foreign law and U.S. Federal income tax law, and foreign entities that are considered corporate entities under foreign law but are treated as partnerships for U.S. Federal income tax purposes under Treasury regulation §301.7701-3.

The regulations include a provision that explicitly removes from the scope of section 7874 a partnership’s deemed acquisition of assets and liabilities under §1.708-1(b)(4) upon a termination of the partnership due to change of ownership. In the absence of such a provision, section 7874 might apply to a deemed acquisition by a publicly traded foreign partnership of a domestic entity representing at least 60 percent of the value of the partnership’s assets, merely because of active trading of interests in the partnership. There is no indication in the legislative history that section 7874 was intended to apply in that situation.

Comments were received by the IRS and Treasury Department regarding the consequences under section 7874 where a foreign partnership satisfies the definition of a surrogate foreign corporation when treated as a foreign corporation for definitional purposes. It was argued that, in cases of 80 percent or greater ownership of the foreign partnership by former owners of the acquired domestic entity by reason of their former ownership, the foreign partnership should not be treated as a domestic corporation, despite the language of section 7874(b), but rather should be treated as a domestic partnership. The reasons given included: (1) because a partnership is a flow-through entity for tax purposes, the United States persons owning interests in the partnership would be taxable on the partnership’s income, including subpart F income attributable to earnings-stripping transactions between domestic subsidiaries of the partnership and foreign subsidiaries; and (2) the entity classification rules of §§301.7701-2 and 301.7701-3 are intended to allow taxpayers to choose whether a foreign eligible entity is a corporation or partnership for Federal income tax purposes, and section 7874(b) does not impinge on that freedom of choice, but only deems a foreign corporation to be a domestic corporation.

On balance, the IRS and Treasury Department do not find these arguments determinative. Section 7874 does not focus on the taxation of the owners of the acquired domestic entity and the acquiring foreign entity, nor does the statute focus on whether such owners are United States persons or foreign persons. The section imposes tax consequences only on either the acquiring foreign entity or the acquired domestic entity (or related domestic entities). Therefore, the fact that United States persons owning interests in the acquiring partnership would be subject to United States tax on the partnership’s income is not determinative of the appropriate treatment of a foreign partnership that is within the scope of section 7874(b) after application of the anti-avoidance rule of paragraph (e) of these regulations.

The argument relating to the entity classification rules has perhaps a stronger foundation. However, for the reasons mentioned above, the IRS and Treasury Department believe that the intention of Congress in enacting both section 7874 and section 7704 is carried out by a rule which treats a publicly traded foreign partnership as a domestic corporation in those circumstances in which the partnership otherwise would be within the scope of section 7874(b) if it were a corporation.

The IRS and Treasury Department recognize that the use of a foreign partnership that is not publicly traded, or the use of a domestic partnership, to acquire the properties of a domestic corporation might enable taxpayers to avoid the purposes of section 7874 in certain cases. Comments are solicited below on whether future regulations under section 7874 or another provision of the Code should address these situations.

Based on the regulatory authority provided in section 7874(c)(6), §1.7874-2T(f) of the regulations provides that options and similar interests held by a former shareholder or former partner of the expatriated entity by reason of holding stock or a partnership interest in the expatriated entity will be treated, for purposes of the ownership test of section 7874(a)(2)(B)(ii), as exercised, to the extent that the effect is to treat the foreign corporation as a surrogate foreign corporation. An interest that is similar to an option is defined for these purposes as including, without limitation, a warrant, a convertible debt instrument or other convertible instrument, a put, a stock interest subject to risk of forfeiture, and a contract to acquire or sell stock.

These rules are consistent with existing rules under section 382, which has identical statutory language, in section 382(k)(6)B), to that of section 7874(c)(6). The IRS and Treasury Department are continuing to study whether other types of interests should also be treated as stock of the acquirer under regulations issued under the authority of section 7874(c)(6).

Section 1.7874-2T(g) provides that a foreign corporation that is treated as a domestic corporation under section 7874(b) is treated, for purposes of the Code other than determining whether the foreign corporation is a surrogate foreign corporation, as converting to a domestic corporation pursuant to a reorganization described in section 368(a)(1)(F) immediately before the commencement of the acquisition. It follows that, in a case in which the foreign corporation was newly formed for the purpose of the transaction, the effect will be that it is treated as a domestic corporation from its inception. Further, §1.7874-2T(h) provides that, if section 7874(b) applies to a surrogate foreign corporation, section 367 does not apply to any transfer of stock or other property to such entity as part of the acquisition described in section 7874(a)(2)(B)(i).

The regulations apply to acquisitions completed on or after the date of their publication in the Federal Register. However, taxpayers may apply the regulations to acquisitions completed prior to such date, but must do so consistently with respect to all acquisitions within the scope of the regulations.

(a) Scope. This section provides rules under section 7874(a)(2)(B) for determining whether a foreign corporation shall be treated as a surrogate foreign corporation. Paragraph (b) of this section provides rules under section 7874(a)(2)(B)(i) regarding the indirect acquisition of properties held directly or indirectly by a domestic corporation or domestic partnership. Paragraph (c) of this section provides rules under section 7874(a)(2)(B)(ii) for identifying stock of the entity held by former shareholders or partners of the domestic entity by reason of holding stock or a partnership interest in the domestic entity. Paragraph (d) of this section provides rules under section 7874(a)(2)(B)(iii) for determining whether the expanded affiliated group (as defined in section 7874(c)(1)) that includes the entity EAG (Expanded Affiliated Group) has substantial business activities in the foreign country in which, or under the laws of which, the entity was created or organized, when compared to the total business activities of the EAG. Paragraph (e) of this section provides rules under which a publicly traded foreign partnership is treated as a foreign corporation for purposes of determining whether it is a surrogate foreign corporation under section 7874(a)(2)(B), and rules regarding the consequences under the Internal Revenue Code if a partnership is treated as a surrogate foreign corporation. Paragraph (f) of this section provides rules under which certain interests held by former shareholders or partners of the domestic entity are treated as stock of the foreign entity making the acquisition described in section 7874(a)(2)(B)(i). Paragraph (g) of this section provides rules relating to the change in status from a foreign corporation to a domestic corporation under section 7874(b). Paragraph (h) of this section provides that section 367 is not applicable to the transfer of assets or stock to a surrogate foreign corporation that is treated as a domestic corporation under section 7874(b).

(b) Indirect acquisition of properties—(1) Acquisition of stock of a domestic corporation. For purposes of section 7874(a)(2)(B)(i), an acquisition by a foreign corporation of stock of a domestic corporation is considered an indirect acquisition by such foreign corporation of a proportionate amount of the properties held directly or indirectly by such domestic corporation.

(2) Acquisition of stock of a foreign corporation. For purposes of section 7874(a)(2)(B)(i), an acquisition by a foreign corporation of stock of a second foreign corporation is not considered an indirect acquisition by the first foreign corporation of any properties held directly or indirectly by a domestic corporation or domestic partnership owned directly or indirectly, wholly or partly, by the second foreign corporation.

(3) Acquisition of an interest in a partnership. For purposes of section 7874(a)(2)(B)(i), an acquisition by a foreign corporation of a capital or profits interest in a foreign or domestic partnership that holds stock in a domestic corporation is considered an indirect acquisition by such foreign corporation of a proportionate amount of the properties held directly or indirectly by such domestic corporation.

(4) Acquisition of stock or assets of a domestic corporation by controlled subsidiary. For purposes of section 7874(a)(2)(B)(i) and paragraph (b)(1) of this section, if a corporation acquires stock or assets of a domestic corporation in exchange for stock of a foreign corporation which owns directly or indirectly, after the acquisition, more than 50 percent of the stock (by vote or value) of the acquiring corporation, such foreign corporation is considered as acquiring a proportionate amount of such stock or assets of the domestic corporation.

(5) Examples. The application of this paragraph is illustrated by the following examples. It is assumed that all transactions in the examples occur after March 4, 2003. The examples read as follows:

Example 1. Acquisition of stock of domestic corporation. A is a domestic corporation with 100 shares of a single class of common stock outstanding. F, a foreign corporation, acquires 25 shares of A stock from a shareholder of A. For purposes of section 7874(a)(2)(B)(i), F is considered to have made an indirect acquisition of 25% of the properties held directly or indirectly by A.

Example 2. Acquisition of stock of foreign corporation. The facts are the same as in Example 1 except as follows: All of A’s stock is held by B, a foreign corporation. C, a foreign corporation, acquires 25 shares of B stock from a shareholder of B. For purposes of section 7874(a)(2)(B)(i), C is not considered to have made an indirect acquisition of any portion of the properties held directly or indirectly by A.

Example 3. Acquisition of partnership interest. D is a partnership which owns all of the issued and outstanding stock of E, a domestic corporation. G, a foreign corporation, acquires a 40% interest in D from a partner in D. For purposes of section 7874(a)(2)(B)(i), G is considered to have made an indirect acquisition of 40% of the properties held directly or indirectly by E.

Example 4. Acquisition by controlled corporation. FS, a foreign corporation, is 90% owned by foreign corporation FP. Pursuant to a plan of reorganization, FS acquires all the stock of DT, a domestic corporation, in exchange for stock of FP which is exchanged with the shareholders of DT on a one-for-one basis. For purposes of section 7874(a)(2)(B)(i) and paragraph (b)(1) of this section, FP is considered to have acquired 90% of the stock of DT and thus to have made an indirect acquisition of 90% of the properties held directly or indirectly by DT. If FS had acquired substantially all the assets of DT, rather than the stock of DT, in exchange for stock of FP, FP would be considered to have acquired 90% of the assets of DT for purposes of section 7874(a)(2)(B)(i).

(c) Stock held by former shareholders or partners by reason of holding stock or a partnership interest in the domestic entity—(1) General rule. For purposes of section 7874(a)(2)(B)(ii), stock of the foreign corporation which is received by a former shareholder of the domestic corporation in exchange for stock of the domestic corporation is considered stock held by reason of holding stock in the domestic corporation. Similarly, for purposes of section 7874(a)(2)(B)(ii), stock of the foreign corporation which is received by a former partner of the domestic partnership in exchange for a capital or profits interest in the domestic partnership is considered stock held by reason of holding a capital or profits interest in the domestic partnership. Subject to section 7874(c)(4), in cases where the foreign corporation also issues stock to a former shareholder of the domestic corporation or partner of the domestic partnership in the same transaction or series of transactions in exchange for consideration other than stock in the domestic corporation or a capital or profits interest in the domestic partnership, the percentage of the foreign corporation’s stock considered to be held by former shareholders of the domestic corporation or former partners of the domestic partnership by reason of holding stock in the domestic corporation or a capital or profits interest in the domestic partnership shall be determined on the basis of the relative value of the property in exchange for which the foreign corporation’s stock was issued.

(2) Former shareholders and former partners. For purposes of this section, former shareholders of the domestic corporation are persons who held stock in the domestic corporation before the acquisition, including persons (if any) who held stock in the domestic corporation both before and after the acquisition. Former partners of the domestic partnership are persons who held a capital or profits interest in the domestic partnership before the acquisition, including persons (if any) who held a capital or profits interest in the domestic partnership both before and after the acquisition.

(3) Example. The following example illustrates the application of this paragraph:

Example. Contribution of stock of domestic and foreign corporations. A holds all of the issued and outstanding common stock of DC, FC1, FC2, and FC3. DC is a domestic corporation, and FC1, FC2, and FC3 are foreign corporations. Each of DC, FC1, FC2, and FC3 has only one class of stock outstanding. DC’s outstanding stock is worth $40x, FC1’s outstanding stock is worth $20x, FC2’s outstanding stock is worth $25x, and FC3’s outstanding stock is worth $15x. In a transaction subject to section 351, A contributes the stock of DC, FC1, FC2, and FC3 to FP, a foreign corporation, in exchange for all of the issued and outstanding common stock of FP. The transaction occurs after March 4, 2003. For purposes of section 7874(a)(2)(B)(ii), A is considered to hold 40% of the stock of FP by reason of holding stock in DC.

(d) Substantial business activities of the EAG—(1) General rule—(i) Facts and circumstances test. Subject to paragraph (d)(2) of this section, the determination of whether, after the acquisition, the EAG has substantial business activities in the foreign country in which, or under the law of which, the acquiring foreign entity is created or organized, when compared to the total business activities of the EAG, shall be made on the basis of all of the facts and circumstances. However, the factors described in paragraph (d)(1)(iii) of this section shall not be taken into account in making the determination. For the EAG to have substantial business activities in the foreign country when compared to the total business activities of the EAG, there is no minimum percentage of its total business activities (regardless of how measured) that must be in the foreign country. It is necessary, however, for the determination of substantiality to be made on the basis of a comparison to the total business activities of the EAG, and the factors set forth in paragraph (d)(1)(ii) of this section are to be evaluated accordingly. Thus, it is possible that the business activities of an EAG in a particular country would be substantial when compared to the total business activities of such EAG, but the identical business activities of another EAG in the same country would not be substantial when compared to the total business activities of that EAG because the total business activities of the second EAG were much more extensive than the total business activities of the first EAG.

(ii) Factors to be considered. Relevant factors indicating that the EAG has substantial business activities in the foreign country when compared to the total business activities of the EAG include, but are not limited to, the factors set forth below. The presence or absence of any factor, or of a particular number of factors, is not determinative. Moreover, the weight given to any factor (whether or not set forth below) depends on the particular case. Relevant factors include, but are not limited to —

(A) Historical presence. The conduct of continuous business activities in the foreign country by EAG members prior to the acquisition;

(B) Operational activities. Business activities of the EAG in the foreign country occurring in the ordinary course of the active conduct of one or more trades or businesses, involving—

(1) Property located in the foreign country which is owned by members of the EAG;

(2) The performance of services by individuals in the foreign country who are employed by members of the EAG; and

(3) Sales to customers in the foreign country by EAG members;

(C) Management activities. The performance in the foreign country of substantial managerial activities by EAG members’ officers and employees who are based in the foreign country;

(D) Ownership. A substantial degree of ownership of the EAG by investors resident in the foreign country.

(E) Strategic factors. The existence of business activities in the foreign country that are material to the achievement of the EAG’s overall business objectives.

(iii) Factors not to be considered. Any assets, activities, or income attributable to a transfer or transfers disregarded under section 7874(c)(4) are not relevant factors to be considered. In addition, any assets that are temporarily located in a foreign country at any time as part of a plan a principal purpose of which is to avoid the purposes of section 7874 are not relevant factors to be considered.

(2) Safe harbor—(i) Elements. The EAG will be considered to have substantial business activities, after the acquisition, in the foreign country in which, or under the law of which, the acquiring foreign entity was created or organized, when compared to the total business activities of the EAG, if paragraphs (d)(2)(ii), (iii), and (iv) of this section apply.

(ii) Employees. This paragraph (d)(2)(ii) applies if, after the acquisition, the group employees based in the foreign country account for at least 10 percent (by headcount and compensation) of total group employees.

(iii) Assets. This paragraph (d)(2)(iii) applies if, after the acquisition, the total value of the group assets located in the foreign country is at least 10 percent of the total value of all group assets.

(iv) Sales. This paragraph (d)(2)(iv) applies if, during the testing period, the group sales made in the foreign country accounted for at least 10 percent of total group sales.

(3) Definitions and application of rules. For purposes of paragraph (d) of this section—

(i) The term group employee means a common law employee of one or more members of the EAG who worked full time (meaning normally 35 or more hours per week) throughout the testing period. An independent contractor performing activities on behalf of an EAG member is not a group employee. A group employee is considered to be based in a country only if the group employee spent more time providing services in such country than in any other country throughout the testing period and continues to provide services in such country immediately after the acquisition. The compensation of a group employee is determined in United States dollars and, in the case of compensation denominated in a foreign currency, translated into United States dollars using the weighted average exchange rate for the taxable year, as defined in §1.989(b)-1.

(ii) The term group assets means tangible property used or held for use in the active conduct of a trade or business by a member of the EAG. An item of tangible personal property is considered to be located in a country only if such item was physically present in such country for more time than in any other country during the testing period. The total value of group assets is determined for purposes of this paragraph on the last day of the testing period, on a gross basis (that is, not reduced by liabilities), measured by either tax book value or fair market value, but not both, in United States dollars translated if necessary at the spot rate determined under the principles of §1.988-1(d)(1), (2) and (4). Group assets do not include property located in a country by reason of a transfer, or a change of geographic location, pursuant to a plan a principal purpose of which is to avoid the application of section 7874. In addition, intangible assets are not taken into account (in either the numerator or denominator) in calculating the amount of group assets.

(iii) The term group sales means sales and the provision of services by members of the EAG, measured by gross receipts from such sales and services, in United States dollars (determined, in the case of gross receipts denominated in a foreign currency, using the weighted average exchange rate for the taxable year, as defined in Treas. Reg. §1.989(b)-1). A group sale is considered to be made in a country only if the services, goods or other property transferred by such sale are sold for use, consumption or disposition in such country.

(iv) If one or more members of the EAG own capital or profits interests in a partnership, the proportionate amount of activities, employees, assets, income and sales of such partnership are considered to be activities, employees, assets, income and sales of the member or members of the EAG. A partner’s proportionate share shall be determined under the rules and principles of sections 701 through 706 and the regulations thereunder.

(v) The term testing period means the 12 month period ending on the last day of the EAG’s monthly or quarterly management accounting period in which the acquisition is completed and the term after the acquisition means, for purposes of paragraphs (d)(1)(i) and (d)(2)(ii) and (iii) of this section, the last day of the testing period.

(4) Examples. The application of paragraph (d)(1) of this section is illustrated by the following examples of business activities of an EAG in a foreign country after an acquisition described in section 7874(a)(2)(B)(i). In each example, the acquiring foreign entity is incorporated in Country A. Paragraph (d)(2) of this section does not apply to any of the examples. The examples are not intended to allow any inferences to be drawn as to whether the presence or absence, in a particular case, of one or more facts described in an example is determinative as to whether an EAG does, or does not, have substantial business activities in the relevant foreign country when compared to the total business activities of the EAG. The examples read as follows:

Example 1. Administrative activities and some customer services—(i) Facts. Group employees based in Country A regularly perform administrative, back office services for other EAG members, and regularly provide customer service globally via telephone and email at a communications center located in Country A. After the acquisition, fewer than 2% of group employees are based in Country A. Less than 3% of group sales were made in Country A in the 12-month period ending on the date of the acquisition. The total value of group assets located in Country A on the date of the acquisition is approximately 2% of total group assets. None of the EAG’s senior managers are based in Country A.

(ii) Conclusion. In light of all the facts and circumstances, after the acquisition, the EAG does not have substantial business activities in Country A when compared to the total business activities of the EAG.

Example 2. Manufacturing in foreign country—(i) Facts. EAG members own and have continuously operated a manufacturing facility and warehouses in Country A for several years prior to the acquisition. The goods produced in Country A represented approximately 2% of the total value of the EAG’s production of finished goods in the 12-month period ending on the date of the acquisition. Group employees based in Country A also regularly perform back office services for other EAG members. Fewer than 5% of group employees were based in Country A during the 12-month period ending after the acquisition. Less than 2% of group sales were made in Country A during the 12-month period ending after the acquisition. The total value of group assets located in Country A after the acquisition is approximately 4% of total group assets. None of the EAG’s senior managers are based in Country A.

(ii) Conclusion. In light of all the facts and circumstances, after the acquisition, the EAG does not have substantial business activities in Country A when compared to the total business activities of the EAG.

Example 3. Financial services group; real estate in foreign country—(i) Facts. The EAG’s main line of business is financial services. Group employees based in Country A regularly perform back office services for other EAG members. Fewer than 5% of group employees were based in Country A during the 12-month period ending on the date of the acquisition. Less than 3% of group sales were made in Country A during the same period. However, the total value of group assets located in Country A after the acquisition is more than 10% of the value of total group assets, due to the fact that EAG members purchased a substantial amount of commercial and residential real estate in Country A during the 24 months preceding the acquisition. The management of the real estate is performed by an unrelated independent agent. Most of the EAG’s senior managers are based outside Country A. The EAG’s real estate portfolio in Country A was not acquired pursuant to a strategic plan for one or more of the EAG’s worldwide lines of business, nor are the EAG’s business activities in Country A material to the achievement of the EAG’s overall business objectives.

(ii) Conclusion. In light of all the facts and circumstances, after the acquisition, the EAG does not have substantial business activities in Country A when compared to the total business activities of the EAG.

Example 4. Foreign group merging with larger U.S. group—(i) Facts. The Country A corporation that is the parent entity in the EAG acquired a domestic corporation and its subsidiaries pursuant to a merger agreement. Before the merger, the stock of both the Country A corporation and the domestic corporation was publicly traded in their respective countries of incorporation. The two groups were competitors in the same global line of business for many years preceding the merger. The merger was prompted by a third group’s attempt to obtain control of the domestic corporation and its subsidiaries without the consent of the management of the domestic corporation. After the merger, the Country A corporation is more than 60% owned by former shareholders of the domestic corporation, due to the fact that the domestic corporation was significantly more valuable than the Country A corporation. After the merger, the stock of the Country A corporation is publicly traded on stock exchanges in both Country A and the United States. Group employees based in Country A perform all of the functions involved in the EAG’s overall business activities, including headquarters and senior management functions. After the merger, approximately 11% of group employees are based in Country A, the total value of group assets located in Country A is approximately 10% of the value of total group assets, and the estimated percentage of group sales that will be made in Country A during the year following the merger is approximately 7%.

(ii) Conclusion. In light of all the facts and circumstances, after the acquisition, the EAG has substantial business activities in Country A when compared to the total business activities of the EAG.

Example 5. Relocation of business to foreign country—(i) Facts. The EAG’s business involves advanced technology. The controlling shareholders of the Country A corporation that is the parent entity in the EAG, and the senior managers of the EAG, are resident in Country A. The controlling shareholders originally established DC, a domestic corporation, which established its head office in City B in the United States, where a leading institute of technology is located. Part of DC’s business strategy was to hire research personnel who had been trained at the institute of technology and had settled in City B. DC hired 10 researchers who worked at DC’s premises in City B. DC also established FS, a wholly owned Country A subsidiary, which hired research personnel in Country A to perform research and product development functions at FS’s premises in Country A. Subsequently, the senior managers and controlling shareholders adopted a new business strategy involving the closure of the U.S. operations and the transfer of DC’s business and FS’s stock to FP, a new Country A corporation, with the result of centering the EAG’s business in Country A. Pursuant to the new strategy, DC terminated the employment of seven researchers and the lease on its City B premises, relocated the other three researchers from City B to Country A, and transferred its remaining assets, including the stock of FS, to FP in exchange for more than 80% of the stock of FP. After the acquisition, substantially all of the group employees were based in Country A, and substantially all of the group assets were located in Country A.

(ii) Conclusion. In light of all the facts and circumstances, after the acquisition, the EAG has substantial business activities in Country A when compared to the total business activities of the EAG.

(e) Acquisition by publicly traded foreign partnership—(1) Treatment as a foreign corporation. For purposes of applying section 7874(a)(2)(B) and this section, a publicly traded foreign partnership shall be treated as a foreign corporation created or organized in, or under the laws of, the foreign country in which, or under the laws of which, such partnership was created or organized, and interests in such partnership shall be treated as stock of such foreign corporation. In determining whether the publicly traded foreign partnership is a surrogate foreign corporation, the publicly traded foreign partnership will be treated as a member of the EAG, if the requirements of section 7874(c)(1) are met. If this paragraph is applicable and the provisions of section 7874(a)(2)(B) are satisfied such that the foreign entity making the acquisition is a surrogate foreign corporation to which section 7874(b) applies, the foreign entity shall be treated as a domestic corporation for purposes of the Internal Revenue Code. See paragraph (e)(3) of this section for the deemed treatment of the change in form from a foreign partnership to a domestic corporation. If this paragraph is applicable and the provisions of section 7874(a)(2)(B) are satisfied such that the foreign entity making the acquisition is a surrogate foreign corporation to which section 7874(b) does not apply, the foreign entity shall continue to be a foreign partnership for purposes of the Internal Revenue Code, but the tax treatment of the expatriated entity shall be governed by section 7874(a)(1). If this paragraph is applicable, but the provisions of section 7874(a)(2)(B) are not satisfied such that the foreign partnership making the acquisition is not a surrogate foreign corporation, the status of the publicly traded foreign partnership will not be affected by section 7874 or §1.7874-2T.

(2) Publicly traded foreign partnership. For purposes of this section, the term publicly traded foreign partnership means any foreign partnership that would, but for the application of section 7704(c), be treated as a corporation under section 7704 at any time during the two-year period following the partnership’s completion of an acquisition described in section 7874(a)(2)(B)(i).

(3) Deemed treatment of change from foreign partnership to domestic corporation. Except for purposes of determining whether it is a surrogate foreign corporation under section 7874(a)(2)(B) and §1.7874-2T, a foreign partnership that is treated as a domestic corporation pursuant to the application of paragraph (e)(1) of this section and the application of section 7874(b) and §1.7874-2T shall, immediately before commencement of the acquisition, be treated as transferring all of its assets and liabilities to a newly formed domestic corporation in exchange for the stock of the domestic corporation, and distributing such stock to its partners in liquidation of their interests in the partnership. The tax treatment of the transaction shall be determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine.

(4) Disregard of deemed acquisition. For purposes of paragraph (e)(1) of this section, a publicly traded foreign partnership’s deemed acquisition of assets and liabilities under §1.708-1(b)(4) is not a direct or indirect acquisition of properties to which section 7874(a)(2)(B)(i) could apply.

(5) Examples. The application of this paragraph is illustrated by the following examples. It is assumed that all transactions in the examples occur after March 4, 2003, and that any foreign partnership referred to in an example is not treated as a corporation under section 7704. The examples read as follows:

Example 1. Foreign hybrid entity; public trading of ownership interests on stock market following triangular merger—(i) Facts. The stock of DP, a domestic corporation, is publicly traded on stock exchange SE. Pursuant to a plan, DP and an unrelated person form a foreign subsidiary entity, FQ, under the laws of foreign country X, transferring a minimal amount of cash to FQ in the process. DP owns 99.9% of FQ and the unrelated party owns 0.1% of FQ. FQ is a limited liability company and is a foreign eligible entity under §301.7701-2. FQ makes an election under §301.7701-3 to be treated as a partnership for Federal income tax purposes as of the date of its formation. FQ forms a wholly owned domestic corporation, DS, under the laws of State A. Under a merger agreement and State A law, DS merges into DP, with DP surviving the merger as a wholly owned subsidiary of FQ and the former shareholders of DP receiving ownership interests in FQ in exchange for their DP stock. On the day of the merger, the stock of DP ceases to be listed on stock exchange SE. Trading of ownership interests of FQ on stock exchange SE commences on the day after the day of the merger. FQ, however, is not treated as a corporation under section 7704, due to the application of section 7704(c). After the acquisition, the corporate group owned by FQ does not have substantial business activities in foreign country X when compared to its total business activities.

(ii) Analysis. FQ is a publicly traded foreign partnership under paragraph (e)(1) of this section. For purposes of determining whether FQ is a surrogate foreign corporation under section 7874(a)(2)(B), FQ is considered to be a foreign corporation rather than a foreign partnership, and ownership interests in FQ are considered to be stock of FQ. Therefore, on the basis of these facts, FQ is a surrogate foreign corporation because all of the conditions stated in section 7874(a)(2)(B) are satisfied. Because the former shareholders of DP hold more than 80% of FQ’s ownership interests, FQ is treated under section 7874(b) as a domestic corporation for purposes of the Internal Revenue Code. In addition, the former shareholders of DP are treated as having received stock of domestic corporation FQ in exchange for their stock of DP.

Example 2. Substantial business activities of the EAG in the foreign country of incorporation—(i) Facts. The facts are the same as in Example 1 except that, after the acquisition, the EAG that includes FQ has substantial business activities in foreign country X when compared to the total business activities of the EAG under the criteria set forth in paragraph (d) of this section.

(ii) Analysis. For purposes of determining whether FQ is a surrogate foreign corporation under section 7874(a)(2)(B), FQ is considered to be a foreign corporation rather than a foreign partnership, and ownership interests in FQ are considered to be stock of FQ. On the basis of these facts, FQ is not a surrogate foreign corporation, because, after the acquisition, the EAG that includes FQ has substantial business activities in foreign country X when compared to the total business activities of the EAG. Therefore, section 7874 does not apply to the acquisition, and the status of FQ as a foreign partnership is unaffected.

Example 3. Acquisition by publicly traded foreign partnership owned by former shareholders and unrelated persons—(i) Facts. The facts are the same as in Example 1 except that, at the time of the merger transaction, unrelated persons who did not own any stock of DP transfer stock of a foreign corporation to FQ in exchange for 25% of the ownership interests in FQ. Former shareholders of DP receive 75% of the ownership interests in FQ.

(ii) Analysis. For purposes of determining whether FQ is a surrogate foreign corporation under section 7874(a)(2)(B), FQ is considered to be a foreign corporation rather than a foreign partnership, and ownership interests in FQ are considered to be stock of FQ. Therefore, on the basis of these facts, and taking into account the provisions of section 7874(c)(4), FQ is a surrogate foreign corporation, because all of the conditions stated in section 7874(a)(2)(B) are satisfied. Because the former shareholders of DP hold less than 80% of FQ’s ownership interests, FQ is not treated under section 7874(b) as a domestic corporation for purposes of the Internal Revenue Code. Rather, FQ is a foreign partnership for purposes of the Internal Revenue Code, and section 7874(a)(1) applies in determining the Federal income tax liability of DP and any other expatriated entity (as defined in section 7874(a)(2)).

(f) Options and similar interests treated as stock of the foreign acquiring corporation—(1) General rule. For purposes of section 7874(a)(2)(B)(ii), options and interests that are similar to options held by a person by reason of holding stock in the domestic corporation or a capital or profits interest in the domestic partnership described in section 7874(a)(2)(B)(i) shall be treated as exercised. The prior sentence shall apply, however, only to the extent that the effect of such exercise is to treat the foreign entity that has made the acquisition described in section 7874(a)(2)(B)(i) as a surrogate foreign corporation under section 7874(a)(2)(B).

(2) Interests that are similar to options. For purposes of paragraph (f)(1) of this section, an interest that is similar to an option includes, but is not limited to, a warrant, a convertible debt instrument, an instrument other than debt that is convertible into stock, a put, a stock interest subject to risk of forfeiture, and a contract to acquire or sell stock.

(3) Example. The application of this paragraph is illustrated by the following example. It is assumed that the transaction in the example occurs after March 4, 2003. The example reads as follows:

Example. Convertible bonds treated as stock of foreign corporation—(i) Facts. DT, a domestic corporation with 80 shares of stock issued and outstanding, is owned by a group of individuals. FA, a foreign corporation unrelated to DT, has 20 shares of stock issued and outstanding. Pursuant to a plan, the shareholders of DT transfer all of their shares of DT to FA in exchange for 25 newly issued shares of FA stock (with a value of $25x) and $55x of FA bonds that are convertible at the election of the holder into 55 shares of FA stock, for no additional consideration, at any time during the ensuing 5-year period. After the acquisition, the EAG that includes FA does not have substantial business activities in FA’s country of incorporation when compared to the total business activities of the EAG.

(ii) Analysis. FA has indirectly acquired substantially all the properties held directly or indirectly by DT pursuant to a plan. Before the application of this paragraph (f), the former shareholders of DT own 25 shares of FA stock by reason of holding stock in DT. Accordingly, the section 7874(a)(2)(B)(ii) fraction would be 25/45, the resulting percentage would be 55%, and FA would not be a surrogate foreign corporation. Pursuant to paragraph (f)(2) of this section, the FA convertible bonds issued to the former shareholders of DT are treated as interests that are similar to options. As a result, and pursuant to paragraph (f)(1) of this section, the convertible bonds are treated as being converted into 55 shares of FA stock for purposes of section 7874(a)(2)(B)(ii). Therefore, the section 7874(a)(2)(B)(ii) fraction is 80/100, the resulting percentage is 80% and FA is a surrogate foreign corporation. In addition, pursuant to section 7874(b), FA is treated as a domestic corporation.

(g) Change from foreign to domestic status—(1) Conversion—(i) General rule. Except for purposes of determining whether it is a surrogate foreign corporation under section 7874(a)(2)(B) and §1.7874-2T, the conversion of a foreign corporation to a domestic corporation under section 7874(b) shall, immediately before commencement of the acquisition described in section 7874(a)(2)(B)(i), be treated as a reorganization described in section 368(a)(1)(F). For the consequences of the conversion, see §1.367(b)-2(f). See also §1.367(b)-3. The tax treatment of all aspects of the transaction other than such conversion shall be determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

(ii) Example. The following example illustrates the application of paragraph (g)(1)(i) of this section. It is assumed that the transaction in the example occurs after March 4, 2003. The example reads as follows:

Example. Conversion treated as reorganization under section 368(a)(1)(F)—(i) Facts. DT, a domestic corporation is owned by a group of individuals. FA, a foreign corporation unrelated to DT which has been conducting a trade or business for several years, has 20 shares of stock issued and outstanding. Pursuant to a plan, the shareholders of DT transfer all of their shares of DT to FA in exchange for 80 newly issued shares of FA stock. After the acquisition, the EAG that includes FA does not have substantial business activities in FA’s country of incorporation when compared to the total business activities of the EAG.

(ii) Analysis. FA has indirectly acquired substantially all the properties held directly or indirectly by DT pursuant to a plan. After the acquisition, the former shareholders of DT own 80 shares of FA stock by reason of holding stock in DT. Accordingly, the section 7874(a)(2)(B)(ii) fraction is 80/100, the resulting percentage is 80%, and FA is a surrogate foreign corporation. In addition, pursuant to section 7874(b), FA is treated as a domestic corporation. Other than for purposes of determining whether FA is a surrogate foreign corporation, the conversion of FA from a foreign corporation to a domestic corporation shall, immediately before FA’s acquisition of the DT stock, be treated as a reorganization under section 368(a)(1)(F). See §§1.367(b)-2(f) and 1.367(b)-3. The tax treatment of all other aspects of the transaction, including the acquisition of the DT stock by FA, is determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

(2) Entity classification. An entity that is treated as a domestic corporation under section 7874(b) is not an eligible entity as defined in §301.7701-3(a) of this chapter and therefore may not elect noncorporate status.

(3) Time of determination. Subject to the application of the step transaction doctrine and section 7874(c)(4), the determination of whether a foreign entity is a surrogate foreign corporation is made immediately after completion of the acquisition described in section 7874(a)(2)(B)(i), except as provided in paragraphs (d)(3)(v) and (e)(2) of this section. A foreign entity that is treated as a domestic corporation under section 7874(b) shall continue to be treated as a domestic corporation without regard to whether the provisions of section 7874(a)(2)(B)(ii) and (iii) are satisfied at a later time.

(h) Nonapplication of section 367—(1) General rule. If section 7874(b) applies to a surrogate foreign corporation, section 367 shall not apply to the transfer of stock or other property to such entity as part of the acquisition described in section 7874(a)(2)(B)(i).

(2) Example. The following example illustrates the application of paragraphs (g) and (h)(1) of this section. It is assumed that the transaction in the example occurs after March 4, 2003. The example reads as follows:

Example. Conversion of foreign corporation to domestic corporation—(i) Facts. FP, a newly formed foreign corporation, acquires pursuant to a plan substantially all of the stock of DX, a domestic corporation, by issuing its stock to the owners of DX in exchange for their DX stock. The former owners of DX, all of whom are U.S. persons, hold more than 80% of the stock of FP by reason of their ownership of DX stock. The EAG that includes FP does not have substantial business activities in FP’s country of incorporation after the acquisition when compared to the total business activities of the EAG.

(ii) Analysis. FP is a surrogate foreign corporation under section 7874(a)(2)(B). Under section 7874(b), FP is treated as a domestic corporation for purposes of the Internal Revenue Code. In addition, the former owners of DX are not subject to section 367 with respect to the transfer of their DX stock to FP.

(i) [Reserved.]

(j) Effective date.This section shall apply to acquisitions completed on or after June 6, 2006. However, taxpayers may apply this section to acquisitions completed prior to that date, but must apply it consistently to all acquisitions within its scope.

Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.

Approved May 22, 2006.

Eric Solomon,
Acting Deputy Assistant
Secretary of the Treasury.

The Treasury Department and the IRS believe that it is important that the section 1248 regulations make explicit that only the appropriate amount of earnings and profits are attributed to stock of a foreign corporation for purposes of section 1248 following relevant nonrecognition transactions. The proposed regulations provided in §1.1248-8 supplement and clarify the existing rules under §§1.1248-2 and 1.1248-3. The results obtained under the proposed regulations are consistent with the results provided under section 1248 and the existing regulations under sections 367(b) and 1248. However, some taxpayers have raised concerns that those existing regulations may attribute an excessive amount of earnings and profits to stock after certain nonrecognition transactions. The Treasury Department and the IRS believe that this view is not a correct interpretation of the existing regulations. Nevertheless, in order to remove this uncertainty, the proposed regulations clarify how the principles of section 1248 should be applied so that a section 1248 shareholder or a foreign corporation to which section 964(e) applies includes the appropriate amount in income as a dividend upon the sale or exchange of stock of a current or former controlled foreign corporation.

The proposed regulations provide rules for accurately attributing earnings and profits to stock of a foreign corporation that is received by an exchanging shareholder, or received by an acquiring corporation, pursuant to one or more restructuring transactions in which the holding period of such stock is determined by application of section 1223(1) or 1223(2), and in which the exchanging shareholder is not required, as a result of the exchange, to include in income the section 1248 amount pursuant to §1.367(b)-4(b). The proposed regulations also provide rules for attributing earnings and profits to stock of a foreign corporation that participates in a restructuring transaction that is held by a non-exchanging shareholder in such a restructuring transaction.

For purposes of the proposed regulations, a restructuring transaction is a transaction that qualifies as a nonrecognition transaction (within the meaning of section 7701(a)(45)) under section 351, 354, 356, or 361. The proposed regulations provide special rules for liquidations described in section 332 and consequently, these transactions are not included in the definition of a restructuring transaction. An exchanging shareholder is defined in the proposed regulations as a person that, in a restructuring transaction qualifying for nonrecognition under section 354, 356, or 361(a), exchanges stock of an acquired corporation for stock in either a foreign acquiring corporation or a foreign corporation that is in control of the acquiring corporation. In a restructuring transaction qualifying for nonrecognition under section 351, the proposed regulations define an exchanging shareholder as a person that exchanges property (including stock) for stock in a foreign acquiring corporation. An acquiring corporation is defined in the proposed regulations as a corporation that, in a restructuring transaction, acquires the stock or assets of an acquired corporation. For purposes of the proposed regulations, a foreign corporate shareholder is a foreign corporation that owns stock of another foreign corporation, and has a section 1248 shareholder that is also a section 1248 shareholder of the other foreign corporation. A non-exchanging shareholder is defined in the proposed regulations as a person that, at the time of the restructuring transaction, is either a section 1248 shareholder or a foreign corporate shareholder of the acquiring corporation and that is not an exchanging shareholder with respect to that corporation.

The proposed regulations also set forth rules for the attribution of earnings and profits for purposes of section 1248 with respect to stock of a foreign corporation that receives assets and liabilities of a foreign corporation in a complete liquidation described in section 332 if the foreign distributee is a foreign corporate shareholder of the liquidating corporation. In addition, the proposed regulations provide that with respect to the sale by a foreign partnership of the stock of certain foreign corporations, the partners in such foreign partnership shall be treated as selling or exchanging their proportionate share of the stock of such corporations for purposes of section 1248.Finally, the proposed regulations provide additional rules to ensure the proper attribution of earnings and profits to stock of controlled foreign corporations or foreign corporate shareholders as a result of certain nonrecognition transactions.

Some taxpayers have expressed concern that an excessive amount of earnings and profits could be attributed to stock that an exchanging shareholder receives in a restructuring transaction under the existing section 1248 regulations through the application of the holding period rules of section 1223(1). For example, in a transaction described in section 351, a domestic corporation (DC1) contributes property to a foreign acquiring corporation (FA) in exchange for 80 percent of the voting stock in FA. Prior to the transaction, FA was wholly owned by another domestic corporation (DC2). Assume in the transaction that DC1 does not recognize gain under section 367(a) and the regulations under that section or include income under section 367(b) and the regulations under that section. The basis of the stock in FA received by DC1 in the transaction will be determined pursuant to section 358, and in determining DC1’s holding period in the FA stock, DC1 will include, under section 1223(1), the period DC1 held the property it contributed to FA. Some taxpayers incorrectly interpret the existing section 1248 regulations to require that, if DC1 subsequently sells or exchanges the FA stock received in the restructuring transaction, the earnings and profits accumulated by FA before the transaction (i.e., before DC1’s period of actual ownership of the FA stock), but within the section 1223(1) holding period, are attributed to the FA stock received and sold by DC1. This interpretation would result in the inappropriate attribution of such accumulated earnings and profits to the FA stock held by both DC2 and DC1 (if DC2 sells or exchanges its FA stock, the accumulated earnings and profits of FA that were attributed to the FA stock sold by DC1 would correctly be attributed under the existing section 1248 regulations to the FA stock held by DC2).

This interpretation of the existing section 1248 regulations is not correct and any such double attribution is not intended. However, to provide greater certainty, the proposed regulations clarify that excessive attribution of earnings and profits does not occur as a result of restructuring transactions. The proposed regulations provide that where an exchanging shareholder receives, in a restructuring transaction, stock in a foreign corporation, the holding period of which is determined under section 1223(1), and the exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder with respect to that foreign corporation immediately after the restructuring transaction, the earnings and profits attributable to the stock the exchanging shareholder receives shall be determined on the basis of the type of property exchanged.

If the property exchanged is not stock of a foreign acquired corporation with respect to which the exchanging shareholder is a section 1248 shareholder or a foreign corporate shareholder immediately before the transaction, the earnings and profits attributable to the foreign corporation stock received by the exchanging shareholder shall be determined in accordance with §1.1248-2 or §1.1248-3 (whichever is applicable) without regard to any portion of the section 1223(1) holding period in that stock that reflects periods prior to the restructuring transaction.

If, on the other hand, the property exchanged is stock in a foreign acquired corporation with respect to which the exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder with respect to the foreign corporation immediately before the transaction, the proposed regulations provide that the earnings and profits attributable to the stock received by the exchanging shareholder shall equal the sum of the earnings and profits attributable to: (1) the stock of the foreign acquired corporation accumulated prior to the restructuring transaction; and (2) the stock of the foreign corporation that the exchanging shareholder receives in the restructuring transaction without regard to any portion of the section 1223(1) holding period in that stock that is prior to the restructuring transaction. The earnings and profits attributable to any portion of the section 1223(1) holding period in the foreign acquiring stock that is prior to the restructuring transaction remain attributable through the operation of the existing section 1248 regulations to the foreign acquiring stock held by non-exchanging shareholders. See proposed §1.1248-8(b)(4) and (7), Example 2.

The proposed regulations provide an exception to this general rule, however, in certain triangular reorganizations involving a foreign issuing corporation that controls a domestic acquiring corporation. This exception applies, for example, where a United States person (DC) exchanges its stock in a foreign acquired corporation (FS) for stock of a foreign issuing corporation (FI) that controls the domestic acquiring corporation (DA) in a restructuring transaction (i.e., a triangular reorganization described in section 368(a)(1)(B)). To prevent the attribution of FS’s pre-acquisition earnings and profits to stock owned by both DC and DA, the proposed regulations provide that the earnings and profits attributable to the FI stock received by DC shall consist solely of the earnings and profits attributable to the FI stock received (determined under §1.1248-2 or §1.1248-3, whichever is applicable, and proposed §1.1248-8, if applicable) without regard to any portion of DC’s section 1223(1) holding period in the FI stock received that includes periods of time prior to the restructuring transaction. See proposed §1.1248-8(b)(7), Example 5. As discussed in paragraph (B)(2) of this preamble, the earnings and profits attributable to the FS stock for periods before the triangular reorganization generally are attributed to the FS stock owned by DA after the transaction.

In addition to potential excessive attribution resulting from section 1223(1) holding periods discussed above, some taxpayers are concerned that an excessive amount of earnings and profits could be attributed to stock under the existing section 1248 regulations through the application of the section 1223(2) holding period rules to an acquiring corporation in a restructuring transaction. For example, in a transaction described in section 351, a foreign corporation (FP) that owns 100 percent of the stock of another foreign corporation (FS) and 100 percent of the stock of a domestic corporation (DC), transfers its FS stock to DC. Prior to the transaction, FP was not a section 1248 shareholder or a foreign corporate shareholder with respect to FS. DC’s basis in the FS stock received by DC in the restructuring transaction will be determined pursuant to section 362, and in determining DC’s holding period in the FS stock, DC will include, under section 1223(2), the period FP held the FS stock. Some taxpayers incorrectly interpret the existing section 1248 regulations to require that if DC subsequently sells or exchanges the FS stock received in the restructuring transaction, the earnings and profits accumulated by FS before the transaction (i.e., before DC’s period of actual ownership of the FS stock), but within the 1223(2) holding period, are attributed to the FS stock received and sold by DC. This interpretation would result in the attribution of earnings and profits to the FS stock held by DC even though such earnings and profits were accumulated by FS when it was not a controlled foreign corporation.

Such interpretation of the existing section 1248 regulations is not correct. However, to provide greater certainty, the proposed regulations clarify that excessive attribution of earnings and profits does not occur as a result of such transactions. The proposed regulations provide that where, in a restructuring transaction, an acquiring corporation receives stock in a foreign acquired corporation, the holding period of which is determined under section 1223(2), and the acquiring corporation is either a section 1248 shareholder or a foreign corporate shareholder with respect to that foreign acquired corporation immediately after the restructuring transaction, the earnings and profits attributable to the foreign acquired corporation stock that the acquiring corporation receives shall be determined depending on whether the exchanging shareholder was a section 1248 shareholder or a foreign corporate shareholder with respect to the acquired corporation. If the exchanging shareholder is neither a section 1248 shareholder nor a foreign corporate shareholder with respect to the foreign acquired corporation immediately before the restructuring transaction, the proposed regulations provide that the earnings and profits attributable to the stock of the foreign acquired corporation shall be determined in accordance with §1.1248-2 or §1.1248-3 (whichever is applicable) without regard to any portion of the section 1223(2) holding period in that stock that is prior to the restructuring transaction.

However, in a restructuring transaction where the acquiring corporation receives stock of a foreign acquired corporation with respect to which an exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder immediately before the transaction, the proposed regulations modify the approach discussed above in order to ensure the proper amount of earnings and profits is attributable to stock that the acquiring corporation receives. For example, assume a domestic corporation (DC1) has owned all the stock of a foreign corporation (FS) since its formation. In a transaction described in section 368(a)(1)(B), DC1 transfers all its FS stock to another domestic corporation (DC2), in exchange for DC2 voting stock. The section 1248 amount attributable to the FS stock is $100 but section 367(b) does not require DC1 to include it in income as a deemed dividend. See §1.367(b)-4(a) (income inclusion rules only apply when there is a foreign acquiring corporation). If DC2 subsequently recognizes gain upon the sale or exchange of its stock in FS and if the earnings and profits attributable to that stock do not include the earnings and profits that accumulated before DC2’s actual period of ownership, then those earnings and profits would escape inclusion in income as a dividend under section 1248.

To ensure the proper attribution of earnings and profits in these situations, the proposed regulations provide that where the stock exchanged in the restructuring transaction is stock of a foreign corporation, with respect to which the exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder immediately before the restructuring transaction, the earnings and profits attributable to the stock of the acquired corporation will be determined with regard to the portion of the section 1223(2) holding period in that stock that the exchanging shareholder took into account for purposes of attributing earnings and profits to that stock. See proposed §1.1248-8(b)(7), Example 3 and Example 5.

The proposed regulations generally provide that the earnings and profits attributable to stock of an acquiring corporation held by a non-exchanging shareholder immediately prior to a restructuring transaction continue to be attributed to such stock, and the earnings and profits of the acquired corporation accumulated prior to the restructuring transaction attributable to the stock of an acquired corporation are not attributed to the non-exchanging shareholder’s stock in the acquiring corporation. See proposed §1.1248-8(b)(7), Example 2 and Example 4.

However, a special rule applies to a nonexchanging shareholder that owns stock in a foreign corporation that is both an acquiring corporation and an exchanging shareholder in the same restructuring transaction (i.e., an upstream merger). This rule is necessary because the acquiring corporation does not receive stock in exchange for its stock in the acquired corporation and, as a result, the general attribution rules in the proposed regulations would not preserve the earnings and profits attributable to such acquired corporation stock. For example, assume a domestic corporation (DC) owns all the stock of a controlled foreign corporation (CFC1), CFC1’s only asset is 79 percent of the stock of another controlled foreign corporation (CFC2), and the other 21 percent of the CFC2 stock is owned by an unrelated party (X). Pursuant to a restructuring transaction described in section 368(a)(1)(C), CFC2 transfers all its assets to CFC1. In exchange, CFC1 assumes the liabilities of CFC2 and transfers to CFC2 voting stock representing 21 percent of the stock of CFC1. CFC2 distributes the voting stock to X and liquidates. In such a transaction, the earnings and profits attributable to the CFC1 stock held by DC (i.e., the nonexchanging shareholder) shall be the sum of the earnings and profits attributable to the stock of CFC1 (i.e., the foreign acquiring corporation) immediately before the restructuring transaction (including amounts attributed under section 1248(c)(2)) and the earnings and profits attributable to the stock of CFC1 accumulated after the restructuring transaction (including amounts attributed under section 1248(c)(2)). See proposed §1.1248-8(b)(7), Example 8. Cf. proposed §1.1248-8(c) (providing similar rules for liquidations described in section 332).

The proposed regulations require that, to the extent consistent with the principles of section 1248, adjustments to earnings and profits attributable to stock shall be made so that section 1223(1) and (2) and the proposed regulations are applied in a manner that results in earnings and profits being taken into account only once. Accordingly, the proposed regulations provide that upon the sale by a controlled foreign corporation of stock of another foreign corporation to which earnings and profits had been attributed under the rules of the proposed regulations, proportionate reductions shall be made to the earnings and profits attributed to the stock of the selling foreign corporate shareholder owned by a section 1248 shareholder. See proposed §1.1248-8(b)(7), Example 7. For example, assume a section 1248 shareholder owns 80 percent of a controlled foreign corporation (CFC1) and an unrelated foreign person owns the remaining 20 percent of CFC1. The section 1248 shareholder receives the CFC1 stock in exchange for the stock of its wholly owned foreign subsidiary (CFC2) in a restructuring transaction described in section 368(a)(1)(B). Immediately before the transaction, $100 of earnings and profits is attributable to the CFC2 stock owned by the section 1248 shareholder. As previously discussed, the proposed regulations provide for the attribution of the $100 of CFC2’s pre-acquisition earnings and profits to the CFC1 stock received by the section 1248 shareholder in the transaction and to the CFC2 stock received by CFC1 in the transaction. Assume that CFC2 accumulates another $100 of earnings and profits after the transaction, and in a subsequent year, CFC1 sells 30 percent of its stock in CFC2. If the requirements of section 964(e) are met, CFC1 will include in its gross income as a dividend $30 of CFC2’s pre-acquisition earnings and profits and $30 of CFC2’s post-acquisition earnings and profits. In order to prevent the attribution of a portion of these earnings and profits to the section 1248 shareholder’s stock in CFC1, the proposed regulations provide that the earnings and profits attributable to the section 1248 shareholder’s stock in CFC1 will be reduced by $54, $24 (80 percent of $30) of the earnings and profits accumulated by CFC2 after the restructuring transaction and $30 of the earnings and profits accumulated by CFC2 prior to the restructuring transaction.

The proposed regulations also provide a special rule in order to avoid possible double counting of earnings and profits as a result of the operation of section 381(a) in a restructuring transaction and the proposed rules. Under section 381, an acquiring corporation succeeds to and takes into account the earnings and profits of the transferor or distributor corporation as of the close of the day of the transfer or distribution. Because the earnings and profits carry over from one corporation to another corporation at the close of the day, the same earnings and profits accumulated by the transferor or distributor corporation before the transaction could also be considered to have been accumulated by the transferee or distributee corporation after the transfer or distribution. For example, assume a domestic corporation (DC1) owns 100 percent of controlled foreign corporation (CFC1) that generates $100 of earnings and profits. CFC1 merges into another controlled foreign corporation (CFC2) in a reorganization described in section 368(a)(1)(A), and DC1 receives 25 percent of the CFC2 stock in exchange for its CFC1 stock in the merger. If, for purposes of section 1248, the $100 of earnings and profits of CFC1 is attributable to the CFC2 stock received by DC1, and is also taken into account by CFC2 pursuant to section 381, the same $100 of earnings and profits would be taken into account twice.

Except with respect to upstream mergers, the proposed regulations attribute the pre-acquisition earnings and profits of the transferor, where appropriate, to the stock received by the exchanging shareholder. Therefore, in order to prevent the double counting of earnings and profits, the proposed regulations provide that earnings and profits of another corporation to which the foreign corporation succeeded through the operation of section 381 will not be attributed to its stock. See proposed §1.1248-8(b)(6) and (7), Example 4, and (c)(2) and (3).

Under the existing section 1248 regulations, issues have arisen as to whether the so-called hovering deficit rule under section 381(c)(2)(B) applies for purposes of attributing earnings and profits to stock of the foreign distributee corporation following certain liquidations of foreign corporations under section 332. The hovering deficit rule generally restricts access to certain deficits in earnings and profits following section 381 transactions. The Treasury Department and the IRS believe that the hovering deficit rule should not apply in these types of section 332 liquidations because section 1248(c)(2) generally provides for the attribution of a foreign subsidiary’s earnings and profits (including any deficits) to the stock of its foreign parent. Thus, the foreign parent already had, in effect, access to the deficit of the foreign subsidiary pursuant to section 1248(c)(2) prior to the section 332 liquidation. In that case, application of the hovering deficit rule is not appropriate for section 1248 purposes.

Accordingly, the proposed regulations provide a special rule that clarifies application of the hovering deficit rule to a distributee foreign corporate shareholder in a section 332 liquidation. In this circumstance, the earnings and profits of the distributing foreign corporation to which the foreign distributee corporation succeeds through the operation of section 381 will not be taken into account by the foreign distributee for purposes of section 1248 and consequently, the hovering deficit rule will not apply. Instead, the proposed regulations provide a rule for attributing earnings and profits of the foreign liquidating corporation to the stock of the foreign distributee in such a liquidation that is consistent with the principles of section 1248(c)(2). In such a case, the earnings and profits attributable to the distributee stock shall be the sum of: (1) the earnings and profits attributable to the stock of the distributee immediately before the liquidation (including amounts attributed under section 1248(c)(2)); and (2) the earnings and profits attributable to the stock of the distributee accumulated after the liquidation (including amounts attributed under section 1248(c)(2)). See proposed §1.1248-8(b)(7), Example 3, and (c).

A domestic partnership is treated as a United States person for purposes of section 1248. See section 7701(a)(30)(B) and §1.1248-1(a)(1). Accordingly, the sale by a domestic partnership of the stock of a foreign corporation is subject to section 1248(a). Section 1248 and the existing regulations do not, however, address specifically sales or exchanges of stock by foreign partnerships with United States persons as partners.

The legislative history of subchapter K of the Code provides that, for purposes of interpreting Code provisions outside of that subchapter, a partnership may be treated as either an entity separate from its partners or an aggregate of its partners, depending on which characterization is more appropriate to carry out the purpose of the particular Code section under consideration. H.R. Conf. Rep. No. 2543, 83rd Cong. 2d. Sess. 59 (1954). The purpose of section 1248 is to ensure that earnings and profits of controlled foreign corporations (or former controlled foreign corporations) are taxed as a dividend when certain United States persons recognize gain on the sale or exchange of stock in such corporations. In cases in which the United States person is a partner in a foreign partnership and recognizes income on the sale of stock of a foreign corporation by such foreign partnership, the purpose of section 1248 is fulfilled only if the partnership is treated as an aggregate for section 1248 purposes. Treatment of a foreign partnership as an entity, in contrast, could result in partners in the partnership inappropriately receiving capital gain treatment on the sale by the partnership of stock of the foreign corporation.

Thus, under proposed §1.1248-1(a)(4), a foreign partnership is treated as an aggregate of its partners for purposes of section 1248(a). Under the proposed regulations, for example, the partners in a foreign partnership shall be treated as selling or exchanging their proportionate share of stock held by the foreign partnership. The proposed regulations also apply section 1248(a) in cases where the stock in a corporation that is sold or exchanged is held through tiers of foreign partnerships. This treatment of the foreign partnership as an aggregate, rather than as an entity, for purposes of applying section 1248 is necessary to reflect properly the attributable earnings and profits as a dividend.

Section 1.367(b)-3 requires that an exchanging shareholder, as defined in §1.367(b)-3(b)(1), include the all earnings and profits amount (as defined generally in §1.367(b)-2(d)) in income as a deemed dividend (with respect to its stock in the foreign acquired corporation) when a domestic corporation acquires the assets of the foreign corporation in a section 332 liquidation or a section 368(a)(1) asset acquisition. Section 1.367(b)-2(d)(3)(ii) excludes, for purposes of determining the all earnings and profits amount, amounts attributable to holding periods determined under section 1223(2) during which there was no direct or indirect ownership by a United States person. Pursuant to §1.367(b)-2(d)(3)(i)(A)(1), the all earnings and profits amount with respect to stock of a foreign corporation is determined according to the attribution principles of section 1248 and the regulations under that section. Since the rules of proposed §1.1248-8(b)(2) conform to the rule set forth in §1.367(b)-2(d)(3)(ii), the proposed regulations remove paragraph (d)(3)(ii) from §1.367(b)-2.

Section 1.367(b)-4 applies to an acquisition by a foreign corporation of the stock or assets of a foreign corporation in an exchange described in section 351 or a reorganization described in section 368(a)(1). If the exchange meets certain criteria, an exchanging shareholder, as defined in §1.367(b)-4(b)(1)(i)(A), must include in income as a deemed dividend the section 1248 amount attributable to the stock that it exchanges. If in a particular exchange, income is not required to be included pursuant to §1.367(b)-4(b), §1.367(b)-4(d) provides rules governing the attribution of earnings and profits to the stock received by the exchanging shareholder in the non-inclusion exchange for purposes of applying section 367(b) or section 1248 to subsequent sales or exchanges of that stock.

Because proposed §1.1248-8 provides rules for the attribution of earnings and profits to stock with respect to the §1.367(b)-4(b) non-inclusion exchanges, the proposed regulations remove the substantive rules and examples in §1.367(b)-4(d) from the final regulations. In their place, taxpayers are referred to proposed §1.1248-8.

The proposed regulations do not apply to determine the earnings and profits attributable to stock in a foreign corporation that a United States person receives as a gift. The Treasury Department and the IRS seek comments as to whether additional guidance is needed to address the attribution of earnings and profits with respect to stock of a foreign corporation that a United States person receives by gift.

The proposed regulations do not apply to determine the earnings and profits attributable to stock in a foreign corporation that a United States person receives in a distribution to which section 355 applies. The Treasury Department and the IRS seek comments as to whether additional guidance is needed to address the attribution of earnings and profits with respect to stock of a foreign corporation that a United States person receives in such distributions.

The proposed regulations do not address the interaction of proposed §1.1248-8 with §§1.1248-4 and 1.1248-5. The Treasury Department and the IRS seek comments as to whether additional guidance on how the proposed regulations should affect those sections of the existing regulations.

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(d) Rules for subsequent sales or exchanges. If an exchanging shareholder (as defined in §1.1248-8(b)(1)(iv)) is not required to include in income as a deemed dividend the section 1248 amount under paragraph (b) of this section in a section 367(b) exchange described in paragraph (a) of this section (non-inclusion exchange), then, for purposes of applying section 367(b) or section 1248 to subsequent sales or exchanges, and subject to the limitation of §1.367(b)-2(d)(3)(ii) (in the case of a transaction described in §1.367(b)-3), the determination of the earnings and profits attributable to the stock an exchanging shareholder receives in the non-inclusion exchange shall be determined pursuant to the rules of section 1248 and the regulations under that section.

Par. 4. Section 1.1248-1 is amended by:

1. Amending the first sentence of paragraph (a)(1) by removing the language “(or was considered as held by reason of the application of section 1223)” and adding the language “(or was considered as held by reason of the application of section 1223, taking into account §1.1248-8)” in its place.

2. Adding a new third sentence in paragraph (a)(1).

3. Redesignating paragraph (a)(4) as paragraph (a)(5).

4. Adding new paragraph (a)(4).

5. Adding Example 4 in newly designated paragraph (a)(5).

The additions read as follows:

(a) In general. (1) * * * See §1.1248-8 for additional rules regarding the attribution of earnings and profits to the stock of a foreign corporation following certain nonrecognition transactions. * * *

* * * * *

(4) For purposes of paragraph (a)(1) of this section, stock of a corporation that is owned by a foreign partnership shall be considered as owned proportionately by its partners. Consequently, if a foreign partnership sells or exchanges stock of a corporation, the partners in such foreign partnership shall be treated as selling or exchanging their proportionate share of the stock of such corporation. Stock considered to be owned by a partner by reason of the application of the first sentence of this paragraph (a)(4) shall, for purposes of applying such sentence, be treated as actually owned by such partner.

(5) * * *

Example 4. (i) Facts. X, a domestic corporation, and Y, a foreign corporation that is not a controlled foreign corporation, are partners in foreign partnership Z. X has a 60% interest in Z, and Y has a 40% interest in Z. All parties are calendar year taxpayers. On January 1, year 1, Z forms foreign corporation H, a controlled foreign corporation that conducts a business in Country C. On December 31, year 2, Z sells all of the H stock for $600 when Z’s adjusted basis in the stock is $100. Therefore, Z recognizes a gain of $500 on the sale, of which $300 is allocable to X as a 60% partner. At the time of the sale, H had $300 of earnings and profits, $180 of which (i.e., 60% of $300) is attributable to X’s 60% share of the H stock.

(ii) Analysis. Pursuant to section 1248(a) and paragraphs (a)(1) and (4) of this section, X and Y are treated as selling 60% and 40%, respectively, of the H stock. X includes in its gross income as a dividend $180 of the gain recognized on the sale. Because Y is a foreign corporation that is not a CFC, neither section 1248 nor section 964 applies to the sale of Y’s 40% share of the H stock.

(iii) Alternative facts. If, instead, X owned its 60% interest in Z through another foreign partnership, the result would be the same.

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(a) Scope. This section sets forth rules for the attribution of earnings and profits for purposes of section 1248 and §1.1248-1(a)(1) and to supplement the rules in §§1.1248-2 and 1.1248-3 with respect to—

(1) Stock that an exchanging shareholder receives, or an acquiring corporation receives, in restructuring transactions. Except as otherwise provided in this paragraph (a), stock of a foreign corporation that an exchanging shareholder receives, or an acquiring corporation receives, pursuant to a restructuring transaction (as defined in paragraph (b)(1)(vii) of this section) in which the holding period of such stock is determined by application of section 1223(1) or 1223(2), whichever is appropriate. This section shall not apply to an exchange otherwise described in this paragraph (a)(1) if, as a result of the exchange, the exchanging shareholder is required to include in income as a deemed dividend the section 1248 amount pursuant to §1.367(b)-4(b). See paragraphs (b)(2) and (3) of this section;

(2) Nonexchanging shareholders. Stock of a foreign corporation that participates in a restructuring transaction that is held by a non-exchanging shareholder (as defined in paragraph (b)(1)(vi) of this section) in the restructuring transaction. See paragraph (b)(4) of this section;

(3) Application of section 381. Stock of a foreign corporation that receives assets in a transfer to which section 361(a) applies in connection with a reorganization described in section 368(a)(1)(A), (C), (D), (F), or (G), or in a distribution to which section 332 applies, and to which section 381(c)(2)(A) and §1.381(c)(2)-1(a) apply. See paragraph (b)(6) of this section; or

(4) Section 332 liquidations. Stock of a foreign corporation that receives the assets and liabilities of a foreign corporation in a complete liquidation described in section 332 if the foreign distributee is a foreign corporate shareholder (as defined in paragraph (b)(1)(v) of this section) of the liquidating corporation. See paragraph (c) of this section.

(b) Earnings and profits attributable to stock following a restructuring transaction—(1) Definitions. The following definitions apply for purposes of this section—

(i) Acquired corporation is a corporation whose stock or assets are acquired in exchange for stock in (or stock in and other property of) either the acquiring corporation or a foreign corporation that controls, within the meaning of section 368(c), the acquiring corporation in a restructuring transaction.

(ii) Acquiring corporation is a corporation that acquires the stock or assets of an acquired corporation in a restructuring transaction.

(iii) Controlled foreign corporation is a corporation described in section 957.

(iv) Exchanging shareholder is a person that exchanges—

(A) In a restructuring transaction qualifying as a nonrecognition transaction within the meaning of section 7701(a)(45) and described in section 354, 356, or 361(a), stock in an acquired corporation for stock in either a foreign acquiring corporation or a foreign corporation that is in control, within the meaning of section 368(c), of an acquiring corporation (whether domestic or foreign); or

(B) In a restructuring transaction qualifying as a nonrecognition transaction within the meaning of section 7701(a)(45) and described in section 351, property (including stock) for stock in a foreign acquiring corporation.

(v) Foreign corporate shareholder is a foreign corporation that—

(A) Owns stock of another foreign corporation; and

(B) Has a section 1248 shareholder that is also a section 1248 shareholder of the other foreign corporation.

(vi) Non-exchanging shareholder is, at the time the acquiring corporation participates in a restructuring transaction, either a section 1248 shareholder or a foreign corporate shareholder of the acquiring corporation that is not an exchanging shareholder with respect to that corporation.

(vii) Restructuring transaction is a transaction qualifying as a nonrecognition transaction within the meaning of section 7701(a)(45) and described in section 351, 354, 356, or 361.

(viii) Section 1248 shareholder is any United States person that satisfies the ownership requirements of section 1248(a)(2) and §1.1248-1(a)(2) with respect to a foreign corporation.

(2) Earnings and profits attributable to stock that an exchanging shareholder receives in a restructuring transaction. Where, in a restructuring transaction, an exchanging shareholder receives stock in a foreign corporation, the holding period of which is determined under section 1223(1), and the exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder with respect to that foreign corporation immediately after the restructuring transaction, the earnings and profits attributable to the stock the exchanging shareholder receives shall be determined pursuant to the rules in paragraphs (b)(2)(i), (ii) and (iii) of this section.

(i) Exchanging shareholder exchanges property that is not stock of a foreign acquired corporation with respect to which the exchanging shareholder is a section 1248 shareholder or a foreign corporate shareholder. Where the exchanging shareholder exchanges in a restructuring transaction property that is not stock of a foreign acquired corporation with respect to which the exchanging shareholder is a section 1248 shareholder or a foreign corporate shareholder immediately before such transaction, the earnings and profits attributable to the stock that the exchanging shareholder receives in the restructuring transaction shall be determined in accordance with §1.1248-2 or §1.1248-3, whichever is applicable, without regard to any portion of the section 1223(1) holding period in that stock that is prior to the restructuring transaction. See paragraph (b)(7), Example 1 of this section.

(ii) Exchanging shareholder exchanges stock of a foreign corporation with respect to which the exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder. Except as provided in paragraph (b)(2)(iii) of this section, where the exchanging shareholder exchanges in a restructuring transaction stock of a foreign acquired corporation with respect to which the exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder immediately before such restructuring transaction, the earnings and profits attributable to the stock that the exchanging shareholder receives in the restructuring transaction shall be the sum of the earnings and profits attributable to—

(A) The stock of the foreign acquired corporation exchanged (determined in accordance with §1.1248-2 or §1.1248-3, whichever is applicable, and this section, if applicable) that was accumulated before the restructuring transaction; and

(B) The stock of the foreign corporation that the exchanging shareholder receives in the restructuring transaction (determined in accordance with §1.1248-2 or §1.1248-3, whichever is applicable, and this section, if applicable), without regard to any portion of the section 1223(1) holding period in that stock that is prior to the restructuring transaction. See paragraph (b)(7), Example 2, Example 4, and Example 6 of this section.

(iii) Exchanging shareholder receives stock in a foreign corporation that controls a domestic acquiring corporation. Where the acquiring corporation is a domestic corporation and the exchanging shareholder receives in a restructuring transaction stock in a foreign corporation that controls (within the meaning of section 368(c)) the domestic acquiring corporation, the earnings and profits attributable to the stock that the exchanging shareholder receives in the restructuring transaction shall consist solely of the amount of earnings and profits attributable to such stock (determined in accordance with §1.1248-2 or §1.1248-3, whichever is applicable, and this section, if applicable) without regard to any portion of the section 1223(1) holding period in that stock that is prior to the restructuring transaction. See paragraph (b)(7), Example 5 of this section.

(3) Earnings and profits attributable to stock in a foreign corporation certain acquiring corporations receive in a restructuring transaction. Where an acquiring corporation receives, in a restructuring transaction, stock in a foreign acquired corporation, the holding period of which is determined under section 1223(2), and the acquiring corporation is either a section 1248 shareholder or a foreign corporate shareholder with respect to that foreign acquired corporation immediately after the restructuring transaction, the earnings and profits attributable to the foreign acquired corporation stock that the acquiring corporation receives shall be determined pursuant to the rules in paragraphs (b)(3)(i) and (ii) of this section.

(i) Stock of a foreign corporation with respect to which the exchanging shareholder is neither a section 1248 shareholder nor a foreign corporate shareholder. The earnings and profits attributable to the stock of the foreign acquired corporation that the acquiring corporation receives in a restructuring transaction where the exchanging shareholder is neither a section 1248 shareholder nor a foreign corporate shareholder with respect to that foreign acquired corporation immediately before the restructuring transaction shall be determined in accordance with §1.1248-2 or §1.1248-3, whichever is applicable, without regard to any portion of the section 1223(2) holding period in that stock that is prior to the restructuring transaction.

(ii) Stock of a foreign corporation with respect to which the exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder. The earnings and profits attributable to the stock of a foreign acquired corporation that the acquiring corporation receives in the restructuring transaction where the exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder with respect to that foreign corporation immediately before the restructuring transaction shall be determined in accordance with §1.1248-2 or §1.1248-3, whichever is applicable, with regard to the portion of the section 1223(2) holding period of the stock that the exchanging shareholder took into account for purposes of attributing earnings and profits to that stock (determined in accordance with this section). See paragraph (b)(7), Example 3, Example 5, and Example 7 of this section.

(4) Earnings and profits attributable to stock held by a non-exchanging shareholder in a foreign acquiring corporation. (i) Except to the extent paragraph (b)(4)(ii) of this section applies, see §1.1248-2 or §1.1248-3 (whichever is applicable) and, as applicable, paragraph (b)(6) of this section for the determination of the earnings and profits attributable to the stock held by a non-exchanging shareholder in a foreign acquiring corporation. See also paragraph (b)(7), Example 2 and Example 4 of this section.

(ii) Where a non-exchanging shareholder holds stock in a foreign corporation that is also an exchanging shareholder and a foreign acquiring corporation in the same restructuring transaction—

(A) The earnings and profits attributable to such stock shall be the sum of the earnings and profits attributable to the stock of such foreign corporation immediately before the restructuring transaction (including amounts attributed under section 1248(c)(2)) and the earnings and profits attributable to the stock of the foreign acquiring corporation accumulated after the restructuring transaction (including amounts attributed under section 1248(c)(2)); and

(B) Paragraph (b)(6) of this section applies. See paragraph (b)(7), Example 8 of this section.

(iii) Where the acquiring corporation is a foreign corporate shareholder with respect to stock of a foreign acquired corporation, paragraph (b)(3) of this section shall not apply for purposes of determining the earnings and profits attributable to stock in the foreign acquiring corporation owned by a non-exchanging shareholder thereof (see section 1248(c)(2)). See paragraph (b)(7), Example 6 of this section.

(5) Reduction in earnings and profits attributable to stock to prevent multiple inclusions with respect to the same earnings and profits. To the extent consistent with the principles of section 1248, adjustments to earnings and profits attributable to stock shall be made such that section 1223(1) and (2) and this section are applied in a manner that results in earnings and profits being taken into account only once. Thus, for example, when a controlled foreign corporation sells or exchanges all or part of the stock of another foreign corporation to which earnings and profits are attributable pursuant to this paragraph (b) or paragraph (c) of this section, proportionate reductions shall be made to the earnings and profits attributed to the stock of the selling foreign corporate shareholder owned by a section 1248 shareholder. See paragraph (b)(7), Example 7 of this section.

(6) Special rule regarding section 381. Solely for purposes of determining the earnings and profits (or deficit in earnings and profits) attributable to stock pursuant to this paragraph (b), the earnings and profits of a corporation shall not include earnings and profits that are treated as received or incurred under section 381(c)(2)(A) and §1.381(c)(2)-1(a). See paragraph (b)(7), Example 4 of this section.

(7) Examples. The application of this paragraph (b) is illustrated by the following examples. Unless otherwise indicated, in the following examples assume that—

(i) There is no immediate gain recognition pursuant to section 367(a)(1) and the regulations under that section (either through operation of the rules or because the appropriate parties have entered into a gain recognition agreement under §§1.367(a)-3(b) and 1.367(a)-8);

(ii) There is no income inclusion required pursuant to section 367(b) and the regulations under that section, and all reporting requirements in those regulations are complied with;

(iii) References to earnings and profits are to earnings and profits that would be includible in income as a dividend under section 1248 and the regulations under that section if stock to which the earnings and profits are attributable were sold or exchanged by its shareholder;

(iv) Each corporation has only a single class of stock outstanding and uses the calendar year as its taxable year; and

(v) Each transaction is unrelated to all other transactions.

Example 1. A section 351 exchange of property other than stock in a foreign corporation with respect to which the exchanging shareholder is either a section 1248 shareholder or a foreign corporate shareholder. (i) Facts. DC1, a domestic corporation, has owned all the stock of CFC, a foreign corporation, since CFC’s formation on January 1, year 3. On December 31, year 5, DC2, a domestic corporation unrelated to DC1, contributes property it has held since January 1, year 1, to CFC in exchange for voting stock of CFC in a restructuring transaction that is an exchange under section 351. The property that DC2 contributes is not stock in a foreign corporation with respect to which DC2 was either a section 1248 shareholder or a foreign corporate shareholder. DC2 receives 80% of the voting stock of CFC in the restructuring transaction and its holding period in that CFC stock, determined pursuant to section 1223(1), began on January 1, year 1. CFC has $100 of accumulated earnings and profits on December 31, year 5. On December 31, year 7, when the accumulated earnings and profits of CFC are $200, DC2, a section 1248 shareholder with respect to CFC, sells its CFC stock.

(ii) Analysis. Under paragraph (b)(2)(i) of this section, the earnings and profits attributable to the CFC stock sold by DC2 are $80. This amount consists of none of the $100 of earnings and profits accumulated by CFC before the restructuring transaction, and 80% of the $100 of earnings and profits of CFC accumulated after the restructuring transaction.

Example 2. A section 351 exchange of controlled foreign corporation stock by a United States person for stock in a controlled foreign corporation in a restructuring transaction. (i) Facts. The facts are the same as in Example 1 except as follows. The property that DC2 contributes is 100% of the stock in CFC2, a foreign corporation. DC2 has owned all the stock of CFC2 since CFC2’s formation on January 1, year 2, and CFC2 has $200 of earnings and profits as of December 31, year 5. CFC2 does not accumulate any additional earnings and profits from December 31, year 5, to December 31, year 7. On December 31, year 7, when the accumulated earnings and profits of CFC are $200, DC2, a section 1248 shareholder with respect to CFC, sells its CFC stock. Also on that date, DC1 sells its CFC stock.

(ii) Analysis. (A) DC2 sale. Pursuant to paragraph (b)(2)(ii) of this section, the earnings and profits attributable to the CFC stock sold by DC2 are $280. This amount consists of all of the $200 of earnings and profits of CFC2 accumulated before the restructuring transaction (see also section 1248(c)(2)), none of the $100 of earnings and profits accumulated by CFC before the restructuring transaction, and 80% of the $100 of earnings and profits of CFC accumulated after the restructuring transaction.

(B) DC1 sale. Pursuant to paragraph (b)(4) of this section, the earnings and profits attributable to the CFC stock sold by DC1, a non-exchanging shareholder in the restructuring transaction, are $120. This amount consists of all of the $100 of earnings and profits of CFC accumulated before the restructuring transaction, none of the $200 of earnings and profits of CFC2 accumulated before the restructuring transaction, and 20% of the $100 of earnings and profits of CFC accumulated after the restructuring transaction.

Example 3. A section 351 exchange of controlled foreign corporation stock by a United States person for stock in a domestic corporation in a restructuring transaction. (i) Facts. DC1, a domestic corporation, has owned all of the stock of CFC, a foreign corporation, since CFC’s formation on January 1, year 1. DC1 has also owned all the stock of DC2, a domestic corporation, since DC2’s formation on January 1, year 1. On December 31, year 2, DC1 contributes the stock of CFC to DC2 in exchange for stock in DC2 in a restructuring transaction that is an exchange described in section 351. On December 31, year 2, CFC has $100 of accumulated earnings and profits. DC2 has a basis in the CFC stock determined under section 362, and is considered to have held the CFC stock since January 1, year 1, pursuant to section 1223(2). On December 31, year 4, when the accumulated earnings and profits of CFC are still $100, DC2 sells its CFC stock.

(ii) Analysis. Under paragraph (b)(3)(ii) of this section, $100 of accumulated earnings and profits of CFC is attributable to the stock of CFC sold by DC2, even though DC2 did not hold the stock of CFC during the time CFC accumulated the earnings and profits.

Example 4. Acquisition of a controlled foreign corporation by a controlled foreign corporation in a reorganization described in section 368(a)(1)(C) (or section 368(a)(1)(B)). (i) Facts. DC1, a domestic corporation, has owned all the stock of CFC1, a foreign corporation, since its formation on January 1, year 1. DC2, a domestic corporation unrelated to DC1, has owned all of the stock of CFC2, a foreign corporation, since its formation on January 1, year 2. On December 31, year 3, pursuant to a restructuring transaction that is a reorganization described in section 368(a)(1)(C), CFC1 transfers all of its assets to CFC2 in exchange for 25% of the voting stock of CFC2. CFC1 distributes the CFC2 stock to DC1 and the CFC1 stock is cancelled. DC1’s holding period in the CFC2 stock, determined under section 1223(1), begins on January 1, year 1. On December 31, year 3, CFC1 has $100 of accumulated earnings and profits and CFC2 has $200 of accumulated earnings and profits. CFC2 succeeds to the $100 of CFC1 accumulated earnings and profits in the reorganization under section 381. From January 1, year 4 to December 31, year 5, CFC2 incurred a deficit in earnings and profits in the amount of ($200). On December 31, year 5, both DC1 and DC2 sell their stock in CFC2.

(ii) Analysis. (A) DC1. Pursuant to paragraph (b)(2)(ii) of this section, $50 of earnings and profits is attributable to the CFC2 stock sold by DC1. This amount consists of $100 of CFC1’s earnings and profits accumulated before the restructuring transaction, reduced by 25% of CFC2’s ($200) post-restructuring transaction deficit in earnings and profits. None of the $200 of CFC2’s earnings and profits accumulated by CFC2 prior to the reorganization is attributed to the CFC2 stock sold by DC1. Also, none of the earnings and profits CFC2 succeeded to under section 381 is attributed to the CFC2 stock sold by DC1, pursuant to paragraph (b)(6) of this section.

(B) DC2. Pursuant to paragraph (b)(4) of this section, there is $50 of accumulated earnings and profits attributable to the CFC2 stock sold by DC2. This amount consists of all of the $200 of CFC2’s earnings and profits accumulated by CFC2 prior to the reorganization, reduced by 75% of CFC2’s deficit in earnings and profits in the amount of ($200) incurred after the restructuring transaction. None of the $100 of CFC1 accumulated earnings and profits succeeded to under section 381 is attributable to the CFC2 stock sold by DC2, pursuant to paragraph (b)(6) of this section.

(C) Section 368(a)(1)(B) reorganization. If, instead of DC1 acquiring its 25% interest in CFC2 pursuant to a reorganization described in section 368(a)(1)(C), DC1 had transferred the stock of CFC1 to CFC2 in exchange for 25% of the voting stock of CFC2 in a reorganization described in section 368(a)(1)(B), the results would be the same as described in paragraphs (ii) (A) and (B) of this Example 4.

Example 5. Acquisition of the stock of a foreign corporation that controls a domestic acquiring corporation in a triangular reorganization described in section 368(a)(1)(C). (i) Facts. DC1, a domestic corporation, has owned all the stock of CFC1, a foreign corporation, since its formation on January 1, year 1. CFC1 has owned all the stock of CFC2, a foreign corporation, since its formation on January 1, year 1. FC, a foreign corporation that is not a controlled foreign corporation, has owned all of the stock of DC2, a domestic corporation, since its formation on January 1, year 2. On December 31, year 3, pursuant to a restructuring transaction that was a triangular reorganization described in section 368(a)(1)(C), CFC1 transfers all of its assets, including the CFC2 stock, to DC2 in exchange for 60% of the voting stock of FC. CFC1 transferred the voting stock of FC to DC1 and the CFC1 stock was cancelled. Pursuant to section 1223(1), DC1 is considered to have held the stock of FC since January 1, year 1. Under section 1223(2), DC2 is considered to have held the stock of CFC2 since January 1, year 1. On December 31, year 3, CFC1 has $100 of earnings and profits, CFC2 has $300 of earnings and profits, and FC has $200 of earnings and profits. DC1 includes the $100 all earnings and profits amount attributable to its CFC1 stock in income as a deemed dividend under §1.367(b)-3 upon the exchange of CFC1 stock for FC stock. Pursuant to the lower tier earning exclusion of §1.367(b)-2(d)(3)(ii), that amount does not include the $300 of earnings and profits of CFC2. From January 1, year 4, until December 31, year 5, FC (now a controlled foreign corporation) accumulates an additional $50 of earnings and profits. From January 1, year 4 until December 31, year 5, CFC2 accumulates an additional $100 of earnings and profits. On December 31, year 5, DC1 sells its stock in FC and DC2 sells its stock in CFC2.

(ii) Analysis. (A) DC1. Pursuant to paragraph (b)(2)(iii) of this section, there is $30 of earnings and profits attributable to the stock of FC sold by DC1. This amount consists of 60% of the $50 of earnings and profits accumulated by FC after the restructuring transaction, and none of the earnings and profits accumulated by CFC1, CFC2, or FC before the restructuring transaction.

(B) DC2. Pursuant to paragraph (b)(3)(ii) of this section, there is $400 of earnings and profits attributable to the stock of CFC2 sold by DC2. This amount consists of all of the earnings and profits accumulated by CFC2 during DC2’s section 1223(2) holding period.

Example 6. Acquisition of the stock of a foreign corporation that controls a foreign acquiring corporation in a reorganization described in section 368(a)(1)(C). (i) Facts. DC1, a domestic corporation, has owned all the stock of CFC1, a foreign corporation, since its formation on January 1, year 1. CFC1 has owned all the stock of CFC2, a foreign corporation, since its formation on January 1, year 1. FC, a foreign corporation that is not a controlled foreign corporation, has owned all of the stock of FC2, a foreign corporation, since its formation on January 1, year 2. On December 31, year 3, pursuant to a restructuring transaction that was a triangular reorganization described in section 368(a)(1)(C), CFC1 transfers all of its assets, including the CFC2 stock, to FC2 in exchange for 60% of the voting stock of FC. CFC1 transferred the voting stock of FC to DC1 and the CFC1 stock was cancelled. Pursuant to section 1223(1), DC1 is considered to have held the stock of FC since January 1, year 1. Under section 1223(2), FC2 is considered to have held the stock of CFC2 since January 1, year 1. On December 31, year 3, CFC1 has $100 of earnings and profits, CFC2 has $300 of earnings and profits, FC has $200 of earnings and profits, and FC2 has no earnings and profits. From January 1, year 4, until December 31, year 5, FC (now a controlled foreign corporation) accumulates an additional $50 of earnings and profits. From January 1, year 4 until December 31, year 5, CFC2 accumulates an additional $100 of earnings and profits. FC2, a controlled foreign corporation after the restructuring transaction, accumulates $100 of earnings and profits from January 1, year 4, until December 31, year 5. On December 31, year 5, DC1 sells its stock in FC.

(ii) Analysis. Pursuant to paragraphs (b)(2)(ii) and (b)(4)(iii) of this section, there is $550 of earnings and profits attributable to the stock of FC sold by DC1. This amount consists of all $400 of the CFC1 and CFC2 earnings and profits accumulated before the restructuring transaction (see also section 1248(c)(2)), and 60% of the $250 of the earnings and profits accumulated by FC, FC2, and CFC2 after the restructuring transaction.

Example 7. Acquisition of controlled foreign corporation stock by a controlled foreign corporation in a reorganization described in section 368(a)(1)(B), followed by a sale of the acquired stock by the acquiring controlled foreign corporation. (i) Facts. DC1, a domestic corporation, has owned all of the outstanding stock of CFC1, a foreign corporation, since its formation on January 1, year 1. CFC1 has owned all of the outstanding stock of CFC3, a foreign corporation, since its formation on January 1, year 1. DC2, a domestic corporation unrelated to DC1, has owned all of the outstanding stock of CFC2, a foreign corporation, since its formation on January 1, year 2. On December 31, year 3, pursuant to a restructuring transaction that is a reorganization described in section 368(a)(1)(B), CFC1 transfers all of the stock of CFC3 to CFC2 in exchange for 40% of CFC2’s stock. On December 31, year 3, CFC2 and CFC3 have, respectively, $40 and $20 of earnings and profits. On December 31, year 5, when the accumulated earnings and profits of CFC3 are $50 ($20 of earnings and profits as of December 31, year 3, plus $30 of earnings and profits generated from January 1, year 4, through December 31, year 5), CFC2 sells the stock of CFC3 in a transaction to which section 964(e) applies.

(ii) Analysis. (A) CFC2. Pursuant to paragraph (b)(3)(ii) of this section, there is $50 of earnings and profits attributable to the CFC3 stock sold by CFC2. This amount consists of the accumulated earnings and profits attributable to CFC2’s entire section 1223(2) holding period in the CFC3 stock.

(B) CFC1, DC2, and DC1. Under paragraph (b)(5) of this section, the earnings and profits attributable to the CFC2 stock held by CFC1 and DC2, and the earnings and profits attributable to the CFC1 stock held by DC1, will be reduced (regardless of whether CFC2 recognizes gain on its sale of CFC3 stock).

(1) CFC1. The earnings and profits attributable to the CFC2 stock held by CFC1 will be reduced by $32, or the amount of earnings and profits as of December 31, year 5, that would have been attributable to the CFC2 stock held by CFC1 pursuant to paragraph (b)(2)(ii) of this section. This amount consists of all of the $20 of earnings and profits accumulated by CFC3 before the restructuring transaction and 40% of the $30 of earnings and profits accumulated by CFC3 after the restructuring transaction (.40 X $30 = $12).

(2) DC1. The earnings and profits attributable to the CFC1 stock held by DC1 will also be reduced by $32, or the amount of earnings and profits that would have been attributable to the CFC1 stock held by DC1 as of December 31, year 5.

(3) DC2. The earnings and profits attributable to the CFC2 stock held by DC2 will be reduced by $18, or the amount of earnings and profits that would have been attributable to the CFC2 stock held by DC2 as of December 31, year 5, under paragraph (b)(4) of this section. This amount consists of 60% of the $30 (.60 X $30 = $18) of earnings and profits accumulated by CFC3 after the restructuring transaction.

(C) Partial sale by CFC2. If, instead of selling 100% of the CFC3 stock, on December 31, year 5, CFC2 sells only 50% of its CFC3 stock, paragraph (b)(5) of this section requires CFC1 to reduce the earnings and profits of CFC3 attributable to its CFC2 stock to $16. Similarly, DC1 would be required to reduce the earnings and profits of CFC3 attributable to its CFC1 stock by $16. Paragraph (b)(5) of this section also requires DC2 to reduce the CFC3 earnings and profits attributable to its CFC2 stock by $9. These reductions occur without regard to whether CFC2 recognizes gain on its sale of CFC3 stock.

Example 8. Acquisition of the assets of a lower-tier controlled foreign corporation by an upper-tier controlled foreign corporation in a restructuring transaction described in section 368(a)(1)(C). (i) Facts. DC, a domestic corporation, has owned all the stock of CFC1, a controlled foreign corporation, since its formation on January 1, year 1. CFC1 is a holding company that has owned 79% of the stock of CFC2, a controlled foreign corporation, since its formation on January 1, year 1. The other 21% of CFC2 stock is owned by X, an unrelated party. On December 31, year 1, CFC2 has $200 of earnings and profits. On December 31, year 1, CFC1 has no accumulated earnings and profits. On December 31, year 1, pursuant to a restructuring transaction described in section 368(a)(1)(C), CFC2 transfers all its properties to CFC1. In exchange, CFC1 assumes the liabilities of CFC2 and transfers to CFC2 voting stock representing 21% of the stock of CFC1. CFC2 distributes the voting stock to X and liquidates. The liabilities assumed do not exceed 20% of the value of the properties of CFC2. From January 1, year 2, to December 31, year 3, CFC1 accumulates $100 of earnings and profits. On December 31, year 3, DC sells its CFC1 stock.

(ii) Analysis. Pursuant to paragraphs (b)(4)(ii) of this section, there is $237 of earnings and profits attributable to DC’s CFC1 stock. This amount consists of 79% of CFC2’s $200 of earnings and profits accumulated before the restructuring transaction (see section 1248(c)(2)), and 79% of CFC1’s $100 of earnings and profits accumulated after the restructuring transaction. Pursuant to paragraph (b)(6) of this section, none of CFC2’s $200 of earnings and profits to which CFC1 succeeded under section 381 would be attributable to DC’s CFC1 stock.

(c) Earnings and profits attributable to stock of a foreign distributee corporation that is a foreign corporate shareholder with respect to a foreign liquidating corporation—(1) General rule. If a foreign corporation (liquidating corporation) makes a distribution of property in complete liquidation under section 332 to a foreign corporation (distributee), and immediately before the liquidation the distributee was a foreign corporate shareholder with respect to the liquidating foreign corporation, the amount of earnings and profits attributable to the distributee stock, upon its subsequent sale or exchange will be determined under this paragraph (c)(1). The earnings and profits attributable will be the sum of the earnings and profits attributable to the stock of the distributee immediately before the liquidation (including amounts attributed under section 1248(c)(2)) and the earnings and profits attributable to the stock of the distributee accumulated after the liquidation (including amounts attributed under section 1248(c)(2)).

(2) Special rule regarding section 381. Solely for purposes of determining the earnings and profits (or deficit in earnings and profits) attributable to stock under this paragraph (c), the attributed earnings and profits of a corporation shall not include earnings and profits that are treated as received or incurred pursuant to section 381(c)(2)(A) and §1.381(c)(2)-1(a).

(3) Example. (i) Facts. DC, a domestic corporation, has owned all of the stock of CFC1, a foreign corporation, since its formation on January 1, year 1. CFC1 is an operating company that has owned all of the stock of CFC2, a foreign corporation, since its formation on January 1, year 1. On December 31, year 2, CFC1 has $200 of accumulated earnings and profits and CFC2 has a ($200) deficit in earnings and profits. On December 31, year 2, CFC2 distributes all of its assets and liabilities to CFC1 in a liquidation to which section 332 applies. From January 1, year 3, until December 31, year 4, CFC1 accumulates no additional earnings and profits. On December 31, year 4, DC sells its stock in CFC1.

(ii) Analysis. Pursuant to paragraph (c)(1) of this section, there are no earnings and profits attributable to DC’s CFC1 stock. This amount consists of the sum of the earnings and profits attributable to the CFC1 stock immediately before the liquidation (100% of the $200 accumulated earnings and profits of CFC1 and 100% of CFC2’s ($200) deficit in earnings and profits) and the amount of earnings and profits accumulated after the section 332 liquidation (see also section 1248(c)(2)).

(d) Effective date. This section applies to income inclusions that occur on or after the date these regulations are published as final regulations in the Federal Register.

Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.

[The text of proposed §1.7874-2 is the same as the text of §1.7874-2T published elsewhere in this issue of the Bulletin].

Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.