[Federal Register Volume 70, Number 248 (Wednesday, December 28, 2005)]
[Rules and Regulations]
[Pages 76685-76689]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-24450]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9238]
RIN 1545-BE94


Guidance Under Section 7874 for Determining Ownership by Former 
Shareholders or Partners of Domestic Entities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations under section 
7874 of the Internal Revenue Code (Code) relating to the disregard of 
certain affiliate-owned stock in determining whether a corporation is a 
surrogate foreign corporation under section 7874(a)(2)(B) of the Code. 
The text of the temporary regulations also serves as the text of the 
proposed regulations set forth in the notice of proposed rulemaking on 
this subject in the Proposed Rules section in this issue of the Federal 
Register.

DATES: Effective Date: These regulations are effective December 28, 
2005.
    Applicability Dates: For the date of applicability, see Sec.  
1.7874-1T(e).

FOR FURTHER INFORMATION CONTACT: Jefferson VanderWolk, 202-622-3800 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains temporary amendments to 26 CFR part 1 under 
section 7874 of the Code relating to the determination of the 
percentage of stock in a foreign corporation held by former 
shareholders or partners of a domestic corporation or partnership 
(domestic entity) by reason of holding stock or a partnership interest 
in the domestic entity, for purposes of determining whether the foreign 
corporation is a surrogate foreign corporation under section 
7874(a)(2)(B).
    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 any U.S. person related (within the meaning of section 
267(b) or 707(b)(1)) to such domestic corporation or partnership. 
Generally, a foreign corporation is 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 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 such 
group.
    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) by vote or value, the surrogate foreign 
corporation is treated as a foreign corporation but any applicable 
corporate-level income or gain required to be recognized by the 
expatriated entity under section 304, 311(b), 367, 1001, 1248 or any 
other applicable provision with respect to the transfer or license of 
property (other than inventory or similar property) cannot be offset by 
net operating losses or credits (other than credits allowed under 
section 901). This treatment of an expatriated entity generally applies 
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)(2) provides that stock held by members of the 
expanded affiliated group which includes the foreign corporation is not 
taken into account for purposes of the ownership percentage test 
(affiliate-owned stock rule). 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 threshold.
    The statute provides the Secretary of the Treasury significant 
regulatory authority. 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. Section 7874(g) authorizes the 
Secretary of the Treasury to provide such regulations as are necessary 
to carry out the section.
    The legislative history of section 7874 indicates that it 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 parent corporation without significant change in the ultimate 
ownership of the group. See H.R. Conf. Rep. No. 108-755, 108th Cong., 
2d Sess., at 568 (Oct. 7, 2004). The statute was also intended to apply 
to similar transactions in which a trade or business of a domestic 
partnership is transferred to a foreign corporation at

[[Page 76686]]

least 60 percent of which is owned by former partners.
    A key feature of section 7874 is the affiliate-owned stock rule. 
Congress intended to accomplish two main objectives with this rule. See 
Joint Committee on Taxation, General Explanation of Tax Legislation 
Enacted in the 108th Congress, at 344. First, Congress intended that 
the ownership percentage test should be applied to prevent avoidance of 
the provisions when they otherwise should apply, including situations 
involving the use of so-called hook stock. In this context, hook stock 
is stock of the acquiring foreign corporation held by an entity that is 
at least 50 percent owned (by vote or value) directly or indirectly by 
the acquiring foreign corporation. If hook stock were respected as 
stock of the foreign corporation for purposes of section 
7874(a)(2)(B)(ii), a taxpayer might implement an inversion and take the 
position that section 7874 was not applicable by ensuring that hook 
stock accounted for over 40 percent of the value and voting power of 
the foreign corporation's stock.
    Second, Congress intended that the affiliate-owned stock rule could 
operate in specified situations to prevent the section from applying to 
certain transactions occurring within a group of corporations owned by 
the same common parent corporation before and after the transaction, 
such as the conversion of a wholly owned domestic subsidiary into a new 
wholly owned controlled foreign corporation. Id. In the absence of this 
rule, section 7874 could apply to internal group restructuring 
transactions involving the transfer of a wholly owned domestic 
corporation (or its assets) to a wholly owned foreign corporation, 
without a change in the parent corporation of the group.
    The IRS and Treasury Department have concluded that the affiliate-
owned stock rule should not operate in a manner that allows the 
avoidance of section 7874 in situations where it should apply. For 
example, the affiliate-owned stock rule should prevent the use of hook 
stock to avoid section 7874. On the other hand, the IRS and Treasury 
Department have also concluded that the rule should not operate in a 
manner that would result in section 7874 applying to certain types of 
transactions that are outside the intended scope of the section. For 
example, the type of concerns that Congress meant to address in 
enacting section 7874 do not result from certain internal group 
restructuring transactions involving the transfer to a foreign 
corporation of the stock or assets of a domestic corporation where 
minority shareholders have a relatively small percentage interest in 
such stock or assets before and after the transaction.
    In addition, the IRS and Treasury Department believe that the 
affiliate-owned stock rule was not intended to cause section 7874 to 
apply to certain acquisitive business transactions, such as the 
acquisition of stock or assets of a domestic corporation by an 
unrelated foreign corporation where after the acquisition the former 
owners of the domestic entity do not own more than 50 percent (by vote 
or value) of the stock of any member of the expanded affiliate group. 
For example, the contribution of a domestic entity or its assets to a 
foreign joint venture corporation in exchange for a minority interest 
in the joint venture corporation should not result in the joint venture 
corporation's being treated, for purposes of the ownership percentage 
test, as wholly owned by the former owners of the domestic entity by 
operation of the affiliate-owned stock rule. In contrast, section 7874 
may properly apply to the acquisition of an existing domestic joint 
venture entity by a foreign corporation which is at least 60 percent 
owned, after the acquisition, by the former owners of the acquired 
domestic entity. Congress intended the section to apply to transactions 
(other than internal group restructurings, as discussed above) that 
effectively replace a domestic corporation or partnership with a 
foreign corporation at least 60 percent of which is held by former 
owners of the domestic entity.

Explanation of Provisions

    The IRS and Treasury Department believe that guidance is necessary 
to 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, where that provision should apply. However, the IRS and 
Treasury Department also believe that guidance is needed to make sure 
that this test does not apply to certain transactions that are properly 
viewed as outside the scope of section 7874. Consequently, 
clarification is needed with respect to the application of the 
affiliate-owned stock rule.
    The temporary regulation provides, as a general rule, that 
affiliate-owned stock is excluded from both the numerator and the 
denominator of the fraction that determines the stock ownership 
percentage for purposes of section 7874(a)(2)(B)(ii). This rule 
prevents the use of hook stock (and similar techniques) as means to 
remove an otherwise covered transaction from the scope of section 7874.
    The temporary regulation also provides limited exceptions to the 
general rule pursuant to which affiliate-owned stock (other than hook 
stock) is included in the denominator of the fraction that determines 
the stock ownership percentage for purposes of section 
7874(a)(2)(B)(ii), but is excluded from the numerator of that fraction. 
These exceptions are necessary to prevent section 7874 from applying to 
(1) certain transactions occurring as part of an internal group 
restructuring involving a domestic entity; and (2) certain acquisitive 
business transactions between unrelated parties where the former 
shareholders or partners of the domestic entity have a minority 
interest in the acquired properties after the acquisition.
    With respect to internal group restructurings, the special rule 
applies where the common parent corporation owns directly or indirectly 
at least 80 percent of the domestic entity before the transaction, and 
continuing owners that are not members of the expanded affiliated group 
hold no more than 20 percent of the stock of the acquiring foreign 
corporation after the transaction.
    With respect to transactions between unrelated parties, the special 
rule applies to the acquisition of a domestic entity or its assets by a 
foreign corporation where, after the acquisition, the former owners of 
the domestic entity do not own, in the aggregate, directly or 
indirectly, more than 50 percent of the stock (by vote or value) of any 
member of the expanded affiliated group that includes the acquiring 
foreign corporation.
    The temporary regulation also provides a rule that prevents hook 
stock from being taken into account for purposes of (1) determining the 
percentage of ownership of an entity for purposes of determining 
whether the special rule is applicable; and (2) the application of the 
special rule itself.
    The IRS and Treasury Department decided it was important to issue 
these regulations to deal with affiliate-owned stock as soon as 
possible. As a result, these temporary regulations are being published 
without further delay and with the same applicability date as section 
7874, which applies for taxable years ending after March 4, 2003.

Request for Comments

    The IRS and Treasury Department identified internal restructurings 
and acquisitions by unrelated parties as categories of transactions 
requiring a special rule regarding affiliate-owned stock in order to 
prevent unintended consequences under section 7874. Comments are 
requested as to any other

[[Page 76687]]

categories of transactions that may give rise to unintended 
consequences under section 7874 and these regulations.
    The IRS and Treasury Department are considering issuing subsequent 
public guidance that addresses additional issues under section 7874. 
This guidance may address issues related to (1) the determination of 
whether there has been a direct or indirect acquisition of 
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; (2) the requirement that 
such acquisition be pursuant to a plan or a series of related 
transactions; (3) the requirement, in the ownership percentage test, 
that ownership of stock be by reason of holding an interest in the 
domestic corporation or partnership; (4) the treatment of stock sold in 
a public offering that is related to the acquisition; (5) the 
requirement that the group's activities in the relevant foreign country 
are insubstantial when compared to the group's total business 
activities; (6) whether and to what extent options on stock and other 
similar interests are treated as stock for the purpose of determining 
whether a corporation is a surrogate foreign corporation; (7) the 
disregard of transfers of properties or liabilities if the transfers 
are part of a plan a principal purpose of which is to avoid the 
purposes of section 7874; and (8) any adjustments to the application of 
the section that are necessary to carry out its purposes, including 
adjustments necessary to prevent avoidance. The IRS and Treasury 
Department specifically request comments regarding appropriate rules in 
relation to these and other issues arising under section 7874.
    The IRS and Treasury Department also are considering possible 
changes to Sec.  1.367(a)-3(c), which governs the tax consequences at 
the shareholder level of certain transactions similar to those 
addressed by section 7874, in light of the enactment of section 7874. 
Comments are requested in this regard.

Regulations Addressing Avoidance of the Purposes of Section 7874

    The IRS and Treasury Department understand that taxpayers are 
implementing structures that result in the same overall tax 
consequences as structures that Congress intended to be subject to 
section 7874, but taxpayers are taking the position these structures 
are not within the scope of section 7874. For example, the IRS and 
Treasury Department understand that the shareholders (or partners) of a 
domestic corporation (or domestic partnership) may arrange to transfer 
their shares (or partnership interests) to a newly-formed foreign 
entity for which an entity classification election under Treasury 
regulations Sec.  301.7701-3 is made to treat such entity as a foreign 
partnership for Federal tax purposes. Taxpayers may take the position 
that these transactions are not subject to section 7874 because the 
foreign entity is not a foreign corporation for Federal tax purposes 
and thus is not a surrogate foreign corporation under section 
7874(a)(2)(B). In some cases, taxpayers further take the position that 
the foreign entity, the interests in which are publicly traded, is 
treated as a partnership for Federal tax purposes.
    The IRS and Treasury Department believe that such structures have 
the effect of inversion transactions. Section 7874(g) grants broad 
regulatory authority to make adjustments to the application of section 
7874 to prevent the avoidance of the purpose of section 7874 through 
the use of non-corporate entities or other intermediaries. In addition, 
sections 7805(b)(2) and (3) provide exceptions in certain situations to 
the general prohibition against the issuance of retroactive regulations 
found in section 7805(b)(1). Accordingly, the IRS and Treasury 
Department are considering issuing regulations, which may be 
retroactive, addressing these structures. The IRS and Treasury 
Department specifically request comments regarding appropriate rules in 
relation to these and other uses of intermediary entities (and other 
techniques, including the use of exchangeable shares) to avoid the 
purpose of section 7874.

Effective Date

    Section 1.7874-1T applies to taxable years ending after March 4, 
2003.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. For the 
applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
refer to the Special Analyses section of the preamble to the cross-
reference notice of proposed rulemaking published in the Proposed Rules 
section in this issue of the Federal Register. Pursuant to section 
7805(f), this Treasury decision will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Drafting Information

    The principal author of this regulation is Jefferson VanderWolk, 
Office of Associate Chief Counsel (International). However, other 
personnel from the IRS and Treasury Department participated in its 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry in numerical order to read, in part, as follows:

    Authority: 26 U.S.C. 7805 * * *. Section 1.7874-1T also issued 
under 26 U.S.C. 7874(c)(6) and (g).

0
Par. 2. Section 1.7874-1T is added to read as follows:


Sec.  1.7874-1T  Disregard of affiliate-owned stock (temporary).

    (a) Scope. Section 7874(c)(2)(A) provides that stock of the foreign 
corporation referred to in section 7874(a)(2)(B) held by members of the 
expanded affiliated group that includes such foreign corporation (the 
EAG) shall not be taken into account in determining, for purposes of 
section 7874(a)(2)(B)(ii), the percentage of stock in such foreign 
corporation held, after the acquisition, by former shareholders or 
partners of the domestic corporation or partnership referred to in 
section 7874(a)(2)(B)(i) (the domestic entity) by reason of having held 
stock or a partnership interest in the domestic entity. This section 
provides rules under section 7874(c)(2)(A).
    (b) General rule. Except as provided in paragraph (c) of this 
section, for purposes of the ownership percentage determination 
required by section 7874(a)(2)(B)(ii), stock held by one or more 
members of the EAG is not included in either the numerator or the 
denominator of the fraction that determines such percentage. For 
purposes of this Sec.  1.7874-1T, stock held by a partnership shall be 
considered as held proportionately by its partners.
    (c) Special rules. For purposes of the ownership percentage 
determination required by section 7874(a)(2)(B)(ii), stock held by one 
or more members of the EAG shall be included in the denominator, but 
not in the numerator, of the fraction that determines the percentage 
if:

[[Page 76688]]

    (1)(i) Before the acquisition, 80 percent or more of the stock (by 
vote or value) or the capital or profits interest in the domestic 
entity was owned directly or indirectly by the corporation that is the 
common parent of the EAG after the acquisition; and
    (ii) After the acquisition, stock held by non-members of the EAG by 
reason of holding stock or a capital or profits interest in the 
domestic entity, if any, does not exceed 20 percent of the stock (by 
vote or value) of the foreign corporation; or
    (2) After the acquisition, the former shareholders or partners of 
the domestic entity do not own, in the aggregate, directly or 
indirectly, more than 50 percent of the stock (by vote or value) of any 
member of the EAG.
    (d) Disregard of subsidiary-owned interests. Stock or partnership 
interests owned by an entity in which at least 50 percent of the stock 
(by vote or value), or at least 50 percent of the capital or profits 
interest, is owned directly or indirectly by the issuer of such stock 
or by the partnership in question shall not be taken into account for 
purposes of:
    (1) Determining the percentage of ownership of an entity under 
paragraphs (c)(1) and (c)(2) of this section; or
    (2) Treating stock held by one or more members of the EAG as 
included in the denominator but not in the numerator under paragraph 
(c) of this section.
    (e) Examples. The application of this section is illustrated by the 
following examples. It is assumed that all transactions in the examples 
occur after March 4, 2003. In all the examples, the EAG means the 
expanded affiliated group which includes the foreign corporation that 
has completed the direct or indirect acquisition referred to in section 
7874(a)(2)(B)(i). In all the examples, if an entity or other person is 
not described as either domestic or foreign, it may be either domestic 
or foreign. The analysis of the following examples is limited to a 
discussion of issues under section 7874, even though the examples may 
raise other issues (for example, under section 367):

    Example 1. Disregard of hook stock--(i) Facts. A is a domestic 
corporation with 100 shares of a single class of common stock 
outstanding. A's stock is held by a group of individuals. Pursuant 
to a plan, A forms F, a foreign corporation, and transfers to F the 
stock of several wholly owned foreign subsidiaries, in exchange for 
90 shares of F stock. F then forms Merger Sub, a domestic 
corporation. Under a merger agreement and state law, Merger Sub 
merges into A, with A surviving the merger as a subsidiary of F. In 
exchange for their A stock, the former shareholders of A receive, in 
the aggregate, 100 shares of F stock. A continues to hold 90 shares 
of F stock.
    (ii) Analysis. F has indirectly acquired substantially all the 
properties of A pursuant to a plan. After the acquisition, the 
former shareholders of A own 100 shares of F stock by reason of 
holding stock in A, and A owns 90 shares of F stock. Under paragraph 
(b) of this section, the 90 shares of F stock held by A, a member of 
the EAG, are not included in either the numerator or the denominator 
of the fraction that determines the percentage of F stock owned by 
former shareholders of A by reason of holding stock in A. 
Accordingly, the fraction is 100/100 and the percentage is 100%. If 
the condition stated in section 7874(a)(2)(B)(iii) regarding 
relatively insubstantial business activities in F's country of 
incorporation is satisfied, F is a surrogate foreign corporation 
which is treated as a domestic corporation under section 7874(b).
    Example 2. Intra-group restructuring; wholly owned corporation--
(i) Facts. USS, a domestic corporation, has 100 shares of common 
stock outstanding, all of which are owned by P, a corporation. As 
part of an internal restructuring within the P group, USS transfers 
all its assets to FS, a newly formed foreign corporation, in 
exchange for stock of FS, in a reorganization described in section 
368(a)(1)(F). P exchanges its USS stock for FS stock under section 
354.
    (ii) Analysis. FS has acquired substantially all the properties 
held directly or indirectly by USS pursuant to a plan. P, the common 
parent of the EAG, held more than 80% of the stock of USS before the 
acquisition. After the acquisition, less than 20% of FS's stock is 
owned by non-members of the EAG. Under paragraph (c)(1) of this 
section, the FS stock owned by P by reason of holding stock in USS 
is included in the denominator but not in the numerator of the 
fraction that determines the percentage of FS stock owned by former 
shareholders of USS by reason of holding stock in USS. Accordingly, 
the fraction is 0/100 and the percentage is 0%. FS is not a 
surrogate foreign corporation.
    Example 3. Intra-group restructuring; wholly owned corporation--
(i) Facts. The facts are the same as in Example 2 except that USS 
does not transfer any of its assets. P transfers all 100 shares of 
USS stock to FS in exchange for FS stock.
    (ii) Analysis. FS has indirectly acquired substantially all the 
properties held directly or indirectly by USS pursuant to a plan. P, 
the common parent of the EAG, held more than 80% of the stock of USS 
before the acquisition. After the acquisition, less than 20% of FS's 
stock is owned by non-members of the EAG. Under paragraph (c)(1) of 
this section, the FS stock owned by P by reason of holding stock in 
USS is included in the denominator but not in the numerator of the 
fraction that determines the percentage of stock owned by former 
shareholders of USS by reason of holding stock in USS. Accordingly, 
the fraction is 0/100 and the percentage is 0%. FS is not a 
surrogate foreign corporation.
    Example 4. Intra-group restructuring; less than wholly owned 
corporation--(i) Facts. The facts are the same as in Example 2 
except that P owns 85 shares of USS stock. The remaining 15 shares 
of USS stock are owned by A, a person unrelated to P. As part of an 
internal restructuring within the P group, P and A transfer all 
their USS stock to FS, in exchange for an equal number of shares of 
FS stock.
    (ii) Analysis. FS has indirectly acquired substantially all the 
properties held directly or indirectly by USS pursuant to a plan. 
After the acquisition, P owns 85 shares of FS stock by reason of 
holding stock in USS, and A owns 15 shares of FS stock by reason of 
holding stock in USS. Before the acquisition, USS was more than 80% 
owned by P, which is the common parent of the EAG, and after the 
acquisition, less than 20% of FS's stock is owned by non-members of 
the EAG (i.e., by A) by reason of holding stock in USS. Under 
paragraph (c)(1) of this section, the FS stock owned by P is 
included in the denominator, but is not included in the numerator, 
of the fraction that determines the percentage of FS stock owned by 
former shareholders of USS by reason of holding stock in USS. 
Accordingly, the fraction is 15/100 and the percentage is 15%. FS is 
not a surrogate foreign corporation. FS is a controlled foreign 
corporation.
    Example 5. Formation of joint venture corporation--(i) Facts. M, 
a corporation, owns all the outstanding stock of S, a domestic 
corporation engaged in business Y in the United States. B, a 
corporation unrelated to M, owns several foreign subsidiaries that 
are engaged in business Y outside the United States. M and B enter 
into an agreement under which each will transfer certain assets to 
FJV, a newly formed foreign corporation, in exchange for stock of 
FJV. FJV will conduct business Y on a worldwide basis. Pursuant to 
the plan, M transfers to FJV all the outstanding stock of S in 
exchange for 40 shares of FJV stock, and B transfers to FJV the 
stock of several foreign corporations in exchange for 60 shares of 
FJV stock. FJV has no other stock outstanding.
    (ii) Analysis. FJV has indirectly acquired substantially all the 
properties held directly or indirectly by S pursuant to a plan. 
After the acquisition, M owns 40 shares of FJV stock by reason of 
holding stock in S, and B owns the remaining 60 shares of FJV stock. 
M does not own, directly or indirectly, more than 50% of the stock 
of any member of the EAG. Under paragraph (c)(2) of this section, 
the FJV stock owned by B is included in the denominator but not the 
numerator of the fraction that determines the percentage of FJV 
stock owned by former shareholders of S by reason of holding stock 
in S. Accordingly, the fraction is 40/100 and the percentage is 40%. 
FJV is not a surrogate foreign corporation.
    Example 6. Acquisition of existing joint venture entity--(i) 
Facts. K and L are unrelated corporations. T is a domestic 
corporation with 100 shares of stock outstanding, 55 of which are 
held by K and 45 of which are held by L. K and L contribute their T 
stock to U, a newly formed foreign corporation, in exchange for an 
equal number of shares of U stock.
    (ii) Analysis. U has indirectly acquired substantially all the 
properties held directly or indirectly by T pursuant to a plan. 
After the acquisition, K owns 55 shares of U stock

[[Page 76689]]

by reason of holding stock in T, and L owns 45 shares of U stock by 
reason of holding stock in T. Under paragraph (b) of this section, 
the U stock held by K is not included in either the numerator or the 
denominator of the fraction that determines the percentage of U 
stock owned by former shareholders of T by reason of holding stock 
in T. Accordingly, the fraction is 45/45 and the percentage is 100%. 
If the EAG does not have substantial business activities in U's 
country of incorporation when compared to the total business 
activities of the EAG, U is a surrogate foreign corporation which is 
treated as a domestic corporation under section 7874(b).
    Example 7. Intra-group restructuring; less than wholly owned 
partnership--(i) Facts. LLC, a Delaware limited liability company 
engaged in the conduct of a trade or business, is 90% owned by C, a 
corporation, and 10% owned by D, a person unrelated to C. LLC has 
not elected to be treated as an association taxable as a 
corporation. As part of an internal restructuring within the C 
group, C and D transfer their interests in LLC to E, a newly formed 
foreign corporation, in exchange for 90 shares and 10 shares, 
respectively, of E's common stock, which are all of the issued and 
outstanding shares of E.
    (ii) Analysis. LLC is a domestic partnership for Federal income 
tax purposes. E has indirectly acquired substantially all the 
properties constituting a trade or business of LLC pursuant to a 
plan. After the acquisition, C holds 90% of E's stock by reason of 
holding a capital or profits interest in LLC, and D holds 10% of E's 
stock by reason of holding a capital or profits interest in LLC. 
Before the acquisition, LLC is more than 80% owned by C, the common 
parent of the EAG, and after the acquisition, less than 20% of E's 
stock is owned by non-members of the EAG (that is by D) by reason of 
holding a capital or profits interest in LLC. Under paragraph (c)(1) 
of this section, the E stock held by C is included in the 
denominator but not the numerator of the fraction that determines 
the percentage of E stock owned by former partners of LLC by reason 
of holding an interest in LLC. Accordingly, the fraction is 10/100 
and the percentage is 10%. E is not a surrogate foreign corporation.
    Example 8. Acquisition of 50-50 joint venture partnership--(i) 
Facts. The facts are the same as in Example 7 except that C and D 
each own 50% of the capital and profits interests in LLC. C and D 
transfer their interests in LLC to G, a newly formed foreign 
corporation, in exchange for 50 shares each of G's common stock, 
which are all of the issued and outstanding shares of G.
    (ii) Analysis. G has indirectly acquired substantially all the 
properties constituting a trade or business of LLC, a domestic 
partnership, pursuant to a plan. After the acquisition, C and D each 
hold 50% of G's stock by reason of holding an interest in LLC. G is 
not included in an expanded affiliated group after the acquisition. 
Accordingly, none of the stock of G is disregarded under this 
section in determining the percentage of G stock held by former 
partners of LLC by reason of holding an interest in LLC. Thus, the 
fraction is 100/100 and the percentage is 100%. If the EAG does not 
have substantial business activities in G's country of incorporation 
when compared to the total business activities of the EAG, G is a 
surrogate foreign corporation which is treated as a domestic 
corporation under section 7874(b).

    (e) Effective date. This section applies to taxable years ending 
after March 4, 2003.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: December 13, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 05-24450 Filed 12-27-05; 8:45 am]
BILLING CODE 4830-01-P