[Federal Register Volume 71, Number 108 (Tuesday, June 6, 2006)]
[Rules and Regulations]
[Pages 32437-32448]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-8699]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9265]
RIN 1545-BF48


Guidance Under Section 7874 Regarding Expatriated Entities and 
Their Foreign Parents

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 determination 
of whether a foreign entity shall be treated as a surrogate foreign 
corporation under section 7874(a)(2)(B) of the Code. The text of these 
temporary regulations also serves as the text of the proposed 
regulations (REG-112994-06) set forth in the notice of proposed 
rulemaking on this subject published elsewhere in this issue of the 
Federal Register.

DATES: Effective Date: These regulations are effective June 6, 2006.
    Applicability Dates: For dates of applicability, see Sec.  1.7874-
2T(j).

FOR FURTHER INFORMATION CONTACT: Milton Cahn, 202-622-3860 (not a toll-
free number).

SUPPLEMENTARY INFORMATION:

Background

A. Section 7874--Overview

    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, 108th 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, 108th Cong., 1st Sess., at 
142 (Nov. 7, 2003). In particular, Congress believed that such 
transactions permit corporations and other entities to

[[Page 32438]]

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 108th 
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 TD 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.

B. Temporary and Proposed Regulations

    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).
1. Indirect Acquisition of Properties
    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, 108th 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.
2. Stock Held by Reason of Holding an Interest in the Domestic Entity
    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.
3. Substantial Business Activities of the EAG
    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, 108th 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.
4. Preventing Avoidance of the Purposes of the Section
(i). Publicly Traded Foreign Partnership as Acquiring Entity
    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

[[Page 32439]]

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.
(ii). Options and Similar Interests
    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.
5. Effects of Section 7874(b)
    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.

Explanation of Provisions

A. Indirect Acquisition of Properties Held by a Domestic Corporation

    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, 108th 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.

B. Stock Held by Reason of Holding an Interest in the Domestic Entity

    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.

C. Substantial Business Activities in the Foreign Country of 
Incorporation

    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.
1. Facts and Circumstances Test
    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

[[Page 32440]]

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.
2. Safe Harbor Test
    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 Sec.  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.

D. Prevention of Avoidance of Section 7874

1. Acquisitions by Publicly Traded Foreign Partnerships
    It has been brought to the attention of the IRS and Treasury 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

[[Page 32441]]

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, Sec.  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 Sec.  
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 Sec.  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 Sec.  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 Sec. Sec.  
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

[[Page 32442]]

certain cases. Comments are solicited below on whether future 
regulations under section 7874 or another provision of the Code should 
address these situations.
2. Options and Similar Interests Treated as Stock of the Foreign 
Acquirer
    Based on the regulatory authority provided in section 7874(c)(6), 
Sec.  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).

E. Effects of Section 7874(b)

    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, Sec.  
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).

F. Effective Dates

    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.

Request for Comments

    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 treatment of stock sold in a public offering that 
is related to the acquisition; and (4) 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. 
The IRS and Treasury Department specifically request comments regarding 
appropriate rules in relation to these issues arising under section 
7874.
    One commentator has recommended that preferred stock described in 
section 1504(a)(4) should be disregarded in applying the ownership 
percentage test of section 7874(a)(2)(B)(ii) and the special safe 
harbor rules of Sec.  1.7874-1T(c). The IRS and Treasury Department are 
carefully considering this recommendation and solicit additional 
comments as to whether future guidance should include such a rule.
    In addition, the IRS and Treasury Department are considering 
whether and how to amend Sec.  1.367(a)-3(c), which deals with the tax 
consequences of a United States person's transfer of stock of a 
domestic corporation to a foreign acquiring corporation, as a result of 
the enactment of section 7874 and the promulgation of regulations 
thereunder. A commentator has asked for these amendments. Additional 
comments are requested.
    Based on comments received, the IRS and Treasury Department 
identified inversion transactions using a publicly traded foreign 
partnership as the new foreign parent entity of the inverted group as a 
category of transactions requiring a special rule in order to prevent 
avoidance of the purposes of section 7874, in light of the 
Congressional purpose in enacting section 7704. Comments are requested 
as to whether other types of partnerships, such as foreign partnerships 
that are not publicly traded and domestic partnerships (including 
limited liability companies), could also be used to avoid the purposes 
of sections 7874 and 7704, and whether further guidance addressing such 
avoidance is warranted.

Effective Date

    Section 1.7874-2T applies to acquisitions completed on or after 
June 6, 2006. Taxpayers may elect to apply the section to acquisitions 
completed prior to that date, but must apply it consistently to all 
acquisitions within its scope.

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.
    These regulations are necessary to provide immediate guidance to 
prevent avoidance of section 7874 in situations where it should apply 
as well as to provide immediate guidance on situations where it should 
not apply. Accordingly, good cause is found for dispensing with notice 
and public comment pursuant to 5 U.S.C. 553(b)(B) and with a delayed 
effective date pursuant to 5 U.S.C. 553(d)(3). For 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 continues to read, in 
part, as follows:

    Authority: 26 U.S.C. 7805 * * *

[[Page 32443]]


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


Sec.  1.7874-2T  Surrogate foreign corporation (temporary).

    (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) 
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 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

[[Page 32444]]

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 
Sec.  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 Sec.  
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

[[Page 32445]]

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. Sec.  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 e-
mail 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

[[Page 32446]]

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 Sec.  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 Sec.  
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 Sec.  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 Sec.  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 Sec.  
301.7701-2. FQ makes an election under Sec.  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

[[Page 32447]]

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 Sec.  
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 Sec.  1.367(b)-2(f). See also 
Sec.  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 Sec. Sec.  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 Sec.  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.


[[Page 32448]]


    Approved: May 22, 2006.
Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.

Eric Solomon,
 Acting Deputy Assistant Secretary of the Treasury.
 [FR Doc. E6-8699 Filed 6-5-06; 8:45 am]
BILLING CODE 4830-01-P