[Federal Register Volume 77, Number 113 (Tuesday, June 12, 2012)]
[Rules and Regulations]
[Pages 34785-34788]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-14226]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9592]
RIN 1545-BK86


Substantial Business Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary Regulations.

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SUMMARY: This document contains temporary regulations regarding whether 
a foreign corporation has substantial business activities in a foreign 
country. These regulations affect certain domestic corporations and 
partnerships (and certain parties related thereto), and foreign 
corporations that acquire substantially all of the properties of such 
domestic corporations or partnerships. The text of these temporary 
regulations serves as the text of the proposed regulations set forth in 
the notice of proposed rulemaking on this subject also published in 
this issue of the Federal Register.

DATES: Effective Date: These regulations are effective on June 12, 
2012.
    Applicability Date: For date of applicability, see Sec.  1.7874-
3T(f).

FOR FURTHER INFORMATION CONTACT: Mary W. Lyons, (202) 622-3860 and 
David A. Levine, (202) 622-3860 (not a toll-free number).

SUPPLEMENTARY INFORMATION: 

Background

    On June 6, 2006, temporary regulations under section 7874 (TD 9265, 
2006-2 CB 1) were published in the Federal Register (71 FR 32437) 
concerning the treatment of a foreign corporation as a surrogate 
foreign corporation (2006 temporary regulations). A notice of proposed 
rulemaking (REG-112994-06) cross-referencing the 2006 temporary 
regulations was published in the same issue of the Federal Register (71 
FR

[[Page 34786]]

32495, 2006-2 CB 47). On July 28, 2006, Notice 2006-70 (2006-2 CB 252) 
was published, announcing a modification to the effective date 
contained in the 2006 temporary regulations. See Sec.  
601.601(d)(2)(ii)(b). On June 12, 2009, the 2006 temporary regulations 
and the related notice of proposed rulemaking were withdrawn and 
replaced with new temporary regulations (2009 temporary regulations), 
which generally applied to acquisitions completed on or after June 9, 
2009. TD 9453 (74 FR 27920, 2009-2 CB 114). A notice of proposed 
rulemaking (REG-112994-06) cross-referencing the 2009 temporary 
regulations was published in the same issue of the Federal Register (74 
FR 27947, 2009-2 CB 144). No public hearing was requested or held; 
however, comments were received. All comments are available at 
www.regulations.gov or upon request. After consideration of the 
comments received regarding whether a foreign corporation has 
substantial business activities in a foreign country, the Internal 
Revenue Service (IRS) and the Department of the Treasury (Treasury 
Department) have decided to issue new temporary regulations under Sec.  
1.7874-3T (2012 temporary regulations) and a new notice of proposed 
rulemaking that provide guidance regarding this determination. The 
other portions of the 2009 temporary regulations are finalized in a 
separate Treasury Decision published elsewhere in this issue of the 
Federal Register.

Explanation of Provisions

A. General Approach

    A foreign corporation is generally 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 completes 
after March 4, 2003, the direct or indirect acquisition of 
substantially all of the properties held directly or indirectly by a 
domestic corporation; (ii) after the acquisition at least 60 percent of 
the stock (by vote or value) of the foreign corporation is held by 
former shareholders of the domestic corporation by reason of holding 
stock in the domestic corporation; and (iii) after the acquisition, the 
expanded affiliated group that includes the foreign corporation does 
not have substantial business activities in the foreign country 
(relevant foreign country) in which, or under the law of which, the 
foreign corporation is created or organized, when compared to the total 
business activities of the expanded affiliated group. Similar 
provisions apply if a foreign corporation acquires substantially all of 
the properties constituting a trade or business of a domestic 
partnership.
    The 2006 temporary regulations provided that the determination of 
whether the expanded affiliated group has substantial business 
activities in the relevant foreign country is based on all the facts 
and circumstances. The 2006 temporary regulations also provided a safe 
harbor, which generally was satisfied if at least ten percent of the 
employees, assets, and sales of the expanded affiliated group were in 
the relevant foreign country. The 2009 temporary regulations retained 
the facts and circumstances general rule provided in the 2006 temporary 
regulations, with certain modifications, but removed the safe harbor.
    The IRS and the Treasury Department received comments requesting 
additional guidance on the level of business activities necessary for 
an expanded affiliated group to have substantial business activities in 
the relevant foreign country. One comment suggested providing a new 
safe harbor, which would require a higher percentage of business 
activities in the relevant foreign country than was required under the 
safe harbor included in the 2006 temporary regulations. The comment 
also recommended different safe harbors depending on the extent of the 
expanded affiliated group's business activities in the United States.
    After consideration of the comments and the underlying policies of 
section 7874, the IRS and the Treasury Department believe the facts and 
circumstances test of the 2009 temporary regulations should be replaced 
with a bright-line rule describing the threshold of activities required 
for an expanded affiliated group to have substantial business 
activities in the relevant foreign country. The IRS and the Treasury 
Department believe that such a rule will provide more certainty in 
applying section 7874 to particular transactions than the 2009 
temporary regulations and will improve the administrability of this 
provision.

B. Threshold of Business Activities

    The 2012 temporary regulations provide that an expanded affiliated 
group will have substantial business activities in the relevant foreign 
country only if at least 25 percent of the group employees, group 
assets, and group income are located or derived in the relevant foreign 
country, determined as follows:
1. Group Employees
    The 2012 temporary regulations set forth two tests, each of which 
must be satisfied, based on employees of members of the expanded 
affiliated group (group employees). The first test is calculated as the 
number of group employees based in the relevant foreign country divided 
by the total number of group employees determined on the applicable 
date discussed in section B.4. of this preamble. The second test is 
calculated as employee compensation with respect to group employees 
based in the relevant foreign country divided by the total employee 
compensation with respect to all group employees determined during the 
one-year testing period.
2. Group Assets
    The group assets test is calculated as the value of the group 
assets located in the relevant foreign country divided by the total 
value of all group assets determined on the applicable date. The term 
group assets generally means tangible personal property or real 
property used or held for use in the active conduct of a trade or 
business by members of the expanded affiliated group. For this purpose, 
group assets include certain property rented by members of the expanded 
affiliated group, with the value of such rented property being deemed 
to be eight times the net annual rent paid or accrued with respect to 
such property. The IRS and the Treasury Department believe that using 
an eight-times multiple for this purpose is administrable and 
consistent with the treatment of rented property for other purposes. 
See, for example, Uniform Division of Income for Tax Purposes Act, 
Sec. Sec.  10 and 11. In order to constitute group assets, such rented 
property must satisfy the other applicable requirements for group 
assets, including that the property is used or held for use in the 
active conduct of a trade or business.
3. Group Income
    The group income test is calculated as the group income derived in 
the relevant foreign country divided by the total group income 
determined during the one-year testing period. The term group income 
means gross income of members of the expanded affiliated group from 
transactions occurring in the ordinary course of business with 
customers that are not related persons. Group income is considered to 
be derived in a foreign country only if the customer is located in such 
country.

[[Page 34787]]

4. Applicable Date
    Section 7874(a)(2)(B)(iii) provides that the determination of 
whether the expanded affiliated group has substantial business 
activities is made after the acquisition. However, the IRS and the 
Treasury Department believe that when the acquisition occurs other than 
at the end of a month the factors used to determine whether the 
substantial business activities test is satisfied may not be readily 
determinable in some cases. Accordingly, the 2012 temporary regulations 
provide that the number of group employees and the value of group 
assets can be measured as of the applicable date, which is either the 
date on which the acquisition is completed or the last day of the month 
immediately preceding the month in which the acquisition is completed. 
The applicable date is also used to determine the testing period, which 
is used in computing group income and employee compensation. When the 
applicable date is the last day of the month immediately preceding the 
month in which the acquisition is completed, group employees, employee 
compensation, group assets, and group income consist of those items or 
amounts of members that comprise the expanded affiliated group 
determined at the close of the acquisition date.

C. Attribution From a Partnership

    The 2009 temporary regulations provided that for purposes of the 
substantial business activities test, a member of an expanded 
affiliated group that holds at least a ten-percent capital and profits 
interest in a partnership takes into account its proportionate share of 
all items of the partnership. The IRS and the Treasury Department 
believe that the policies of section 7874 are better advanced if the 
treatment of partnerships is made consistent with that of corporations 
for purposes of applying the substantial business activities test on a 
group basis. Accordingly, the 2012 temporary regulations provide that 
the items of a partnership should be taken into account for this 
purpose only if one or more members of the expanded affiliated group 
holds, in the aggregate, more than 50 percent (by value) of the 
interests in the partnership. The IRS and the Treasury Department 
further believe that, consistent with the treatment of corporations, if 
this ownership requirement is satisfied, then all the items of the 
partnership should be taken into account for this purpose.

D. Effective Date

    Subject to a transition rule, the 2012 temporary regulations apply 
to acquisitions completed on or after June 7, 2012.

Special Analyses

    It has been determined that that these temporary regulations are 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to the 2012 temporary regulations 
and because the regulations do not impose a collection of information 
on small entities, the requirements of the Regulatory Flexibility Act 
(5 U.S.C. chapter 6) do not apply. Accordingly, a regulatory 
flexibility analysis is not required. Pursuant to section 7805(f) of 
the Code, the 2012 temporary regulations have been submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small business.

Requests for Comments

    The IRS and the Treasury Department are considering to what extent 
partners of a partnership should be treated as if they were employees 
solely for purposes of the two tests based on group employees, and 
specifically request comments on these issues. For information on how 
to submit comments or request a public hearing, see the section 
``Comments and Requests for a Public Hearing'' set forth in the notice 
of proposed rulemaking published elsewhere in this issue of the Federal 
Register.

Drafting Information

    The principal authors of the 2012 temporary regulations are Mary W. 
Lyons and David A. Levine of the Office of Associate Chief Counsel 
(International). However, other personnel from the IRS and the Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    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 * * *
    Section 1.7874-3T is also issued under 26 U.S.C. 7874(c)(6) and 
(g).* * *

0
Par. 2. Section 1.7874-3T is added to read as follows:


Sec.  1.7874-3T  Substantial business activities (temporary).

    (a) Scope. This section provides rules regarding whether a foreign 
corporation has substantial business activities in the relevant foreign 
country when compared to the total business activities of the expanded 
affiliated group for purposes of section 7874(a)(2)(B)(iii). Paragraph 
(b) of this section sets forth the threshold of business activities 
that constitute substantial business activities. Paragraph (c) of this 
section describes certain items not to be taken into account as located 
or derived in the relevant foreign country. Paragraph (d) of this 
section provides definitions and certain rules of application. 
Paragraph (e) of this section provides rules regarding the treatment of 
a partnership in which one or more members of an expanded affiliated 
group own an interest. Paragraph (f) of this section provides the dates 
of applicability and expiration.
    (b) Threshold of business activities. The expanded affiliated group 
will have substantial business activities in the relevant foreign 
country after the acquisition when compared to the total business 
activities of the expanded affiliated group only if, subject to 
paragraph (c) of this section, each of the tests described in 
paragraphs (b)(1) through (b)(3) of this section is satisfied.
    (1) Group employees--(i) Number of employees. The number of group 
employees based in the relevant foreign country is at least 25 percent 
of the total number of group employees on the applicable date.
    (ii) Employee compensation. The employee compensation incurred with 
respect to group employees based in the relevant foreign country is at 
least 25 percent of the total employee compensation incurred with 
respect to all group employees during the testing period.
    (2) Group assets. The value of the group assets located in the 
relevant foreign country is at least 25 percent of the total value of 
all group assets on the applicable date.
    (3) Group income. The group income derived in the relevant foreign 
country is at least 25 percent of the total group income during the 
testing period.
    (c) Items not to be considered. The following items are not taken 
into account in the numerator, but are taken into account in the 
denominator, for each of the tests described in paragraphs (b)(1) 
through (b)(3) of this section:

[[Page 34788]]

    (1) Any group assets, group employees, or group income attributable 
to business activities that are associated with properties or 
liabilities the transfer of which is disregarded under section 
7874(c)(4).
    (2) Any group assets or group employees located in, or group income 
derived in, the relevant foreign country as part of a plan with a 
principal purpose of avoiding the purposes of section 7874.
    (3) Any group assets or group employees located in, or group income 
derived in, the relevant foreign country if such group assets or group 
employees, or the business activities to which such group income is 
attributable, are subsequently transferred to another country in 
connection with a plan that existed at the time of the acquisition 
described in section 7874(a)(2)(B)(i).
    (d) Definitions and application of rules. The following definitions 
and rules apply for purposes of this section:
    (1) The term acquisition date means the date on which the 
acquisition described in section 7874(a)(2)(B)(i) is completed.
    (2) The term applicable date means either of the following dates, 
applied consistently for all purposes of this section:
    (i) The acquisition date; or
    (ii) The last day of the month immediately preceding the month in 
which the acquisition described in section 7874(a)(2)(B)(i) is 
completed.
    (3) The term employee compensation means all amounts incurred by 
members of the expanded affiliated group that directly relate to 
services performed by group employees (including, for example, wages, 
salaries, deferred compensation, employee benefits, and employer 
payroll taxes). Employee compensation is determined in U.S. dollars 
translated, if necessary, using the weighted average exchange rate (as 
defined in Sec.  1.989(b)-1) for the testing period.
    (4) The term expanded affiliated group means the affiliated group 
defined in section 7874(c)(1) determined at the close of the 
acquisition date. The term member of the expanded affiliated group 
means an entity included in the expanded affiliated group. A reference 
to a member of the expanded affiliated group includes a predecessor 
with respect to such member.
    (5) The term group assets means tangible personal property or real 
property used or held for use in the active conduct of a trade or 
business by members of the expanded affiliated group, provided such 
property is owned by members of the expanded affiliated group at the 
close of the acquisition date. A group asset is considered to be 
located in the relevant foreign country only if the asset was 
physically present in such country at the close of the acquisition date 
and for more time than in any other country during the testing period. 
All group assets must be valued consistently and on a gross basis (that 
is, not reduced by liabilities) using either the adjusted tax basis or 
fair market value determined in U.S. dollars translated, if necessary, 
at the spot rate determined under the principles of Sec.  1.988-
1(d)(1), (2), and (4). Tangible personal property or real property that 
is rented by members of the expanded affiliated group from a person 
other than a member of the expanded affiliated group is also treated as 
a group asset, provided such property is used in the active conduct of 
a trade or business and is being rented by members of the expanded 
affiliated group at the close of the acquisition date. For purposes of 
this section, a group asset that is rented is valued at eight times the 
net annual rent paid or accrued with respect to the property by members 
of the expanded affiliated group.
    (6) The term group employees means employees of members of the 
expanded affiliated group. A group employee is considered to be based 
in the relevant foreign country only if the employee spent more time 
providing services in such country than in any other single country 
during the testing period.
    (7) The term group income means gross income of members of the 
expanded affiliated group from transactions occurring in the ordinary 
course of business with customers that are not related persons. Group 
income is translated into U.S. dollars, if necessary, using the 
weighted average exchange rate (as defined in Sec.  1.989(b)-1) for the 
testing period. Group income is considered derived in the relevant 
foreign country only if it is derived from a transaction with a 
customer located in such country.
    (8) The term net annual rent means the annual rent paid or accrued 
with respect to property, less any payments received or accrued from 
subleasing such property (or other similar arrangement).
    (9) The term related person has the meaning specified in section 
954(d)(3), except that section 954(d)(3) is applied by substituting 
``one or more members of the expanded affiliated group'' for ``a 
controlled foreign corporation'' and ``the controlled foreign 
corporation'' each place they appear.
    (10) The term relevant foreign country means the foreign country in 
which, or under the law of which, the foreign corporation was created 
or organized.
    (11) The term testing period means the one-year period ending on 
the applicable date.
    (e) Treatment of partnerships. For purposes of this section, if one 
or more members of the expanded affiliated group own, in the aggregate, 
more than 50 percent (by value) of the interests in a partnership, such 
partnership will be treated as a corporation that is a member of the 
expanded affiliated group. Thus, all items of such a partnership are 
taken into account for purposes of this section. No items of a 
partnership are taken into account for purposes of this section unless 
the partnership is treated as a member of the expanded affiliated group 
pursuant to this paragraph.
    (f) Effective/applicability and expiration dates. Except as 
otherwise provided in this paragraph, this section shall apply to 
acquisitions that are completed on or after June 7, 2012. For 
acquisitions completed on or after June 7, 2012 that were either 
described in a filing with the Securities and Exchange Commission on or 
before June 7, 2012, or that were subject to a written agreement that 
was binding on June 7, 2012, and at all times thereafter, taxpayers may 
apply either the rules in Sec.  1.7874-2T(g), as contained in 26 CFR 
part 1 revised as of April 12, 2012, or the rules set forth in this 
section. The applicability of this section expires on June 5, 2015.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: June 4, 2012.

Emily S. McMahon,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2012-14226 Filed 6-7-12; 4:15 pm]
BILLING CODE 4830-01-P