[Federal Register Volume 77, Number 113 (Tuesday, June 12, 2012)]
[Rules and Regulations]
[Pages 34788-34797]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-14237]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9591]
RIN 1545-BF47


Surrogate Foreign Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations regarding whether a 
foreign corporation is treated as a surrogate foreign corporation. The 
final

[[Page 34789]]

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.

DATES: Effective Date: These regulations are effective on June 12, 
2012.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.7874-1(g) and 1.7874-2(l).

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

SUPPLEMENTARY INFORMATION: 

Background

    On June 6, 2006, temporary regulations under section 7874 of the 
Internal Revenue Code (Code) (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 32495). 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and the related notice of proposed rulemaking were withdrawn and 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, the 2009 proposed regulations are adopted as final 
regulations with the modifications described in this preamble. The 2009 
temporary regulations are removed. As discussed in paragraph A. of this 
preamble, new temporary regulations under section 7874 regarding 
whether a foreign corporation has substantial business activities in a 
foreign country, and a corresponding notice of proposed rulemaking, are 
published elsewhere in this issue of the Federal Register.

Summary of Comments and Explanation of Revisions

A. Substantial Business Activities

    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.
    Comments were received regarding the determination as to whether an 
expanded affiliated group has substantial business activities in a 
foreign country. These comments are discussed in the preamble to 
temporary regulations, published elsewhere in this issue of the Federal 
Register, that provide guidance on the substantial business activities 
test.

B. Options

1. General Approach
    The 2009 temporary regulations generally provide that, for purposes 
of section 7874, an option or similar interest (together, an 
``option'') with respect to a corporation is treated as stock of the 
corporation with a value equal to the holder's claim on the equity of 
the corporation. For this purpose, the equity of the corporation does 
not include the value of any property the holder of the option would be 
required to provide to the corporation pursuant to the terms of the 
option if such option were exercised. The 2009 temporary regulations 
provide similar rules for an option with respect to a partnership.
    A comment suggested that, subject to an anti-abuse rule, options 
should be ignored for purposes of section 7874. The comment asserts 
that this approach, consistent with the treatment of options under 
other Code sections, would be more administrable; the comment 
recognized, however, that unlike the approach taken in the 2009 
temporary regulations, this approach does not properly take into 
account the economic interest of an option holder. Alternatively, the 
comment suggested that if the approach taken in the 2009 temporary 
regulations is retained, certain types of options (for example, 
publicly traded options and customary compensatory options) should be 
excluded from the general rule.
    The Internal Revenue Service (IRS) and the Department of the 
Treasury (Treasury Department) believe that the claim-on-equity 
approach in the 2009 temporary regulations is preferable to 
disregarding options subject to an anti-avoidance rule. The IRS and the 
Treasury Department believe this approach most properly reflects the 
economics of the transaction and is not easily manipulated. Moreover, 
the IRS and the Treasury Department believe that the simplicity of 
uniformly treating all types of options outweighs the benefits of 
excluding, or providing other special rules for, certain types of 
options. Accordingly, the claim-on-equity approach provided in the 2009 
temporary regulations is retained, with certain modifications, in these 
final regulations.
2. Voting Power
    Certain portions of section 7874 also look to the voting power of 
stock. For example, one of the requirements for a foreign corporation 
to be treated as a surrogate foreign corporation is that, after the 
acquisition, at least 60 percent of the stock (by vote or value) of the 
entity is held, in the case of an acquisition with respect to a 
domestic corporation, by former shareholders of the domestic 
corporation by reason of holding stock in the domestic corporation. 
Section 7874(a)(2)(B)(ii). As discussed in section B.1. of this 
preamble, however, the 2009 temporary regulations only address options 
with

[[Page 34790]]

respect to the amount of stock treated as held by value; they do not 
address the effect of options on voting power.
    A comment suggested that if the general approach of the 2009 
temporary regulations is retained, the effect options have on voting 
power, if any, should be addressed. Specifically, the comment suggested 
that options could be treated as: (i) Not having voting power; (ii) 
having voting power corresponding to the number of shares the value of 
which equals the claim on equity; or (iii) having voting power 
corresponding to the number of shares that would be obtained upon 
exercise of the option.
    In response to this comment, the final regulations provide that for 
purposes of determining the voting power of stock under section 7874, 
an option will be treated as exercised if a principal purpose of the 
issuance or acquisition of the option is to avoid treating the foreign 
corporation as a surrogate foreign corporation. In all other cases, 
options are not taken into account for purposes of determining the 
voting power of stock under section 7874.
3. Effect of Options on Equity Holders
    A comment requested clarification that if an option is treated as 
stock under the claim-on-equity approach, then the ownership 
percentages of shareholders are reduced. The IRS and the Treasury 
Department believe that the value of stock inherently reflects the 
existence of options that have a claim on equity. Therefore, no 
adjustment to the value of stock under the regulations is necessary. 
For example, if the stock of a foreign corporation has an aggregate 
value of $100x (which reflects the existence of options) and there is a 
single option outstanding with a claim on equity of $10x with respect 
to the foreign corporation, then under the regulations the total value 
of the stock of the foreign corporation is treated as $110x for 
purposes of section 7874. An example in the regulations is modified to 
clarify this result.
4. Other Rules
    The 2009 temporary regulations provide that, with respect to a 
foreign corporation, the general option rule does not apply if a 
principal purpose of the issuance or acquisition of the option is to 
avoid the foreign corporation being treated as a surrogate foreign 
corporation. The 2009 temporary regulations do not contain a similar 
rule with respect to domestic corporations or domestic partnerships.
    A comment questioned why the anti-abuse rule only applies to 
foreign corporations and noted that avoidance concerns may equally be 
present with options in domestic corporations or partnerships. 
Accordingly, the comment suggested that the anti-abuse rule be extended 
to apply to options with respect to domestic corporations and domestic 
partnerships. The IRS and the Treasury Department agree with this 
comment. As a result, the final regulations modify the anti-abuse rule 
such that it applies to options with respect to all corporations and 
partnerships, domestic or foreign.
    Another comment suggested that the regulations include special 
rules to take into account certain types of options, such as options 
subject to vesting and nontransferable options. In response to this 
comment, the final regulations provide that the claim-on-equity 
approach does not apply if, at the time of the acquisition, the 
probability that the option will be exercised is remote.
    The final regulations clarify that the rules addressing options 
also apply for purposes of determining the membership of an expanded 
affiliated group under section 7874(c)(1). In addition, the text of the 
final regulations is clarified to provide that a claim on equity equals 
the value of the stock or partnership interest that may be acquired 
pursuant to the option, less the exercise price (but in no case is a 
claim on equity less than zero).

C. Insolvent Entities

    The 2009 temporary regulations provide that, for purposes of 
section 7874, if immediately prior to the first date properties are 
acquired as part of an acquisition described in section 
7874(a)(2)(B)(i), a domestic corporation is in a title 11 or similar 
case (as defined in section 368(a)(3)), or the liabilities of the 
domestic corporation exceed the value of its assets, then any claim by 
a creditor against the domestic corporation shall be treated as stock 
of the domestic corporation. A similar rule applies with respect to a 
domestic partnership, or a foreign partnership that owns stock of a 
domestic corporation.
    A comment was received stating that, in certain cases, the 
creditors should be viewed as purchasers of the insolvent entity's 
assets and, as a result, the transaction should not be subject to 
section 7874. The comment further stated that applying section 7874 to 
such creditors could provide third-party bidders for the entity's 
assets an undue advantage over existing creditors because such bidders 
would not be subject to section 7874. Accordingly, the comment 
suggested that the insolvency rule be modified to only apply where 
creditors acquire the insolvent entity's debt pursuant to a plan to 
acquire its stock or assets.
    The IRS and the Treasury Department believe that, for purposes of 
section 7874, the creditors of an insolvent entity should be considered 
the equity holders of the entity. Furthermore, the IRS and the Treasury 
Department do not believe that insolvent entities should be treated 
more favorably than other entities under section 7874. Accordingly, 
this comment is not adopted.

D. Acquisitions of Multiple Domestic Entities and Disregard of 
Affiliate-Owned Stock

    The 2009 temporary regulations generally provide that if, pursuant 
to a plan (or series of related transactions), a foreign corporation 
completes two or more acquisitions described in section 
7874(a)(2)(B)(i) involving domestic corporations or partnerships 
(domestic entities) then, for purposes of section 7874(a)(2)(B)(ii), 
the acquisitions are treated as a single acquisition and the domestic 
entities are treated as a single domestic entity.
    Section 7874(c)(2)(A) and Sec.  1.7874-1 provide special rules for 
determining ownership under section 7874(a)(2)(B)(ii) for stock held by 
members of the expanded affiliated group that includes the foreign 
corporation. Section 7874(c)(2)(B) provides that stock of the foreign 
corporation that is sold in a public offering related to the 
acquisition described in section 7874(a)(2)(B)(i) is not taken into 
account for purposes of determining ownership under section 
7874(a)(2)(B)(ii).
    A comment requested clarification as to the application of section 
7874(c)(2)(A) and Sec.  1.7874-1 when acquisitions of two or more 
domestic entities are treated as a single domestic entity under the 
2009 temporary regulations. The IRS and the Treasury Department are 
studying the manner in which Sec.  1.7874-1 should interact with 
various rules under section 7874, including the rules in section 
7874(c)(2)(B), Sec.  1.7874-2(e), and Notice 2009-78 (2009-2 CB 452) 
(determination of the ownership fraction when stock is issued in 
exchange for certain types of property). See Sec.  
601.601(d)(2)(ii)(b). Accordingly, no change has been made to this 
regulation, but the IRS and the Treasury Department request comments 
regarding the interaction of Sec.  1.7874-1 and other rules under 
section 7874 related to the ownership fraction.

E. Downstream Transactions

    The final regulations clarify that an acquisition by a corporation 
of its stock

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from another corporation or a partnership is an acquisition of the 
transferor's properties for purposes of section 7874(a)(2)(B)(i). This 
rule applies even though, for Federal tax purposes, the acquired stock 
no longer exists after the transaction. Thus, for example, if a 
domestic corporation that holds stock in a foreign corporation merges 
into the foreign corporation, the foreign corporation is, for purposes 
of section 7874(a)(2)(B)(i), treated as acquiring properties of the 
domestic corporation in the form of the foreign corporation's stock.

Effective/Applicability Dates

    These final regulations apply to acquisitions completed on or after 
June 7, 2012.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. Chapter 5) does not apply to this regulation and because the 
regulation does not impose a collection of information on small 
entities, the requirements of the Regulatory Flexibility Act (5 U.S.C. 
601 et seq.) do not apply. Pursuant to section 7805(f) of the Internal 
Revenue Code, the notice of proposed rulemaking preceding this 
regulation was 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 these regulations is Milton M. Cahn 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.

Adoption of 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 * * *
    Sections 1.7874-1 and 1.7874-2 also issued under 26 U.S.C. 
7874(c)(6) and (g). * * *


0
Par. 2. Section 1.7874-1 is amended by:
0
1. Revising paragraph (e).
0
2. Adding two sentences at the end of paragraph (g).
    The revision and addition read as follows:


Sec.  1.7874-1  Disregard of affiliate-owned stock.

* * * * *
    (e) Stock held by a partnership. For purposes of this section, each 
partner in a partnership shall be treated as holding its proportionate 
share of stock held by the partnership, as determined under the rules 
and principles of sections 701 through 777.
* * * * *
    (g) * * * Paragraph (e) of this section shall apply to acquisitions 
completed on or after June 7, 2012. See Sec.  1.7874-1T(e), as 
contained in 26 CFR part 1 revised as of April 1, 2012, for 
acquisitions completed before June 7, 2012.


Sec.  1.7874-1T  [Removed]

0
Par. 3. Section 1.7874-1T is removed.

0
Par. 4. Section 1.7874-2 is added to read as follows:


Sec.  1.7874-2  Surrogate foreign corporation.

    (a) Scope. This section provides rules for determining whether a 
foreign corporation is treated as a surrogate foreign corporation under 
section 7874(a)(2)(B). Paragraph (b) of this section provides 
definitions and special rules. Paragraph (c) of this section provides 
rules to determine whether a foreign corporation has acquired 
properties held by a domestic corporation (or a partnership). Paragraph 
(d) of this section provides rules that apply when two or more foreign 
corporations complete, in the aggregate, an acquisition described in 
section 7874(a)(2)(B)(i). Paragraph (e) of this section provides rules 
that apply when a single foreign corporation completes more than one 
acquisition described in section 7874(a)(2)(B)(i). Paragraph (f) of 
this section provides rules to identify the stock of a foreign 
corporation that is held by reason of holding stock in a domestic 
corporation (or an interest in a domestic partnership). Paragraph (g) 
of this section provides rules that treat certain publicly traded 
foreign partnerships as foreign corporations for purposes of section 
7874. Paragraph (h) of this section provides rules concerning the 
treatment of certain options (or similar interests) for purposes of 
section 7874. Paragraph (i) of this section provides rules that treat 
certain interests (including debt, stock, or a partnership interest) as 
stock of a foreign corporation for purposes of section 7874. Paragraph 
(j) of this section provides rules concerning the conversion of a 
foreign corporation to a domestic corporation by reason of section 
7874(b). Paragraph (k) of this section provides examples that 
illustrate the rules of this section. Paragraph (l) of this section 
provides the effective/applicability date of this section.
    (b) Definitions and special rules. Except as otherwise indicated, 
the following definitions and special rules apply for purposes of this 
section.
    (1) The rules of this section are subject to section 7874(c)(4).
    (2) A former shareholder of a domestic corporation is any person 
that held stock in the domestic corporation before the acquisition 
described in section 7874(a)(2)(B)(i), including any person that holds 
stock in the domestic corporation both before and after the 
acquisition.
    (3) A former partner of a domestic partnership is any person that 
held an interest in the domestic partnership before the acquisition 
described in section 7874(a)(2)(B)(i), including any person that holds 
an interest in the domestic partnership both before and after the 
acquisition.
    (4) An interest in a partnership includes a capital or profits 
interest.
    (5) References to properties held by a domestic corporation include 
properties held directly or indirectly by the domestic corporation.
    (6) The rules and principles of sections 701 through 777 shall be 
applied for purposes of determining a proportionate amount (or share) 
of properties held by a partnership (such as stock).
    (7) Any reference to the acquisition of properties held by a 
domestic corporation (or a partnership) includes a direct or indirect 
acquisition of such properties.
    (8) In the case of an acquisition of stock of a domestic 
corporation or an interest in a partnership, the proportionate amount 
of properties held by the domestic corporation (or the partnership) 
that is treated as indirectly acquired shall, as applicable, be 
determined at the time of the acquisition based on the relative value 
of--
    (i) The stock acquired compared to all outstanding stock of the 
domestic corporation; or
    (ii) The interest acquired compared to all interests in the 
partnership.
    (9) The determination of whether a foreign corporation is a 
surrogate foreign corporation is made after the acquisition described 
in section 7874(a)(2)(B)(i). A foreign corporation that is treated as a

[[Page 34792]]

surrogate foreign corporation (including a surrogate foreign 
corporation treated as a domestic corporation described in section 
7874(b)) shall continue to be treated as a surrogate foreign 
corporation (or a domestic corporation), even if the conditions of 
section 7874(a)(2)(B)(ii) and (iii) are not satisfied at a later date.
    (c) Acquisition of properties--(1) Indirect acquisition of 
properties. For purposes of section 7874(a)(2)(B)(i), an indirect 
acquisition of properties held by a domestic corporation (or a 
partnership) includes, but is not limited to, the acquisitions 
described in paragraphs (c)(1)(i) through (iv) of this section. An 
acquisition of less than all of the stock of a domestic corporation (or 
interests in a partnership) shall constitute an indirect acquisition of 
a proportionate amount of the properties held by the domestic 
corporation or the partnership. See paragraph (b)(8) of this section 
for rules determining the proportionate amount of properties indirectly 
acquired.
    (i) An acquisition of stock of a domestic corporation. See Example 
1 of paragraph (k) of this section for an illustration of the rules of 
this paragraph (c)(1)(i).
    (ii) An acquisition of an interest in a partnership. See Example 2 
of paragraph (k) of this section for an illustration of the rules of 
this paragraph (c)(1)(ii).
    (iii) An acquisition by a corporation (acquiring corporation) of 
properties held by a domestic corporation (or a partnership) in 
exchange for stock of a foreign corporation (foreign issuing 
corporation) that is part of the expanded affiliated group that 
includes the acquiring corporation after the acquisition shall be 
treated as an acquisition by the foreign issuing corporation. See 
Example 3 of paragraph (k) of this section for an illustration of the 
rules of this paragraph (c)(1)(iii).
    (iv) An acquisition by a partnership (acquiring partnership) of 
properties held by a domestic corporation (or a partnership) in 
exchange for stock of a foreign corporation that is part of the 
expanded affiliated group that would include the acquiring partnership 
after the acquisition (if the partnership were a corporation) shall be 
treated as an acquisition by the foreign issuing corporation.
    (2) Acquisition of stock of a foreign corporation. An acquisition 
of stock of a foreign corporation that owns directly or indirectly 
stock of a domestic corporation (or an interest in a partnership) shall 
not constitute an indirect acquisition of any properties held by the 
domestic corporation (or the partnership). See Example 4 of paragraph 
(k) of this section for an illustration of the rules of this paragraph 
(c)(2).
    (3) Downstream transactions. An acquisition by a corporation of its 
stock from another corporation or a partnership (for example, as a 
result of a downstream merger) is an acquisition of the other 
corporation's or partnership's properties for purposes of section 
7874(a)(2)(B)(i).
    (d) Acquisitions by multiple foreign corporations. If, pursuant to 
a plan (or a series of related transactions), two or more foreign 
corporations complete, in the aggregate, an acquisition described in 
section 7874(a)(2)(B)(i), then each foreign corporation shall be 
treated as completing the acquisition for purposes of determining 
whether such foreign corporation is treated as a surrogate foreign 
corporation. See Examples 5 and 6 of paragraph (k) of this section for 
illustrations of the rules of this paragraph (d).
    (e) Acquisitions of multiple domestic entities. If, pursuant to a 
plan (or a series of related transactions), a foreign corporation 
completes two or more acquisitions described in section 
7874(a)(2)(B)(i) involving domestic corporations and/or domestic 
partnerships (domestic entities), then, for purposes of section 
7874(a)(2)(B)(ii), the acquisitions shall be treated as a single 
acquisition and the domestic entities shall be treated as a single 
domestic entity. If the transaction involves one or more domestic 
corporations and one or more domestic partnerships, the stock of the 
foreign corporation held by former shareholders and former partners by 
reason of holding stock or a partnership interest in the domestic 
entities shall be aggregated for purposes of determining whether the 
ownership condition of section 7874(a)(2)(B)(ii) is satisfied. See 
Example 7 of paragraph (k) of this section for an illustration of the 
rules of this paragraph (e).
    (f) Stock held by reason of holding stock in a domestic corporation 
or an interest in a domestic partnership--(1) Specified transactions. 
For purposes of section 7874(a)(2)(B)(ii), stock of a foreign 
corporation that is held by reason of holding stock in a domestic 
corporation (or an interest in a domestic partnership) includes, but is 
not limited to, the stock described in paragraphs (f)(1)(i) through 
(iii) of this section.
    (i) Stock of a foreign corporation received in exchange for, or 
with respect to, stock of a domestic corporation.
    (ii) Stock of a foreign corporation received in exchange for, or 
with respect to, an interest in a domestic partnership.
    (iii) To the extent that paragraph (f)(1)(ii) of this section does 
not apply, stock of a foreign corporation received by a domestic 
partnership in exchange for all or part of its properties. In such a 
case, each partner in the domestic partnership shall be treated as 
holding its proportionate share of the stock of the foreign corporation 
by reason of holding an interest in the domestic partnership.
    (2) Transactions involving other property--(i) Stock of a domestic 
corporation. If, pursuant to the same transaction, stock of a foreign 
corporation is received in exchange for, or with respect to, stock of a 
domestic corporation and other property, the stock of the foreign 
corporation that was received in exchange for, or with respect to, the 
stock of the domestic corporation shall be determined based on the 
relative value of the stock of the domestic corporation compared to the 
aggregate value of such stock and the other property.
    (ii) Interest in a domestic partnership. If, pursuant to the same 
transaction, stock of a foreign corporation is received in exchange 
for, or with respect to, an interest in a domestic partnership and 
other property, the stock of the foreign corporation that was received 
in exchange for, or with respect to, the interest in the domestic 
partnership shall be determined based on the relative value of the 
interest in the domestic partnership compared to the aggregate value of 
such interest and the other property.
    (3) See Examples 8 through 10 of paragraph (k) of this section for 
illustrations of the rules of this paragraph (f).
    (g) Publicly traded foreign partnerships--(1) Treatment as a 
foreign corporation. For purposes of section 7874, a publicly traded 
foreign partnership described in paragraph (g)(2) of this section shall 
be treated as a foreign corporation that is organized in the foreign 
country in which, or under the law of which, the publicly traded 
foreign partnership was created or organized, and the partnership 
interests in the publicly traded foreign partnership shall be treated 
as stock of the foreign corporation. For purposes of determining 
whether the foreign corporation shall be treated as a surrogate foreign 
corporation, a deemed acquisition of assets and liabilities by reason 
of Sec.  1.708-1(b)(4) shall not constitute an acquisition described in 
section 7874(a)(2)(B)(i).

[[Page 34793]]

    (2) Publicly traded foreign partnership. A publicly traded foreign 
partnership described in this paragraph (g)(2) is any foreign 
partnership that would, but for section 7704(c), be treated as a 
corporation under section 7704(a)--
    (i) At the time of the acquisition described in section 
7874(a)(2)(B)(i); or
    (ii) At any time after the acquisition pursuant to a plan that 
existed at the time of the acquisition. For this purpose, a plan shall 
be deemed to exist at the time of the acquisition if the foreign 
partnership would, but for section 7704(c), be treated as a corporation 
under section 7704(a) at any time during the two-year period following 
the completion of the acquisition.
    (3) Surrogate foreign corporation to which section 7874(b) applies. 
If paragraph (g)(1) of this section applies to a publicly traded 
foreign partnership and the foreign corporation is a surrogate foreign 
corporation to which section 7874(b) applies, the publicly traded 
foreign partnership shall be treated as a domestic corporation for 
purposes of the Internal Revenue Code (Code). See paragraph (g)(6) of 
this section for the timing and treatment of the conversion of the 
publicly traded foreign partnership to a domestic corporation. See 
Example 11 of paragraph (k) of this section for an illustration of the 
rules of this paragraph (g)(3).
    (4) Surrogate foreign corporation to which section 7874(b) does not 
apply. If paragraph (g)(1) of this section applies to a publicly traded 
foreign partnership and the foreign corporation is a surrogate foreign 
corporation to which section 7874(b) does not apply, the publicly 
traded foreign partnership shall continue to be treated as a foreign 
partnership for purposes of the Code, but section 7874(a)(1) shall 
apply to any expatriated entity (as defined in section 7874(a)(2)(A)). 
See Example 13 of paragraph (k) of this section for an illustration of 
the rules of this paragraph (g)(4).
    (5) Foreign corporation not treated as a surrogate foreign 
corporation. If paragraph (g)(1) of this section applies to a publicly 
traded foreign partnership and the foreign corporation is not treated 
as a surrogate foreign corporation, the status of the publicly traded 
foreign partnership as a foreign partnership shall not be affected by 
section 7874. See Example 12 of paragraph (k) of this section for an 
illustration of the rules of this paragraph (g)(5).
    (6) Conversion to a domestic corporation. Except for purposes of 
determining whether the publicly traded foreign partnership is a 
surrogate foreign corporation, if paragraph (g)(1) of this section 
applies to a publicly traded foreign partnership and the foreign 
corporation is a surrogate foreign corporation to which section 7874(b) 
applies, then at the later of the end of the day immediately preceding 
the first date properties are acquired as part of the acquisition 
described in section 7874(a)(2)(B)(i) or immediately after the 
formation of the publicly traded foreign partnership, the publicly 
traded foreign partnership shall be treated as transferring all of its 
assets and liabilities to a newly formed domestic corporation in 
exchange solely for stock of the domestic corporation, and then 
distributing such stock to its partners in proportion to their 
partnership interests in liquidation of the partnership. The treatment 
of the transfer of assets and liabilities to the domestic corporation 
and the distribution of the stock of the domestic corporation to the 
partners in liquidation of the partnership shall be determined under 
all relevant provisions of the Code and general tax principles.
    (h) Options--(1) Value. Except to the extent otherwise provided in 
this paragraph (h), for purposes of section 7874, including for 
purposes of determining the membership of an expanded affiliated group 
under section 7874(c)(1), an option with respect to a corporation or 
partnership will be treated as stock in the corporation, or an interest 
in the partnership, as applicable, with a value equal to the holder's 
claim on the equity of the corporation or partnership. For this 
purpose, claim on the equity equals the value of the stock or 
partnership interest that may be acquired pursuant to the option, less 
the exercise price (but in no case is a claim on the equity less than 
zero). Also for this purpose, the equity of the corporation or 
partnership shall not include the amount of any property the holder of 
the option would be required to provide to the corporation or 
partnership under the terms of the option if such option were 
exercised. See Example 14 and Example 16 of paragraph (k) of this 
section for illustrations of the rules of this paragraph (h)(1).
    (2) Voting power. Except to the extent otherwise provided in this 
paragraph (h), for purposes of determining the voting power of a 
foreign corporation under section 7874, including for purposes of 
determining the membership of an expanded affiliated group under 
section 7874(c)(1), an option will be treated as exercised only if a 
principal purpose of the issuance or transfer of the option is to avoid 
the foreign corporation being treated as a surrogate foreign 
corporation.
    (3) Timing. For purposes of this paragraph (h), the value of the 
holder's claim on the equity is determined--
    (i) In the case of a domestic corporation or a domestic 
partnership, immediately before the acquisition described in section 
7874(a)(2)(B)(i).
    (ii) In the case of a foreign corporation or foreign partnership, 
immediately after the acquisition described in section 
7874(a)(2)(B)(i).
    (4) Certain options disregarded. The rules of paragraph (h)(1) of 
this section shall not apply to an option if--
    (i) A principal purpose of the issuance or acquisition of the 
option is to avoid the foreign corporation being treated as a surrogate 
foreign corporation, or
    (ii) At the time of the acquisition described in section 
7874(a)(2)(B)(i), the probability of the option being exercised is 
remote.
    (5) Options and interests similar to an option. For purposes of 
this paragraph (h), an option includes an interest similar to an 
option. Examples of options (including interests similar to options) 
include, but are not limited to, a warrant, a convertible debt 
instrument, an instrument other than debt that is convertible into 
stock or a partnership interest, a put, stock or a partnership interest 
subject to risk of forfeiture, a contract to acquire or sell stock or a 
partnership interest, and an exchangeable share or exchangeable 
partnership interest.
    (6) Multiple claims on equity. Paragraph (h)(1) of this section 
shall not apply to an option to the extent treating the option as stock 
or a partnership interest would duplicate a shareholder's or partner's 
claim on the equity of the corporation or partnership by reason of 
holding stock in the corporation or an interest in the partnership. See 
Example 15 of paragraph (k) of this section for an illustration of the 
rules of this paragraph (h)(6).
    (i) Interests treated as stock of a foreign corporation--(1) Stock 
or other interests. If the conditions of paragraphs (i)(1)(i) and (ii) 
of this section are satisfied, then, for purposes of section 7874, any 
interest (including stock or a partnership interest) that is not 
otherwise treated as stock of a foreign corporation (including under 
paragraph (h) of this section) shall be treated as stock of the foreign 
corporation. See Examples 17 and 18 of paragraph (k) of this section 
for illustrations of the rules of this paragraph (i)(1).
    (i) The interest provides the holder distribution rights that are 
substantially similar in all material respects to the

[[Page 34794]]

distribution rights provided by stock in the foreign corporation. For 
this purpose, distribution rights include rights to dividends (or 
partnership distributions), distributions in redemption of the interest 
(in whole or in part), distributions in liquidation, or other similar 
distributions that represent a return on, or of, the holder's 
investment in the interest.
    (ii) Treating the interest as stock of the foreign corporation has 
the effect of treating the foreign corporation as a surrogate foreign 
corporation under section 7874(a)(2)(B).
    (2) Creditor claims--(i) Domestic corporation. For purposes of 
section 7874, if, immediately prior to the first date properties are 
acquired as part of an acquisition described in section 
7874(a)(2)(B)(i), a domestic corporation is in a title 11 or similar 
case (as defined in section 368(a)(3)), or the liabilities of the 
domestic corporation exceed the value of its assets, then each creditor 
of the domestic corporation shall be treated as a shareholder of the 
domestic corporation and any claim of the creditor against the domestic 
corporation shall be treated as stock of the domestic corporation. See 
Example 19 of paragraph (k) of this section for an illustration of the 
rules of this paragraph (i)(2)(i).
    (ii) Domestic or foreign partnership. For purposes of section 7874, 
if, immediately prior to the first date properties are acquired as part 
of an acquisition described in section 7874(a)(2)(B)(i), a partnership 
(foreign or domestic) is in a title 11 or similar case (as defined in 
section 368(a)(3)), or the liabilities of the partnership exceed the 
value of its assets, then each creditor of the partnership shall be 
treated as a partner in the partnership and any claim of the creditor 
against the partnership shall be treated as an interest in the 
partnership.
    (iii) Treatment of creditor as shareholder or partner. A creditor 
that is treated as a shareholder or partner under paragraph (i)(2)(i) 
or (ii) of this section shall be treated as a shareholder or partner 
for all purposes of section 7874. See, for example, Sec.  1.7874-1(c) 
and paragraph (f) of this section. See Example 19 of paragraph (k) of 
this section for an illustration of the rules of this paragraph 
(i)(2)(iii).
    (j) Application of section 7874(b)--(1) Conversion to a domestic 
corporation. Except for purposes of determining whether a foreign 
corporation is treated as a surrogate foreign corporation, the 
conversion of a foreign corporation to a domestic corporation by reason 
of section 7874(b) shall constitute a reorganization described in 
section 368(a)(1)(F) that occurs at the later of the end of the day 
immediately preceding the first date properties are acquired as part of 
the acquisition described in section 7874(a)(2)(B)(i) or immediately 
after the formation of the foreign corporation. See, for example, 
Sec. Sec.  1.367(b)-2 and 1.367(b)-3 for certain consequences of the 
reorganization. The treatment of all other aspects of the conversion 
shall be determined under the relevant provisions of the Code and 
general tax principles. See Example 20 of paragraph (k) of this section 
for an illustration of the rules of this paragraph (j)(1).
    (2) Entity classification. A foreign corporation that is treated as 
a domestic corporation under section 7874(b) is not an eligible entity 
as defined in Sec.  301.7701-3(a), and therefore may not elect to be 
classified as other than an association (and thus cannot be treated as 
other than a corporation) for Federal tax purposes.
    (3) Application of section 367. If a foreign corporation is treated 
as a domestic corporation under section 7874(b), section 367 shall not 
apply to any transfer of property by a United States person to such 
foreign corporation as part of the acquisition described in section 
7874(a)(2)(B)(i). However, section 367 shall apply to the conversion of 
the foreign corporation to a domestic corporation. See paragraph (j)(1) 
of this section. See Example 20 of paragraph (k) of this section for an 
illustration of the rules of this paragraph (j)(3).
    (k) Examples--(1) Assumed facts. Except as otherwise stated, assume 
the following for purposes of the examples included in paragraph (k)(2) 
of this section.
    (i) DC1 and DC2 are domestic corporations.
    (ii) FA, FP, F1, F2, F3, and F4 are foreign corporations organized 
in Country A.
    (iii) DPS is a domestic partnership that conducts a trade or 
business.
    (iv) FPS is a foreign partnership that is not publicly traded.
    (v) Under the terms of the partnership agreements of DPS and FPS, 
each partner's share in the partnership's items of income, gain, 
deduction, and loss is determined in accordance with the partner's 
partnership interest percentage in the partnership, as stated in the 
examples.
    (vi) A, B, and C are unrelated individuals.
    (vii) Each entity has a single class of equity outstanding and is 
unrelated to all other entities.
    (viii) All transactions are completed pursuant to a plan.
    (ix) All acquisitions of properties are completed after March 4, 
2003.
    (x) Section 7874(c)(4) does not apply, and no option is issued or 
acquired with a principal purpose to avoid a foreign corporation being 
treated as a surrogate foreign corporation.
    (2) Examples. The following examples illustrate the rules of this 
section.

    Example 1. Acquisition of stock of a domestic corporation. (i) 
Facts. FA acquires 25% of the outstanding stock of DC1.
    (ii) Analysis. Under paragraph (c)(1)(i) of this section, for 
purposes of section 7874(a)(2)(B)(i), FA is treated as acquiring 25% 
of the properties held by DC1 on the date of the stock acquisition.
    Example 2. Acquisition of a partnership interest. (i) Facts. DPS 
wholly owns DC1. FA acquires a 40% interest in DPS.
    (ii) Analysis. Under paragraph (c)(1)(ii) of this section, for 
purposes of section 7874(a)(2)(B)(i), FA is treated as acquiring 40 
percent of the DC1 stock held by DPS on the date of the acquisition 
of the partnership interest. Further, under paragraph (c)(1)(i) of 
this section, for purposes of section 7874(a)(2)(B)(i), FA is 
treated as acquiring 40% of the properties held by DC1 on the date 
of the acquisition of the partnership interest.
    Example 3. Acquisition of stock by a subsidiary.  (i) Facts. FP 
wholly owns FA. FA acquires all the outstanding stock of DC1 in 
exchange solely for FP stock. FP and FA are members of the same 
expanded affiliated group after the acquisition.
    (ii) Analysis. Under paragraph (c)(1)(i) of this section, for 
purposes of section 7874(a)(2)(B)(i), FA is treated as acquiring 
100% of the properties held by DC1 on the date of the stock 
acquisition. Further, under paragraph (c)(1)(iii) of this section, 
for purposes of section 7874(a)(2)(B)(i), FP is also treated as 
acquiring 100% of the properties held by DC1 on the date of the 
stock acquisition. The result would be the same if instead FA had 
directly acquired all the properties held by DC1 in exchange for FP 
stock.
    Example 4. Acquisition of stock of a foreign corporation.  (i) 
Facts. FP wholly owns DC1. FA acquires all of the outstanding stock 
of FP.
    (ii) Analysis. Under paragraph (c)(2) of this section, for 
purposes of section 7874(a)(2)(B)(i), FA is not treated as acquiring 
any properties held by DC1 on the date of the acquisition of the FP 
stock.
    Example 5. Acquisition of stock by multiple foreign 
corporations.  (i) Facts. Pursuant to the same plan, the 
shareholders of DC1 transfer all of their DC1 stock equally to F1, 
F2, F3, and F4 in exchange solely for stock of each foreign 
corporation.
    (ii) Analysis. Under paragraph (c)(1)(i) of this section, in the 
aggregate F1, F2, F3, and F4 are treated as acquiring substantially 
all of the properties held by DC1. Because the acquisition was 
pursuant to the same plan, under paragraph (d) of this section, F1, 
F2, F3, and F4 are each treated as acquiring substantially all of 
the properties held by DC1 for purposes of determining whether each 
foreign corporation shall be treated as a surrogate foreign 
corporation.

[[Page 34795]]

    Example 6. Acquisition of assets by multiple foreign 
corporations.  (i) Facts. Individual A wholly owns DC1. DC1 forms 
F1, F2, F3, and F4, and transfers an equal portion of its properties 
to each corporation in exchange solely for stock of the corporation. 
Pursuant to the same plan DC1 then distributes the stock of each 
foreign corporation to individual A.
    (ii) Analysis. Because pursuant to the same plan F1, F2, F3, and 
F4 acquired, in the aggregate, substantially all of the properties 
held by DC1, under paragraph (d) of this section, F1, F2, F3, and F4 
are each treated as acquiring substantially all of the properties 
held by DC1 for purposes of determining whether each foreign 
corporation shall be treated as a surrogate foreign corporation.
    Example 7. Acquisition of multiple domestic corporations. (i) 
Facts. Individual A wholly owns DC1, and individual B wholly owns 
DC2. Pursuant to the same plan, individuals A and B transfer all of 
their DC1 stock and DC2 stock to FA, a newly formed corporation, in 
exchange solely for all 100 shares of FA stock outstanding.
    (ii) Analysis. Under paragraph (c)(1)(i) of this section, for 
purposes of section 7874(a)(2)(B)(i), FA is treated as acquiring all 
of the properties held by DC1 and DC2 on the date of the stock 
acquisition. Under paragraph (e) of this section, because pursuant 
to the same plan FA acquired substantially all of the properties 
held by DC1 and DC2, for purposes of determining whether FA shall be 
treated as a surrogate foreign corporation, DC1 and DC2 shall be 
treated as a single domestic corporation, of which individuals A and 
B are former shareholders. Thus, individuals A and B are treated as 
holding all 100 shares of the FA stock by reason of holding stock of 
such domestic corporation, and the ownership fraction under section 
7874(a)(2)(B)(ii) is 100/100, or 100%.
    Example 8. Exchange of stock and other property.  (i) Facts. 
Individual A wholly owns DC1 and F1. DC1 has a $40x value and F1 has 
a $60x value. Individual A transfers all of the DC1 stock and F1 
stock to FA, a newly formed corporation, in exchange solely for FA 
stock.
    (ii) Analysis. Under paragraphs (f)(1)(i) and (f)(2)(i) of this 
section, for purposes of section 7874(a)(2)(B)(ii), individual A is 
considered to hold 40% of the FA stock by reason of holding stock in 
DC1 ($100x FA stock multiplied by $40x/$100x, the relative value of 
the DC1 stock to all the property transferred by A to FA).
    Example 9. Stock received as a distribution.  (i) Facts. 
Pursuant to a divisive reorganization described in section 
368(a)(1)(D), DC1 contributes substantially all of its properties to 
FA, a newly formed corporation, in exchange solely for FA stock and 
then distributes the FA stock to its shareholders in a transaction 
qualifying under section 355.
    (ii) Analysis. Under paragraph (f)(1)(i) of this section, for 
purposes of section 7874(a)(2)(B)(ii), the FA stock received by the 
DC1 shareholders as a distribution with respect to the DC1 stock is 
considered held by reason of holding stock in DC1. The result would 
be the same if the transaction did not qualify as a reorganization 
(for example, if the distribution were subject to sections 301 and 
311(b)).
    Example 10. Incorporation of a partnership trade or business.  
(i) Facts. Individuals A and B equally own DPS. DPS transfers 
substantially all of its properties constituting a trade or business 
to FA, a newly formed corporation, solely in exchange for FA stock. 
DPS retains the FA stock after the transaction.
    (ii) Analysis. Under paragraph (f)(1)(iii) of this section, for 
purposes of section 7874(a)(2)(B)(ii), individuals A and B are 
treated as holding a proportionate amount (that is, an equal amount) 
of the FA stock held by DPS by reason of holding an interest in DPS.
    Example 11. Publicly traded foreign partnership treated as 
domestic corporation.  (i) Facts. Pursuant to a plan, DC1 and 
individual B organize a limited liability company (HPS) under the 
law of Country A. DC1 owns 90% of the membership interests in HPS, 
and B owns 10% of the membership interests in HPS. HPS is a foreign 
eligible entity under Sec.  301.7701-2, and DC1 and B make an 
election under Sec.  301.7701-3 to treat HPS as a partnership for 
Federal tax purposes as of the date of the formation of HPS. HPS 
forms DC2. One day after the formation of HPS, DC2 merges with and 
into DC1. Pursuant to the merger agreement, the DC1 shareholders 
exchange their DC1 stock solely for membership interests in HPS. 
After the merger HPS wholly owns DC1, and the former shareholders of 
DC1 own a greater than 80% interest in HPS by reason of holding 
stock of DC1. Public trading of the HPS ownership interests begins 
the day after the date on which the merger is completed. HPS is not 
treated as a corporation under section 7704(a) by reason of section 
7704(c). If HPS were a corporation, the condition of section 
7874(a)(2)(B)(iii) would be satisfied.
    (ii) Analysis. HPS is a publicly traded foreign partnership that 
is described in paragraph (g)(2) of this section. Therefore, under 
paragraph (g)(1) of this section, for purposes of section 7874, HPS 
is treated as a foreign corporation organized under the law of 
Country A and the membership interests in HPS are treated as stock 
of the foreign corporation. The foreign corporation is treated as a 
surrogate foreign corporation under section 7874(a)(2)(B) because, 
pursuant to the merger, HPS acquired substantially all of the 
properties held by DC1, the former shareholders of DC1 hold at least 
60% of the stock of the foreign corporation by reason of holding 
stock of DC1, and the expanded affiliated group that includes the 
foreign corporation does not have substantial business activities in 
Country A when compared to the total business activities of the 
expanded affiliated group. Further, because the former shareholders 
of DC1 hold at least 80% of the stock of the foreign corporation by 
reason of holding stock of DC1, section 7874(b) applies to the 
surrogate foreign corporation, and therefore HPS is treated as a 
domestic corporation for purposes of the Code. Under paragraph 
(g)(6) of this section, except for purposes of determining whether 
HPS is a surrogate foreign corporation, at the end of the day 
immediately preceding the date of the merger of DC2 with and into 
DC1, HPS is treated as transferring all of its assets and 
liabilities to a new domestic corporation in exchange solely for 
stock of the domestic corporation. HPS is then treated as 
proportionately distributing such stock to its membership interest 
holders in liquidation of the partnership. In addition, as a result 
of the merger of DC2 with and into DC1, the former shareholders of 
DC1 shall be treated as receiving stock of a domestic corporation in 
exchange for their DC1 stock.
    Example 12. Publicly traded foreign partnership not treated as a 
surrogate foreign corporation.  (i) Facts. The facts are the same as 
in Example 11 of this section, except that, after the acquisition, 
the expanded affiliated group that includes HPS (treated as a 
foreign corporation for this purpose) has substantial business 
activities in Country A when compared to the total business 
activities of the expanded affiliated group.
    (ii) Analysis. Under paragraph (g)(1) of this section, for 
purposes of section 7874, HPS is treated as a foreign corporation 
and the membership interests in HPS are treated as stock of the 
foreign corporation. However, the foreign corporation is not treated 
as a surrogate foreign corporation under section 7874(a)(2)(B) 
because, after the acquisition, the expanded affiliated group that 
includes HPS has substantial business activities in Country A when 
compared to the total business activities of the expanded affiliated 
group. Therefore, under paragraph (g)(5) of this section, section 
7874 does not apply and the status of HPS as a foreign partnership 
is not affected. In addition, DC1 is not treated as an expatriated 
entity under section 7874(a) by reason of the acquisition.
    Example 13. Publicly traded foreign partnership treated as a 
surrogate foreign corporation but not as a domestic corporation.  
(i) Facts. FPS is a publicly traded foreign partnership organized in 
Country A that, by reason of section 7704(c), is not treated as a 
corporation under section 7704(a). FPS acquires all the stock of DC1 
in exchange for partnership interests in FPS. After the acquisition, 
the former shareholders of DC1 hold a 75%-interest in FPS by reason 
of holding DC1 stock. After the acquisition, the expanded affiliated 
group that includes FPS (treated as a foreign corporation for this 
purpose) does not have substantial business activities in Country A 
when compared to the total business activities of the expanded 
affiliated group.
    (ii) Analysis. Under paragraph (g)(1) of this section, for 
purposes of section 7874, FPS is treated as a foreign corporation 
and the partnership interests in FPS are treated as stock of the 
foreign corporation. FPS is treated as a surrogate foreign 
corporation because the conditions of section 7874(a)(2)(B) are 
satisfied. However, because the former shareholders of DC1 hold less 
than an 80%-interest in FPS by reason of holding DC1 stock, section 
7874(b) does not apply to FPS. Therefore, under paragraph (g)(4) of 
this section FPS continues to be treated as a foreign partnership 
for purposes of the Code, but section 7874(a)(1) applies to DC1 and 
any other expatriated entity.
    Example 14. Warrant to acquire stock from the foreign 
corporation.  (i) Facts. Individual

[[Page 34796]]

A wholly owns DC1. DC1 has a $200x value. Individual B wholly owns 
FA. The value of B's FA stock is $400x. Individual C holds a warrant 
to acquire FA stock from FA at an exercise price of $20x. Individual 
A transfers all of its DC1 stock to FA in exchange solely for FA 
stock with a value of $200x. At the time of the transfer, the FA 
stock that individual C can acquire pursuant to the warrant has a 
$70x value.
    (ii) Analysis. Under paragraphs (h)(1) of this section, for 
purposes of section 7874, individual C is treated as owning FA stock 
with a $50x value. This amount represents individual C's claim on 
the equity of FA after the acquisition ($70x value of FA stock that 
may be acquired pursuant to the warrant, less the $20x exercise 
price), without taking into account the $20x individual C would be 
required to provide to FA upon the exercise of the warrant. Thus, 
for purposes of section 7874, the value of the stock of FA 
immediately after the transaction is $650x ($600x of FA stock, plus 
C's $50x claim on the equity of FA). C's warrant is not taken into 
account for purposes of determining the voting power of FA under 
section 7874.
    Example 15. Option to acquire stock from another shareholder.  
(i) Facts. The facts are the same as in Example 14 except that, 
instead of holding a warrant issued by FA, individual C holds an 
option to acquire FA stock from individual B for an exercise price 
of $20x. At the time of the acquisition, the FA stock that 
individual C can acquire under the option has a $70x value.
    (ii) Analysis. Under paragraph (h)(6) of this section, for 
purposes of section 7874, individual C is not treated as owning FA 
stock by reason of holding the option because treating the option as 
FA stock would have the effect of partially duplicating individual 
B's claim on the equity of FA at the time of the acquisition by 
reason of holding FA stock. However, all of the FA stock owned by 
individual B will be taken into account for purposes of section 
7874. C's warrant is not taken into account for purposes of 
determining voting power of FA under section 7874.
    Example 16. Warrant to acquire stock from the domestic 
corporation.  (i) Facts. A DC1 employee holds a warrant to acquire 
DC1 stock from DC1. In connection with the acquisition by FA of 
substantially all of the properties held by DC1, the DC1 employee 
receives a warrant from FA to acquire 15 shares of FA stock in 
exchange for the warrant to acquire DC1 stock.
    (ii) Analysis. Under paragraphs (h)(1) of this section, for 
purposes of section 7874, the warrant held by the DC1 employee is 
treated as DC1 stock with a value equal to the employee's claim on 
the equity of DC1 immediately before the acquisition. Further, for 
purposes of section 7874, the DC1 employee is treated as holding FA 
stock with a value equal to the employee's claim on the equity of FA 
after the acquisition by reason of holding the warrant to acquire 
DC1 stock (treated as DC1 stock for this purpose). The option held 
by the DC1 employee is not taken into account for purposes of 
determining the voting power of FA under section 7874.
    Example 17. Stock in a subsidiary treated as stock of a foreign 
parent corporation.  (i) Facts. (A) Individuals A and B equally own 
DC1. FA, a newly formed corporation, issues stock in a public 
offering for cash. FA contributes part of the cash from the public 
offering to DC2, a newly formed corporation, in exchange for all the 
stock of DC2. DC2 merges with and into DC1 with DC1 surviving. 
Pursuant to the merger agreement, individuals A and B exchange their 
DC1 stock for cash and shares of class B stock of DC1. Following the 
merger FA owns all the class A stock of DC1. FA does not hold 
significant assets other than the class A stock of DC1. Individuals 
A and B own all the class B stock of DC1. DC1 has no other class of 
stock outstanding.
    (B) The class B stock entitles individuals A and B to dividend 
distributions approximately equal to any dividend distributions made 
by FA with respect to its publicly traded stock. In certain 
circumstances, the class B stock also permits individuals A and B to 
require DC1 to redeem the stock at fair market value. The class B 
stock does not provide individuals A and B voting rights with 
respect to FA.
    (ii) Analysis. The dividend rights provided by the class B stock 
are substantially similar in all material respects to the dividend 
rights provided by the FA stock. In addition, because FA does not 
hold significant assets other than the class A stock, the value of 
the class B stock held by individuals A and B is approximately equal 
to the value of a corresponding amount of publicly traded FA stock. 
The distribution rights on liquidation (or redemption) provided by 
the class B stock, therefore, are substantially similar in all 
material respects to the distribution rights on liquidation (or 
redemption) provided by the FA stock. As a result, the distribution 
rights provided by the class B stock are substantially similar in 
all material respects to the distribution rights provided by the 
publicly traded FA stock. Thus, if treating the class B stock as FA 
stock would have the effect of treating FA as a surrogate foreign 
corporation, under paragraph (i)(1) of this section the class B 
stock will be treated as FA stock for purposes of section 7874.
    Example 18. Partnership interest treated as stock of foreign 
acquiring corporation.  (i) Facts. (A) Individuals A and B equally 
own DC1. FA, a newly formed corporation, issues stock in a public 
offering for cash. Individuals A and B and FA organize FPS. FA 
transfers part of the cash from the public offering to FPS in 
exchange for a class A partnership interest. FA does not hold any 
significant assets other than the class A partnership interest. 
Individuals A and B transfer their DC1 stock to FPS in exchange for 
class B partnership interests.
    (B) The class B partnership interests entitle individuals A and 
B to cash distributions from FPS approximately equal to any dividend 
distributions made by FA with respect to its publicly traded stock. 
In certain circumstances, the class B partnership interests also 
permit individuals A and B to require FPS to redeem the interests in 
exchange for cash equal to the value of an amount of FA stock as 
determined on the redemption date. The class B partnership interests 
do not provide individuals A or B voting rights with respect to FA.
    (ii) Analysis. The non-liquidating distribution rights provided 
by the class B partnership interests are substantially similar in 
all material respects to the dividend rights provided by the FA 
stock. Because FA does not hold any significant assets other than 
the class A partnership interest, the value of the class B 
partnership interests held by individuals A and B is approximately 
equal to a corresponding amount of FA stock. The distribution rights 
on liquidation (or redemption) provided by the class B partnership 
interests, therefore, are substantially similar in all material 
respects to distribution rights on liquidation (or redemption) 
provided by the FA stock. Thus, the distribution rights provided by 
the class B partnership interests are substantially similar in all 
material respects to the distribution rights provided by the 
publicly traded FA stock. As a result, if treating the class B 
partnership interests as FA stock would have the effect of treating 
FA as a surrogate foreign corporation, under paragraph (i)(1) of 
this section the class B partnership interests will be treated as FA 
stock for purposes of section 7874.
    Example 19. Creditor treated as a shareholder.  (i) Facts. 
Individuals A and B equally own DC1. The liabilities of DC1 exceed 
the value of its assets. Pursuant to a plan, FA, a newly formed 
corporation, acquires substantially all of the properties held by 
DC1 in exchange solely for FA stock. Pursuant to the plan, the DC1 
stock held by individuals A and B is cancelled, and the creditors of 
DC1 receive all the FA stock in exchange for their claims against 
DC1.
    (ii) Analysis. Because immediately before the first date on 
which properties are acquired as part of the acquisition described 
in section 7874(a)(2)(B)(i) the liabilities of DC1 exceed the value 
of its assets, under paragraph (i)(2)(i) of this section, for 
purposes of section 7874, the creditors of DC1 are treated as 
shareholders of DC1 and the creditors' claims against DC1 are 
treated as DC1 stock. Therefore, for purposes of section 
7874(a)(2)(B)(ii), the FA stock received by the creditors of DC1 by 
reason of their claims against DC1 is considered held by former 
shareholders of DC1 by reason of holding DC1 stock.
    Example 20. Conversion to a domestic corporation and application 
of section 367. (i) Facts. Individuals A and B are United States 
persons and equally own DC1. Pursuant to a plan, individuals A and B 
transfer their DC1 stock to FA in exchange solely for 80% of the 
outstanding FA stock. After the acquisition, the expanded affiliated 
group that includes FA does not have substantial business activities 
in Country A when compared to the total business activities of the 
expanded affiliated group.
    (ii) Analysis. Under paragraph (c)(1)(i) of this section, for 
purposes of section 7874(a)(2)(B)(i), FA is treated as acquiring all 
of the properties held by DC1 on the date of the stock acquisition. 
After the acquisition, the former shareholders of DC1 own 80% of the 
stock of FA by reason of holding DC1 stock. Therefore, FA is a 
surrogate foreign corporation that is treated as a domestic 
corporation under section 7874(b). Under paragraph (j)(1) of this 
section, except for

[[Page 34797]]

purposes of determining whether FA is treated as a surrogate foreign 
corporation, the conversion of FA to a domestic corporation 
constitutes a reorganization described in section 368(a)(1)(F) that 
occurs at the end of the day immediately preceding the date of the 
stock acquisition. Section 367 applies to the conversion of FA to a 
domestic corporation. See, for example, Sec. Sec.  1.367(b)-2 and 
1.367(b)-3 for the consequences of the conversion. Under paragraph 
(j)(3) of this section, section 367 does not apply to the transfers 
of DC1 stock by individuals A and B to FA.

    (l) Effective/applicability date. This section applies to 
acquisitions completed on or after June 7, 2012. For acquisitions 
completed prior to June 7, 2012, see Sec.  1.7874-2T(o), as contained 
in 26 CFR part 1, revised as of April 1, 2012.


Sec.  1.7874-2T  [Removed]

0
Par. 5. Section 1.7874-2T is removed.

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. 2012-14237 Filed 6-7-12; 4:15 pm]
BILLING CODE 4830-01-P