[Federal Register Volume 80, Number 107 (Thursday, June 4, 2015)]
[Rules and Regulations]
[Pages 31837-31843]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-13541]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9720]
RIN 1545-BK85


Substantial Business Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations regarding when an 
expanded affiliated group will be considered to have substantial 
business activities in a foreign country. These regulations affect 
certain domestic corporations and partnerships (and certain parties 
related to them), 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 4, 2015.
    Applicability date: For date of applicability, see Sec.  1.7874-
3(f).

FOR FURTHER INFORMATION CONTACT: David A. Levine, (202) 317-6937 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION: 

Background

    On June 6, 2006, temporary regulations under section 7874 (TD 9265) 
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were withdrawn and replaced with new temporary regulations (2009 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 apply to acquisitions completed 
on or after June 9, 2009. TD 9453 (74 FR 27920). 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). On June 12, 2012, the 2009 temporary regulations and the 
related notice of proposed rulemaking were withdrawn and replaced with 
new temporary regulations (2012 temporary regulations), which generally 
apply to acquisitions completed on or after June 7, 2012. TD 9592 (77 
FR 34785). A notice of proposed rulemaking (REG-107889-12) cross-
referencing the 2012 temporary regulations was published in the same 
issue of the Federal Register (77 FR 34887). 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 2012 temporary regulations are adopted as final 
regulations with the modifications described in this preamble. The 2012 
temporary regulations are removed.

Explanation of Revisions and Summary of Comments

A. General Approach

    A foreign corporation generally 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 completes 
after March 4, 2003, the direct or indirect acquisition of 
substantially all of the properties held directly or indirectly by a 
domestic corporation (acquisition); (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 (EAG) does not have substantial business activities 
in the foreign country in which, or under the law of which, the foreign 
corporation is created or organized (relevant foreign country), when 
compared to the total business activities of the EAG. Similar 
provisions apply if a foreign corporation acquires substantially all of 
the properties constituting a trade or business of a domestic 
partnership.
    The 2009 temporary regulations provided that whether an EAG will be 
considered to have substantial business activities in the relevant 
foreign country is based on all the facts and circumstances and, unlike 
the 2006 temporary regulations, did not provide a safe harbor. The 2012 
temporary regulations replaced this facts-and-circumstances test with a 
bright-line rule describing the threshold of activities required for an 
EAG to be considered to have substantial business activities in the 
relevant foreign country. Under this bright-line rule, an EAG will be 
considered to 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.
    Some comments criticized this approach and asserted that there is 
insufficient support for this bright-line rule in the legislative 
history. In addition, some comments recommended reverting to a general 
facts and circumstances test, along with a safe harbor, given the 
difficulty of formulating a bright-line rule that produces appropriate 
results in all circumstances. As an alternative, comments suggested 
that the failure to satisfy the bright-line rule could establish a 
rebuttable presumption that an EAG does not have substantial business 
activities in the relevant foreign country.
    After consideration of the comments, the Department of the Treasury 
(Treasury Department) and the IRS have concluded that the bright-line 
rule in the 2012 temporary regulations is consistent with section 7874 
and its underlying policies. In addition, the bright-line rule has 
proven more administrable than a facts-and-circumstances test and has 
the benefit of providing certainty in applying section 7874 to 
particular transactions. As a result, these final regulations retain 
the bright-line rule subject to certain modifications, which are 
described in this preamble.

B. Threshold of Business Activities

    As described in section A of this preamble, the 2012 temporary 
regulations provide that an EAG will be considered to have substantial 
business activities in the relevant foreign country only if at least 25 
percent of its group employees, group assets, and group income are 
located or derived in the relevant foreign country. Comments addressed 
both the magnitude of the 25-percent threshold and the requirement that 
each of the group employees, group assets, and group income tests must 
be satisfied. Although one comment stated that a 25-percent threshold 
is a reasonable measure of substantiality, other comments stated that 
it is overly

[[Page 31838]]

stringent, asserting that it is unlikely that an EAG would have 25 
percent of its business activities in any one country given the global 
nature of commerce. Another comment suggested that an EAG should only 
be required to satisfy the 25-percent threshold with respect to two out 
of the three tests provided that the average of all three tests is at 
least 25 percent.
    After consideration of these comments, the Treasury Department and 
the IRS have concluded that requiring an EAG to satisfy a 25-percent 
threshold for all three tests in order to be considered to have 
substantial business activities in the relevant foreign country is 
consistent with the policies underlying section 7874. Accordingly, the 
final regulations retain the 25-percent threshold for all three tests 
in the 2012 temporary regulations.

C. Standards for Determining Group Employees, Group Assets, and Group 
Income

    The 2012 temporary regulations provide standards for determining 
which employees, assets, and income are group employees, group assets, 
and group income, respectively, for purposes of determining if the EAG 
has substantial business activities in the relevant foreign country. 
All employees of members of the EAG constitute group employees. Group 
income generally is limited to the gross income of members of the EAG 
from transactions occurring in the ordinary course of business with 
customers that are not related persons. In order to constitute group 
assets, assets must be tangible personal property or real property used 
or held for use in the active conduct of a trade or business by members 
of the EAG.
    A comment questioned the need for these different standards and 
suggested applying the same standard for determining the employees, 
assets, and income that are taken into account, with the one standard 
being based on whether the employees, assets, or income relate to the 
active conduct of a trade of business. The comment acknowledged, 
however, that, under this alternative approach, special rules would be 
necessary to exclude gain from the sale of capital assets and section 
1231 property from group income and to address situations in which an 
EAG has primarily passive income and only a small active business.
    The Treasury Department and the IRS have concluded that it is not 
necessary for the definitions of group employees, group assets, and 
group income to be based on the same standard, as they measure 
different facets of an EAG's business activities. In addition, the 
standards used in the 2012 temporary regulations are commonly used in 
other areas of the tax law and therefore are more administrable than 
the recommended alternative. Consequently, the final regulations do not 
adopt this recommendation.

D. Applicable Date

    Section 7874(a)(2)(B)(iii) provides that the determination of 
whether an EAG has substantial business activities is made after an 
acquisition described in section 7874(a)(2)(B)(i). Under the 2012 
temporary regulations, group assets and the number of group employees 
are measured as of the ``applicable date,'' and group income and 
employee compensation are calculated for a one-year ``testing period'' 
ending on the applicable date. The applicable date, which must be 
applied consistently, is either the date on which the acquisition is 
completed (acquisition date) or the last day of the month immediately 
preceding the month in which the acquisition is completed. The 2012 
temporary regulations permit taxpayers to use the latter date because 
certain information required for the tests may not be readily 
determinable as of the acquisition date if the acquisition is not 
completed on the last day of the month.
    A comment suggested that the definition of applicable date be 
modified to be either the acquisition date or, for transactions 
involving unrelated parties, the first date on which the written 
agreement to effect the acquisition becomes binding. The comment stated 
that this change would allow taxpayers sufficient opportunity to unwind 
their contractual commitments if it appears that the EAG would not be 
treated as having substantial business activities in the relevant 
foreign country. Because a written agreement may become binding long 
before the date on which the acquisition is completed, the Treasury 
Department and the IRS have determined that this change would be 
inconsistent with section 7874(a)(2)(B)(iii), which looks to whether 
the EAG has substantial business activities in the relevant foreign 
country after the acquisition. In addition, as the comment noted, 
taxpayers may condition the closing of the acquisition on the EAG's 
having substantial business activities in the relevant foreign country 
after the acquisition. Accordingly, the final regulations do not adopt 
this suggestion.

E. Determining the Members of the EAG

1. In General
    The 2012 temporary regulations provide that the EAG that includes 
the foreign acquiring corporation is determined as of the close of the 
acquisition date. One comment requested that this standard be clarified 
to provide that the EAG includes both the foreign acquiring corporation 
and the domestic entity that it acquires, but that it excludes entities 
that are disposed of (or substantially all the assets of which are 
disposed of) before the acquisition.
    The Treasury Department and the IRS believe that it is clear under 
the 2012 temporary regulations that the EAG generally does not include 
an entity that is disposed of before the acquisition. Nonetheless, in 
response to this comment and for the avoidance of doubt, the final 
regulations are modified to further clarify that an entity that is not 
a member of the EAG on the acquisition date is not a member of the EAG, 
even though the entity would have qualified as a member if the EAG were 
determined at some earlier point during the testing period. The 
disposition of substantially all the assets of an entity may or may not 
cause it to cease to be a member of the EAG, depending on whether the 
entity remains in existence on the acquisition date.
    The final regulations also clarify that, consistent with the 
requirement under section 7874(a)(2)(B) to take into account all events 
that occur ``pursuant to a plan (or series of related transactions)'' 
in determining whether an entity is a surrogate foreign corporation, 
members of the EAG are determined taking into account all transactions 
related to the acquisition, even if they occur after the acquisition 
date. This clarification is consistent with the rule provided in 
section 2.03(b)(i) of Notice 2014-52 (2014-42 IRB 712), which provides 
that all transactions related to an acquisition must be taken into 
account for purposes of determining the members of an EAG, a U.S-
parented group, and a foreign-parented group.
2. Treatment of Partnerships
    The 2012 temporary regulations provide that, for purposes of the 
substantial business activities test, a partnership is treated as a 
corporation that is a member of an EAG if, in the aggregate, more than 
50 percent (by value) of its interests are owned by one or more members 
of the EAG (deemed corporation rule). A comment stated that the deemed 
corporation rule would not treat a partnership owning more

[[Page 31839]]

than 50 percent of the stock of the foreign acquiring corporation or 
its corporate partners as members of the EAG because the partnership is 
not otherwise owned by a member of the EAG. For example, assume that P, 
a corporation, owns (by value) 75 percent of the interests of PS, a 
domestic partnership. PS forms FA, a foreign corporation, and transfers 
substantially all of its assets constituting a trade or business to FA 
in exchange for all the stock of FA. According to the comment, neither 
PS nor P is treated as a member of the EAG that includes FA under the 
2012 temporary regulations.
    The Treasury Department and the IRS have determined that this 
result is inappropriate. Accordingly, the final regulations provide 
that, in determining the corporations that are members of the EAG, each 
partner in a partnership is treated as holding its proportionate share 
of the stock held by the partnership (look-through rule). This rule is 
consistent with the rules provided in Sec.  1.7874-1(e) (disregarding 
certain affiliate-owned stock) and section 2.03(b)(i) of Notice 2014-52 
(addressing subsequent transfers of stock of the foreign acquiring 
corporation). The final regulations coordinate the application of the 
deemed corporation rule with the look-through rule by providing that 
the look-through rule applies first and without regard to the deemed 
corporation rule. The result is that the look-through rule applies only 
for purposes of determining whether an entity that is actually a 
corporation for U.S. income tax purposes is a member of the EAG. Then, 
once those corporate entities are identified, the deemed corporation 
rule applies to treat certain partnerships in which those corporate 
entities are partners as corporations that are members of the EAG.

F. Anti-Abuse Rule

    The 2012 temporary regulations contain an anti-abuse rule pursuant 
to which the following items are not taken into account in the 
numerator, but are taken into account in the denominator, for purposes 
of the group employees, group assets, and group income tests: (i) Any 
group assets, group employees, or group income attributable to business 
activities that are associated with property or liabilities the 
transfer of which is disregarded under section 7874(c)(4) (generally, 
if the transfer is part of a plan with a principal purpose of avoiding 
the purposes of section 7874); (ii) 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; and (iii) 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.
    A comment suggested modifying the anti-abuse rule by revising the 
first prong and eliminating the second prong. The comment stated that 
the first prong of the rule should exclude items from both the 
numerator and the denominator for consistency. Although such a rule 
may, for example, produce appropriate results in the case of certain 
transfers through which the EAG acquires assets from shareholders, it 
would not produce appropriate results for certain other transfers, such 
as distributions of assets by EAG members to shareholders. Accordingly, 
the final regulations adopt this suggestion for items associated with a 
transfer of property to the EAG that is disregarded under section 
7874(c)(4), but retain the rule in the 2012 temporary regulations in 
all other cases.
    The comment also suggested eliminating the second prong of the 
anti-abuse rule because it relies on an inherently subjective 
determination and has the potential to detract from the certainty 
provided by the bright-line rule. Although the same argument could be 
made for eliminating the third prong, the comment recommended retaining 
the third prong because the statute looks to whether the EAG has 
substantial business activities in the relevant foreign country after 
the acquisition.
    The Treasury Department and the IRS believe, in this context, that 
it is appropriate to bolster bright-line rules with anti-abuse rules. 
Furthermore, the Treasury Department and the IRS have determined that 
the second prong of the rule is necessary because otherwise a member of 
the EAG may be able to relocate assets or employees or shift income to 
the relevant foreign country without engaging in a ``transfer'' that 
would implicate the first prong. Accordingly, the final regulations do 
not adopt this suggestion.

G. Comments on Specific Tests

    This section discusses comments that are specific to each of the 
group employees, group assets, and group income tests.
1. Group Employees
    The 2012 temporary regulations set forth two prongs of the group 
employees test, both of which must be satisfied based on individuals 
who are employees of members of the EAG (group employees). The first 
prong is satisfied if, on the applicable date, the number of group 
employees based in the relevant foreign country is at least 25 percent 
of the total number of group employees. The second prong is satisfied 
if, during the one-year testing period, 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. The final regulations 
adopt the definition of the terms ``group employees'' and ``employee 
compensation'' in the 2012 temporary regulations, subject to certain 
modifications.
    Under the 2012 temporary regulations and the final regulations, a 
group employee is considered to be based in the relevant foreign 
country only if the employee spent more time providing services in that 
country than in any other country during the testing period. One 
comment noted that other potential approaches might be more reflective 
of where the employee's activities take place, but nevertheless 
suggested that the standard in the 2012 temporary regulations be 
retained for its simplicity. The Treasury Department and the IRS agree 
with this comment, and the final regulations retain this standard.
    The 2012 temporary regulations do not specify the standard for 
determining if an individual is an employee for purposes of the group 
employees test. One comment suggested that individuals who are treated 
as employees under either U.S. federal tax principles or under 
applicable local country law should be treated as employees for this 
purpose. In response to this comment, and to simplify the application 
of the group employees test, the final regulations provide that whether 
individuals are employees must be determined for all members of the EAG 
under U.S. federal tax principles or for all members of the EAG based 
on the relevant tax laws (in general, for each member of the EAG, the 
tax law to which that member is subject). For example, if the EAG has 
two members, FA, the foreign acquiring corporation that is subject to 
the tax law of Country A, and USP, the domestic entity, the EAG may 
determine its employees either (i) under U.S. federal tax principles, 
or (ii) based on the tax law of Country A for those individuals who 
perform services for FA and U.S. federal tax law for those individuals 
who perform services for USP.

[[Page 31840]]

    A comment suggested taking into account independent contractors for 
purposes of the group employees test in certain circumstances, as they 
may constitute the majority of the workforce in certain industries. The 
comment further suggested as a possible approach that the rule include 
only those independent contractors who perform core functions of the 
business. The Treasury Department and the IRS have determined that it 
is not appropriate to include independent contractors for this purpose 
given, at least in some cases, the transient nature of their 
relationships with the member of the EAG for which they perform 
services. In addition, the Treasury Department and the IRS have 
concluded that taking into account independent contractors based on 
whether they perform core functions of the business would add undue 
complexity. Accordingly, this comment is not adopted.
    Comments requested clarification of when employee compensation is 
deemed to be incurred, as well as the standard for determining the 
amount of compensation. One comment recommended that the compensation 
be treated as incurred in the period for which it would be deductible 
for U.S. federal income tax purposes. In response to these comments, 
and to simplify the determination of employee compensation, the final 
regulations provide that employee compensation is treated as incurred 
when it would be deductible by the employer as compensation, and the 
amount of employee compensation equals the amount that would be 
deductible by the employer as compensation. Both the timing and the 
amount of the deduction for all employee compensation must be 
determined for all group employees under U.S. federal income tax 
principles or for all group employees based on the relevant tax laws.
2. Group Assets
    Under the 2012 temporary regulations, the group assets test is 
satisfied if, on the applicable date, 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. 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 EAG, provided such 
property is owned (or leased from a non-member) by members of the EAG 
at the close of the acquisition date. Group assets must be valued 
consistently using either their adjusted tax basis or fair market 
value. A group asset that is leased, however, is valued at eight times 
the annual rent. The final regulations adopt the definition of the term 
``group assets'' in the 2012 temporary regulations, subject to the 
modifications discussed below.
    The 2012 temporary regulations provide that a group asset is 
considered to be located in the relevant foreign country only if the 
asset was physically present in such country (i) at the close of the 
acquisition date, and (ii) for more time than in any other country 
during the testing period. One comment stated that the requirement that 
an asset be present in the relevant country on the acquisition date is 
problematic for highly mobile assets (such as aircraft and vessels) and 
therefore should be eliminated. The comment also suggested, as an 
alternative, special rules for determining the location of assets, 
including, depending on the type of asset: (i) Applying a proportionate 
approach based on the source of income produced from the asset during 
the testing period, (ii) ignoring the asset for purposes of the group 
asset test (for example, an asset used in space), or (iii) treating the 
asset as located outside of the relevant foreign country (for example, 
an offshore drilling rig located exclusively in international waters). 
The Treasury Department and the IRS have determined that providing 
special rules to address all types of assets in all fact patterns would 
be unduly complex. The Treasury Department and the IRS agree, however, 
that relief should be provided for assets that are mobile in nature and 
are used in transportation activities, like vessels, aircraft, and 
motor vehicles. Accordingly, the final regulations provide that such 
assets do not have to be physically present in the relevant foreign 
country at the close of the acquisition date, and need only be 
physically present in such country for more time than in any other 
country during the testing period, to be considered present in the 
relevant foreign country.
    The 2012 temporary regulations provide that group assets include 
certain property rented by members of the EAG and treat the value of 
such rented property as equal to eight times the net annual rent paid 
or accrued with respect to such property. One comment stated that 
valuing all rented assets at eight times the net annual rent is 
potentially distortive and suggested that the multiple instead be based 
on the type of asset (for example, based on the applicable recovery 
period of the asset under section 168). After consideration of these 
comments, the Treasury Department and the IRS have concluded that the 
benefits of using different multiples for different classes of rented 
assets would be outweighed by the complexity and difficulty of 
determining appropriate multiples and classes. Consequently, the final 
regulations retain the rule in the 2012 temporary regulations.
    A comment suggested excluding from the test certain assets that are 
owned and maintained by third parties, such as computer servers. The 
comment noted that start-up companies may be especially reliant on such 
assets, and their ability to satisfy the bright-line rule may depend on 
the location of such assets and whether they are viewed as leased by 
the company or as being used by the third party to provide a service to 
the company. The Treasury Department and the IRS have concluded that 
these types of assets do not merit special treatment, and the final 
regulations do not adopt this comment.
3. Group Income
    Under the 2012 temporary regulations, the group income test is 
satisfied if, during the one-year testing period, group income derived 
in the relevant foreign country is at least 25 percent of the total 
group income. The term group income means the gross income of members 
of the EAG from transactions occurring in the ordinary course of 
business with customers that are not related persons. The final 
regulations adopt the definition of the term ``group income'' in the 
2012 temporary regulations, subject to the modifications discussed 
below.
    The 2012 temporary regulations state that group income is 
considered to be derived in the relevant foreign country only if it is 
derived from a transaction with a customer located in that country. One 
comment stated that this standard is difficult to apply in practice 
because it is difficult to determine where a customer is located in 
certain contexts. The comment suggested instead that income be treated 
as derived in a relevant foreign country if the services, goods, or 
other property are sold for use, consumption, or disposition within 
that country. The comment also suggested that special rules for certain 
financial income could be developed based on the current rules for 
determining whether such income is effectively connected with a trade 
or business conducted in the United States. The Treasury Department and 
the IRS have concluded that the location of the customer provides a 
more accurate and less manipulable measure of the business activities 
of the EAG than the suggested alternative. Accordingly, the final 
regulations retain the standard in the 2012 temporary regulations.

[[Page 31841]]

    A comment also suggested that the group income test be based on 
gross receipts rather than gross income. The comment stated that gross 
receipts may be a more appropriate standard because (i) the amount of 
gross income will depend on the choice of inventory accounting method, 
(ii) the gross receipts standard would take into account sales that 
generate losses or no income, and (iii) an EAG's gross income will be 
reduced if there are intermediate transactions among members of the 
EAG. The Treasury Department and the IRS have determined that gross 
income should be the standard for determining group income, as this 
standard better reflects the location of an EAG's profitable business 
activities. In addition, gross income is a standard used in analogous 
contexts. See, for example, Sec.  1.884-5(e)(3)(i)(B) (regarding the 
substantial presence test for purposes of determining whether a foreign 
corporation is a qualified resident of a foreign country for treaty 
purposes). Thus, the final regulations do not adopt this comment. 
However, to simplify the application of the group income test, the 
final regulations provide that group income must be determined 
consistently for all members of the EAG using either U.S. federal 
income tax principles or relevant financial statements, in general, 
defined as financial statements prepared in accordance with U.S. 
Generally Accepted Accounting Principles (U.S. GAAP) or International 
Financial Reporting Standards (IFRS).

H. Effective/Applicability Date

    The final regulations apply to acquisitions completed on or after 
June 3, 2015.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866, as 
supplemented by Executive Order 13563. 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 these 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. 
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 David A. Levine of the 
Office of Associate Chief Counsel (International). However, other 
personnel from the Treasury Department and the IRS 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 is revised by adding an 
entry for Sec.  1.7874-3 to read as follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.7874-3 is also issued under 26 U.S.C. 7874(c)(6) and 
(g). * * *


0
Par. 2. Section 1.7874-3T is removed.

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


Sec.  1.7874-3  Substantial business activities.

    (a) Scope. This section provides rules regarding when an expanded 
affiliated group will be considered to have 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 provides the 
threshold of business activities that constitute substantial business 
activities. Paragraph (c) of this section describes certain items that 
are not 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 partnerships for purposes of this 
section. Paragraph (f) of this section provides the effective/
applicability dates.
    (b) Threshold of business activities. The expanded affiliated group 
will be considered to have substantial business activities in the 
relevant foreign country after an acquisition described in section 
7874(a)(2)(B)(i) 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 (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--(1) General rule. Except to the 
extent provided in paragraph (c)(2) of this section, 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 (3) of this section:
    (i) 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).
    (ii) 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.
    (iii) 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).
    (2) Transfers of properties to the expanded affiliated group. Any 
group assets, group employees, or group income attributable to business 
activities that are associated with property that is transferred to the 
expanded affiliated group in a transfer that is disregarded under 
section 7874(c)(4) are not taken into account in the numerator or the 
denominator for each of the tests described in paragraphs (b)(1) 
through (3) of this section.
    (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

[[Page 31842]]

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 that 
includes the acquisition date.
    (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 with respect to a particular 
group employee is treated as incurred when it would be deductible by 
the employer as compensation, and the amount of employee compensation 
equals the amount that would be deductible by the employer as 
compensation. Both the timing and the amount of the deduction for 
employee compensation must be determined for all group employees under 
U.S. federal income tax principles or for all group employees based on 
the relevant tax laws. 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, with respect to an 
acquisition described in section 7874(a)(2)(B)(i), the affiliated group 
defined in section 7874(c)(1) determined as of the close of the 
acquisition date, but taking into account all transactions related to 
the acquisition. Thus, for example, the expanded affiliated group does 
not include a corporation wholly owned by a member of the expanded 
affiliated group during a portion of the testing period if, before the 
end of the testing period, the member sells all of its stock in the 
corporation to a person that is not a member of the expanded affiliated 
group. 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 either owned or, in the circumstances described below, 
rented 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 the asset was 
physically present in such country for more time than in any other 
country during the testing period. Notwithstanding the foregoing, a 
group asset that is mobile in nature and is used in a transportation 
activity, such as a vessel, an aircraft, or a motor vehicle, is 
considered to be located in the relevant foreign country if the asset 
was physically present in such country for more time than in any other 
country during the testing period, regardless of whether the asset was 
physically present in such country at the close of the acquisition 
date. Group assets must be valued on a gross basis (that is, not 
reduced by liabilities) by consistently using for all group assets of 
the expanded affiliated group 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 all individuals who are 
employees of members of the expanded affiliated group. Whether 
individuals are employees must be determined for all members of the 
expanded affiliated group under U.S. federal tax principles or for all 
members of the expanded affiliated group based on the relevant tax 
laws. 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 must be determined consistently for all members of the expanded 
affiliated group either under U.S. federal income tax principles or as 
reflected in the relevant financial statements. 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 financial statements means financial 
statements prepared consistently for all members of the expanded 
affiliated group in accordance with either U.S. Generally Accepted 
Accounting Principles (U.S. GAAP) or International Financial Reporting 
Standards (IFRS) used for consolidated financial statement purposes, 
but, if, after the acquisition described in section 7874(a)(2)(B)(i), 
financial statements will not be prepared consistently for all members 
of the expanded affiliated group in accordance with either U.S. GAAP or 
IFRS, then, for each member, financial statements prepared in 
accordance with either U.S. GAAP or IFRS.
    (11) The term relevant foreign country means the foreign country in 
which, or under the law of which, the foreign corporation described in 
section 7874(a)(2)(B) was created or organized.
    (12) The term relevant tax law means, for purposes of determining 
whether a particular individual who performs services for a member of 
the expanded affiliated group is an employee for purposes of paragraph 
(d)(6) of this section and the timing and amount of employee 
compensation for a particular employee of a member of the expanded 
affiliated group for purposes of paragraph (d)(3) of this section, the 
tax law to which the member is subject. Notwithstanding the foregoing, 
if the tax law to which a member is subject does not distinguish 
between whether an individual is an employee, or, for example, an 
independent contractor, then for this purpose the relevant tax law is 
considered to be U.S. federal tax law.
    (13) The term testing period means the one-year period ending on 
the applicable date.

[[Page 31843]]

    (e) Treatment of partnerships--(1) Stock held by a partnership. In 
determining the members of the expanded affiliated group for purposes 
of this section, each partner in a partnership, as determined without 
regard to the application of paragraph (e)(2) of this section, shall be 
treated as holding its proportionate share of the stock held by the 
partnership, as determined under the rules and principles of sections 
701 through 777.
    (2) Business activities of a partnership. For purposes of this 
section, if one or more members of the expanded affiliated group, as 
determined after the application of paragraph (e)(1) of this section, 
own, in the aggregate, more than 50 percent (by value) of the interests 
in a partnership, the 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 (e)(2).
    (f) Effective/applicability dates. This section applies to 
acquisitions that are completed on or after June 3, 2015. For 
acquisitions completed before June 3, 2015, see Sec.  1.7874-3T as 
contained in 26 CFR part 1 revised as of April 1, 2015.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
    Approved: May 20, 2015.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2015-13541 Filed 6-3-15; 8:45 am]
 BILLING CODE 4830-01-P