SECTION 3. TRANSACTIONS AT ISSUE

The IRS and the Treasury Department are aware that taxpayers are engaging in transactions designed to avoid U.S. tax by exploiting the deemed contribution provided under the final regulations. The IRS and the Treasury Department believe that the deemed contribution is inconsistent with the purpose of § 1.367(b)–10, regardless of whether S acquires P stock or securities from P or from a person other than P.

The IRS and the Treasury Department also are aware that the priority rules may facilitate certain transactions designed to avoid recognizing gain under § 1.367(a)– 3(c). For example, FP, a foreign corporation, intends to acquire all the stock of UST, a domestic corporation owned by U.S. persons, in exchange for FP stock in a reorganization described in section 368(a)(1)(B). FP forms USS, a domestic corporation. USS generates a small amount of earnings and profits. USS acquires FP stock from FP in exchange for a note and uses the FP stock to acquire all the stock of UST. The shareholders of UST receive 75 percent of the outstanding FP stock. The stock in USS is not a United States real property interest (within the meaning of section 897(c)), and FP would not be subject to U.S. tax under section 882 on a disposition of the stock of USS. The transaction is structured to result in a small amount of dividend income that would be subject to U.S. withholding tax on a distribution and in a significant amount of section 367(b) income in the form of section 301(c)(3) gain. The taxpayer takes the position that the transaction avoids the application of the no-U.S.tax exception because of the small amount of dividend income. In addition, the taxpayer takes the position that the section 367(b) priority rule applies because the section 367(b) income recognized by FP by reason of the application of § 1.367(b)–10 exceeds the amount of gain that would be recognized by shareholders of UST under section 367(a)(1) with respect to the UST stock. This position is taken even though the section 301(c)(3) gain that FP recognizes by reason of the application of § 1.367(b)–10 (and therefore takes into account in determining section 367(b) income) is not subject to U.S.

tax. Finally, the taxpayer takes the position that the anti-abuse rule does not apply with respect to the earnings and profits of UST (see further discussion of this position below).

Based on the policy underlying the priority rules, the IRS and the Treasury Department believe that section 367(b) income should include only dividend income and gain that are subject to U.S. tax or dividend income and gain that give rise to an income inclusion under section 951(a)(1)(A) that is subject to U.S. tax. The IRS and the Treasury Department are also concerned that some taxpayers may be taking the position that the noU.S.-tax exception is inapplicable when S (the stock of which is not a United States real property interest) has no current or accumulated earnings and profits based on the fact that if S instead did have current or accumulated earnings and profits, the resulting dividend would be subject to U.S. tax. The IRS and the Treasury Department disagree with this interpretation of the no-U.S.-tax exception.

Finally, the IRS and the Treasury Department are concerned that some taxpayers may be interpreting the anti-abuse rule too narrowly, including with respect to what constitutes a funding for purposes of invoking the anti-abuse rule. In addition, the IRS and the Treasury Department understand that taxpayers may be taking the position that the anti-abuse rule does not apply with respect to the earnings and profits of T, including in cases where T is unrelated to P and S before the triangular reorganization or where T is acquired pursuant to a triangular asset reorganization. The IRS and the Treasury Department disagree with these interpretations.

The IRS and the Treasury Department believe that these transactions raise significant policy concerns and will revise the final regulations in the manner described in Section 4 of this notice.