SECTION 3. REGULATIONS — Internal Revenue Bulletin 2014-42

ADDRESS POST-INVERSION TAX AVOIDANCE TRANSACTIONS

.01 Regulations to Address Acquisi- tions of Obligations and Stock that Avoid Section 956

(a) Section 956 Background Section 957(a) defines a CFC as a foreign corporation with respect to which more than 50 percent of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned (directly, indirectly, or constructively) by United States shareholders (U.S. shareholders). Section 951(b) defines a U.S. shareholder as a U.S. person that owns (directly, indirectly, or constructively) 10 percent or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.

Section 951(a)(1) provides that every person that is a U.S. shareholder of a CFC and owns (within the meaning of section 958(a)) stock in the corporation on the last day of the CFC’s taxable year must include in its gross income for its taxable year in which or with which such taxable year of the CFC ends the amount determined under section 956 with respect to the shareholder for the year (but only to the extent not excluded from gross income under section 959(a)(2)).

Section 956(a) provides: In the case of any controlled foreign corporation, the amount determined under this section with respect to any United States shareholder for any taxable year is the lesser of—

(1) the excess (if any) of— (A) such shareholder’s pro rata share of the average of the amounts of United States property held (directly or indirectly) by the controlled foreign corporation as of the close of each quarter of such taxable year, over

(B) the amount of earnings and profits described in section 959(c)(1)(A) with respect to such shareholder, or

(2) such shareholder’s pro rata share of the applicable earnings of such controlled foreign corporation.

Section 956(c)(1) provides that, for this purpose:

“United States property” means any property acquired after December 31, 1962, which is— (A) tangible property located in the United States;

(B) stock of a domestic corporation; (C) an obligation of a United States person; or

(D) any right to the use in the United States of—

(i) a patent or copyright, (ii) an invention, model, or design (whether or not patented),

(iii) a secret formula or process, or (iv) any other similar right, which is acquired or developed by the controlled foreign corporation for use in the United States.

Section 956(c)(2) provides exceptions that apply to the definition of United States property, including exceptions that limit the scope of obligations of U.S. persons and stock of domestic corporations that will be treated as United States property to obligations of sufficiently related U.S. persons and stock of sufficiently related domestic corporations. See sections 956(c)(1)(B) and (C) and 956(c)(2)(F) and (L).

Section 956 is intended to prevent a U.S. shareholder of a CFC from inappropriately deferring U.S. taxation of CFC earnings and profits by “prevent[ing] the repatriation of income to the United States in a manner which does not subject it to U.S. taxation.” H.R. Rep. No. 1447, 87th Cong., 2d Sess., at 58 (1962). In the absence of section 956, a U.S. shareholder of a CFC could access the CFC’s funds (untaxed earnings and profits) in a variety of ways other than by the payment of an actual taxable dividend, such that there would be no reason for the U.S. shareholder to incur the dividend tax. Section 956 eliminates this disincentive to pay a dividend by ensuring parity of treatment for different ways that CFC earnings can be made available for use in the United States or for use by the U.S. shareholder. Accordingly, under section 956, the investment by a CFC of its earnings and profits in United States property is “taxed to the [CFC’s] shareholders on the grounds that this is substantially the equivalent of a dividend.” S. Rep. No. 1881, 87th Cong., 2d Sess., at 88 (1962). Section 956(e) provides the Secretary

with authority to “prescribe such regulations as may be necessary . . . to prevent the avoidance of the provisions of [section 956] through reorganizations or otherwise.”

(b) Transactions at Issue and Regula- tions to be Issued

An inversion transaction may permit the top corporate parent in the newly inverted group, a group still principally comprised of U.S. shareholders and their CFCs, to avoid section 956 by accessing the untaxed earnings and profits of the CFCs without a current tax to the U.S. shareholders. This is a result that the U.S. shareholders could not achieve before the inversion. The ability of the new foreign parent to access deferred CFC earnings and profits would in many cases eliminate the need for the CFCs to pay dividends to the U.S. shareholders, thereby circumventing the purposes of section 956. Section 956(e) directs the Secretary to prescribe regulations to prevent the avoidance of the provisions of section 956 through reorganizations or otherwise; an inversion is an example of such a transaction.

In order to prevent this avoidance of section 956, the Treasury Department and the IRS intend to issue regulations under section 956(e) providing that, solely for purposes of section 956, any obligation or stock of a foreign related person (within the meaning of section 7874(d)(3) other than an “expatriated foreign subsidiary”) (such person, a “non-CFC foreign related person”) will be treated as United States property within the meaning of section 956(c)(1) to the extent such obligation or stock is acquired by an expatriated foreign subsidiary during the applicable period (within the meaning of section 7874(d)(1)). For purposes of this notice, except as provided in the succeeding sentence, an expatriated foreign subsidiary is a CFC with respect to which an expatriated entity (as defined in section 2.01(a) of this notice) is a U.S. shareholder. An expatriated foreign subsidiary does not include a CFC that is a member of the EAG immediately after the acquisition and all transactions related to the acquisition are completed (completion date) if the domestic entity is not a U.S. shareholder with respect to the CFC on or before the completion date. In addition, for purposes of

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this section, an expatriated foreign subsidiary that is a pledgor or guarantor of an obligation of a non-CFC foreign related person under the principles of section 956(d) and § 1.956–2(c) will be considered as holding such obligation.

The Treasury Department and the IRS are considering, and request comments on, whether any exceptions under section 956(c)(2) or § 1.956–2 should apply to an obligation or stock of a foreign related person that is determined to be United States property within the meaning of section 956(c)(1) pursuant to the regulations described in this section 3.01(b). However, the exception to the definition of obligation provided by Notice 88–108, 1988–2 C.B. 446, will not apply to such obligations.

.02 Regulations to Address Transac- tions to De-Control or Significantly Dilute CFCs

(a) Section 7701(l) Background Section 7701(l) provides that “[t]he Secretary may prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any 2 or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed [under the Code].” The legislative history notes that, as a general matter, “[t]he tax treatment of a transaction may depend on the identity of the parties to the transaction,” and cites as an example that whether a loan by a CFC to a related person will result in a section 956 inclusion depends upon whether the borrower is a U.S. person or an unrelated foreign person. H.R. Rep. No. 213, 103rd Cong., 1st Sess., at 654 (1993). The legislative history indicates that regulations could be issued under section 7701(l) to prevent the avoidance of tax under a wide variety of Code sections. “It is intended that the provision apply not solely to back-to-back loan transactions, but also to other financing transactions. For example, it would be within the proper scope of the provision for the Secretary to issue regulations dealing with multiple-party transactions involving debt guarantees or equity investments.” H.R. Rep. No. 213, 103rd Cong., 1st Sess., at 655 (1993). In describing the “reasons for change,” the legislative history cites with approval

several IRS rulings that disregard conduit entities, and goes on to note, “the committee does not intend that the Secretary be bound, in developing regulations, by the standards on which those rulings are based, if the Secretary deems it necessary or appropriate to adopt other standards in order to properly recharacterize a financing transaction.” H.R. Rep. No. 103–111, 103rd Cong., 1st Sess., at 729 (1993). Thus, while Congress intended regulations under section 7701(l) to address conduit transactions, the legislative history indicates a broader purpose and notes that traditional approaches need not be the only appropriate response when taxpayers use financing transactions to avoid any tax imposed by the Code. Consistent with the legislative history, the statute’s wording is not limited to conduit fact patterns. In this regard, see § 1.7701(l)–3 (regarding fastpay arrangements), which treats the holders of fast-pay stock in a corporation as having acquired instruments issued by other shareholders of the corporation instead of having acquired interests in the corporation.

(b) Sections 964(e) and 954(c)(6) Background

Section 964(e)(1) provides that if a CFC sells or exchanges stock in any other foreign corporation, gain recognized on such sale or exchange is included in the gross income of the CFC as a dividend to the same extent that it would have been so included under section 1248(a) if the CFC were a United States person. Section 964(e)(2) provides that section 954(c)(3)(A)(i) (the “same country exception” to foreign personal holding company income for interest and dividends) does not apply to any amount treated as a dividend by reason of section 964(e)(1).

Section 954(c)(6)(A) provides that, for purposes of section 954(c), dividends, interest, rents, and royalties received or accrued from a CFC which is a related person shall not be treated as foreign personal holding company income to the extent attributable or properly allocable (determined under rules similar to the rules of subparagraphs (C) and (D) of section 904(d)(3)) to income of the related person which is neither subpart F income nor effectively connected income. Section 954(c)(6)(A) also provides that the Secretary shall prescribe such regulations as may be necessary or appropriate to carry

out the provision, including regulations to prevent the abuse of the purposes of the provision. Notice 2007–9, 2007–1 C.B. 401, provides that, for purposes of section 954(c)(6), the term “dividend” includes gains treated as dividends pursuant to sections 964(e).

(c) Section 367(b) Background Section 367(b)(1) provides that, in the case of an exchange described in section 332, 351, 354, 355, 356, or 361 in connection with which there is no transfer of property described in section 367(a)(1), a foreign corporation shall be considered to be a corporation except to the extent provided in regulations prescribed by the Secretary which are necessary or appropriate to prevent the avoidance of Federal income taxes. Section 367(b)(2) provides that the regulations prescribed pursuant to section 367(b)(1) shall include (but shall not be limited to) regulations dealing with the sale or exchange of stock or securities in a foreign corporation by a United States person, including regulations providing the circumstances under which gain is recognized or deferred, amounts are included in gross income as a dividend, adjustments are made to earnings and profits, or adjustments are made to the basis of stock or securities.

Regulations under section 367(b) generally provide that if the potential application of section 1248 cannot be preserved following the acquisition of the stock or assets of a foreign corporation (foreign acquired corporation) by another foreign corporation in an exchange subject to section 367(b), then certain exchanging shareholders of the foreign acquired corporation must include in income as a dividend the section 1248 amount (as defined in § 1.367(b)–2(c)(1)) attributable to the stock of the foreign acquired corporation exchanged. See § 1.367(b)–4(b). Specifically, subject to certain exceptions, § 1.367(b)–4(b)(1)(i) requires a deemed dividend inclusion if the exchange satisfies two conditions. First, immediately before the exchange, the exchanging shareholder is either (i) a U.S. person that is a section 1248 shareholder with respect to the foreign acquired corporation, or (ii) a foreign corporation in which a U.S. person is a section 1248 shareholder with respect to such foreign corporation and the foreign acquired corporation. See

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§ 1.367(b)–4(b)(1)(i)(A). Second, immediately after the exchange, either (i) the stock received by the exchanging shareholder is not stock in a CFC as to which the U.S. person described in the preceding sentence is a section 1248 shareholder, or (ii) the foreign acquiring corporation (for this purpose, as defined in § 1.367(b)– 4(a)) or the foreign acquired corporation (in the case of an acquisition of the stock of the foreign acquired corporation) is not a CFC as to which the U.S. person is a section 1248 shareholder. See § 1.367(b)– 4(b)(1)(i)(B). Section 1.367(b)–4(c)(1) provides that a section 1248 amount included as a deemed dividend under § 1.367(b)–4(b) is not included as foreign personal holding company income under section 954(c).

(d) Transactions at Issue Inversion transactions facilitate the avoidance of section 956 through techniques in addition to those discussed in section 3.01(b) of this notice. After an inversion transaction, the inverted group may cause an expatriated foreign subsidiary to cease to be a CFC using transactions that avoid the imposition of U.S. income tax, so as to avoid U.S. tax on the CFC’s pre-inversion earnings and profits. For example, after an inversion transaction, a foreign acquiring corporation could issue a note or transfer property to an expatriated foreign subsidiary in exchange for stock representing at least 50 percent of the voting power and value of the expatriated foreign subsidiary. The expatriated foreign subsidiary would cease to be a CFC, and the U.S. shareholders would no longer be subject to subpart F of the Code with respect to the expatriated foreign subsidiary. As a result, the expatriated foreign subsidiary could make its pre-inversion earnings and profits available to the U.S. shareholders without causing an income inclusion under section 956.

Even if the foreign acquiring corporation acquired less stock of an expatriated foreign subsidiary, such that the expatriated foreign subsidiary remains a CFC, it could nevertheless substantially dilute a U.S. shareholder’s ownership of the CFC. As a result, the U.S. shareholder could avoid tax on the CFC’s pre-inversion earnings and profits if, for example, the CFC later redeemed, on a non pro rata basis, its stock held by the foreign acquir

ing corporation. As another example, the U.S. shareholder could avoid tax on a CFC’s pre-inversion earnings and profits if the CFC paid a pro rata extraordinary distribution, although in this case the U.S. shareholder could be required to pay some tax.

The Treasury Department and the IRS have determined that it is appropriate, in order to prevent the avoidance of U.S. tax, to issue regulations under section 7701(l) that will recharacterize certain transactions that facilitate the avoidance of U.S. tax on the expatriated foreign subsidiary’s pre-inversion earnings and profits. The Treasury Department and the IRS also intend to issue regulations that will modify the application of section 367(b), so as to require an income inclusion in certain nonrecognition transactions that dilute a U.S. shareholder’s ownership of a CFC.

(e) Regulations to be Issued (i) Regulations under section 7701(l) The Treasury Department and the IRS intend to issue regulations under section 7701(l) providing that a “specified transaction” completed during the applicable period (as defined in section 7874(d)(1)) will be recharacterized in the manner described in section 3.02(e)(i)(A) of this notice, subject to the exceptions described in section 3.02(e)(i)(C) of this notice. For this purpose, a specified transaction is a transaction in which stock in an expatriated foreign subsidiary (as defined in section 3.01(b) of this notice) (specified stock) is transferred (including by issuance) to a “specified related person.” For this purpose, a specified related person means a non-CFC foreign related person (as defined in section 3.01(b) of this notice), a U.S. partnership that has one or more partners that is a non-CFC foreign related person, or a U.S. trust that has one or more beneficiaries that is a non-CFC foreign related person.

In addition, the Treasury Department and the IRS intend to issue regulations providing that if a deemed dividend is included in a CFC’s income under section 964(e) as a result of a specified transaction that is completed during the applicable period, the deemed dividend will not be excluded from foreign personal holding company income under section 954(c)(6) (to the extent in effect, and notwithstand

ing the rule described in Notice 2007–9, 2007–1 C.B. 401). (A) Recharacterization of a Specified Transaction

A specified transaction is recharacterized for all purposes of the Code, as of the date on which the specified transaction occurs, as an arrangement directly between the specified related person and one or more section 958(a) U.S. shareholders of the expatriated foreign subsidiary. However, if the specified transaction is a fast-pay arrangement that is recharacterized under § 1.7701(l)–3(c)(2), then the rules of § 1.7701(l)–3 will apply instead of the regulations described in this section 3.02(e)(i). For purposes of this notice, a section 958(a) U.S. shareholder of an expatriated foreign subsidiary is a U.S. shareholder (within the meaning of section 951(b)) with respect to the expatriated foreign subsidiary that owns (within the meaning of section 958(a)) stock in the expatriated foreign subsidiary, but only if such U.S. shareholder is related (within the meaning of section 267(b) or 707(b)(1)) to the specified related person or is under the same common control (within the meaning of section 482) as the specified related person.

If an expatriated foreign subsidiary issues the specified stock to a specified related person, the specified transaction will be recharacterized as follows: (i) the property transferred by the specified related person to acquire the specified stock (transferred property) will be treated as having been transferred by the specified related person to the section 958(a) U.S. shareholder(s) of the expatriated foreign subsidiary in exchange for instruments deemed issued by the section 958(a) U.S. shareholder(s) (deemed instrument(s)); and (ii) the transferred property or proportionate share thereof will be treated as having been contributed by the section 958(a) U.S. shareholder(s) (through intervening entities, if any, in exchange for equity in such entities) to the expatriated foreign subsidiary in exchange for stock in the expatriated foreign subsidiary. See section 3.02(e)(iii), Example 1, of this notice.

Similar principles will apply to recharacterize a specified transaction in which a shareholder transfers specified stock of the expatriated foreign subsidiary to a specified

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related person. Section 3.02(e)(1)(iii), Exam- ple 2, of this notice illustrates an application of these principles when a shareholder of an expatriated foreign subsidiary transfers stock of an expatriated foreign subsidiary to a partnership that is a specified related person. The Treasury Department and the IRS request comments on this example, and specifically, on alternative recharacterizations that could apply to transfers to partnerships.

(B) Other Rules Relating to the Re- characterization

A deemed instrument described in section 3.02(e)(i)(A) of this notice will have the same terms as the specified stock (other than issuer). Accordingly, if a distribution is made with respect to specified stock of the expatriated foreign subsidiary, matching seriatim distributions with respect to stock will be treated as made by the expatriated foreign subsidiary (through intervening entities, if any) to the section 958(a) U.S. shareholder(s). The section 958(a) U.S. shareholder(s), in turn, will be treated as making payments, with respect to the deemed instrument(s), to the specified related person(s).

An expatriated foreign subsidiary will be treated as the paying agent of a section 958(a) U.S. shareholder of the expatriated foreign subsidiary with respect to the deemed instrument treated as issued by the section 958(a) U.S. shareholder to a specified related person. In addition, rules similar to those described in § 1.7701(l)– 3(b)(3)(iii) (regarding transactions that affect benefited stock) will apply to transactions affecting specified stock.

A specified transaction will not be recharacterized under the rules of section 3.02(e)(i)(A) of this notice in two situations. The first exception applies if the specified stock was transferred by a shareholder of the expatriated foreign subsidiary and, under applicable U.S. tax rules, the shareholder either is required to recognize and include in income all of the gain in the specified stock (including gain treated as a deemed dividend pursuant to section 964(e) or 1248(a) or characterized as a dividend pursuant to section 356(a)(2)) or has a deemed dividend included in income with respect to the specified stock under 1.367(b)–4 (including by reason of

the regulations described in section 3.02(e)(ii) of this notice that apply to specified exchanges).

The second exception applies if (i) the expatriated foreign subsidiary is a CFC immediately after the specified transaction and all related transactions, and (ii) the amount of stock (by value) in the expatriated foreign subsidiary (and any lowertier expatriated foreign subsidiary) that is owned, in the aggregate, directly or indirectly by the section 958(a) U.S. shareholders of the expatriated foreign subsidiary immediately before the specified transaction and any transactions related to the specified transaction does not decrease by more than 10 percent as a result of the specified transaction and any related transactions.

(ii) Regulations under Section 367(b) The Treasury Department and the IRS intend to amend the regulations under section 367(b) to provide that an exchanging shareholder described in § 1.367(b)– 4(b)(1)(i)(A) will be required to include in income as a deemed dividend the section 1248 amount attributable to the stock of an expatriated foreign subsidiary exchanged in a “specified exchange,” without regard to whether the conditions set forth in § 1.367(b)–4(b)(1)(i)(B) are satisfied. The regulations will apply to specified exchanges completed during the applicable period (as defined in section 7874(d)(1)). For this purpose, a specified exchange is an exchange in which a shareholder of an expatriated foreign subsidiary exchanges stock in the expatriated foreign subsidiary for stock in another foreign corporation pursuant to a transaction described in § 1.367(b)–4(a). See section 3.02(e)(iii), Example 3, of this notice. In addition, the regulations will provide an exception that incorporates the principles of the second exception described in section 3.02(e)(i)(C) of this notice (regarding specified transactions that do not decrease, in aggregate, the section 958(a) U.S. shareholders’ ownership of stock in an expatriated foreign subsidiary (or lower-tier expatriated foreign subsidiary) by more than 10 percent).

Finally, the regulations will provide that § 1.367(b)–4(c)(1) (regarding the exclusion of a deemed dividend from foreign personal holding company income) will not apply to a deemed dividend that

results from a specified exchange pursuant to the regulations described in this section 3.02(e)(ii) and that such deemed dividend will not qualify for the exceptions from foreign personal holding company income provided by section 954(c)(3)(A)(i) or section 954(c)(6) (to the extent in effect).

(iii) Examples The following examples illustrate the regulations described in this section 3.02(e). For each of the examples, assume that FA, a foreign corporation, wholly owns DT, a domestic corporation, which, in turn, wholly owns FT, a foreign corporation that is a CFC. FA wholly owns FS, a foreign corporation. FA acquired DT in an inversion transaction that was completed on January 1, 2015. Accordingly, DT is a domestic entity, FT is an expatriated foreign subsidiary, and FS is a specified related person with respect to FT.

Example 1 . (i) Facts . On February 1, 2015, FA acquires $10x of FT stock from FT, representing 60 percent of total voting power and value of the stock of FT, in exchange for $10x of cash.

(ii) Analysis . (A) FA’s acquisition of the FT stock from FT is a specified transaction, because stock of an expatriated foreign subsidiary was transferred (by issuance) to a specified related person (FA).

(B) FA’s acquisition of the FT stock is recharacterized as follows, with the result that FT continues to be a CFC:

( 1 ) DT is treated as having issued a deemed instrument to FA in exchange for $10x of cash.

( 2 ) DT is treated as having contributed the $10x of cash to FT in exchange for FT stock.

(C) Any distribution with respect to the FT stock actually acquired by FA will be treated as a distribution to DT, which, in turn, will be treated as making a matching distribution with respect to the deemed instrument that DT is treated as having issued to FA. FT is treated as the paying agent of DT with respect to the deemed instrument issued by DT to FA.

(iii) Alternative facts and analysis . The facts are the same as in paragraph (i) of this example, except that instead of acquiring FT stock from FT in exchange for $10x of cash, FA acquires 60% of the FT stock held by DT in exchange for $4x of cash in a fully taxable transaction. In this case, the specified transaction is not recharacterized under section 3.02(e)(i)(A) of this notice pursuant to the first exception described in section 3.02(e)(i)(C) of this notice. This is because DT is required to recognize and include in income all of the gain (including any gain treated as a deemed dividend pursuant to section 1248(a)) with respect to the FT stock transferred to FA.

Example 2 . (i) Facts . On February 1, 2015, DT transfers all of the stock of FT to FPRS, a foreign partnership, in exchange for 40% of the capital and profits interests in the partnership. Furthermore, FA

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contributes property to FPRS in exchange for the other 60% of the capital and profits interests.

(ii) Analysis . (A) DT’s transfer of the FT stock is a specified transaction, because stock of an expatriated foreign subsidiary was transferred to a specified related person (FPRS).

(B) Under the principles of section 3.02(e)(i)(A) of this notice, DT’s transfer of the FT stock is recharacterized as follows, with the result that FT continues to be a CFC:

( 1 ) FPRS is treated as having issued 40% of its capital and profits interests to DT in exchange for a deemed instrument treated as having been issued by DT.

( 2 ) DT is treated as continuing to own all of the stock of FT.

(C) Any distribution with respect to the FT stock actually acquired by FPRS will be treated as a distribution to DT, which, in turn, will be treated as making a matching distribution with respect to the deemed instrument that DT is treated as having issued to FPRS. FT is treated as the paying agent of DT with respect to the deemed instrument issued by DT to FPRS.

Example 3 . (i) Facts . On February 1, 2015, DT exchanges all of the stock of FT solely in exchange for 60% of the stock of FS pursuant to a reorganization described in section 368(a)(1)(B). Immediately before the exchange, FT is a CFC in which DT is a section 1248 shareholder. Immediately after the exchange, FS and FT are CFCs in which DT is a section 1248 shareholder.

(ii) Analysis . (A) DT’s exchange of the FT stock is a specified exchange described in section 3.02(e)(ii) of this notice, because DT exchanged stock of an expatriated foreign subsidiary (FT) for stock in a foreign corporation (FS) pursuant to a transaction described in § 1.367(b)–4(a) (which includes a reorganization described in section 368(a)(1)(B)). Although the specified exchange is also a specified transaction because there is a transfer of FT stock to a specified related person (FS), the exchange is not recharacterized under section 3.02(e)(i)(A) of this notice pursuant to the first exception in section 3.02(e)(i)(C) of this notice.

(B) Under § 1.367(b)–4(b)(1)(i), as modified by the regulations described in section 3.02(e)(ii) of this notice, DT must include in income the section 1248 amount with respect to the FT stock exchanged, without regard to the fact that immediately after the exchange, (i) the FS stock received by DT in the exchange is stock in a corporation that is a CFC as to which DT is a section 1248 shareholder, and (ii) FT is a CFC as to which DT is a section 1248 shareholder.

(iv) Request for Comments The Treasury Department and the IRS are considering whether to provide an exception to the application of the regulations described in this section 3.02(e), such that a taxpayer’s chosen form would be respected, when (1) a specified transaction is undertaken in order to integrate similar or complementary businesses, and (2) after the inversion transaction, the inverted group in fact does not exploit that

form in order to avoid U.S. taxation on the expatriated foreign subsidiary’s preinversion earnings and profits. For example, the exception could be limited to situations in which the expatriated foreign subsidiary does not, during the applicable period (within the meaning of section 7874(d)(1)), engage in any avoidance transactions, such as, for example, acquiring United States property (including obligations or stock treated as United States property under the regulations described in section 3.01(b) of this notice), paying extraordinary dividends out of preinversion earnings and profits, or engaging in non pro rata redemptions of the new foreign shareholder in order to bail out pre-inversion earnings and profits.

In addition to comments on whether any such exception is warranted, the Treasury Department and the IRS request comments on the types of transactions that taxpayers can use to avoid tax on a CFC’s pre-inversion earnings after a specified transaction and that therefore should serve as triggers for denying the exception. The Treasury Department and the IRS also request comments on the provisions that would be necessary to administer any such exception. For example, in order to avoid the recharacterization of any specified transaction, the regulations could require a taxpayer to (i) extend the statute of limitations with respect to the U.S. tax consequences of the specified transaction until the close of the third full taxable year following the close of the applicable period; (ii) agree to certify annually that there have been no avoidance transactions for the taxable year, or, if there is an avoidance transaction, to file amended returns, as appropriate; and (iii) maintain sufficient documentation regarding, for example, accounts tracking pre-inversion earnings and profits described in section 959(c)(3) and the extent to which such earnings and profits are reduced during the applicable period.

.03 Regulations under Section 304 to Prevent the Removal of Untaxed Foreign Earnings and Profits

(a) Section 304(b)(5)(B) Background Section 304(a)(1) generally provides that, for purposes of sections 302 and 303, if one or more persons are in control of each of two corporations and in return for property one of the corporations (acquir

ing corporation) acquires stock in the other corporation (issuing corporation) from the person (or persons) so in control, then (unless section 304(a)(2) applies) the property shall be treated as a distribution in redemption of the stock of the acquiring corporation.

Section 304(a)(2) provides that, for purposes of sections 302 and 303, if in return for property, one corporation acquires from a shareholder of another corporation stock in such other corporation, and the issuing corporation controls the acquiring corporation, then the property shall be treated as a distribution in redemption of the stock of the issuing corporation.

Section 304(b)(2) provides that, in the case of any acquisition to which section 304(a) applies, the determination of the amount that is a dividend (and the source thereof) shall be made as if the property were distributed by the acquiring corporation to the extent of its earnings and profits, and then by the issuing corporation to the extent of its earnings and profits.

Section 304(b)(5)(B) limits the earnings and profits taken into account under section 304(b)(2) where the acquiring corporation is foreign. Specifically, section 304(b)(5)(B) provides that no earnings and profits are taken into account for purposes of section 304(b)(2)(A) (and section 304(b)(2)(A) shall not apply) if more than 50 percent of the dividends arising from such acquisition (determined without regard to section 304(b)(5)(B)) would neither be subject to tax for the taxable year in which the dividends arise, nor be included in the earnings and profits of a CFC. The Staff of the Joint Committee on Taxation’s technical explanation of section 304(b)(5)(B) provides:

The provision prevents the foreign acquiring

corporation’s E&P from permanently escaping

U.S. taxation by being deemed to be distributed

directly to a foreign person (i.e., the transferor)

without an intermediate distribution to a do mestic corporation in the chain of ownership

between the acquiring corporation and the

transferor corporation.

Staff of the Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Senate Amendment to the House Amendment to the Senate Amendment to H.R. 1586, Scheduled for Consideration by the

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House of Representatives on August 10, 2010, at 28 (August 10, 2010). Section 304(b)(5)(C) provides that the Secretary shall prescribe such regulations as are necessary to carry out the purposes of section 304(b)(5).

Dividends paid by a domestic corporation to a foreign person generally are subject to a 30-percent gross basis tax under section 871(a) or 881(a), and to withholding under section 1441 or 1442, unless reduced or eliminated pursuant to an applicable income tax treaty.

(b) Transactions at Issue and Regula- tions to be Issued

Taxpayers may be engaging in certain transactions following an inversion transaction that reduce the earnings and profits of a CFC to facilitate repatriation of cash and other property of the CFC. For example, after an inversion transaction, the foreign acquiring corporation may sell a portion of the stock of the domestic corporation acquired in the inversion transaction to a wholly owned CFC of the domestic corporation in exchange for property of the CFC. This sale would be subject to section 304(a)(2). The exchange of property (for stock of the domestic corporation) by the CFC in many cases will not result in income or gain that gives rise to an income inclusion under section 951, even though the CFC generally will recognize income or gain on the exchange of the property (other than cash) for U.S. tax purposes pursuant to section 1001. For example, the property exchanged may be property used by the CFC in a trade or business, including property held by the CFC through an entity that is disregarded as an entity separate from its owner, as described in § 301.7701–2(c)(2)(i). See § 1.954–2(e)(1)(ii). The Treasury Department and the IRS understand that taxpayers may interpret section 304(b)(5)(B) to not apply where more than 50 percent of the dividend arising upon application of section 304 is sourced from the domestic corporation, even though, for example, pursuant to an income tax treaty there may be no (or a reduced rate of) U.S. withholding tax imposed on a dividend sourced from the domestic corporation. Under this position, the dividend sourced from earnings and profits of the CFC would never be subject to U.S. tax. To address these transactions, the Treasury Department and

the IRS intend to issue regulations under section 304(b)(5)(C) as described below.

The Treasury Department and the IRS intend to issue regulations providing that, for purposes of applying section 304(b)(5)(B), the determination of whether more than 50 percent of the dividends that arise under section 304(b)(2) is subject to tax or includible in the earnings and profits of a CFC will be made by taking into account only the earnings and profits of the acquiring corporation (and therefore excluding the earnings and profits of the issuing corporation). If a partnership, option (or similar interest), or other arrangement, is used with a principal purpose of avoiding the application of the rule in this section 3.03(b) (for example, to treat a transferor as a CFC), then the partnership, option (or similar interest), or other arrangement will be disregarded for purposes of applying the rule in this section 3.03(b).

The rules of this section 3.03(b) will apply as a general matter, without regard to whether an inversion transaction has occurred.

The following examples illustrate the regulations described in this section 3.03(b): Example 1 . (i) Facts . FA, a foreign corporation that is not a CFC, wholly owns DT, a domestic corporation. DT wholly owns FS1, a CFC. DT has earnings and profits of $51x, and FS1 has earnings and profits of $49x. FA transfers DT stock with a value of $100x to FS1 in exchange for $100x of cash.

(ii) Analysis . Under section 304(a)(2), the $100x of cash is treated as a distribution in redemption of the stock of DT. The redemption of the DT stock is treated as a distribution to which section 301 applies pursuant to section 302(d), which ordinarily would be sourced first from FS1 under section 304(b)(2)(A). Without regard to the application of section 304(b)(5)(B), more than 50 percent of the dividend arising from the acquisition, taking into account only the earnings and profits of FS1 pursuant to this section 3.03(b), would not be subject to tax under Chapter 1 of the Code. In particular, no portion of a dividend from FS1 would be subject to U.S. tax or includible in the earnings and profits of a CFC. Accordingly, section 304(b)(5)(B) applies to the transaction, and no portion of the distribution of $100x is treated under section 301(c)(1) as a dividend (as defined in section 316) out of the earnings and profits of FS1. Furthermore, the $100x of cash is treated as a dividend to the extent of the earnings and profits of DT ($51x).

Example 2 . (i) Facts . FA, a foreign corporation that is not a CFC, wholly owns DT, a domestic corporation. DT wholly owns FS1, a CFC. FA and DT own 40 percent and 60 percent, respectively, of the capital and profits interests of PRS, a foreign partnership. PRS wholly owns FS2, a CFC. The FS2

stock has a fair market value of $100x. FS1 has earnings and profits of $150x. PRS transfers all of its FS2 stock to FS1 in exchange for $100x of cash. DT enters into a gain recognition agreement that complies with the requirements set forth in section 4.01 of Notice 2012–15, 2012–9 IRB 424, with respect to the portion (60 percent) of the FS2 stock that DT is deemed to transfer to FS1 in an exchange described in section 367(a)(1). See § 1.367(a)–1T(c)(3)(i)(A).

(ii) Analysis . Under section 304(a)(1), PRS and FS1 are treated as if PRS transferred its FS2 stock to FS1 in an exchange described in section 351(a) solely for FS1 stock, and, in turn, FS1 redeemed such FS1 stock in exchange for $100x of cash. The redemption of the FS1 stock is treated as a distribution to which section 301 applies pursuant to section 302(d). Without regard to the application of section 304(b)(5)(B), more than 50 percent of a dividend arising from the acquisition, taking into account only the earnings and profits of FS1 pursuant to this section 3.03(b), would be subject to tax under Chapter 1 of the Code. In particular, 60 percent of a dividend from FS1 would be included in DT’s distributive share of PRS’s partnership income and therefore would be subject to tax. Accordingly, section 304(b)(5)(B) does not apply and the entire distribution of $100x is treated under section 301(c)(1) as a dividend (as defined in section 316) out of the earnings and profits of FS1.