SECTION 2. REGULATIONS TO

ADDRESS TRANSACTIONS CONTRARY TO THE PURPOSES OF SECTION 7874

.01 Section 7874 Background

Under section 7874(a)(2)(B), a foreign corporation (foreign acquiring corporation) generally is treated as a surrogate foreign corporation if, pursuant to a plan (or a series of related transactions), three conditions are satisfied. First, the foreign acquiring 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). Second, after the acquisition, at least 60 percent of the stock (by vote or value) of the foreign acquiring corporation is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation (at times this notice refers to such percentage as the “ownership percentage,” and the fraction used to calculate such percentage as the “ownership fraction”). And third, after the acquisition, the expanded affiliated group that includes the foreign acquiring corporation (EAG) does not have substantial business activi

ties in the foreign country in which, or under the law of which, the foreign acquiring corporation is created or organized (relevant foreign country) when compared to the total business activities of the EAG. Similar provisions apply if a foreign acquiring corporation acquires substantially all of the properties constituting a trade or business of a domestic partnership. The domestic corporation or the domestic partnership described in this paragraph is referred to in this notice at times as the “domestic entity.” For purposes of this notice, a reference to a domestic corporation, a domestic partnership, or a domestic entity includes a successor, and the term “EAG” has the meaning provided in § 1.7874–3(d)(4).

The tax treatment of an acquisition in which the EAG does not have substantial business activities in the relevant foreign country varies depending on the level of owner continuity. If the ownership percentage is at least 80, the foreign acquiring corporation is treated as a domestic corporation for all purposes of the Code pursuant to section 7874(b). If, instead, the ownership percentage is at least 60 but less than 80 (in which case the acquisition is referred to in this notice as an “inversion transaction”), the foreign acquiring corporation is respected as a foreign corporation, but the domestic entity and certain related U.S. persons are treated as expatriated entities under section 7874(a)(2)(A). In the case of an inversion transaction, section 7874(a)(1) and (e) prevent the use of certain tax attributes to reduce the U.S. tax owed with respect to certain income or gain (referred to as “inversion gain”) recognized by an expatriated entity with respect to certain transfers or licenses of property that occur as part of, or after, the inversion transaction. See section 3.01(a) of this notice for additional discussion of the taxation of inversion gain.

Under section 7874(c)(4), a transfer of properties or liabilities (including by contribution or distribution) is disregarded if the transfer is part of a plan a principal purpose of which is to avoid the purposes of section 7874.

Section 7874(c)(6) grants the Secretary authority to prescribe regulations as may

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be appropriate to determine whether a corporation is a surrogate foreign corporation, including regulations to treat stock as not stock. In addition, section 7874(g) grants the Secretary authority to provide regulations necessary to carry out section 7874, including regulations adjusting the application of section 7874 as necessary to prevent the avoidance of the purposes of section 7874, including the avoidance of such purposes through (i) the use of related persons, pass-through or other non-corporate entities, or other intermediaries, or (ii) transactions designed to have persons cease to be (or not become) members of EAGs or related persons.

Congress enacted section 7874 because it believed that “inversion transactions resulting in a minimal presence in a foreign country of incorporation are a means of avoiding U.S. tax and should be curtailed.” S. Rep. No. 192, 108th Cong., 1st. Sess. 142 (Nov. 7, 2003) (Senate Report); Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress (JCS-5-05) 343 (May 31, 2005) (JCT Explanation). Congress expressed particular concern about how inversion transactions “permit corporations and other entities to continue to conduct business in the same manner as they did prior to the inversion, but with the result that the inverted entity avoids U.S. tax on foreign operations and may engage in earnings stripping techniques to avoid U.S. tax on domestic operations.” Senate Report at 142; JCT Explanation at 343.

.02 Transactions at Issue and Regulations to be Issued

(a) Substantial Business Activities of a Foreign Acquiring Corporation that is not Subject to Tax as a Resident of the Relevant Foreign Country

The Treasury Department and the IRS are aware of transactions in which the taxpayer asserts that the EAG has substantial business activities in the relevant foreign country (that is, the foreign country in which, or under the law of which, the foreign acquiring corporation is created or organized) when compared to the EAG’s total business activities, but the foreign acquiring corporation is not subject to income taxation in the relevant foreign country as a resident. This could occur,

for example, if the relevant foreign country determines the tax residency of an entity based on criteria other than the place of creation or formation, such as the location in which the entity is managed or controlled. If the foreign acquiring corporation is managed and controlled in a third country, the foreign acquiring corporation may not be subject to tax as a resident of the relevant foreign country (or, in some cases, of any foreign country). Alternatively, the foreign acquiring corporation may not be subject to tax as a resident of the relevant foreign country because of disparate entity classification rules in the United States and the relevant foreign country. For example, the foreign acquiring corporation may be treated as a corporation for U.S. tax purposes under the entity classification regulations promulgated under section 7701 (including by reason of a “check-the-box” election), but as a fiscally transparent entity under the tax law of the relevant foreign country. In such a case, the foreign acquiring corporation would not be subject to tax as a resident of the relevant foreign country.

The Treasury Department and the IRS have determined that the policy underlying the exception to section 7874 when there are substantial business activities in the relevant foreign country is premised on the foreign acquiring corporation being subject to tax as a resident of the relevant foreign country. For this purpose, the statute’s reference to country of creation or organization reflects the U.S. standard for determining tax residency. However, the U.S. standard for determining tax residency does not always align with foreign countries’ standards. Allowing the exception to apply when the foreign acquiring corporation is not subject to tax as a resident of the relevant foreign country effectively permits an EAG to replace its U.S. tax residence with tax residence in any other country (or, in certain cases, in no other country), without regard to the location of any substantial business activities conducted by the EAG. The Treasury Department and the IRS believe that this result is contrary to the policy underlying the substantial business activities test.

Accordingly, the Treasury Department and the IRS intend to issue regulations under section 7874 to provide that an EAG cannot have substantial business ac

tivities in the relevant foreign country when compared to the EAG’s total business activities unless the foreign acquiring corporation is subject to tax as a resident of the relevant foreign country.

(b) Third-Country Transactions

The Treasury Department and the IRS are aware that certain acquisitions in which a domestic entity combines with an existing foreign corporation are structured by establishing a new foreign parent corporation for the combined group with a tax residence that is different from that of the existing foreign corporation. In other words, the parent corporation of the combined group will be a tax resident of a “third country.” In such transactions, the stock or assets of the existing foreign corporation are acquired by the new thirdcountry parent, and the shareholders of the existing foreign corporation receive more than 20 percent of the stock of the new third-country parent. Similarly, the stock or assets of the domestic entity are acquired by the new third-country parent, and the shareholders of the domestic entity receive less than 80 percent of the stock of the new third-country parent.

In enacting section 7874, Congress believed that certain transactions in which a U.S. parent corporation is replaced with a new foreign parent corporation have little or no non-tax effect or purpose and should be disregarded for U.S. tax purposes, while in other cases such transactions may have sufficient non-tax effect and purpose to be respected, but warrant that any applicable corporate-level “toll charges” for establishing the inverted structure not be offset by tax attributes such as net operating losses or foreign tax credits. See Senate Report at 142, 143; JCT Explanation at 343. The Treasury Department and the IRS have considered whether certain stock issued in an acquisition structured with a third-country parent should be disregarded pursuant to the authority under sections 7874(c)(6) and (g) in order to effectuate this general purpose. In particular, the Treasury Department and the IRS are concerned that a decision to locate the tax residence of a new foreign parent corporation outside of both the United States and the jurisdiction in which the existing foreign corporation is tax resident gener

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ally is driven by tax planning, including the facilitation of U.S. tax avoidance following the acquisition. For example, the third country may have a more favorable income tax treaty with the United States than the country in which the existing foreign corporation is tax resident, with the result that U.S. withholding taxes on dividends, interest, and royalties paid by the domestic entity may be reduced or eliminated. The third country may also have a more favorable tax system than the country in which the existing foreign parent corporation is tax resident, including a less restrictive regime for controlled foreign corporations than the country in which the existing foreign corporation is tax resident. Thus, a third-country parent typically is chosen to facilitate the use of low- or no-taxed entities to erode the U.S. tax base following the acquisition.

The Senate Report and the JCT Explanation indicate that the 80-percent threshold under section 7874(b) for treating a foreign acquiring corporation as a domestic corporation reflects an assumption that, when the existing foreign corporation’s shareholders will own more than 20 percent of the interests in the combined group, there is a sufficient likelihood of a non-tax business purpose for replacing the U.S. parent with a foreign parent to warrant respecting the new foreign parent. However, the Treasury Department and the IRS have concluded that, when a domestic entity combines with an existing foreign corporation by establishing a new parent for the combined group that is tax resident in a third country, the likelihood that there is a sufficient non-tax business purpose for replacing the U.S. parent with a foreign parent is significantly lower than Congress assumed in establishing the 80percent threshold.

The Treasury Department and the IRS have accordingly determined that, in certain circumstances, the use of a thirdcountry parent is contrary to the policy underlying the 80-percent threshold of section 7874(b) and is an appropriate circumstance for the exercise of regulatory authority under sections 7874(c)(6) and (g). The Treasury Department and the IRS therefore intend to issue regulations under sections 7874(c)(6) and (g) to address these transactions by disregarding certain stock of a foreign acquiring corporation

that is issued to the shareholders of the existing foreign corporation for purposes of determining whether the 80-percent threshold is met. The regulations will apply to an acquisition that satisfies four requirements.

First, in a transaction related to the acquisition (referred to in this notice as the “foreign target acquisition”), the foreign acquiring corporation directly or indirectly acquires substantially all of the properties held directly or indirectly by another foreign corporation (foreign target corporation). For purposes of determining if there is a foreign target acquisition with respect to a foreign corporation, the principles of section 7874(a)(2)(B)(i) (defining an acquisition) and § 1.7874–2(c) (regarding acquisitions of properties of a domestic entity and stock of a foreign corporation) apply with the following modifications: (i) the principles of § 1.7874–2(c)(1) (providing rules for determining whether there is an indirect acquisition of properties of a domestic entity) shall be applied by substituting the term “foreign target” for “domestic” wherever it appears, and (ii) the principles of § 1.7874–2(c)(2) (regarding acquisitions of stock of a foreign corporation that owns a domestic corporation or partnership) shall be applied by substituting the term “domestic” for “foreign” and the term “foreign” for “domestic” wherever such terms appear. Furthermore, except as provided in this paragraph, if there is a foreign target acquisition of a foreign corporation (upper-tier foreign corporation) that owns directly stock of another foreign corporation (lower-tier foreign corporation), for purposes of this section 2.02(b) there is not also a foreign target acquisition with respect to the lower-tier foreign corporation (or any foreign corporation owned directly or indirectly by the lowertier foreign corporation). However, if the upper-tier foreign corporation acquired the stock of the lower-tier foreign corporation in a transaction related to the acquisition, then there would also be a foreign target acquisition with respect to the lower-tier foreign corporation (which would be treated as an upper-tier foreign corporation for purposes of further applying the rules of this paragraph).

Second, the gross value of all property directly or indirectly acquired by the for

eign acquiring corporation in the foreign target acquisition exceeds 60 percent of the gross value of all foreign group property (as defined in section 2.01(b) of Notice 2014–52), but, for this purpose, gross value shall not include any property that is foreign group nonqualified property (as defined in section 2.01(b) of Notice 2014–52, but taking into account the corrections to the definition of foreign group nonqualified property described in section 4.01(b) of this notice). Third, the tax residence of the foreign acquiring corporation is not the same as that of the foreign target corporation, as determined before the foreign target acquisition and any transaction related to the foreign target acquisition. A change in the location of the management and control of a foreign target corporation is treated as a transaction for this purpose.

Fourth, not taking into account the rules announced in this section 2.02(b), the ownership percentage is at least 60 but less than 80.

When these four requirements are satisfied, the regulations will provide that stock of the foreign acquiring corporation that otherwise would be included in the denominator of the ownership fraction will be excluded from the denominator to the extent the stock is held by former owners of the foreign target corporation by reason of holding stock in the foreign target corporation (based on the principles of section 7874(a)(2)(B)(ii)).

If, in one or more transactions related to the acquisition described in section 7874(a)(2)(B)(i), the foreign acquiring corporation directly or indirectly acquires multiple foreign target corporations that are tax residents of the same foreign country, then, for purposes of applying the regulations described in this section 2.02(b), all such transactions that otherwise would separately qualify as a foreign target acquisition will be treated as a single foreign target acquisition and those foreign target corporations will be treated as a single entity.

The following examples illustrate the regulations described in this section 2.02(b): Example 1 . (i) Facts . FA, a newly formed foreign corporation that is a tax resident of Country Y, acquires all the stock of DT, a domestic corporation that is wholly owned by Individual A, solely in exchange for 65 shares of newly issued FA stock

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(DT acquisition). In a transaction related to the DT acquisition, FA acquires all the stock of FT, a foreign corporation that is a tax resident of Country X and wholly owned by Individual B, solely in exchange for the remaining 35 shares of newly issued FA stock (FT acquisition).

(ii) Analysis . A portion of the FA stock is excluded from the denominator of the ownership fraction because the DT acquisition satisfies the four requirements set forth in section 2.02(b) of this notice. The first requirement is satisfied because under the principles of section 7874(a)(2)(B)(i) and § 1.7874–2(c) (as modified by section 2.02(b) of this notice), FA is treated as acquiring 100 percent of the properties held by FT as a result of the FT acquisition. Therefore, the FT acquisition is a foreign target acquisition with respect to FT. The second requirement (that the gross value of all property directly or indirectly acquired in the FT acquisition exceeds 60 percent of the gross value of all foreign group property) is also satisfied because the foreign group property is comprised solely of the property acquired in the FT acquisition. The third requirement is satisfied because the foreign country in which FA is a tax resident (Country Y) is not the foreign country in which FT is a tax resident (Country X). Finally, the fourth requirement is satisfied because, absent the rules described in section 2.02(b) of this notice, the ownership fraction would be 65/100 and the ownership percentage would be 65. Accordingly, section 2.02(b) of this notice excludes from the denominator of the ownership fraction the 35 shares of FA stock held by the former shareholder of FT by reason of holding stock in FT. As a result, the ownership fraction is 65/65 and the ownership percentage is 100. The result would be the same if FA instead had directly acquired all of the properties held by FT in exchange for FA stock, for example, in a transaction that would qualify for U.S. income tax purposes as an asset reorganization under section 368.

Example 2 . (i) Facts . The facts are the same as in Example 1 except that, before the FT acquisition, but in a transaction related to the FT acquisition, FT reincorporates in Country Y and, consequently, becomes a tax resident of Country Y.

(ii) Analysis . The analysis is the same as in Example 1 with respect to the first, second, and fourth requirements set forth in section 2.02(b) of this notice. The third requirement is applied by comparing the foreign country in which FA is a tax resident, which is Country Y, to the country in which FT was a tax resident prior to the FT acquisition and any transaction related to the FT acquisition, which is Country X. As a result, the third requirement is also satisfied because FA and FT are not tax residents of the same country for this purpose. Accordingly, section 2.02(b) of this notice excludes from the denominator of the ownership fraction the 35 shares of FA stock held by the former shareholder of FT by reason of holding stock in FT. Consequently, the ownership fraction is 65/65 and the ownership percentage is 100.

.03 Clarification of Regulations under § 1.7874–4T That Disregard Certain Stock Transferred in Exchange for Nonqualified Property

(a) Background

Under section 7874(c)(2)(B) (statutory public offering rule), stock of the foreign acquiring corporation that is sold in a public offering related to the acquisition is excluded from the denominator of the ownership fraction. Section 1.7874–4T modifies the statutory public offering rule. Specifically, § 1.7874–4T(b) provides that, subject to a de minimis exception, “disqualified stock” is not included in the denominator of the ownership fraction. Disqualified stock generally includes stock of the foreign acquiring corporation that is transferred in exchange for “nonqualified property” when that exchange is related to the acquisition. Section 1.7874– 4T(i)(7) provides that the term nonqualified property means: (i) cash or cash equivalents, (ii) marketable securities, (iii) certain obligations (for example, obligations owed by members of the EAG that includes the foreign acquiring corporation), or (iv) any other property acquired in a transaction (or series of transactions) related to the acquisition with a principal purpose of avoiding the purposes of section 7874. Section 1.7874–4T(i)(6) provides that, for this purpose, the term marketable securities has the meaning set forth in section 453(f)(2), except that the term does not include stock of a corporation or an interest in a partnership that becomes a member of the expanded affiliated group that includes the foreign acquiring corporation in a transaction (or series of transactions) related to the acquisition, unless a principal purpose for acquiring such stock or partnership interest is to avoid the purposes of section 7874. This notice refers at times to the property described in clauses (i), (ii), and (iii) of this paragraph collectively as “specified nonqualified property” and to the property described in clause (iv) as “avoidance property.”

Example 2 of § 1.7874–4T(j) illustrates a transfer of stock of the foreign acquiring corporation in exchange for avoidance property. In this example, PRS, a partnership with individual partners,

transfers marketable securities to FT, a newly formed foreign corporation, in exchange solely for all of the FT stock. PRS then transfers the FT stock to FA, a newly formed foreign corporation, in exchange solely for 25 shares of FA stock. Individual A, who is unrelated to PRS, transfers all of the stock of DT, a domestic corporation of which Individual A is the sole shareholder, to FA in exchange solely for 75 shares of FA stock. The facts of the example state that FA acquires the FT stock with a principal purpose of avoiding the purposes of section 7874. Accordingly, the example concludes that the FT stock is nonqualified property, and, therefore, that the 25 shares of FA stock transferred to PRS in exchange for the FT stock are disqualified stock and are not included in the denominator of the ownership fraction.

(b) Transactions at Issue and Regulations to be Issued

The Treasury Department and the IRS are concerned that some taxpayers may be narrowly interpreting the definition of avoidance property. In particular, taxpayers may be asserting that avoidance property is limited to property, such as stock, that is used to indirectly transfer specified nonqualified property to the foreign acquiring corporation, as in the transaction described in Example 2 of § 1.7874– 4T(j). This interpretation of § 1.7874–4T is inconsistent with both the plain language and purpose of the regulation. In addition, section 7874(c)(4) separately provides that a transfer of properties or liabilities is disregarded if the transfer is part of a plan a principal purpose of which is to avoid the purposes of section 7874. Accordingly, the Treasury Department and the IRS intend to issue regulations that will clarify § 1.7874–4T to provide that avoidance property means any property (other than specified nonqualified property) acquired with a principal purpose of avoiding the purposes of section 7874, regardless of whether the transaction involves an indirect transfer of specified nonqualified property. Furthermore, the regulations will remove the phrase “in a transaction (or series of transactions) related to the acquisition” from the defini

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(A) as part of the acquisition described in subsection (a)(2)(B)(i), or

(B) after such acquisition if the transfer or license is to a foreign related person.

Subparagraph (B), however, does not apply to property described in section 1221(a)(1) (generally, property that is inventory) in the hands of the expatriated entity.

Section 7874(d)(3) provides that the term “foreign related person” means, with respect to any expatriated entity, a foreign person that is (i) related (within the meaning of section 267(b) or 707(b)(1)) to the entity, or (ii) under the same common control (within the meaning of section 482) as the entity. Finally, section 7874(e)(2)(A) provides that, in the case of an expatriated entity that is a partnership, section 7874(a)(1) shall apply at the partner rather than the partnership level.

Section 7874(a)(1), together with section 7874(e)(1) (which prevents the use of certain credits to offset U.S. tax on inversion gain), ensure that an expatriated entity generally pays current U.S. tax with respect to inversion gain. These rules are intended to ensure that an appropriate “toll charge” is paid on transactions that accompany or follow an inversion transaction and are designed to “remove income from foreign operations from the U.S. taxing jurisdiction.” See H.R. Rep. No. 755, 108th Cong., 2nd Sess. 568, 574 (2004) (Conf. Rep.); JCT Explanation at 342, 345.

(b) Transactions at Issue and Regulations to be Issued

The Treasury Department and the IRS are concerned that certain indirect transfers of stock or other property by an expatriated entity (rather than direct transfers by the expatriated entity itself) may have the effect of removing foreign operations from U.S. taxing jurisdiction while avoiding current U.S. tax, contrary to the policy underlying sections 7874(a)(1) and (e)(1). This is because under current law the income is not inversion gain and therefore could be offset by tax attributes. For example, following an inversion transaction, an expatriated entity that wholly owns a CFC could cause the CFC to transfer property (including stock of a lower

tion of avoidance property. The inclusion of that phrase in the definition is redundant with language contained in the operative rule in § 1.7874–4T(c)(1) for identifying disqualified stock, which itself requires, in relevant part, that there be an exchange of nonqualified property for stock of the foreign acquiring corporation in a transaction that is related to the acquisition. The regulations also will remove the phrase “unless a principal purpose for acquiring such stock or partnership interest is to avoid the purposes of section 7874” from the definition of marketable securities. The inclusion of that phrase in the definition is redundant with the rule for avoidance property, because if stock of a corporation or a partnership interest described in section 453(f)(2) does not constitute marketable securities due to the corporation or partnership becoming a member of the EAG, the stock or partnership interest is not specified nonqualified property and, therefore, may be avoidance property under § 1.7874–4T(i)(7)(iv).

In addition, Example 1 and Example 2 of § 1.7874–4T(j) (which illustrate transfers of stock of the foreign acquiring corporation in exchange for marketable securities and avoidance property, respectively) will be clarified to include a reference to section 7874(c)(4). Finally, in light of section 2.02(b) of this notice, which applies to certain third-country transactions, all the examples described in § 1.7874–4T(j) will be modified to provide that, unless otherwise indicated, FA, FMS, FS, and FT are tax residents of the same foreign country.

The following example illustrates the clarification described in this section 2.03(b): Example . (i) Facts . DT is a publicly traded domestic corporation. PRS is a foreign partnership that is unrelated to DT. PRS transfers certain business assets (PRS properties) to FA, a newly formed foreign corporation, in exchange solely for 25 shares of FA stock. The shareholders of DT transfer all of their DT stock to FA in exchange solely for the remaining 75 shares of FA stock. None of the PRS properties is specified nonqualified property, but FA acquires the PRS properties with a principal purpose of avoiding the purposes of section 7874.

(ii) Analysis . Under § 1.7874–4T(i)(7)(iv), the PRS properties transferred to FA are nonqualified property, because FA acquires the PRS properties in a transaction related to the DT acquisition with a principal purpose of avoiding the purposes of section 7874. Accordingly, the 25 shares of FA stock trans

ferred by FA to PRS in exchange for the PRS properties are disqualified stock described in § 1.7874– 4T(c)(1)(i). Section 1.7874–4T(c)(2) does not apply to reduce the amount of disqualified stock described in § 1.7874–4T(c)(1)(i) because the transfer of FA stock in exchange for the PRS properties increases the fair market value of FA’s assets by the fair market value of the PRS properties. Accordingly, pursuant to § 1.7874–4T(b), the 25 shares of FA stock transferred to PRS in exchange for the PRS properties are not included in the denominator of the ownership fraction. Furthermore, even in the absence of § 1.7874–4T(i)(7)(iv), the transfer of the PRS properties to FA would be disregarded pursuant to section 7874(c)(4). Therefore, the only FA stock included in the ownership fraction is the FA stock transferred to DT’s former shareholders in exchange for their DT stock, and that FA stock is included in both the numerator and the denominator of the ownership fraction. Thus, the ownership fraction is 75/75.