SECTION 3. REGULATIONS TO

ADDRESS POST-INVERSION TAX AVOIDANCE TRANSACTIONS

.01 Regulations under Section 7874 Defining Inversion Gain

(a) Background

If an acquisition is an inversion transaction, section 7874(a)(1) requires that the taxable income of an “expatriated entity” for any taxable year that includes any portion of the “applicable period” be no less than the “inversion gain” of the entity for the taxable year. Section 7874(a)(2)(A) provides that the term “expatriated entity” means a domestic corporation or a domestic partnership referred to in section 7874(a)(2)(B)(i) (which describes the acquisition) or any U.S. person that is related (within the meaning of section 267(b) or 707(b)(1)) to such domestic corporation or domestic partnership. Section 7874(d)(1) defines the term “applicable period” as the period beginning on the first date properties are acquired as part of the acquisition, and ending on the date that is 10 years after the last date properties are acquired as part of the acquisition. In addition, section 7874(d)(2) provides that the term “inversion gain” means:

The income or gain recognized by reason of the transfer during the applicable period of stock or other properties by an expatriated entity, and any income received or accrued during the applicable period by reason of a license of any property by an expatriated entity—

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changed if the exchange results in either a loss of CFC status of the foreign corporation whose stock is exchanged or a loss of section 1248 shareholder status of the exchanging shareholder (or of a shareholder of the exchanging shareholder when there is an exchange of stock of a lower-tier CFC). See § 1.367(b)–4(b)(1)(i)(A) and (B), which describe an exchanging shareholder subject to these regulations and the conditions under which an income inclusion is required, respectively.

Notice 2014–52 announced that the regulations under § 1.367(b)–4(b) would be amended to require an income inclusion in certain nonrecognition transactions that occur after an inversion transaction and that dilute the interest of a U.S. shareholder in a CFC, because such transactions could allow the U.S. shareholder to avoid tax on the CFC’s earnings and profits. Specifically, subject to a de minimis rule, section 3.02(e)(ii) of Notice 2014–52 provides 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 with respect to stock of an expatriated foreign subsidiary that is exchanged in a specified exchange during the applicable period, without regard to whether any condition of § 1.367(b)– 4(b)(1)(i)(B) is satisfied. The terms “expatriated foreign subsidiary” and “specified exchange” are defined in sections 3.01(b) and 3.02(e)(ii), respectively, of Notice 2014–52.

(b) Transactions at Issue and Regulations to be Issued

The Treasury Department and the IRS are concerned that certain nonrecognition transactions that dilute a U.S. shareholder’s ownership of an expatriated foreign subsidiary may allow the U.S. shareholder to avoid U.S. tax on unrealized appreciation in property held by the expatriated foreign subsidiary at the time of the exchange. This could occur when the amount of realized gain in the stock of the expatriated foreign subsidiary that is exchanged in the specified exchange exceeds the earnings and profits attributable to such stock for purposes of section 1248. For example, at the time of the exchange, the expatriated foreign subsidiary could

tier CFC) to a specified related person (as defined in section 3.02(e)(i) of Notice 2014–52) in a fully taxable transaction. Gain from the transfer may be subpart F income of the transferor CFC and, as a result, the expatriated entity may have an income inclusion under section 951(a)(1)(A) attributable to the transfer. However, such an inclusion is not inversion gain under current law, and therefore the expatriated entity’s income can be offset by tax attributes (such as net operating losses). Similar concerns arise in connection with a license of property by a CFC of an expatriated entity to a specified related person.

The Treasury Department and the IRS have determined that it is inconsistent with the purposes of sections 7874(a)(1) and (e) to exclude from the definition of inversion gain income or gain recognized by an expatriated entity from an indirect transfer or license of property in circumstances analogous to those set forth in sections 7874(d)(2)(A) and (B). Accordingly, the Treasury Department and the IRS intend to issue regulations under section 7874(g) that will provide that inversion gain includes income or gain recognized by an expatriated entity from an indirect transfer or license of property, such as an expatriated entity’s section 951(a)(1)(A) gross income inclusions taken into account during the applicable period that are attributable to a transfer of stock or other properties or a license of property, either (i) as part of the acquisition, or (ii) after such acquisition if the transfer or license is to a specified related person. However, clause (ii) of the preceding sentence will not apply to property described in section 1221(a)(1) in the hands of the CFC.

In addition, the Treasury Department and the IRS intend to issue regulations that will provide that, if a partnership that is a foreign related person transfers or licenses property, a partner of the partnership shall be treated as having transferred or licensed its proportionate share of that property, as determined under the rules and principles of sections 701 through 777, for purposes of determining inversion gain.

The following example illustrates the regulations described in this section 3.01(b):

Example . (i) Facts . On July 1, 2016, FA, a foreign corporation, acquires all the stock of DT, a domestic corporation, in an inversion transaction. When the inversion transaction occurred, DT wholly owned FS, a foreign corporation that is a CFC. During the applicable period, FS sells to FA property that is not described in section 1221(a)(1) in the hands of FS. Under section 951(a)(1)(A), DT has a $100x gross income inclusion that is attributable to FS’s sale of the property.

(ii) Analysis . Pursuant to section 7874(a)(2)(A), DT is an expatriated entity. Under section 3.01(b) of this notice, DT’s $100x gross income inclusion under section 951(a)(1)(A) is inversion gain, because it is taken into account during the applicable period and is attributable to a transfer of property after the inversion transaction to a specified related person (FA). Sections 7874(a)(1) and (e) therefore prevent the use of certain tax attributes (such as net operating losses) to reduce the U.S. tax owed with respect to DT’s $100x gross income inclusion under section 951(a)(1)(A).

.02 Regulations under Section 367(b) Regarding Certain Exchanges of Stock of an Expatriated Foreign Subsidiary

(a) 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.

In general, current regulations under § 1.367(b)–4(b), without regard to the regulations described in Notice 2014–52, require a shareholder that exchanges stock of a foreign corporation in an exchange subject to section 367(b) to include in income as a deemed dividend the section 1248 amount (as defined in § 1.367(b)– 2(c)(1)) with respect to the stock ex

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hold valuable self-developed intangible property that has not yet been brought to market and therefore has not generated any significant earnings and profits. Any unrealized appreciation in the intangible property, when recognized by the expatriated foreign subsidiary after the exchange, would create earnings and profits that are attributable to gain that economically had accrued at the time of the exchange.

The Treasury Department and the IRS have determined that net unrealized built-in gain in property held by an expatriated foreign subsidiary at the time of the exchange gives rise to the same policy concerns that arise with respect to earnings and profits of the expatriated foreign subsidiary that exist at the time of the exchange. Therefore, to prevent the avoidance of U.S. tax on such net unrealized gain, it is appropriate to require the exchanging shareholder to recognize all of the gain in the stock of the expatriated foreign subsidiary that is exchanged, without regard to the amount of the expatriated foreign subsidiary’s undistributed earnings and profits. Accordingly, the Treasury Department and the IRS intend to amend the regulations under section 367(b) to provide that, if an exchanging shareholder would be required under the rules announced in section 3.02(e)(ii) of Notice 2014–52 to include in income as a deemed dividend the section 1248 amount (if any) with respect to stock of an expatriated foreign subsidiary, the exchanging shareholder also must recognize all realized gain with respect to such stock, after taking into account any increase in basis resulting from a deemed dividend with respect to the exchange provided in § 1.367(b)–2(e)(3)(ii). For this purpose, the amount of realized gain that would be recognized is reduced by the amount of gain recognized under other applicable provisions of the Code, such as section 356. Furthermore, a conforming change will be made to the regulations described in section 3.02(e)(i) of Notice 2014–52, which will recharacterize under section 7701(l) certain transfers of “specified stock” (as defined in section 3.02(e)(i) of Notice 2014–52), subject to the exceptions described in section 3.02(e)(i)(C) of Notice 2014–52. Specifically, the first exception described in section 3.02(e)(i)(C)

applies either when a transfer of specified stock gives rise to a deemed dividend to the exchanging shareholder under § 1.367(b)–4 (including by reason of the regulations described in section 3.02(e)(ii) of Notice 2014–52), or when the exchanging shareholder is required to recognize and include in income all of the gain in the specified stock. Consistent with the modification described in this section 3.02(b), when the regulations described in Notice 2014–52 are issued, the first exception described in section 3.02(e)(i)(C) will be modified to be applicable only if, as a result of the transfer, all the gain in the specified stock is recognized. See section 4.03 of this notice for additional discussion of the application of this notice and Notice 2014–52 to transfers of specified stock.

The following example illustrates the regulations described in this section 3.02(b): Example 1 . (i) Facts . 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 all the stock of DT in an inversion transaction that was completed on July 1, 2016. Accordingly, DT is a domestic entity, FT is an expatriated foreign subsidiary, and FA and FS are each a specified related person with respect to FT. During the applicable period, DT transfers to FS all of the stock of FT solely in exchange for FS voting stock representing 60% of the outstanding 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. At the time of the exchange, the FT stock owned by DT has a fair market value of $150x and a tax basis of $50x (such that the FT stock has a built-in gain of $100x). In addition, the earnings and profits of FT attributable to DT’s FT stock is $60x and therefore the section 1248 amount with respect to the FT stock is $60x (the lesser of the $60x of earnings and profits attributable to the FT stock and the $100x gain in the FT stock).

(ii) Analysis . Under § 1.367(b)–4(b)(1)(i), as modified by the regulations described in section 3.02(e)(ii) of Notice 2014–52, DT must include in income as a deemed dividend $60x, the section 1248 amount with respect to its FT stock. Because DT is required to include in income as a deemed dividend the section 1248 amount, if any, with respect to its FT stock under section 3.02(e)(ii) of Notice 2014– 52, the rules in section 3.02(b) of this notice apply. As a result, DT must also recognize all realized gain with respect to its FT stock after taking into account the $60x increase in basis in the FT stock under § 1.367(b)–2(e)(3)(ii), or $40x ($150x - ($50x $60x)). If instead the section 1248 amount with respect to the FT stock were zero (because, for

example, FT had no earnings and profits), DT would recognize all $100x of realized gain with respect to its FT stock.