SECTION 4. CORRECTIONS AND

CLARIFYING CHANGES TO CERTAIN RULES IN NOTICE 2014–52

.01 Regulations under Section 7874 to Disregard Certain Stock Attributable to Passive Assets

(a) Background

Notice 2014–52 announced that the Treasury Department and the IRS intend to issue regulations under section 7874(c)(6) that will exclude from the denominator of the ownership fraction certain stock of a foreign acquiring corporation that is attributable to passive assets. Specifically, section 2.01(b) of Notice 2014–52 provides that a portion of the stock of a foreign acquiring corporation will be excluded from the denominator of the ownership fraction when more than 50 percent of the gross value of all “foreign group property” is “foreign group nonqualified property.” For this purpose, section 2.01(b) of Notice 2014–52 provides the general rule that foreign group nonqualified property is foreign group property (as defined in section 2.01(b) of Notice 2014–52) that is described in § 1.7874–4T(i)(7), other than property that gives rise to income described in section 1297(b)(2)(A) (PFIC banking exception) or section 954(h) or (i) (subpart F exceptions for qualified banking or financing income and for qualified insurance income, respectively, determined by substituting the term “foreign corporation” for the term “controlled foreign corporation”). In addition, a special rule treats certain property (referred to as “substitute property”) that would not be foreign group nonqualified property under the general rule as foreign group nonqualified property if, in a transaction related to the acquisition, such property is acquired in exchange for other property that would be foreign group nonqualified property under the general rule.

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(b) Modification of the General Definition of Foreign Group Nonqualified Property

(i) Exclusion for property that gives rise to income described in section 1297(b)(2)(B)

Notice 2014–52 did not exclude property that gives rise to income described in section 1297(b)(2)(B) (PFIC insurance exception) from the general definition of foreign group nonqualified property. Commenters have noted that certain insurance companies may not be able to satisfy the requirements of the subpart F exception for qualified insurance income under section 954(i), which is a narrower provision than section 1297(b)(2)(B). The Treasury Department and the IRS have determined that the rule described in Notice 2014–52 with respect to insurance companies can lead to inappropriate results in certain cases. Accordingly, the regulations described in section 2.01(b) of Notice 2014–52 will provide that property that gives rise to income described in the PFIC insurance exception will be excluded from the general definition of foreign group nonqualified property, but such property will be subject to the special rule for substitute property. Nevertheless, the Treasury Department and the IRS have significant concerns about certain corporations that do not conduct a bona fide active insurance business or whose investment assets exceed the amount necessary to meet their obligations under insurance and annuity contracts, but that nonetheless take the position that they earn income described in section 1297(b)(2)(B) with respect to all of their activities and investment assets. In this regard, on April 24, 2015, proposed regulations under § 1.1297–4 were published in the Federal Register (REG–108214– 15) to provide guidance on when a foreign insurance company’s income is excluded from the definition of passive income under the PFIC insurance exception. In the preamble to those proposed regulations, the Treasury Department and the IRS requested comments on appropriate methodologies for determining the extent to which assets are held to meet obligations under insurance and annuity contracts. Accordingly, the Treasury Department and the IRS expect to issue separate guid

ance under section 1297(b)(2)(B) to prevent companies from inappropriately applying the PFIC insurance exception.

(ii) Exclusion of property held by certain domestic corporations

Commenters have noted that the general definition of foreign group nonqualified property in Notice 2014–52 includes certain property held by domestic corporations engaged in the active conduct of a banking or insurance business. This could occur, for example, if a foreign acquiring corporation held all the stock of a domestic corporation prior to an acquisition. The Treasury Department and the IRS have determined that this definition may lead to inappropriate results in certain cases. Consequently, the regulations described in section 2.01(b) of Notice 2014–52 will provide that the general definition of foreign group nonqualified property does not include property held by a domestic corporation that is subject to tax as an insurance company under subchapter L, provided that the property is required to support, or is substantially related to, the active conduct of an insurance business. Furthermore, the regulations will provide that the general definition of foreign group nonqualified property does not include property held by a domestic corporation if that property gives rise to income described in section 954(h), determined by substituting the term “domestic corporation” for the term “controlled foreign corporation” and without regard to the phrase “located in a country other than the United States” in section 954(h)(3)(A)(ii)(I) and without regard to any inference that the tests in section 954(h) should be calculated or determined without taking into account transactions with customers located in the United States. In these cases, however, the special rule for substitute property will apply.

.02 Regulations under Section 7874 to Disregard Certain Distributions by the Domestic Entity

(a) Background

Notice 2014–52 announced that the Treasury Department and the IRS intend to issue regulations under section 7874 that disregard certain distributions made

by a domestic entity before being acquired by a foreign acquiring corporation. Specifically, section 2.02(b) of Notice 2014–52 provides that non-ordinary course distributions (as defined in section 2.02(b) of Notice 2014–52) made by a domestic entity (including a predecessor) during the 36-month period ending on the acquisition date (within the meaning of § 1.7874–3T(d)(1)) are disregarded for purposes of section 7874.

(b) Addition of a De Minimis Exception

Commenters have noted that the rules announced in section 2.02(b) of Notice 2014–52 could cause section 7874 to apply to an acquisition even though the former owners of the domestic entity actually own no, or only a de minimis amount of, stock in the foreign acquiring corporation after the acquisition. In general, this could occur when stock of the foreign acquiring corporation is disregarded for purposes of section 7874. For example, assume that, pursuant to a plan to purchase the stock of a domestic corporation, which made a non-ordinary course distribution, the purchaser forms a newly formed foreign acquiring corporation with cash and the foreign acquiring corporation uses the cash to purchase the stock of the domestic corporation. In applying the ownership percentage, the stock held by the shareholders of the foreign acquiring corporation is disregarded under § 1.7874–4T(b) (which disregards certain stock of the foreign acquiring corporation received in exchange for nonqualified property). This result is similar to a result that could occur under § 1.7874–4T(b), absent the de minimis exception provided in § 1.7874–4T(d)(1), when the former shareholders of the domestic entity in fact acquire a small interest in the foreign acquiring corporation by reason of having held an interest in the domestic entity. The Treasury Department and the IRS have determined that the policy reasons for providing the de minimis exception in § 1.7874–4T are equally applicable to the regulations described in section 2.02(b) of Notice 2014–52.

Accordingly, the Treasury Department and the IRS intend to include in the regulations described in section 2.02(b) of Notice 2014–52 a de minimis exception that will implement this policy. This ex

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ception will apply to an acquisition that meets two requirements. First, the ownership percentage, determined without regard to the application of § 1.7874–4T(b) and the rules announced in sections 2.01(b) and 2.02(b) of Notice 2014–52, must be less than five (by vote and value). Second, after the acquisition and all transactions related to the acquisition are completed, former shareholders (within the meaning of § 1.7874–2(b)(2)) or former partners (within the meaning of § 1.7874– 2(b)(3)), as applicable, of the domestic entity, in the aggregate, must own (applying the attribution rules of section 318(a) with the modifications described in section 304(c)(3)(B)) less than five percent (by vote and value) of the stock of (or a partnership interest in) any member of the EAG that includes the foreign acquiring corporation. If these two requirements are satisfied, the rules announced in section 2.02(b) of Notice 2014–52 will not apply to the acquisition and, as a result, no distributions will be treated as non-ordinary course distributions that are disregarded under those rules. However, any distributions that are part of a plan a principal purpose of which is to avoid the purposes of section 7874 will be disregarded under section 7874(c)(4).

.03 Regulations to Address Transactions to De-Control or Significantly Dilute Ownership of Certain CFCs

(a) Background

Notice 2014–52 announced that the Treasury Department and the IRS intend to issue regulations under section 7701(l) that will recharacterize certain postinversion transactions that otherwise would de-control or significantly dilute a U.S. shareholder’s ownership of a CFC that is an expatriated foreign subsidiary. The general rule in section 3.02(e)(i) of Notice 2014–52 provides that a specified transaction completed during the applicable period is recharacterized under section 7701(l) in the manner described in section 3.02(e)(i)(A) of Notice 2014–52. For this purpose, a specified transaction is a transaction in which stock in an expatriated foreign subsidiary, referred to as “specified stock,” is transferred (including by issuance) to a specified related person. The term “expatriated foreign subsidiary”

is defined in section 3.01(b) of Notice 2014–52, and the terms “specified transaction,” “specified stock,” and “specified related party” are defined in section 3.02(e)(i) of Notice 2014–52. This general rule is subject to two exceptions described in section 3.02(e)(i)(C) of Notice 2014–52. The first exception is discussed in section 3.02(b) of this notice. The second exception (small dilution 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 lower-tier expatriated foreign subsidiary) that is owned, in the aggregate, directly or indirectly by the section 958(a) U.S. shareholders (as defined in section 3.02(e)(i)(A) of Notice 2014–52) 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.

Example 1 of section 3.02(e)(iii) of Notice 2014–52 illustrates a specified transaction in which neither exception applies and therefore the transaction is recharacterized in the manner described in section 3.02(e)(i)(A) of Notice 2014–52. In the example, FA is a foreign corporation that wholly owns DT, a domestic corporation acquired by FA in an inversion transaction completed on January 1, 2015. In addition, DT wholly owns FT, a foreign corporation that is a CFC and an expatriated foreign subsidiary, and FA wholly owns FS, a foreign corporation that is a specified related person with respect to FT. Shortly after the inversion transaction, 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.

The example states that FA’s acquisition of the FT stock from FT is a specified transaction that must be recharacterized. The small dilution exception is not applicable because the amount of FT stock (by value) that is owned (within the meaning of section 958(a)), in the aggregate, by DT before the specified transaction decreases by more than 10 percent (in fact, by 60 percent, from 100 percent to 40 percent) as a result of the specified transaction.

(b) Clarifying Change to Small Dilution Exception

The Treasury Department and the IRS are concerned that some taxpayers may be inappropriately interpreting the small dilution exception. In particular, some taxpayers may be comparing the value of the stock of an expatriated foreign subsidiary owned by a section 958(a) U.S. shareholder immediately before a specified transaction with the value of the stock owned by the section 958(a) U.S. shareholder immediately after the specified transaction, rather than comparing the percentage of the stock owned (by value) by the section 958(a) U.S. shareholder before and after the specified transaction. This interpretation is plainly inconsistent with the purpose of the rules described in section 3.02(e)(i) of Notice 2014–52 and the small dilution exception, as well as the analysis in Example 1 of section 3.02(e)(iii) of Notice 2014–52. Accordingly, the regulations will clarify the application of the small dilution exception by substituting the phrase “the percentage of stock (by value)” for the phrase “the amount of stock (by value).” A similar clarification will be made to the exception described in section 3.02(e)(ii) of Notice 2014–52 (relating to the circumstances in which an exchanging shareholder is required under section 367(b) to include in income as a deemed dividend the section 1248 amount with respect to stock exchanged in a specified exchange).