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Monday, June 11, 2012
Surrogate foreign corporations - section 7874
Preamble to TD9591, 06/07/2012, Reg. § 1.7874-2
IRS has issued final regs under Code Sec. 7874, which is aimed at inversion transactions in which a U.S. parent corporation of a multinational corporate group is replaced by a foreign entity. The regs, which concern the determination of whether a foreign corporation is treated as a surrogate foreign corporation, finalize 2009 temporary regs, with modifications, effective for acquisitions completed on or after June 7, 2012.
In conjunction with the final regs on surrogate foreign corporations, IRS has also issued temporary regs on whether a foreign corporation has substantial business activities in a foreign country for purposes of determining if it should is treated as a surrogate foreign corporation.
Code Sec. 7874 provides rules for expatriated entities and their surrogate foreign corporations. An expatriated entity is defined in Code Sec. 7874(a)(2)(A) as a domestic corporation or partnership with respect to which a foreign corporation is a surrogate foreign corporation, and also as any U.S. person related to such domestic corporation or partnership.
A foreign corporation is treated as a surrogate foreign corporation under Code Sec. 7874(a)(2)(B), if pursuant to a plan (or a series of related transactions): (1) the foreign corporation completes after Mar. 4, 2003, the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation; (2) after the acquisition, at least 60% of the stock (by vote or value) of the foreign corporation is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation; and (3) after the acquisition, the expanded affiliated group that includes the foreign corporation doesn't have substantial business activities in the foreign country (relevant foreign country) in which, or under the law of which, the foreign corporation is created or organized, when compared to the total business activities of the expanded affiliated group. Similar provisions apply if a foreign corporation acquires substantially all of the properties constituting a trade or business of a domestic partnership.
In 2006, IRS issued temporary and proposed Code Sec. 7874 regs . Later in that year, IRS issued Notice 2006-70, 2006-2 CB 252, which announced that IRS would change the date of the temporary regs for certain acquisitions initiated before Dec. 28, 2005. In 2009, the 2006 temporary and proposed regs were withdrawn and replaced with new temporary and proposed regs . IRS has now finalized those 2009 regs.
Final regs. The final regs retain the claim-on-equity approach provided in the 2009 temporary regs, with certain modifications. For purposes of Code Sec. 7874, an option or similar interest (together, an “option”) with respect to a corporation is treated as the corporation's stock with a value equal to the holder's claim on the equity of the corporation. The final regs clarify that a claim on equity equals the value of the stock or partnership interest that may be acquired under the option, less the exercise price (but in no case is a claim on equity less than zero). For this purpose, the equity of the corporation doesn't include the value of any property the holder of the option would be required to provide to the corporation under the terms of the option if the option were exercised. Similar rules are provided for an option with respect to a partnership. The regs also clarify that the rules addressing options also apply for purposes of determining the membership of an expanded affiliated group under Code Sec. 7874(c)(1). (Reg. § 1.7874-2(h)(1))
The final regs provide that, for purposes of determining the voting power of stock under Code Sec. 7874, an option will be treated as exercised if a principal purpose of the issuance or acquisition of the option is to avoid treating the foreign corporation as a surrogate foreign corporation. In all other cases, options aren't taken into account for purposes of determining the voting power of stock under Code Sec. 7874. (Reg. § 1.7874-2(h)(2))
Where an option is treated as stock under the claim-on-equity approach, there is no adjustment to the stock's value under the regs. For example, if the stock of a foreign corporation has an aggregate value of $100x (which reflects the existence of options) and there is a single option outstanding with a claim on equity of $10x with respect to the foreign corporation, then under the regs the total value of the stock of the foreign corporation is treated as $110x for purposes of Code Sec. 7874. (Reg. § 1.7874-2(k)(2), Example 14)
The final regs modify the anti-abuse rule in the 2009 temporary regs which provided that with respect to foreign corporations, the general option rule didn't apply if a principal purpose of the issuance or acquisition of the option was to avoid the corporation being treated as a surrogate foreign corporation. The final regs now provide that the anti-abuse rule applies to options with respect to all corporations and partnerships, whether domestic or foreign. (Reg. § 1.7874-2(h)(4)(i)) The final regs also provide that the claim-on-equity approach doesn't apply if, at the time of the acquisition, the probability that the option will be exercised is remote. (Reg. § 1.7874-2(h)(4)(ii))
Insolvent entities. As in the 2009 temporary regs, the final regs provide that for purposes of Code Sec. 7874, if immediately before the first date properties are acquired as part of an acquisition in Code Sec. 7874(a)(2)(B)(i), a domestic corporation is in a Title 11 or similar case (as defined in Code Sec. 368(a)(3)), or the liabilities of the domestic corporation exceed the value of its assets, then any claim by a creditor against the domestic corporation will be treated as stock of the domestic corporation. A similar rule applies for a domestic partnership, or a foreign partnership that owns stock of a domestic corporation. (Reg. § 1.7874-2(i)(2)(i), Reg. § 1.7874-2(i)(2)(ii))
Multiple transactions. As in the 2009 temporary regs, if, under a plan (or series of related transactions), a foreign corporation completes two or more acquisitions described in Code Sec. 7874(a)(2)(B)(i) involving domestic corporations or partnerships (domestic entities) then, for purposes of Code Sec. 7874(a)(2)(B)(ii), the acquisitions are treated as a single acquisition and the domestic entities are treated as a single domestic entity. While no change has been made to the final regs, IRS is studying this issue and requests comments on the interaction of Reg. § 1.7874-1 (which provides special rules for determining ownership for stock held by members of the expanded affiliated group that includes a foreign corporation) and other rules under Code Sec. 7874 related to the ownership fraction. (Reg. § 1.7874-2(e))
Downstream transactions. The final regs clarify that an acquisition by a corporation of its stock from another corporation or a partnership is an acquisition of the transferor's properties for purposes of Code Sec. 7874(a)(2)(B)(i), even though, for Federal tax purposes, the acquired stock no longer exists after the transaction. Thus, for example, if a domestic corporation that holds a foreign corporation's stock merges into the foreign corporation, for purposes of Code Sec. 7874(a)(2)(B)(i), the foreign corporation is treated as acquiring properties of the domestic corporation in the form of the foreign corporation's stock. (Reg. § 1.7874-2(c)(3))
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