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proposed regs were withdrawn and replaced with new temporary and proposed regs .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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