Guidance Under Section 7874 Regarding Surrogate Foreign Corporations, 27920-27932 [E9-13770]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 74, Number 112 (Friday, June 12, 2009)]
[Rules and Regulations]
[Pages 27920-27932]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E9-13770]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9453]
RIN 1545-BI81


Guidance Under Section 7874 Regarding Surrogate Foreign 
Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final and temporary regulations under 
section 7874 of the Internal Revenue Code (Code) concerning the 
determination of whether a foreign corporation shall be treated as a 
surrogate foreign corporation. The temporary regulations primarily 
affect domestic corporations or partnerships (and certain parties 
related thereto), and certain foreign corporations that acquire 
substantially all of the properties of such domestic corporations or 
partnerships. The text of these temporary regulations serves as the 
text of the proposed regulations set forth in the notice of proposed 
rulemaking on this subject also published in this issue of the Federal 
Register.

DATES: Effective Dates: The regulations are effective on June 12, 2009.
    Applicability Date: For dates of applicability, see Sec. Sec.  
1.7874-1T(g) and 1.7874-2T(o).

[[Page 27921]]


FOR FURTHER INFORMATION CONTACT: S. James Hawes, (202) 622-3860 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION: 

Background

    A foreign corporation is generally treated as a surrogate foreign 
corporation under section 7874(a)(2)(B) if pursuant to a plan (or a 
series of related transactions) three conditions are satisfied. First, 
the foreign 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. Second, after the 
acquisition at least 60 percent 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. 
Third, after the acquisition the expanded affiliated group (defined in 
section 7874(c)(1)) that includes the foreign corporation does not have 
substantial business activities in the 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 to transactions 
involving the acquisition by a foreign corporation of substantially all 
of the properties constituting a trade or business of a domestic 
partnership. The level of ownership in the surrogate foreign 
corporation by former shareholders of the domestic corporation (or 
former partners in the domestic partnership) determines the treatment 
of the transaction. Compare sections 7874(a)(1) and 7874(b).
    Temporary regulations (TD 9265) were published in the Federal 
Register (71 FR 32437) on June 6, 2006, concerning the treatment of a 
foreign corporation as a surrogate foreign corporation (2006 temporary 
regulations). A notice of proposed rulemaking (REG-112994-06) cross-
referencing the temporary regulations was published in the same issue 
of the Federal Register (71 FR 32495). On July 28, 2006, Notice 2006-70 
(2006-2 CB 252), (see Sec.  601.601(d)(2)(ii)(b)) was published, 
announcing that the effective date in Sec.  1.7874-2T(j) would be 
amended for certain acquisitions initiated prior to December 28, 2005. 
No public hearing was requested or held; however, comments were 
received. After consideration of the comments, the 2006 temporary 
regulations and the related notice of proposed rulemaking are withdrawn 
and replaced with new temporary regulations and a new notice of 
proposed rulemaking. These new temporary regulations are discussed in 
this preamble.

Summary of Temporary Regulations

A. Stock Held by a Partnership

    Section 1.7874-1T(b), as contained in 26 CFR part 1 revised as of 
April 1, 2008, provided that, for purposes of section 7874(c)(2)(A), 
stock held by a partnership shall be considered as held proportionately 
by the partners of the partnership. Final regulations published in the 
Federal Register (73 FR 29054-29058) on May 20, 2008 (2008 final 
regulations) modified this provision to apply for all purposes of 
section 7874. See Sec.  1.7874-1(e). By its terms, Sec.  1.7874-1(e) 
applies only to stock held by a partnership, not to all properties held 
by the partnership.
    Commentators have questioned the scope of Sec.  1.7874-1(e). In 
response to these comments, the temporary regulations modify the rule 
to apply only for purposes of determining whether the ownership 
condition of section 7874(a)(2)(B)(ii) is satisfied. The temporary 
regulations provide other partnership look-through rules, as 
appropriate. See, for example, the discussion in section F.4. of this 
preamble concerning the partnership items that are taken into account 
for purposes of section 7874(a)(2)(B)(iii).

B. Indirect Acquisition of Properties

1. Clarification of Temporary Regulations
    The 2006 temporary regulations identify certain acquisitions that 
constitute indirect acquisitions of properties held by a domestic 
corporation. See Sec.  1.7874-2T(b). The temporary regulations retain 
these rules and clarify that the identified transactions do not 
represent an exclusive list of transactions that constitute indirect 
acquisitions. The temporary regulations also clarify that the 
acquisition of an interest in a partnership is an indirect acquisition 
of a proportionate amount of the properties of the partnership for 
purposes of section 7874(a)(2)(B)(i).
2. Certain Acquisitions by Members of the Expanded Affiliated Group
    The 2006 temporary regulations provide that if a corporation 
(acquiring corporation) acquires stock or assets of a domestic 
corporation in exchange for stock of a foreign corporation (foreign 
issuing corporation) that directly or indirectly owns more than 50 
percent of the stock (by vote or value) of the acquiring corporation 
after the acquisition, the foreign issuing corporation shall be treated 
as acquiring a proportionate amount of the stock or assets of the 
domestic corporation. Sec.  1.7874-2T(b)(4).
    The temporary regulations retain this rule, with modifications. 
First, the rule is modified to apply if the acquiring corporation and 
the foreign issuing corporation are members of the same expanded 
affiliated group after the acquisition. Second, the rule is modified to 
apply to an acquisition of properties of a partnership. Finally, the 
rule is modified to apply if a partnership acquires properties of a 
domestic corporation (or partnership) in exchange for stock of a 
foreign issuing corporation, but only if the foreign issuing 
corporation and the partnership would be members of the same expanded 
affiliated group after the acquisition if the partnership were a 
corporation.

C. Acquisitions by Multiple Foreign Corporations

    The IRS and the Treasury Department have become aware of 
transactions intended to avoid section 7874 that involve two or more 
foreign corporations completing, in the aggregate, an acquisition 
described in section 7874(a)(2)(B)(i). For example, pursuant to a plan 
(or a series of related transactions), two foreign corporations would 
collectively acquire substantially all of the properties held by a 
domestic corporation. Taxpayers may take the position that neither 
foreign corporation is a surrogate foreign corporation because no 
foreign corporation separately acquires substantially all of the 
properties held by the domestic corporation. Taxpayers may also take 
the position that section 7874(c)(4) does not apply to these 
transactions.
    Even if substantially all of the properties held by a domestic 
corporation (or constituting a trade or business of a domestic 
partnership) are not acquired by a single foreign corporation, this 
type of transaction presents the policy concerns that prompted the 
enactment of section 7874. Accordingly, the temporary regulations 
provide that, if pursuant to a plan (or a series of related 
transactions) two or more foreign corporations complete, in the 
aggregate, an acquisition described in section 7874(a)(2)(B)(i), then 
each foreign corporation shall be treated as completing the acquisition 
for purposes of determining whether such foreign corporation shall be 
treated as a surrogate foreign corporation. See also section 
7874(c)(4).

[[Page 27922]]

D. Acquisition of Multiple Domestic Corporations (or Partnerships)

    The preamble to the 2008 final regulations identifies another 
transaction intended to avoid section 7874 that involves a single 
foreign corporation completing more than one acquisition described in 
section 7874(a)(2)(B)(i) as part of the same plan (or a series of 
related transactions). The preamble to the 2008 final regulations 
explains that the IRS and the Treasury Department disagree with the 
characterization of this type of transaction for purposes of section 
7874 under current law and are considering issuing regulations 
clarifying the application of section 7874 to such transactions. In 
particular, the IRS and the Treasury Department disagree with the 
position that in determining whether the foreign corporation is a 
surrogate foreign corporation the ownership percentage under section 
7874(a)(2)(B)(ii) is determined separately with respect to each 
domestic corporation (or partnership).
    The preamble to the 2008 final regulations explains that any 
regulations issued would clarify that references in section 
7874(a)(2)(B) to ``a domestic corporation'' shall, as appropriate, mean 
``one or more domestic corporations'' where the properties of more than 
one domestic corporation are, directly or indirectly, acquired by a 
foreign corporation pursuant to the same plan. See Sec.  1.368-2(h). 
The preamble indicates that similar clarifications would be made for 
transactions involving domestic partnerships.
    The temporary regulations clarify that if a foreign corporation 
completes more than one acquisition described in section 
7874(a)(2)(B)(i) pursuant to a plan (or a series of related 
transactions), then, for purposes of section 7874(a)(2)(B)(ii), the 
acquisitions shall be treated as a single acquisition and the domestic 
corporations (and/or domestic partnerships) shall be treated as a 
single entity. This rule shall apply equally to transactions involving 
multiple corporations, multiple partnerships, or multiple corporations 
and partnerships.
    The IRS and the Treasury Department determined that providing a 
specific operative rule was preferable to simply stating that, for 
purposes of section 7874(a)(2)(B), any reference to a single domestic 
corporation (or partnership) includes one or more domestic corporations 
(or partnerships). However, the operative rule of the temporary 
regulations is not a change from current law.

E. ``By Reason of'' Standard of Section 7874(a)(2)(B)(ii)

1. Distributions and Other Transactions
    The 2006 temporary regulations provide that stock of a foreign 
corporation received by a former shareholder of a domestic corporation 
in exchange for stock of the domestic corporation is held by reason of 
holding stock in the domestic corporation. Sec.  1.7874-2T(c)(1). 
Commentators have questioned whether an exchange is the exclusive means 
by which stock of a foreign corporation can be held by reason of 
holding stock in the domestic corporation. For example, one commentator 
questioned whether stock of a foreign corporation received by a former 
shareholder as a distribution with respect to the stock of the domestic 
corporation is held by reason of holding stock in the domestic 
corporation.
    Section 7874(a)(2)(B)(ii) does not require stock of the foreign 
corporation to be received in exchange for stock of the domestic 
corporation (or an interest in the domestic partnership). Therefore, 
the temporary regulations clarify that the ``by reason of'' condition 
of section 7874(a)(2)(B)(ii) is satisfied if stock of a foreign 
corporation is received in exchange for, or with respect to, stock in a 
domestic corporation (or an interest in a domestic partnership). This 
includes a taxable or nontaxable distribution. The temporary 
regulations also clarify that the ``by reason of'' condition may be 
satisfied other than through exchanges or distributions.
2. Acquisitions Involving Other Property
    One commentator questioned whether all the stock of a foreign 
corporation received by a former shareholder in exchange for stock of a 
domestic corporation and other property could be treated as held by 
reason of holding stock of the domestic corporation, if the other 
property bears some relationship to the stock of the domestic 
corporation.
    In response to this comment, the temporary regulations clarify 
that, subject to section 7874(c)(4) and general tax principles, the 
``by reason of'' standard applies based on the amount of stock of the 
foreign corporation received in exchange for, or with respect to, the 
stock of the domestic corporation (or interest in the domestic 
partnership). This determination is based on the relative values of the 
stock of the domestic corporation (or interest in a domestic 
partnership) and any other property exchanged for the stock of the 
foreign corporation. Thus, subject to section 7874(c)(4) and general 
tax principles, the ``by reason of'' standard is not affected by a 
relationship between stock of the domestic corporation (or interest in 
the domestic partnership) and such other property.

F. Substantial Business Activities Condition of Section 
7874(a)(2)(B)(iii)

1. Removal of Safe Harbor and Examples
    The third condition for the treatment of a foreign corporation as a 
surrogate foreign corporation is that, after the acquisition, the 
expanded affiliated group (defined in section 7874(c)(1)) that includes 
the foreign corporation does not have substantial business activities 
in the 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 (the substantial 
business activities condition). Section 7874(a)(2)(B)(iii). For 
purposes of determining whether the substantial business activities 
condition is satisfied, the 2006 temporary regulations provide a 
general rule that, with certain exceptions, is based on all the facts 
and circumstances, and a safe harbor. Sec.  1.7874-2T(d)(1) through 
(3). The 2006 temporary regulations also provide examples illustrating 
the application of the general rule. Sec.  1.7874-2T(d)(4).
    The IRS and the Treasury Department have concluded that the safe 
harbor provided by the 2006 temporary regulations may apply to certain 
transactions that are inconsistent with the purposes of section 7874, 
which is meant to prevent certain transactions that seek to avoid U.S. 
tax by merely shifting the place of organization of a domestic 
corporation (or partnership). The temporary regulations, therefore, do 
not retain the safe harbor provided by the 2006 temporary regulations. 
The temporary regulations also do not retain the examples illustrating 
the general rule contained in the 2006 temporary regulations. Thus, 
taxpayers can no longer rely on the safe harbor or the examples 
illustrating the general rule provided by the 2006 temporary 
regulations. Instead, taxpayers must apply the general rule to 
determine whether the substantial business activities condition is 
satisfied. In addition, the question of whether the substantial 
business activities condition is satisfied will continue to be on the 
list of provisions with respect to which the IRS will not ordinarily 
issue rulings or determination letters. See Rev. Proc. 2009-7 (2009-1 
IRB 226), Section 4.01(30). Comments are requested with respect to 
these changes.

[[Page 27923]]

2. Sales and Services Between Expanded Affiliated Group Members
    The 2006 temporary regulations identify sales made by the expanded 
affiliated group to customers located in the foreign country as an item 
to consider in determining whether the substantial business activities 
condition is satisfied. Sec.  1.7874-2T(d)(1)(ii)(3 ). Commentators 
have asked whether sales (or the performance of services) between 
expanded affiliated group members may be taken into account for this 
purpose.
    The IRS and the Treasury Department are concerned that sales (and 
the performance of services) between expanded affiliated group members 
can be structured in a manner that does not represent actual business 
activities. However, subject to section 7874(c)(4) and general tax 
principles, the IRS and the Treasury Department believe that in 
appropriate circumstances sales (or the performance of services) 
between members of the expanded affiliated group may be taken into 
account under the general rule.
3. Items Not To Be Considered
    The 2006 temporary regulations identify certain assets, activities, 
or income not to be taken into account in determining whether the 
substantial business activities condition is satisfied. See Sec.  
1.7874-2T(d)(1)(iii). See also section 7874(c)(4). The temporary 
regulations add to these items any assets, business activities, or 
employees located in the foreign country in which, or under the law of 
which, the foreign acquiring corporation is created or organized if 
such assets, business activities or employees are transferred to 
another country pursuant to a plan in existence at the time of the 
acquisition.
4. Partnership Items
    The 2006 temporary regulations provide that if one or more members 
of the expanded affiliated group own capital or profits interests in a 
partnership, the proportionate amount of certain items of the 
partnership are considered to be items of the member (or members) of 
the expanded affiliated group. Sec.  1.7874-2T(d)(3)(iv).
    The temporary regulations retain and modify this provision to 
provide that, for purposes of the substantial business activities 
condition, a member of the expanded affiliated group that holds at 
least a 10 percent capital and profits interest in a partnership shall 
take into account its proportionate share of the items of the 
partnership, including business activities, employees, assets, income, 
and sales.

G. Publicly Traded Foreign Partnerships

1. Scope
    For purposes of section 7874, the 2006 temporary regulations treat 
as a foreign corporation any foreign partnership that would, but for 
section 7704(c), be treated as a corporation under section 7704 at any 
time during the two-year period following the completion by the foreign 
partnership of an acquisition described in section 7874(a)(2)(B)(i). 
The IRS and the Treasury Department are concerned that taxpayers may be 
taking the position that the rule does not apply to a foreign 
partnership whose interests become publicly traded outside this two-
year period, even if the public trading occurs pursuant to a plan that 
existed at the time of the acquisition.
    To address these transactions, the temporary regulations modify the 
rule to apply to any foreign partnership that would, but for section 
7704(c), be treated as a corporation under section 7704(a) at the time 
of the acquisition described in section 7874(a)(2)(B)(i), or at any 
time after the acquisition pursuant to a plan that existed at the time 
of the acquisition. For this purpose, a plan shall be deemed to exist 
at the time of the acquisition if the foreign partnership would, but 
for section 7704(c), be treated as a corporation under section 7704(a) 
at any time during the two-year period following the acquisition.
    The temporary regulations also clarify that a publicly traded 
foreign partnership treated as foreign corporation under the rule is 
treated as a foreign corporation for all purposes of section 7874.
2. Implication Regarding Scope of Public Offering Rule
    Section 1.7874-2T(e)(5), Example 3, involves a publicly traded 
foreign partnership that is treated as a surrogate foreign corporation 
under section 7874(a)(2)(B), but not as a domestic corporation under 
section 7874(b). In the example, the publicly traded foreign 
partnership acquires the stock of a domestic corporation in exchange 
for 75 percent of its outstanding interests. At the same time as the 
acquisition, an unrelated person acquires the remaining 25 percent 
interest in exchange for stock of a foreign corporation. The example 
concludes that the former shareholders of the domestic corporation hold 
75 percent of the interests in the publicly traded foreign partnership 
by reason of holding stock of the domestic corporation. Implicit in 
this conclusion is that the 25 percent interest received by the 
unrelated person in exchange for the stock of the foreign corporation 
is not subject to the public offering rule of section 7874(c)(2)(B).
    The IRS and the Treasury Department did not intend for this example 
to address the scope or application of the public offering rule of 
section 7874(c)(2)(B). The temporary regulations modify the example to 
eliminate the implication. The IRS and the Treasury Department are 
considering issuing guidance concerning the public offering rule of 
section 7874(c)(2)(B). Comments are requested in this regard.

H. Options and Similar Interests

    The 2006 temporary regulations provide that, for purposes of 
section 7874(a)(2)(B)(ii), options and interests that are similar to 
options held by reason of holding stock in a domestic corporation (or 
an interest in a domestic partnership) shall be treated as exercised. 
Not addressed by the 2006 temporary regulations, however, is the 
treatment of options (or similar interests) or stock in a foreign 
corporation held by reason of holding options (or similar interests) in 
a domestic corporation (or a partnership, domestic or foreign). This 
issue may arise, for example, if the holder of a warrant to acquire 
stock of the domestic corporation exchanges the warrant for a warrant 
to acquire stock of the foreign acquiring corporation. The 2006 
regulations also do not address the treatment of options (or similar 
interests) in a foreign corporation not held by reason of holding stock 
in a domestic corporation (or an interest in a domestic partnership). 
Further, the IRS and the Treasury Department believe that treating 
options (or similar interests) as exercised may, in certain cases, lead 
to inappropriate results. For example, treating options (or similar 
interests) as exercised may distort the ownership of the foreign 
corporation for purposes of section 7874(a)(2)(B)(ii). For these 
reasons, the temporary regulations make the following changes to the 
rule provided by the 2006 temporary regulations.
1. Domestic Corporations (or Partnerships)
    An option (or similar interest) represents a claim on equity to the 
extent the value of the stock (or partnership interest) that may be 
acquired pursuant to the option (or similar interest) exceeds the 
exercise price under the terms of the option (or similar interest). As 
a result, the temporary regulations provide that, for purposes of 
section 7874, an option (or similar interest) in a domestic corporation 
(or a partnership, domestic

[[Page 27924]]

or foreign) shall be treated as stock of the domestic corporation (or 
an interest in the partnership) with a value equal to the holder's 
claim on the equity of the domestic corporation (or partnership) 
immediately before the acquisition described in section 
7874(a)(2)(B)(i). For this purpose, the equity of the domestic 
corporation (or partnership) shall not include the value of any 
property the holder of the option (or similar interest) would be 
required to provide to the domestic corporation (or partnership) 
pursuant to the terms of the option (or similar interest) if such 
option (or similar interest) were exercised. Pursuant to these rules, 
for example, if the holder of an option in a domestic corporation 
receives stock of a foreign corporation by reason of holding the 
option, the holder shall be treated as holding the stock of the foreign 
corporation by reason of holding stock in the domestic corporation.
2. Foreign Corporations
    The temporary regulations further provide that an option (or 
similar interest) in a foreign corporation shall generally be treated 
as stock of the foreign corporation with a value equal to the holder's 
claim on the equity of the foreign corporation immediately after the 
acquisition described in section 7874(a)(2)(B)(i). As is the case for 
options (and similar interests) with respect to domestic corporations 
(or partnerships), for this purpose the equity of the foreign 
corporation shall not include the value of any property the holder of 
the option (or similar interest) would be required to provide to the 
foreign corporation pursuant to the terms of the option (or similar 
interest) if such option (or similar interest) were exercised. This 
rule shall not apply, however, if a principal purpose of the issuance 
or acquisition of an option (or similar interest) is to avoid the 
foreign corporation being treated as a surrogate foreign corporation.
3. Multiple Claims on Equity
    The rules of the temporary regulations concerning options (or 
similar interests) shall not apply to the extent treating an option (or 
similar interest) as stock of a corporation (or an interest in a 
partnership) would duplicate, in whole or in part, a shareholder's (or 
partner's) claim on the equity of the corporation (or partnership). 
However, except to the extent otherwise provided in section 7874, stock 
of a corporation held by a shareholder, or an interest in a partnership 
held by a partner, shall in all cases be taken into account for 
purposes of section 7874.
4. Comments
    The IRS and the Treasury Department request comments on the rules 
provided by the temporary regulations concerning options (or similar 
interests). For example, comments are requested as to whether the rules 
should not apply to certain options, such as publicly traded options or 
compensatory options. Comments are also requested on the general 
approach of the rules, which treats the option (or similar interest) as 
stock or a partnership interest to the extent of the holder's claim on 
equity, as compared to an approach that would deem the options (or 
similar interests) as exercised. Any comments should consider the 
potential impact of treating options (or similar interests) as 
exercised on the determination of ownership in the foreign corporation 
under section 7874(a)(2)(B)(ii).

I. Economically Equivalent Interests

    The IRS and the Treasury Department have become aware of 
transactions intended to avoid section 7874 by using interests (such as 
stock or partnership interests) that, although not in form exchangeable 
or convertible into stock of a foreign corporation, are structured to 
be substantially equivalent to an equity interest in the foreign 
corporation. In one such transaction, for example, a privately held 
domestic corporation (UST) intends to make an initial public offering 
of its stock for cash. The UST shareholders, however, would prefer a 
foreign corporation to be the publicly-traded corporation.
    To accomplish these objectives the following transactions are 
completed. A newly formed foreign corporation (FC) issues shares to the 
public in exchange for cash and then contributes all or part of the 
cash to a newly-formed domestic corporation (S) in exchange for all the 
stock of S. S then merges with and into UST. Pursuant to the merger 
agreement, the UST shareholders exchange their UST stock for a new 
class of UST stock (class B stock) and cash. FC exchanges its S stock 
for all of the remaining class of stock of UST (class A stock). FC 
holds few assets other than the class A stock.
    The class B stock entitles the UST shareholders to dividend 
distributions approximately equal to any dividend distributions made by 
FC with respect to its publicly traded stock. The class B stock also 
permits the UST shareholders, in certain cases, to require UST to 
redeem the class B stock at fair market value. The class B stock does 
not provide the holder voting rights with respect to FC.
    Because FC holds few assets other than the class A stock of UST, 
the value of the class B stock held by the former UST shareholders is 
approximately equal the value of a corresponding amount of FC stock. 
Further, the distribution and liquidity rights provided by the class B 
stock are intended to place the former UST shareholders in the same 
approximate economic position as if they had received publicly traded 
FC stock instead of the class B stock in the merger. Nonetheless, the 
former UST shareholders may take the position that they hold UST stock 
(and not FC stock) by reason of holding, in form, stock in UST and that 
the 2006 temporary regulations do not treat the class B stock as FC 
stock. For example, the former UST shareholders may take the position 
that the class B stock is not, in substance, an instrument other than 
debt that is convertible into stock of FC. See Sec.  1.7874-2T(f)(2). 
The former UST shareholders may further take the position that section 
7874(c)(4) does not apply to the transaction. If these positions are 
correct, FC would not be treated as a surrogate foreign corporation. 
The IRS and the Treasury Department understand that similar 
transactions may be structured using a partnership.
    The IRS and the Treasury Department believe these transactions are 
contrary to the policies underlying section 7874. Therefore, the 
temporary regulations provide that, for purposes of section 7874, any 
interest (including stock or a partnership interest) that is not 
otherwise treated as stock of a foreign corporation (including under 
the rules concerning options (or similar interests)) shall be treated 
as stock of the foreign corporation if the following two conditions are 
satisfied: (1) The interest entitles the holder to distribution rights 
that are substantially similar in all material respects to the 
distribution rights entitled to a shareholder of the foreign 
corporation by reason of holding stock in the foreign corporation; and 
(2) treating the interest as stock of the foreign corporation has the 
effect of treating the foreign corporation as a surrogate foreign 
corporation. For purposes of the first condition, distribution rights 
include rights to dividend distributions (or partnership 
distributions), distributions in redemption of the interest (in whole 
or in part), distributions in liquidation, or other similar 
distributions that represent a return on, or of, the holder's 
investment in the interest.

J. Insolvent Entities

    The preamble to the 2008 final regulations describes a transaction 
involving an insolvent domestic

[[Page 27925]]

corporation in which the creditors of the corporation claim not to be 
shareholders of the corporation for purposes of determining whether a 
foreign corporation that acquires substantially all of the properties 
held by the domestic corporation is treated as a surrogate foreign 
corporation. As further stated in the preamble, the IRS and the 
Treasury Department disagree with this interpretation under current 
law. See, for example, Helvering v. Alabama Asphaltic Limestone Co., 
315 U.S. 179 (1942), and Sec.  1.368-1(e)(6).
    The temporary regulations clarify that, for purposes of section 
7874, if immediately prior to the first date properties are acquired as 
part of an acquisition described in section 7874(a)(2)(B)(i), a 
domestic corporation is in a title 11 or similar case (as defined in 
section 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 shall be treated as stock of the domestic 
corporation. Therefore, any stock of a foreign corporation held by a 
creditor of the domestic corporation by reason of its claim against the 
domestic corporation would be considered held by a former shareholder 
of the domestic corporation by reason of holding stock in the domestic 
corporation.
    A similar rule applies with respect to a domestic or foreign 
partnership. Foreign partnerships are included in this rule because, 
for purposes of section 7874(a)(2)(B)(ii), the acquisition of an 
interest in a foreign partnership that owns stock of a domestic 
corporation is considered an acquisition of a proportionate amount of 
the stock of domestic corporation. Therefore, if a foreign corporation 
acquired a sufficient interest in that foreign partnership, the foreign 
corporation could be treated as a surrogate foreign corporation.
    One commentator requested the regulations clarifying the treatment 
of creditors for purposes of section 7874 make clear that a creditor 
that is treated as a shareholder of a domestic corporation is treated 
as a shareholder for all purposes of section 7874. In particular, the 
commentator requested the regulations make clear that the provisions of 
the 2008 final regulations concerning the determination of the stock of 
a foreign corporation held by reason of holding stock of the domestic 
corporation apply equally to such a creditor. The IRS and the Treasury 
Department agree with this comment. Accordingly, the temporary 
regulations clarify that a creditor that is treated as a shareholder of 
a domestic corporation (or as a partner in a partnership) is treated as 
a shareholder (or partner) for all purposes of section 7874. Thus, for 
example, subject to section 7874(c)(4) and general tax principles, 
stock of the foreign corporation received by a creditor in exchange for 
other property would not be taken into account in determining former 
shareholder (or former partner) ownership under section 
7874(a)(2)(B)(ii).

K. Modification to Internal Restructuring Exception of 2008 Final 
Regulations

    The IRS and the Treasury Department have become aware of divisive 
transactions involving an acquisition described in section 
7874(a)(2)(B)(i) in which the ownership condition of section 
7874(a)(2)(B)(ii) may not be satisfied by reason of the internal group 
restructuring exception provided by Sec.  1.7874-1(c)(2). For example, 
assume that a publicly-traded domestic corporation (USP) wholly owns a 
domestic subsidiary (S1) that in turn wholly owns another domestic 
subsidiary (S2). The S2 stock does not represent substantially all of 
the properties of S1. Pursuant to a plan, S2 transfers substantially 
all of its properties to a newly formed foreign corporation (F1) in 
exchange for F1 stock and then distributes the F1 stock to S1. Pursuant 
to the same plan, S1 distributes the F1 stock to USP, and USP then 
distributes the F1 stock to its shareholders.
    The acquisition by F1 of substantially all of the properties held 
by S2 is described in section 7874(a)(2)(B)(i). In addition, S1, the 
former shareholder of S2, holds all the F1 stock by reason of holding 
S2 stock. However, taxpayer may take the position that the condition of 
section 7874(a)(2)(B)(ii) is not satisfied by reason of the internal 
group restructuring exception under Sec.  1.7874-1(c)(2). In relevant 
part, the internal group restructuring exception provides that, for 
purposes of section 7874(a)(2)(B)(ii), stock of the foreign corporation 
held by a member of the expanded affiliated group shall be included in 
the denominator, but not in the numerator, of the ownership fraction, 
if: (i) Before the acquisition, at least 80 percent of the stock (by 
vote and value) of the domestic corporation was held directly or 
indirectly by the corporation that is the common parent of the expanded 
affiliated group after the acquisition; and (ii) after the acquisition, 
at least 80 percent of the stock (by vote and value) of the acquiring 
foreign corporation is held directly or indirectly by such common 
parent. Taxpayer may take the position that the internal restructuring 
exception applies because before the acquisition USP indirectly owned 
100 percent of the stock of S2 and after the acquisition USP indirectly 
owned 100 percent of the stock of F1. Therefore, the F1 stock held by 
S1 would be included in the denominator but not the numerator of the 
ownership fraction, yielding zero percent former shareholder ownership 
and resulting in F1 not being treated as a surrogate foreign 
corporation.
    The IRS and the Treasury Department believe it is inappropriate for 
the internal restructuring exception to apply to divisive transactions 
such as the one described above. Accordingly, the IRS and the Treasury 
Department will issue regulations that determine former shareholder 
ownership under section 7874(a)(2)(B)(ii) when pursuant to the same 
plan (or a series of related transactions) that includes the 
acquisition described in section 7874(a)(2)(B)(i), all or part of the 
stock of the foreign corporation is transferred outside the expanded 
affiliated group that includes the foreign corporation after the 
acquisition. The regulations will provide that the internal group 
restructuring exception of Sec.  1.7874-1(c)(2) does not apply to such 
transactions and will also modify the application of the general rule 
of Sec.  1.7874-1(b) to such transactions. The regulations may apply to 
acquisitions completed on or after June 9, 2009.

L. Effective/Applicability Dates

    The temporary regulations included in this document generally apply 
to acquisitions completed on or after June 9, 2009. However, taxpayers 
may apply the temporary regulations to acquisitions completed prior to 
June 9, 2009, if the temporary regulations are applied consistently to 
all acquisitions completed prior to such date.
    The temporary regulations include the modifications announced by 
Notice 2006-70 (2006-2 CB 252) to the effective date paragraph of Sec.  
1.7874-2T, as contained in 26 CFR part 1 revised as of April 1, 2009, 
for certain acquisitions initiated prior to December 28, 2005.
    No inference is intended as to the applicability of other Code or 
regulatory provisions, or judicial doctrines, to any transactions 
described in this preamble.
    These regulations will expire on or before June 8, 2012.

Effect on Other Documents

    Notice 2006-70 (2006-2 CB 252) is obsolete as of June 9, 2009.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a

[[Page 27926]]

regulatory assessment is not required. It has also been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. Chapter 5) 
does not apply to the temporary regulations.
    The temporary regulations do not impose a collection of 
information. Pursuant to the Regulatory Flexibility Act (5 U.S.C. 
Chapter 6), it is also hereby certified that the temporary regulations 
will not have a significant economic impact on a substantial number of 
small entities. Accordingly, a regulatory flexibility analysis is not 
required. The complexity and cost of a transaction to which section 
7874 may apply makes it unlikely that a substantial number of small 
entities will engage in such a transaction. In addition, the economic 
impact to any entities affected by section 7874 is derived from the 
application of the statute, and not from the temporary regulations. 
Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding these regulations has been submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comments 
on its impact on small business.

Drafting Information

    The principal author of the temporary regulations is S. James 
Hawes, Office of Associate Chief Counsel (International). However, 
other personnel from the IRS and the Treasury Department participated 
in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:


    Authority:  26 U.S.C. 7805 * * *
    Section 1.7874-1T also issued under 26 U.S.C. 7874(g). * * *
    Section 1.7874-2T also issued under 26 U.S.C. 7874(c)(6) and 
(g). * * *

0
Par. 2. Section 1.7874-1(e) is revised to read as follows:


Sec.  1.7874-1  Disregard of affiliate-owned stock.

* * * * *
    (e) [Reserved]. For further guidance, see Sec.  1.7874-1T(e).
* * * * *

0
Par. 3. Section 1.7874-1T is added to read as follows:


Sec.  1.7874-1T  Disregard of affiliate-owned stock (temporary).

    (a) through (d) [Reserved]. For further guidance, see Sec.  1.7874-
1(a) through (d).
    (e) Stock held by a partnership. For purposes of this section, each 
partner in a partnership shall be treated as holding its proportionate 
share of stock held by the partnership, as determined under the rules 
and principles of sections 701 through 777.
    (f) [Reserved]. For further guidance, see Sec.  1.7874-1(f).
    (g) Effective/applicability date. Paragraph (e) of this section 
shall apply to acquisitions completed on or after June 9, 2009. See 
Sec.  1.7874-1(e), as contained in 26 CFR part 1 revised as of April 1, 
2009, for transactions completed before June 9, 2009.
    (h) Expiration date. The applicability of this section expires on 
or before June 8, 2012.

0
Par. 4. Section 1.7874-2T is revised to read as follows:


Sec.  1.7874-2T  Surrogate foreign corporation (temporary).

    (a) Scope. This section provides rules for determining whether a 
foreign corporation shall be treated as a surrogate foreign corporation 
under section 7874(a)(2)(B). Paragraph (b) of this section provides 
definitions and special rules. Paragraph (c) of this section provides 
rules to determine whether a foreign corporation has indirectly 
acquired properties held by a domestic corporation (or of a 
partnership). Paragraph (d) of this section provides rules that apply 
when two or more foreign corporations complete, in the aggregate, an 
acquisition described in section 7874(a)(2)(B)(i). Paragraph (e) of 
this section provides rules that apply when a single foreign 
corporation completes more than one acquisition described in section 
7874(a)(2)(B)(i). Paragraph (f) of this section provides rules to 
identify the stock of a foreign corporation that is held by reason of 
holding stock in a domestic corporation (or an interest in a domestic 
partnership). Paragraph (g) of this section provides rules concerning 
the substantial business activities condition of section 
7874(a)(2)(B)(iii). Paragraph (h) of this section provides rules that 
treat certain publicly traded foreign partnerships as foreign 
corporations for purposes of section 7874. Paragraph (i) of this 
section is reserved. Paragraph (j) of this section provides rules 
concerning the treatment of certain options (or similar interests) for 
purposes of section 7874. Paragraph (k) of this section provides rules 
that treat certain interests (including debt, stock, or a partnership 
interest) as stock of a foreign corporation for purposes of section 
7874. Paragraph (l) of this section is reserved. Paragraph (m) of this 
section provides rules concerning the conversion of a foreign 
corporation to a domestic corporation by reason of section 7874(b). 
Paragraph (n) of this section provides examples that illustrate the 
rules of this section. Paragraph (o) of this section provides the 
effective/applicability dates of this section. Paragraph (p) of this 
section provides the expiration date of this section.
    (b) Definitions and special rules. Except as otherwise indicated, 
the following definitions and special rules apply for purposes of this 
section.
    (1) The rules of this section are subject to section 7874(c)(4).
    (2) An interest in a partnership includes a capital or profits 
interest.
    (3) A former shareholder of a domestic corporation is any person 
that held stock in the domestic corporation before the acquisition 
described in section 7874(a)(2)(B)(i), including any person that holds 
stock in the domestic corporation both before and after the 
acquisition.
    (4) A former partner of a domestic partnership is any person that 
held an interest in the domestic partnership before the acquisition 
described in section 7874(a)(2)(B)(i), including any person that holds 
an interest in the domestic partnership both before and after the 
acquisition.
    (5) References to properties held by a domestic corporation include 
properties held directly or indirectly by the domestic corporation.
    (6) The rules and principles of sections 701 through 777 shall be 
applied for purposes of determining a proportionate amount (or share) 
of items of a partnership (such as stock, properties, activities and 
employees).
    (7) Any reference to the acquisition of properties held by a 
domestic corporation (or of a partnership) includes a direct or 
indirect acquisition of such properties.
    (8) In the case of an acquisition of stock of a domestic 
corporation or an interest in a partnership, the proportionate amount 
of properties held by the domestic corporation (or of the partnership) 
that is treated as indirectly acquired shall, as applicable, be 
determined on the date of the acquisition based on the relative value 
of--
    (i) The stock acquired compared to all outstanding stock of the 
domestic corporation; or
    (ii) The interest acquired compared to all interests in the 
partnership.
    (9) The determination of whether a foreign corporation is a 
surrogate foreign

[[Page 27927]]

corporation is made after the acquisition described in section 
7874(a)(2)(B)(i). A foreign corporation that is treated as a surrogate 
foreign corporation (including a surrogate foreign corporation treated 
as a domestic corporation described in section 7874(b)) shall continue 
to be treated as a surrogate foreign corporation (or a domestic 
corporation), even if the conditions of section 7874(a)(2)(B)(ii) and 
(iii) are not satisfied at a later date.
    (c) Acquisition of properties--(1) Indirect acquisition of 
properties. For purposes of section 7874(a)(2)(B)(i), an indirect 
acquisition of properties held by a domestic corporation (or of a 
partnership) includes the acquisitions described in paragraphs 
(c)(1)(i) through (iv) of this section. An acquisition of less than all 
of the stock of a domestic corporation (or interests in a partnership) 
shall constitute an indirect acquisition of a proportionate amount of 
the properties held by the domestic corporation or of the partnership. 
See paragraph (b)(8) of this section for rules determining the 
proportionate amount of properties indirectly acquired.
    (i) An acquisition of stock of a domestic corporation. See Example 
1 of paragraph (n) of this section for an illustration of the rules of 
this paragraph.
    (ii) An acquisition of an interest in a partnership. See Example 2 
of paragraph (n) of this section for an illustration of the rules of 
this paragraph.
    (iii) An acquisition by a corporation (acquiring corporation) of 
properties held by a domestic corporation (or of a partnership) in 
exchange for stock of a foreign corporation (foreign issuing 
corporation) that is part of the expanded affiliated group that 
includes the acquiring corporation after the acquisition shall be 
treated as an acquisition by the foreign issuing corporation. See 
Example 3 of paragraph (n) of this section for an illustration of the 
rules of this paragraph.
    (iv) An acquisition by a partnership (acquiring partnership) of 
properties held by a domestic corporation (or of a partnership) in 
exchange for stock of a foreign corporation that is part of the 
expanded affiliated group that would include the acquiring partnership 
after the acquisition (if the partnership were a corporation) shall be 
treated as an acquisition by the foreign issuing corporation.
    (2) Acquisition of stock of foreign corporation. An acquisition of 
stock of a foreign corporation that owns directly or indirectly stock 
of a domestic corporation (or an interest in a partnership) shall not 
constitute an indirect acquisition of any properties held by the 
domestic corporation (or the partnership). See Example 4 of paragraph 
(n) of this section for an illustration of the rules of this paragraph.
    (d) Acquisitions by multiple foreign corporations. If, pursuant to 
a plan (or a series of related transactions), two or more foreign 
corporations complete, in the aggregate, an acquisition described in 
section 7874(a)(2)(B)(i), then each foreign corporation shall be 
treated as completing the acquisition for purposes of determining 
whether such foreign corporation is treated as a surrogate foreign 
corporation. See Examples 5 and 6 of paragraph (n) of this section for 
illustrations of the rules of this paragraph.
    (e) Acquisitions of multiple domestic entities. If, pursuant to a 
plan (or a series of related transactions), a foreign corporation 
completes two or more acquisitions described in section 
7874(a)(2)(B)(i) involving domestic corporations and/or domestic 
partnerships (domestic entities), then, for purposes of section 
7874(a)(2)(B)(ii), the acquisitions shall be treated as a single 
acquisition and the domestic entities shall be treated as a single 
domestic entity. If the transaction involves one or more domestic 
corporations and one or more domestic partnerships, the stock of the 
foreign corporation held by former shareholders and former partners by 
reason of holding stock or a partnership interest in the domestic 
entities shall be aggregated for purposes of determining whether the 
ownership condition of section 7874(a)(2)(B)(ii) is satisfied. See 
Example 7 of paragraph (n) of this section for an illustration of the 
rules of this paragraph.
    (f) Stock held by reason of holding stock in a domestic corporation 
or an interest in a domestic partnership--(1) Specified transactions. 
For purposes of section 7874(a)(2)(B)(ii), stock of a foreign 
corporation that is held by reason of holding stock in a domestic 
corporation (or an interest in a domestic partnership) includes the 
stock described in paragraphs (f)(1)(i) through (iii) of this section.
    (i) Stock of a foreign corporation received in exchange for, or 
with respect to, stock of a domestic corporation.
    (ii) Stock of a foreign corporation received in exchange for, or 
with respect to, an interest in a domestic partnership.
    (iii) To the extent that paragraph (f)(1)(ii) of this section does 
not apply, stock of a foreign corporation received by a domestic 
partnership in exchange for all or part of its properties. In such a 
case, each partner in the domestic partnership shall be treated as 
holding its proportionate share of the stock of the foreign corporation 
by reason of holding an interest in the domestic partnership.
    (2) Transactions involving other property--(i) Stock of a domestic 
corporation. If, pursuant to the same transaction, stock of a foreign 
corporation is received in exchange for, or with respect to, stock of a 
domestic corporation and other property, the stock of the foreign 
corporation that was received in exchange for, or with respect to, the 
stock of the domestic corporation shall be determined based on the 
relative value of the stock of the domestic corporation compared to the 
aggregate value of such stock and the other property.
    (ii) Interest in a domestic partnership. If, pursuant to the same 
transaction, stock of a foreign corporation is received in exchange 
for, or with respect to, an interest in a domestic partnership and 
other property, the stock of the foreign corporation that was received 
in exchange for, or with respect to, the interest in the domestic 
partnership shall be determined based on the relative value of the 
interest in the domestic partnership compared to the aggregate value of 
such interest and the other property.
    (3) See Examples 8 through 10 of paragraph (n) of this section for 
illustrations of the rules of this paragraph (f).
    (g) Substantial business activities--(1) General rule. The 
determination of whether, after the acquisition, the expanded 
affiliated group that includes the foreign corporation has substantial 
business activities in the 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, is 
(subject to paragraph (g)(5) of this section) based on all facts and 
circumstances.
    (2) Threshold of business activities. The determination of whether 
the expanded affiliated group has sufficient business activities in a 
foreign country is not solely based on the absolute amount of business 
activities in the foreign country. Rather the determination is based on 
a comparison of the amount of business activities in the foreign 
country to the total business activities of the expanded affiliated 
group. The determination must take into account the total business 
activities of the expanded affiliated group, including the relevant 
items identified in paragraph (g)(3) of this section. Thus, it is 
possible for the business activities of

[[Page 27928]]

one expanded affiliated group in a particular country to be substantial 
when compared to the total business activities of such expanded 
affiliated group, but for identical business activities of another 
expanded affiliated group in the same country not to be substantial 
when compared to the total business activities of that other expanded 
affiliated group. This may result, for example, because the total 
business activities of the second expanded affiliated group are more 
extensive than that of the first expanded affiliated group.
    (3) Items to be considered. Except as provided in paragraph (g)(5) 
of this section, relevant items to be considered for determining 
whether, after the acquisition, the expanded affiliated group has 
substantial business activities in a foreign country when compared to 
the total business activities of the expanded affiliated group include 
the items identified in paragraphs (g)(3)(i) through (v) of this 
section. The presence or absence of any item, or set of items, is not 
determinative and the weight given to any item, or set of items, 
depends on the facts and circumstances.
    (i) The historical conduct of continuous business activities in the 
foreign country by the expanded affiliated group.
    (ii) The conduct of continuous business activities in the foreign 
country by the expanded affiliated group in the ordinary course of one 
or more active trades or businesses, involving--
    (A) Property located in the foreign country that is owned by 
members of the expanded affiliated group;
    (B) The performance of services in the foreign country by employees 
of the expanded affiliated group; and
    (C) Sales of goods to customers.
    (iii) The performance in the foreign country of substantial 
managerial activities by officers and employees of the expanded 
affiliated group who are based in the foreign country.
    (iv) A substantial degree of ownership of the expanded affiliated 
group by investors resident in the foreign country.
    (v) Business activities in the foreign country that are material to 
the achievement of the overall business objectives of the expanded 
affiliated group.
    (4) Attribution from a partnership. For purposes of this paragraph 
(g), a member of the expanded affiliated group that holds at least a 10 
percent capital and profits interest in a partnership shall take into 
account its proportionate share of all the items of the partnership, 
including business activities, employees, assets, income and sales. See 
paragraph (b)(6) of this section for determining a partner's 
proportionate share of the items of a partnership.
    (5) Items not to be considered. The following items shall not be 
taken into account in determining whether, after the acquisition, the 
expanded affiliated group has substantial business activities in a 
foreign country when compared to the total business activities of the 
expanded affiliated group.
    (i) Any business activities or income attributable to properties or 
liabilities the transfer of which is disregarded under section 
7874(c)(4).
    (ii) Any assets, business activities, or employees located in a 
foreign country at any time as part of a plan with a principal purpose 
of avoiding the purposes of section 7874.
    (iii) Any assets, business activities, or employees located in the 
foreign country in which, or under the law of which, the foreign 
corporation is created or organized if such assets, business activities 
or employees are transferred to another country pursuant to a plan that 
existed at the time of the acquisition described in section 
7874(a)(2)(B)(i).
    (h) Publicly traded foreign partnerships--(1) Treatment as a 
foreign corporation. For purposes of section 7874, a publicly traded 
foreign partnership described in paragraph (h)(2) of this section shall 
be treated as a foreign corporation that is organized in the foreign 
country in which, or under the law of which, the publicly traded 
foreign partnership was created or organized, and interests in the 
publicly traded foreign partnership shall be treated as stock of the 
foreign corporation. For purposes of determining whether the foreign 
corporation shall be treated as a surrogate foreign corporation, a 
deemed acquisition of assets and liabilities by reason of Sec.  1.708-
1(b)(4) shall not constitute an acquisition described in section 
7874(a)(2)(B)(i).
    (2) Publicly traded foreign partnership. A publicly traded foreign 
partnership described in this paragraph (h)(2) is any foreign 
partnership that would, but for section 7704(c), be treated as a 
corporation under section 7704(a):
    (i) At the time of the acquisition described in section 
7874(a)(2)(B)(i); or
    (ii) At any time after the acquisition pursuant to a plan that 
existed at the time of the acquisition. For this purpose, a plan shall 
be deemed to exist at the time of the acquisition if the foreign 
partnership would, but for section 7704(c), be treated as a corporation 
under section 7704(a) at any time during the two-year period following 
the completion of the acquisition.
    (3) Surrogate foreign corporation to which section 7874(b) applies. 
If paragraph (h)(1) of this section applies to a publicly traded 
foreign partnership and the foreign corporation is a surrogate foreign 
corporation to which section 7874(b) applies, the publicly traded 
foreign partnership shall be treated as a domestic corporation for 
purposes of the Internal Revenue Code (Code). See paragraph (h)(6) of 
this section for the timing and treatment of the conversion of the 
publicly traded foreign partnership to a domestic corporation. See 
Example 11 of paragraph (n) of this section for an illustration of the 
rules of this paragraph.
    (4) Surrogate foreign corporation to which section 7874(b) does not 
apply. If paragraph (h)(1) of this section applies to a publicly traded 
foreign partnership and the foreign corporation is a surrogate foreign 
corporation to which section 7874(b) does not apply, the publicly 
traded foreign partnership shall continue to be treated as a foreign 
partnership for purposes of the Code, but section 7874(a)(1) shall 
apply to any expatriated entity (as defined in section 7874(a)(2)(A)). 
See Example 13 of paragraph (n) of this section for an illustration of 
the rules of this paragraph.
    (5) Foreign corporation not treated as a surrogate foreign 
corporation. If paragraph (h)(1) of this section applies to a publicly 
traded foreign partnership and the foreign corporation is not treated 
as a surrogate foreign corporation, the status of the publicly traded 
foreign partnership as a foreign partnership shall not be affected by 
section 7874. See Example 12 of paragraph (n) of this section for an 
illustration of the rules of this paragraph.
    (6) Conversion to a domestic corporation. Except for purposes of 
determining whether the publicly traded foreign partnership is a 
surrogate foreign corporation, if paragraph (h)(1) of this section 
applies to a publicly traded foreign partnership and the foreign 
corporation is a surrogate foreign corporation to which section 7874(b) 
applies, then immediately before the first date properties are acquired 
as part of the acquisition described in section 7874(a)(2)(B)(i) the 
publicly traded foreign partnership shall be treated as transferring 
all of its assets and liabilities to a newly formed domestic 
corporation in exchange solely for stock of the domestic corporation, 
and then distributing such stock to its partners in proportion to their 
partnership interests

[[Page 27929]]

in liquidation of the partnership. The treatment of the transfer of 
assets and liabilities to the domestic corporation and the distribution 
of the stock of the domestic corporation to the partners in liquidation 
of the partnership shall be determined under all relevant provisions of 
the Code and general tax principles.
    (i) [Reserved].
    (j) Options and similar interests--(1) Domestic corporation (or 
partnership). Except to the extent provided in this paragraph (j), for 
purposes of section 7874, an option (or similar interest) with respect 
to a domestic corporation (or a partnership, domestic or foreign) shall 
be treated as stock of the domestic corporation (or an interest in the 
partnership) with a value equal to the holder's claim on the equity of 
the domestic corporation (or partnership) immediately before the 
acquisition described in section 7874(a)(2)(B)(i). For this purpose, 
the equity of the domestic corporation (or partnership) shall not 
include the amount of any property the holder of the option (or similar 
interest) would be required to provide to the domestic corporation (or 
partnership) under the terms of the option (or similar interest) if 
such option (or similar interest) were exercised. See Example 16 of 
paragraph (n) of this section for an illustration of the rules of this 
paragraph.
    (2) Foreign corporation--(i) General rule. Except to the extent 
provided in this paragraph (j), for purposes of section 7874 an option 
(or similar interest) with respect to a foreign corporation shall be 
treated as stock of the foreign corporation with a value equal to the 
holder's claim on the equity of the foreign corporation after the 
acquisition described in section 7874(a)(2)(B)(i). For this purpose, 
the equity of the foreign corporation shall not include the amount of 
any property the holder of the option (or similar interest) would be 
required to provide to the foreign corporation under the terms of the 
option (or similar interest) if such option (or similar interest) were 
exercised. See Examples 14 through 16 of paragraph (n) of this section 
for illustrations of the rules of this paragraph (j)(2)(i).
    (ii) Certain options (or similar interests) disregarded. Paragraph 
(j)(2)(i) of this section shall not apply to an option (or similar 
interest) if a principal purpose of the issuance or acquisition of the 
option (or similar interest) is to avoid the foreign corporation being 
treated as a surrogate foreign corporation.
    (3) Similar interest. For purposes of this paragraph (j), an 
interest similar to an option (a similar interest) includes, but is not 
limited to, a warrant, a convertible debt instrument, an instrument 
other than debt that is convertible into stock or a partnership 
interest, a put, stock or a partnership interest subject to risk of 
forfeiture, a contract to acquire or sell stock or a partnership 
interest, and an exchangeable share or exchangeable partnership 
interest.
    (4) Multiple claims on equity. Paragraphs (j)(1) and (j)(2)(i) of 
this section shall not apply to an option (or similar interest) to the 
extent treating the option (or similar interest) as stock of a 
corporation (or interest in a partnership) would duplicate a 
shareholder's (or partner's) claim on the equity of the corporation (or 
partnership) by reason of holding stock in the corporation (or an 
interest in the partnership). However, except to the extent otherwise 
provided in section 7874, in all cases stock of a corporation held by a 
shareholder or an interest in a partnership held by a partner (without 
regard to this paragraph (j)) shall be taken into account for purposes 
of section 7874. See E