Guidance for Determining Stock Ownership; Rules Regarding Inversions and Related Transactions, 5388-5401 [2017-00643]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 82, Number 11 (Wednesday, January 18, 2017)]
[Rules and Regulations]
[Pages 5388-5401]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-00643]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9812]
RIN 1545-BL00; 1545-BM45


Guidance for Determining Stock Ownership; Rules Regarding 
Inversions and Related Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations, temporary regulations, and removal of 
temporary regulations.

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SUMMARY: This document contains final regulations that identify certain 
stock of a foreign corporation that is disregarded in calculating 
ownership of the foreign corporation for purposes of determining 
whether it is a surrogate foreign corporation. These regulations also 
provide guidance on the effect of transfers of stock of a foreign 
corporation after the foreign corporation has acquired substantially 
all of the properties of a domestic corporation or of a trade or 
business of a domestic partnership. These regulations affect certain 
domestic corporations and partnerships (and certain parties related 
thereto) and foreign corporations that acquire substantially all of the 
properties of such domestic corporations or of the trades or businesses 
of such domestic partnerships. The text of the temporary regulations 
also serves as the text of the proposed regulations set forth in the 
notice of proposed rulemaking on Rules

[[Page 5389]]

Regarding Inversions and Related Transactions in the Proposed Rules 
section of this issue of the Federal Register.

DATES: Effective Date: These regulations are effective on January 18, 
2017.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.7874-4(k), 1.7874-5(e), 1.7874-7T(h), and 1.7874-10T(i).

FOR FURTHER INFORMATION CONTACT: Joshua G. Rabon at (202) 317-6937 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains regulations under section 7874 of the 
Internal Revenue Code (Code). On September 17, 2009, the Department of 
the Treasury (Treasury Department) and the IRS issued Notice 2009-78 
(2009-40 IRB 452), which announced that regulations would be issued 
under section 7874 identifying certain stock of a foreign corporation 
that would not be taken into account for purposes of determining the 
ownership percentage described in section 7874(a)(2)(B)(ii) (the 2009 
notice). On January 17, 2014, temporary regulations (TD 9654) were 
published in the Federal Register (79 FR 3094) that implemented and 
obsoleted the 2009 notice and provided guidance with respect to 
subsequent transfers of stock of a foreign corporation described in 
section 7874(a)(2)(B)(ii) (the 2014 temporary regulations). A notice of 
proposed rulemaking (REG-121534-12) cross-referencing the 2014 
temporary regulations was published in the same issue of the Federal 
Register (79 FR 3145) (the 2014 proposed regulations). On November 19, 
2015, the Treasury Department and the IRS issued Notice 2015-79 (2015-
49 IRB 775), which announced, in part, that regulations would be issued 
to clarify certain aspects of the 2014 temporary regulations (the 2015 
notice). On April 8, 2016, the Treasury Department and the IRS 
published temporary regulations (TD 9761) in the Federal Register (81 
FR 20858) that, in part, implemented the clarifications announced in 
the 2015 notice and provided common definitions for purposes of certain 
regulations under sections 367(b), 956, 7701(l), and 7874 (the 2016 
temporary regulations). A notice of proposed rulemaking (REG-135734-14) 
cross-referencing the 2016 temporary regulations was published in the 
same issue of the Federal Register (81 FR 20588) (the 2016 proposed 
regulations). The 2014 temporary regulations as modified by the 2016 
temporary regulations are referred to in this preamble as the 
``temporary regulations.'' No public hearing was requested or held on 
the 2014 proposed regulations or the 2016 proposed regulations; 
however, comments were received. All comments are available at 
www.regulations.gov or upon request. After consideration of the 
comments, the 2014 proposed regulations, as modified by the 2016 
proposed regulations and as updated to reflect the common definitions 
in those regulations, are adopted as amended by this Treasury decision, 
and the corresponding temporary regulations are removed.

Summary of Comments and Explanation of Revisions

I. The Disqualified Stock Rule--General Approach

    A foreign corporation (foreign acquiring corporation) generally is 
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 acquiring 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 (domestic entity acquisition). Second, after the 
domestic entity acquisition, at least 60 percent of the stock (by vote 
or value) of the foreign acquiring corporation is held by former 
shareholders of the domestic corporation (former domestic entity 
shareholders) by reason of holding stock in the domestic corporation 
(such percentage, the ownership percentage, and the fraction used to 
calculate the ownership percentage, the ownership fraction). And third, 
after the domestic entity acquisition, the expanded affiliated group 
(as defined in section 7874(c)(1)) that includes the foreign acquiring 
corporation (EAG) does not have substantial business activities in the 
foreign country in which, or under the law of which, the foreign 
acquiring corporation is created or organized when compared to the 
total business activities of the EAG. Similar provisions apply if a 
foreign acquiring corporation acquires substantially all of the 
properties constituting a trade or business of a domestic partnership. 
The domestic corporation or the domestic partnership described in this 
paragraph is referred to at times in this preamble as the ``domestic 
entity.'' For other definitions used throughout this preamble but not 
defined in this preamble, see Sec.  1.7874-12T (providing common 
definitions for purposes of certain regulations under sections 367(b), 
956, 7701(l), and 7874).
    The temporary regulations provide a rule (the disqualified stock 
rule) that, subject to a de minimis exception, excludes disqualified 
stock from the denominator of the ownership fraction. In general, 
disqualified stock is stock of the foreign acquiring corporation that, 
in a transaction related to the domestic entity acquisition, is 
transferred in one of two types of exchanges. See Parts II.A and B of 
this Summary of Comments and Explanation of Revisions for the 
discussion of these exchanges. However, stock is disqualified stock 
only to the extent that the transfer of the stock in the exchange 
increases the fair market value of the assets of the foreign acquiring 
corporation or decreases the amount of its liabilities (the net asset 
requirement). The disqualified stock rule thus generally prevents stock 
of the foreign acquiring corporation that is transferred in certain 
transactions that increase the net assets of the foreign acquiring 
corporation from inappropriately increasing the denominator of the 
ownership fraction and thereby diluting the ownership percentage.
    Under the temporary regulations, stock may be disqualified stock 
regardless of whether it is, has been, or will be publicly traded. In 
addition, stock may be disqualified stock regardless of whether it is 
transferred by reason of an issuance, sale, distribution, exchange, or 
any other type of disposition, or whether it is transferred by the 
foreign acquiring corporation or another person.
    One comment suggested that disqualified stock should generally 
include only stock transferred by reason of an issuance by the foreign 
acquiring corporation. According to the comment, this would generally 
simplify the disqualified stock rule by obviating the need for the net 
asset requirement, though it noted that special rules regarding hook 
stock would likely be needed. The final regulations do not adopt this 
comment. The Treasury Department and the IRS have determined that 
transfers other than solely by reason of an issuance can 
inappropriately dilute the ownership percentage. For example, see Sec.  
1.7874-4(j) Example 6 (iii) (issuance of stock by the foreign acquiring 
corporation in exchange for qualified property followed by a transfer 
of that stock by the transferee in satisfaction of an obligation of the 
transferee) and Sec.  1.7874-4(j) Example 10 (issuance of stock 
followed by use of the stock to satisfy an obligation). The Treasury 
Department and the IRS have concluded

[[Page 5390]]

that addressing these transactions and other transactions (such as 
transactions involving hook stock) via special rules would largely 
negate the simplicity benefits of the approach recommended by the 
comment.

II. Exchanges That Give Rise to Disqualified Stock

A. Exchanges for Nonqualified Property

1. In General
    Disqualified stock includes stock of the foreign acquiring 
corporation that, in a transaction related to the domestic entity 
acquisition, is transferred to a person other than the domestic entity 
in exchange for ``nonqualified property.'' Nonqualified property means 
(i) cash or cash equivalents, (ii) marketable securities, (iii) certain 
obligations (as discussed in Part II.A.3 of this Summary of Comments 
and Explanation of Revisions), and (iv) any other property acquired 
with a principal purpose of avoiding the purposes of section 7874, 
regardless of whether the transaction involves an indirect transfer of 
property described in clause (i), (ii), or (iii). This preamble refers 
at times to the property described in clauses (i), (ii), and (iii) of 
the preceding sentence collectively as ``specified nonqualified 
property'' and to the property described in clause (iv) as ``avoidance 
property.'' For this purpose, marketable securities has the meaning set 
forth in section 453(f)(2), except that the term does not include stock 
of a corporation or an interest in a partnership that becomes a member 
of the EAG in a transaction (or series of transactions) related to the 
domestic entity acquisition.
2. Different Treatment for Stock and Asset Acquisitions
    Under the temporary regulations, the extent to which stock of a 
foreign acquiring corporation is considered transferred in exchange for 
nonqualified property can differ depending on the structure of a 
transaction. For example, if, in a transaction related to a domestic 
entity acquisition, the foreign acquiring corporation acquires all the 
stock of another foreign corporation (foreign target corporation) in 
exchange for stock of the foreign acquiring corporation, then such 
stock of the foreign acquiring corporation would normally not be 
considered transferred in exchange for nonqualified property, 
regardless of the extent to which the properties of the foreign target 
corporation constitute nonqualified property, unless the stock of the 
foreign target corporation constitutes avoidance property. However, if 
the transaction were instead structured so that the foreign acquiring 
corporation acquires all of the properties of the foreign target 
corporation in exchange for stock of the foreign acquiring corporation, 
then such stock of the foreign acquiring corporation would be 
considered transferred in exchange for nonqualified property, to the 
extent that the properties of the foreign target corporation constitute 
nonqualified property. The preamble to the 2014 temporary regulations 
acknowledged this disparity and the decision not to harmonize the 
treatment of stock and asset acquisitions by, for example, applying a 
look-through approach to stock acquisitions. See Part C of the 
Explanation of Provisions section of the preamble to the 2014 temporary 
regulations. Nevertheless, comments requested more consistent treatment 
between stock and asset acquisitions, noting in particular that, when 
the foreign target corporation is publicly-traded, corporate and other 
legal considerations may dictate the structure of the transaction.
    One comment suggested that this result could be achieved when a 
foreign acquiring corporation acquires substantially all of the 
properties of a foreign target corporation by viewing the two 
corporations as a single combined unit for purposes of the disqualified 
stock rule. Under this view, properties historically held by the 
foreign target corporation (including nonqualified property) would not 
represent an infusion of value into the combined group. The comment 
thus asserted that, regardless of the structure of the transaction, the 
disqualified stock rule generally should not apply to stock 
attributable to such properties. The comment noted, though, that if 
asset acquisitions were to be treated similar to stock acquisitions, 
there might be a heightened need for rules, in addition to the anti-
abuse rule of section 7874(c)(4), to address certain related 
transactions in which stock of the foreign target corporation is 
transferred in exchange for nonqualified property.
    After considering the comments, the Treasury Department and the IRS 
decline to adopt a rule treating certain asset acquisitions as stock 
acquisitions or to otherwise coordinate their treatment. The Treasury 
Department and the IRS have determined that stock of a foreign 
acquiring corporation attributable to any nonqualified property--
whether acquired in a transaction related to the domestic entity 
acquisition or historically held--generally presents opportunities to 
inappropriately dilute the ownership percentage. For example, see, the 
passive assets rule of Sec.  1.7874-7T. Thus, the Treasury Department 
and the IRS have concluded that a look-through approach, pursuant to 
which stock acquisitions would be treated similar to asset 
acquisitions, would be the preferable approach for harmonizing the 
treatment, in contrast to the comments' recommendation to treat certain 
assets acquisitions similar to stock acquisitions. The final 
regulations, however, do not implement a look-through approach out of 
concerns of undue complexity and administrative burden.
    Another comment recommended that, if the final regulations retain 
different treatment for stock and asset acquisitions, working capital 
of a foreign target corporation should be excluded from the definition 
of nonqualified property. After considering this comment, the Treasury 
Department and the IRS have determined that providing special rules 
that exclude working capital from the definition of nonqualified 
property would result in undue complexity and administrative burden. 
Notably, such special rules would have limited applicability when the 
foreign target corporation is a parent corporation of an affiliated 
group--which is often the case--because, in such a structure, working 
capital generally would be held by subsidiaries. Accordingly, the final 
regulations do not adopt the comment.
3. Obligations Constituting Nonqualified Property
    Under the temporary regulations, nonqualified property includes an 
obligation owed by (i) a member of the EAG; (ii) a former domestic 
entity shareholder or former domestic entity partner; or (iii) a person 
that owns, before or after the domestic entity acquisition, stock of 
(or a partnership interest in) a person described in clause (i) or (ii) 
or that is related (within the meaning of section 267 or 707(b)) to 
such a person. Comments requested several modifications to this rule.
    First, a comment recommended that, if the final regulations retain 
different treatment for stock and asset acquisitions, they exclude 
certain obligations owed by a member of the EAG from the definition of 
nonqualified property. In particular, the comment suggested excluding 
intercompany obligations held by the foreign target corporation (that 
is, obligations owed by an affiliate of the foreign target corporation 
to the foreign target corporation), at least to the extent that the 
obligations arose in the ordinary course of the foreign target group's 
cash management program. The comment noted that, in these cases, had 
the

[[Page 5391]]

foreign target corporation instead funded its affiliate through equity 
(rather than debt), stock of the foreign acquiring corporation 
transferred in exchange for the equity generally would not be 
disqualified stock. The comment questioned this disparate treatment.
    After considering the comment, the Treasury Department and the IRS 
have determined that transfers of stock of a foreign acquiring 
corporation in exchange for intercompany obligations generally do not 
present opportunities to inappropriately reduce the ownership fraction. 
Accordingly, the final regulations exclude from the definition of 
nonqualified property an obligation owed by a member of the EAG if the 
holder of the obligation immediately before the domestic entity 
acquisition and any related transaction (or its successor), is a member 
of the EAG after the domestic entity acquisition and all related 
transactions. Sec.  1.7874-4(i)(2)(iii)(A).
    Another comment recommended that nonqualified property generally 
not include an obligation owed by a person that is only a de minimis 
former domestic entity shareholder or former domestic entity partner. 
The comment made a similar recommendation for an obligation owed by a 
person that, before and after the domestic entity acquisition, owns no 
more than a de minimis interest in any member of the EAG. The Treasury 
Department and the IRS agree with this comment, and the final 
regulations are modified accordingly. See Sec.  1.7874-4(i)(2)(iii)(B) 
and (C) (providing a de minimis rule for a less than five percent 
ownership interest). Nevertheless, the anti-abuse rule in section 
7874(c)(4) may still apply to disregard transfers of stock in exchange 
for such obligations.
4. Definition of Obligation
    The temporary regulations define an obligation by reference to 
Sec.  1.752-1(a)(4)(ii), which includes ``any fixed or contingent 
obligation to make payment. . . . Obligations include, but are not 
limited to, debt obligations, environmental obligations, tort 
obligations, contract obligations, pension obligations, obligations 
under a short sale, and obligations under derivative financial 
instruments such as options, forward contracts, futures contracts, and 
swaps.''
    The Treasury Department and the IRS are concerned that the 
reference in the temporary regulations to Sec.  1.752-1(a)(4)(ii) may 
cause confusion when applied outside of a partnership setting. The 
final regulations thus remove the reference to Sec.  1.752-1(a)(4)(ii) 
and provide that an obligation for purposes of the disqualified stock 
rule includes any fixed or contingent obligation to make payment or 
provide value (such as through providing goods or services). Sec.  
1.7874-4(i)(3). No inference is intended regarding the treatment, under 
Sec.  1.752-1(a)(4)(ii) or the temporary regulations, of a contractual 
agreement by a person to provide goods or services.
5. Definition of Avoidance Property
    Avoidance property means any property (other than specified 
nonqualified property) acquired with a principal purpose of avoiding 
the purposes of section 7874. The 2015 notice and the 2016 temporary 
regulations clarified that this definition applies regardless of 
whether the transaction involves an indirect transfer of specified 
nonqualified property. One comment was received regarding this 
clarification.
    The comment agreed with the clarification but asserted that 
avoidance property should not include property that meets two 
conditions. First, the property (or, in cases in which the property is 
stock or a partnership interest, the property indirectly transferred) 
either (i) constitutes a trade or business within the meaning of Sec.  
1.367(a)-2(d)(2), or (ii) is related to an existing business of the 
foreign acquiring corporation. And, second, the property is transferred 
without an intention to dispose of it at a later time. After 
considering the comment, the Treasury Department and the IRS have 
determined that whether property constitutes avoidance property should 
in all cases depend on the principal purpose for the acquisition of the 
property, which cannot be determined based on an exclusive set of 
objective factors, such as the nature of the property or holding 
period. In certain circumstances, property that meets the conditions 
described by the comment could be acquired with a principal purpose of 
avoiding the purposes of section 7874. Thus, the Treasury Department 
and the IRS have concluded that it would be inappropriate to exclude 
such property from the definition of avoidance property. Consequently, 
the final regulations do not adopt the comment.

B. Subsequent Transfers of Stock in Exchange for the Satisfaction or 
Assumption of an Obligation Associated With the Property Exchanged

1. In General
    Disqualified stock also generally includes stock of the foreign 
acquiring corporation that is transferred by a person (the transferor) 
to another person (the transferee) in exchange for property (the 
exchanged property) if, pursuant to the same plan (or series of related 
transactions), the transferee subsequently transfers the stock in 
exchange for the satisfaction or assumption of one or more obligations 
associated with the exchanged property (the associated obligation 
rule). The purpose of the rule is to ensure that the same amount of 
stock of the foreign acquiring corporation is included in the 
denominator of the ownership fraction in economically similar 
situations.
    For example, consider a situation in which a foreign acquiring 
corporation (FA) intends to acquire the property of a domestic entity 
(DT), which holds property with a fair market value of $100x and has a 
$25x obligation that is associated with the property. The parties could 
structure the domestic entity acquisition using the following steps: 
(i) DT transfers all of its property to FA in exchange for $75x of FA 
stock and FA's assumption of the $25x associated obligation, (ii) DT 
distributes the $75x of FA stock to its shareholders, and (iii) in a 
related transaction, FA issues $25x of its stock to the public for cash 
and uses that cash to satisfy the associated obligation. Alternatively, 
FA could not assume the associated obligation and could thus acquire 
all of DT's properties in exchange for $100x of FA stock, followed by 
DT using $25x of FA stock to satisfy the $25x associated obligation and 
distributing the remaining $75x of FA stock to its shareholders in 
liquidation. Under the first alternative, the $25x of FA stock issued 
to the public in exchange for cash (which is nonqualified property) 
would be excluded from the denominator of the ownership fraction. Under 
the second alternative, however, no FA stock would be excluded absent 
the associated obligation rule. Allowing a different result under the 
second alternative would be inappropriate because the first and second 
alternatives are economically similar. That is, under both 
alternatives, FA's value reflects the gross value of the acquired 
property (under the first alternative, because the amount of the 
associated obligation is satisfied with the cash and, under the second 
alternative, because FA did not assume the associated obligation), and 
DT's obligations have been reduced by the amount of the associated 
obligation. The associated obligation rule thus ensures that, as under 
the first alternative, $25x of FA stock is excluded from the 
denominator of the ownership fraction under the second alternative. The 
rule serves the same

[[Page 5392]]

purpose when the transferee is a person other than the domestic entity.
    Several comments were received regarding the purpose and effect of 
the associated obligation rule. First, a comment noted that the rule 
serves an important purpose and suggested that the final regulations 
retain the rule. Another comment questioned the practical significance 
of the rule under the temporary regulations and suggested that the 
final regulations remove it. In particular, the comment asserted that 
creditors typically require obligations to be satisfied in cash, rather 
than stock. Moreover, the comment stated that, under the temporary 
regulations, the rule might not apply if, instead of using stock of the 
foreign acquiring corporation to satisfy an associated obligation, the 
transferee sold the stock for cash and then used the cash to satisfy 
the obligation. One comment acknowledged, however, that a plan (or 
series of related transactions) to satisfy obligations of the 
transferee using the proceeds of the sale of stock of the foreign 
acquiring corporation could be subject to the anti-abuse rule under 
section 7874(c)(4).
    After considering the comments, the Treasury Department and the IRS 
have determined that the associated obligation rule promotes an 
important policy and thus the final regulations retain the rule. The 
Treasury Department and the IRS also have determined that when a 
foreign acquiring corporation issues its stock in lieu of assuming an 
obligation associated with the exchanged property, the rule should not 
be limited to situations in which, pursuant to the same plan (or series 
of related transactions), the transferee uses the stock to directly 
satisfy the associated obligation. Rather, the Treasury Department and 
the IRS have concluded that the rule should generally apply if, 
pursuant to the same plan (or series of related transactions), the 
transferee uses the stock to directly or indirectly satisfy any 
obligation of the transferee (regardless of whether it is an associated 
obligation). For example, the rule should apply if the transferee sells 
the stock and then uses the proceeds to satisfy an amount of an 
obligation of the transferee equal to the amount of the associated 
obligation. In these cases, the transferee and the foreign acquiring 
corporation are in an economic position similar to the one in which 
they would have been had the foreign acquiring corporation assumed the 
associated obligation, issued stock in exchange for cash, and then used 
that cash to satisfy the obligation. The final regulations accordingly 
modify the associated obligation rule. See Sec.  1.7874-4(c)(1)(ii)(A). 
In addition, the final regulations generally limit the amount of 
disqualified stock arising under the associated obligation rule to the 
proportionate share of obligations associated with the exchanged 
property that, pursuant to the same plan (or series of related 
transactions), is not assumed by the foreign acquiring corporation. See 
Sec.  1.7874-4(c)(1)(ii)(B).
2. Acquisitions of Less than Substantially All of the Property of 
Transferee
    A comment requested a modification of the associated obligation 
rule so that it applies only if the transferor acquires substantially 
all of the property of the transferee. The comment asserted that, when 
the transferor acquires only a portion (rather than substantially all) 
of the transferee's property, it may be difficult or burdensome to 
determine which obligations are associated with the exchanged property.
    The associated obligation rule addresses a concern that, absent the 
rule, a different amount of stock of a foreign acquiring corporation 
might be included in the denominator of the ownership fraction in 
economically similar scenarios. The Treasury Department and the IRS 
have determined that this concern may exist regardless of the portion 
of the transferee's property that is acquired. In addition, 
determinations concerning the association between obligations and 
property may be required under the Code for purposes other than 
applying the associated obligation rule. For example, see section 
358(h)(2). Accordingly, the final regulations decline to adopt the 
comment.
3. Application of Rule When Domestic Entity Is Transferee
    One comment suggested broadening the associated obligation rule to 
address certain cases in which the domestic entity is the transferee 
and the foreign acquiring corporation issues its stock in lieu of 
assuming any obligation of the transferee (regardless of whether it is 
associated with the exchanged property). For example, consider a 
situation in which a domestic entity (DT) has two lines of business: 
(i) Business A, which comprises property that, in the aggregate, has a 
fair market value of $90x and no obligations associated with it, and 
(ii) Business B, which comprises property that, in the aggregate, has a 
fair market value of $20x and $10x of obligations associated with it. 
If a foreign acquiring corporation (FA) acquires only the Business A 
property in exchange for $90x of FA stock, DT might use $10x of FA 
stock to satisfy the Business B associated obligations and distribute 
the remaining $80x of FA stock and the $20x of Business B property to 
its shareholders in liquidation. In such a case, the $10x of FA stock 
would not be disqualified stock under the associated obligation rule 
because the transferee did not retain any obligations associated with 
the exchanged property (the Business A property); thus, absent special 
rules, the stock might inappropriately dilute the ownership percentage. 
The comment noted that the associated obligation rule could be modified 
to address such cases.
    The Treasury Department and the IRS acknowledge the concern raised 
by the comment but decline to broaden the associated obligation rule to 
address it at this time. However, the Treasury Department and the IRS 
will monitor transactions in which the foreign acquiring corporation 
transfers its stock in lieu of assuming an obligation of the domestic 
entity and continue to study whether future guidance should broaden the 
rule. In addition, section 7874(c)(4) (which would disregard the 
transfer of the $10x of FA stock in satisfaction of the obligation if 
the transfer is part of a plan a principal purpose of which is to avoid 
the purposes of section 7874) and Sec.  1.7874-10T (which could cause 
DT's distribution of the $20x of Business B assets to give rise to a 
non-ordinary course distribution, which, in turn, would cause the 
former domestic entity shareholders of DT to be deemed to receive 
additional FA stock for purpose of computing the ownership fraction) 
may apply to address the concern raised by the comment.

III. The De Minimis Exception

    The disqualified stock rule contains a de minimis exception, which 
generally applies when two requirements are satisfied. First, the 
ownership percentage--determined without regard to the application of 
the disqualified stock rule, the passive assets rule of Sec.  1.7874-7T 
(the passive assets rule), and the non-ordinary course distribution 
rule of Sec.  1.7874-10T (the non-ordinary course distribution rule)--
must be less than five (by vote and value). Second, after the domestic 
entity acquisition and all related transactions, former domestic entity 
shareholders or former domestic entity partners, 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

[[Page 5393]]

the EAG. When the de minimis exception applies, the disqualified stock 
rule does not apply and, as a result, no stock of the foreign acquiring 
corporation is excluded from the denominator of the ownership fraction 
pursuant to the rule.
    The passive assets rule and the non-ordinary course distribution 
rule contain similar de minimis exceptions (the three exceptions 
collectively, the de minimis exceptions). See Sec. Sec.  1.7874-7T(c) 
and 1.7874-10T(d). Together, the de minimis exceptions generally 
prevent one or more of the disqualified stock rule, the passive assets 
rule, and the non-ordinary course rule from causing section 7874 to 
apply to a domestic entity acquisition that, given minimal actual 
ownership continuity, largely resembles a cash purchase by the foreign 
acquiring corporation of the stock of (or interests in) the domestic 
entity.
    Comments requested expanding the de minimis exceptions in several 
respects. First, comments requested increasing the ownership thresholds 
in the de minimis exceptions. One comment recommended a 20-percent 
threshold, noting that such a threshold would be generally consistent 
with the threshold in the internal group restructuring exception under 
Sec.  1.7874-1(c)(2) (permitting up to 20 percent ownership by non-EAG 
members). The internal group restructuring exception, however, 
addresses different policies than the de minimis exceptions. In 
particular, the internal group restructuring exception addresses 
transactions in which there is no, or only a small, shift in ownership 
of a domestic entity to persons outside of a corporate group, whereas 
the de minimis exceptions address transactions in which there is almost 
a complete shift in ultimate ownership of a domestic entity. Moreover, 
the Treasury Department and the IRS have concluded that a five-percent 
threshold appropriately differentiates between domestic entity 
acquisitions that largely resemble a cash purchase and those that do 
not. Accordingly, the final regulations do not adopt the comment.
    Other comments requested removing the second requirement of the de 
minimis exceptions or, alternatively, modifying the requirement so that 
it looks only to stock held by reason of holding stock (or interests) 
of the domestic entity. The comments noted that, particularly in cases 
involving a publicly-traded domestic entity or a complex ownership 
structure, it could be difficult or burdensome to identify each former 
domestic entity shareholder or former domestic entity partner 
(including a de minimis former domestic entity shareholder or former 
domestic entity partner), as applicable, and then determine (taking 
into account the applicable attribution rules) the former domestic 
entity shareholders' or former domestic entity partners' collective 
ownership of the foreign acquiring corporation and each member of the 
EAG. Accordingly, the comment asserted that, at least in certain cases, 
uncertainty surrounding whether the second requirement is satisfied 
could result in taxpayers having to apply--and thus conduct the 
potentially complicated analyses required by--the disqualified stock 
rule, passive assets rule, and non-ordinary course distribution rule, 
notwithstanding that the domestic entity acquisition may largely 
resemble a purchase.
    After considering the comment, the final regulations modify each of 
the de minimis exceptions to provide that the second requirement is 
satisfied if, after the domestic entity acquisition and all related 
transactions, each former domestic entity shareholder or former 
domestic entity partner, as applicable, owns (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) each member of the EAG. Sec.  1.7874-
4(d)(1)(ii); Sec.  1.7874-7T(c)(2); Sec.  1.7874-10T(d)(2). The 
Treasury Department and the IRS have determined that limiting the 
second requirement to consider only the ownership of former domestic 
entity shareholders or former domestic entity partners (with applicable 
attribution rules), individually, rather than the ownership of all 
former domestic entity shareholders or former domestic entity partners, 
collectively, strikes the appropriate balance between preventing the de 
minimis exceptions from applying in inappropriate circumstances and 
addressing the practical difficulties noted in the comment.

IV. Certain Public Offerings

    The preamble to the 2014 temporary regulations noted that the de 
minimis exception with respect to the disqualified stock rule may 
facilitate certain transactions that have the effect of converting a 
publicly traded domestic corporation into a publicly traded foreign 
corporation over time. For example, a buyer may contribute cash to a 
newly formed foreign acquiring corporation that uses such cash, along 
with the proceeds from borrowings and a small amount of its stock 
(often issued to the management of the domestic corporation), to 
acquire all of the stock of a publicly traded domestic corporation in a 
domestic entity acquisition. After a period of time, the buyer may sell 
its stock of the foreign acquiring corporation pursuant to a public 
offering, which may have been contemplated at the time of the domestic 
entity acquisition. The preamble to the 2014 regulations explained that 
the Treasury Department and the IRS would study these transactions and 
requested comments on the application of section 7874 to such 
transactions.
    A comment asserted that, given the number of non-tax contingencies 
between the domestic entity acquisition and the public offering, it 
would be inappropriate to apply the step-transaction doctrine or 
related principles to the transactions. Comments also suggested that 
these transactions do not violate the policies of section 7874 because 
the domestic entity acquisition is essentially a purchase by the 
foreign acquiring corporation of the stock of the publicly traded 
domestic corporation. Accordingly, comments recommended against new 
rules to address the transactions.
    After further study and consideration of the comments, the Treasury 
Department and the IRS decline at this time to provide special rules to 
address these transactions. However, section 7874(c)(4), Sec.  1.7874-
4(d)(2) (providing that the de minimis exception does not apply to 
disqualified stock that is transferred with a principal purpose of 
avoiding the purposes of section 7874), and judicial doctrines each may 
apply to address the concerns raised by these transactions.

V. Additional Clarifications Requested

A. Stock Included in Numerator Also Included in Denominator

    A comment requested that the Treasury Department and the IRS 
clarify that stock of a foreign acquiring corporation included in the 
numerator of the ownership fraction is also included in the denominator 
of the fraction, regardless of whether the stock is disqualified stock. 
The preamble to the temporary regulations indicated that stock 
described in section 7874(a)(2)(B)(ii) (by reason of stock) is never 
treated as disqualified stock and thus cannot be excluded from the 
denominator of the ownership fraction under the disqualified stock 
rule. See Part A of the Explanation of Provisions section of the 
preamble to the 2014 temporary regulations. Nevertheless, in response 
to the comment and for the avoidance of doubt, the final regulations 
clarify that by reason of stock may never

[[Page 5394]]

be treated as disqualified stock. See Sec.  1.7874-4(c)(1). 
Accordingly, the final regulations clarify that stock of the foreign 
acquiring corporation included in the numerator of the ownership 
fraction is in all cases also included in the denominator of the 
fraction.

B. Treatment of partnerships

    Comments requested clarification about whether an acquisition of a 
partnership interest is treated similarly to an acquisition of stock 
for purposes of the disqualified stock rule. That is, the comment asked 
whether stock of a foreign acquiring corporation transferred in 
exchange for a partnership interest is treated as stock transferred in 
exchange for a proportionate share of partnership assets represented by 
the partnership interest (a look-through approach). The Treasury 
Department and the IRS confirm that a partnership interest does not 
constitute nonqualified property unless it is a marketable security 
(for example, an interest in a publicly traded partnership described in 
Sec.  1.7704-1(a)(1)(i)) or is avoidance property. The definition of 
marketable securities in the temporary regulations excludes an interest 
in a partnership that becomes a member of the EAG in a transaction (or 
series of transactions) related to the domestic entity acquisition, an 
exclusion that would be unnecessary if partnership interests were 
subject to a look-through approach. Nevertheless, in response to the 
comment and for the avoidance of doubt, the definition of nonqualified 
property is clarified to provide that an interest in a partnership is 
nonqualified property only to the extent it is a marketable security or 
avoidance property.

VI. The Subsequent Transfer Rule

    The temporary regulations provide a rule (the subsequent transfer 
rule) pursuant to which stock of a foreign corporation that is 
described in section 7874(a)(2)(B)(ii) (that is, by reason of stock) 
does not cease to be so described as a result of any subsequent 
transfer of the stock by the former domestic entity shareholder or 
former domestic entity partner that received such stock, even if the 
subsequent transfer is related to the domestic entity acquisition. A 
comment requested adding a de minimis exception to the subsequent 
transfer rule, similar to the three de minimis exceptions discussed in 
Part III of this Summary of Comments and Explanation of Revisions. For 
example, the comment suggested that if, pursuant to a subsequent 
transfer (or series of transfers) related to the domestic entity 
acquisition, the former domestic entity shareholders or former domestic 
entity partners, in the aggregate, dispose of all but a de minimis 
amount of stock of the foreign acquiring corporation, then the 
subsequent transfer rule should not apply. In such a case, the 
requested de minimis exception would provide that the stock received by 
the former domestic entity shareholders or former domestic entity 
partners would not be considered by reason of stock and thus would not 
be included in the numerator of the ownership fraction (though it 
generally would be included in the denominator of the ownership 
fraction).
    The final regulations do not adopt the comment. The de minimis 
exceptions, as discussed in Part III of this Summary of Comments and 
Explanation of Revisions, provide relief for transactions that are in 
substance cash purchases by the foreign acquiring corporation of the 
stock of (or interests in) the domestic entity. In contrast, the 
subsequent transfer rule applies to ensure the application of section 
7874 to transactions where a foreign corporation acquires substantially 
all the property (directly or indirectly) of a domestic entity in 
exchange for stock. The ultimate use of the stock received by the 
former domestic entity shareholders or former domestic entity partners 
is irrelevant to the three-factor test established by the statute. 
Accordingly, the final regulations do not adopt a de minimis exception 
for purposes of the subsequent transfer rule.

VII. Applicability Dates

    The final regulations generally apply to domestic entity 
acquisitions completed on or after September 17, 2009, to the extent 
described in the 2009 notice. The final regulations generally apply 
with respect to the remainder of the proposed rules in the 2014 
proposed regulations to domestic entity acquisitions completed on or 
after January 16, 2014. However, see Sec.  1.7874-4(k) for certain 
rules that apply only to domestic entity acquisitions completed on or 
after the publication of the 2015 notice or these final regulations, as 
applicable. Similar to the 2014 temporary regulations, these 
regulations provide that taxpayers may elect to apply all the rules 
contained in these final regulations to domestic entity acquisitions 
completed on or after September 17, 2009, and before January 13, 2017 
(transition period), if the taxpayer applies all of the rules 
consistently to all domestic entity acquisitions completed during the 
transition period.
    No inference is intended as to the treatment of transactions under 
the law before the various applicability dates of these regulations. 
For example, these transactions could be subject to challenge under 
applicable provisions, including under section 7874(c)(4) or judicial 
doctrines such as the substance-over-form doctrine.

Special Analyses

    Certain IRS regulations, including these, are exempt from the 
requirements of Executive Order 12866, as supplemented and reaffirmed 
by Executive Order 13563. Therefore, a regulatory impact assessment is 
not required. The Regulatory Flexibility Act (5 U.S.C. chapter 6) does 
not apply because the regulations do not impose a collection of 
information on small entities. Pursuant to section 7805(f) of the Code, 
the notices of proposed rulemaking that preceded this regulation were 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business. No comments 
were received.

Drafting Information

    The principal author of these regulations is Joshua G. Rabon of the 
Office of Associate Chief Counsel (International). However, other 
personnel from the Treasury Department and the IRS participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.7874-4 also issued under 26 U.S.C. 7874(c)(6) and (g).
    Section 1.7874-5 also issued under 26 U.S.C. 7874(c)(6) and (g).
* * * * *

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


Sec.  1.7874-4   Disregard of certain stock related to the domestic 
entity acquisition.

    (a) Scope. This section identifies certain stock of the foreign 
acquiring corporation that is disregarded in determining the ownership 
fraction and modifies the scope of section 7874(c)(2)(B). Paragraph (b) 
of this section sets forth the general rule that certain stock of the 
foreign acquiring

[[Page 5395]]

corporation, and only such stock, is treated as stock described in 
section 7874(c)(2)(B) and therefore is excluded from the denominator of 
the ownership fraction. Paragraph (c) of this section identifies the 
stock of the foreign acquiring corporation that is subject to paragraph 
(b) of this section. Paragraph (d) of this section provides a de 
minimis exception to the application of the general exclusion rule of 
paragraph (b) of this section. Paragraph (e) of this section provides 
rules for transfers of stock of the foreign acquiring corporation in 
satisfaction of, or in exchange for the assumption of, one or more 
obligations of the transferor. Paragraph (f) of this section provides 
rules for certain transfers of stock of the foreign acquiring 
corporation involving multiple properties or obligations. Paragraph (g) 
of this section provides rules for the treatment of partnerships, and 
paragraph (h) of this section provides rules addressing the interaction 
of this section with the expanded affiliated group rules of section 
7874(c)(2)(A) and Sec.  1.7874-1. Paragraph (i) of this section 
provides definitions. Paragraph (j) of this section provides examples 
illustrating the application of the rules of this section. Paragraph 
(k) of this section provides dates of applicability.
    (b) Exclusion of disqualified stock under section 7874(c)(2)(B). 
Except as provided in paragraph (d) of this section, disqualified stock 
(as determined under paragraph (c) of this section) is treated as stock 
described in section 7874(c)(2)(B) and therefore is not included in the 
denominator of the ownership fraction. Section 7874(c)(2)(B) shall not 
apply to exclude stock from the denominator of the ownership fraction 
that is not disqualified stock.
    (c) Disqualified stock--(1) General rule. Except as provided in 
paragraph (c)(2) of this section, disqualified stock is stock of the 
foreign acquiring corporation (other than stock described in Sec.  
1.7874-2(f)) that is transferred in an exchange described in paragraph 
(c)(1)(i) or (ii) of this section that is related to the domestic 
entity acquisition. This paragraph (c) applies without regard to 
whether the stock of the foreign acquiring corporation is publicly 
traded at the time of the transfer or at any other time.
    (i) Exchanged for nonqualified property. The stock is transferred 
to a person other than the domestic entity in exchange for nonqualified 
property. See Example 1, Example 2, Example 6, Example 8, and Example 9 
of paragraph (j) of this section for illustrations of the application 
of this paragraph (c)(1)(i).
    (ii) Exchanged for property with associated obligations--(A) 
General rule. Subject to the limitation provided in in paragraph 
(c)(1)(ii)(B) of this section, the stock is transferred by a person 
(transferor) to another person (transferee) in exchange for property 
(exchanged property) and, pursuant to the same plan (or series of 
related transactions), the transferee subsequently transfers such stock 
(or, if the transferee exchanges such stock for other property, such 
other property) in satisfaction of, or in exchange for the assumption 
of, one or more obligations of the transferee or a person related 
(within the meaning of section 267 or 707(b)) to the transferee. See 
Example 6 and Example 10 of paragraph (j) of this section for 
illustrations of the application of paragraph (c)(1)(ii) of this 
section.
    (B) Limitation. The amount of stock treated as transferred in an 
exchange described in paragraph (c)(2)(ii)(A) of this section shall not 
exceed--
    (1) With respect to a transferee that is the domestic entity, the 
proportionate share of obligations associated with the exchanged 
property (determined based on the fair market value of the exchanged 
property relative to the fair market value of all properties with which 
the obligations are associated) that, pursuant to the same plan (or 
series of related transactions), is not assumed by the transferor.
    (2) With respect to any other transferee, the proportionate share 
of obligations associated with the exchanged property (determined based 
on the fair market value of the exchanged property relative to the fair 
market value of all properties with which the obligations are 
associated) that, pursuant to the same plan (or series of related 
transactions), is not assumed by the transferor, multiplied by a 
fraction, the numerator of which is the amount of exchanged property 
that is qualified property, and the denominator of which is the total 
amount of exchanged property.
    (C) Associated obligations. For purposes of paragraph (c)(1)(ii) of 
this section, an obligation is associated with property if, for 
example, the obligation arose from the conduct of a trade or business 
in which the property has been used, regardless of whether the 
obligation is a non-recourse obligation.
    (2) Stock transferred in an exchange that does not increase the 
fair market value of the assets or decrease the amount of liabilities 
of the foreign acquiring corporation. Stock is disqualified stock only 
to the extent that the transfer of the stock in the exchange increases 
the fair market value of the assets of the foreign acquiring 
corporation or decreases the amount of its liabilities. This paragraph 
(c)(2) is applied to an exchange without regard to any other exchange 
described in paragraph (c)(1)(i) or (ii) of this section or any other 
transaction related to the domestic entity acquisition. See Example 4 
and Example 7 of paragraph (j) of this section for illustrations of the 
application of this paragraph (c)(2).
    (d) Exception to exclusion of disqualified stock--(1) De minimis 
ownership. Except as provided in paragraph (d)(2) of this section, 
paragraph (b) of this section does not apply if both:
    (i) The ownership percentage described in section 
7874(a)(2)(B)(ii), determined without regard to the application of 
paragraph (b) of this section and Sec. Sec.  1.7874-7T(b) and 1.7874-
10T(b), is less than five (by vote and value); and
    (ii) After the domestic entity acquisition and all related 
transactions, each former domestic entity shareholder or former 
domestic entity partner, as applicable, owns (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) each member of the expanded 
affiliated group. See Example 5 of paragraph (j) of this section for an 
illustration of this paragraph (d).
    (2) Stock issued to avoid the purposes of section 7874. The 
exception in paragraph (d)(1) of this section does not apply to 
disqualified stock that is transferred in a transaction (or series of 
transactions) related to the domestic entity acquisition with a 
principal purpose of avoiding the purposes of section 7874.
    (e) Satisfaction or assumption of obligations. Except to the extent 
stock is treated as disqualified stock as a result of being described 
in paragraph (c)(1)(ii) of this section, this paragraph (e) applies if, 
in a transaction related to the domestic entity acquisition, stock of 
the foreign acquiring corporation is transferred to a person other than 
the domestic entity in exchange for the satisfaction or the assumption 
of one or more obligations of the transferor. In such a case, solely 
for purposes of this section, the stock of the foreign acquiring 
corporation is treated as if it is transferred in exchange for an 
amount of cash equal to the fair market value of such stock.
    (f) Transactions involving multiple properties. For purposes of 
this section, if stock and other property are exchanged for qualified 
property and

[[Page 5396]]

nonqualified property, the stock is treated as transferred in exchange 
for the qualified property or nonqualified property, respectively, 
based on the relative fair market value of the property. See also Sec.  
1.7874-2(f)(2) (allocating stock of a foreign acquiring corporation 
between an interest in the domestic entity and other property).
    (g) Treatment of partnerships. For purposes of this section, if one 
or more members of the expanded affiliated group own, in the aggregate, 
more than 50 percent (by value) of the interests in a partnership, such 
partnership is treated as a corporation that is a member of the 
expanded affiliated group.
    (h) Interaction with expanded affiliated group rules. Disqualified 
stock that is excluded from the denominator of the ownership fraction 
pursuant to paragraph (b) of this section is taken into account for 
purposes of determining whether an entity is a member of the expanded 
affiliated group for purposes of applying section 7874(c)(2)(A) and 
Sec.  1.7874-1(b) and determining whether a domestic entity acquisition 
qualifies as an internal group restructuring or results in a loss of 
control, as described in Sec.  1.7874-1(c)(2) and (c)(3), respectively. 
However, such disqualified stock is excluded from the denominator of 
the ownership fraction for purposes of section 7874(a)(2)(B)(ii) 
regardless of whether it otherwise would be included in the denominator 
of the ownership fraction as a result of the application of Sec.  
1.7874-1(c). See Example 8 and Example 9 of paragraph (j) of this 
section for illustrations of the application of this paragraph (h).
    (i) Definitions. In addition to the definitions in Sec.  1.7874-
12T, the following definitions apply for purposes of this section:
    (1) Marketable securities has the meaning set forth in section 
453(f)(2), except that the term marketable securities does not include 
stock of a corporation or an interest in a partnership that becomes a 
member of the expanded affiliated group in a transaction (or series of 
transactions) related to the domestic entity acquisition. See Example 4 
of paragraph (j) of this section for an illustration of this paragraph 
(i)(1).
    (2) Nonqualified property is property described in paragraphs 
(i)(2)(i) through (iv) of this section. Thus, stock in a corporation or 
an interest in a partnership is nonqualified property to the extent 
provided in paragraph (i)(2)(ii) or (iv) of this section. Qualified 
property is property other than nonqualified property.
    (i) Cash or cash equivalents.
    (ii) Marketable securities, within the meaning of paragraph (i)(1) 
of this section.
    (iii) An obligation owed by any of the following:
    (A) A member of the expanded affiliated group, unless the holder of 
the obligation immediately before the domestic entity acquisition and 
any related transaction (or its successor) is a member of the expanded 
affiliated group after the domestic entity acquisition and all related 
transactions.
    (B) A former domestic entity shareholder or former domestic entity 
partner of the domestic entity that owns (applying the attribution 
rules of section 318(a) with the modifications described in section 
304(c)(3)(B)) at least five percent (by vote or value) of the stock of, 
or partnership interests in, the domestic entity before the domestic 
entity acquisition.
    (C) A person that, before or after the domestic entity acquisition, 
either owns (applying the attribution rules of section 318(a) with the 
modifications described in section 304(c)(3)(B)) at least five percent 
(by vote or value) of the stock of (or partnership interests in) or is 
related (within the meaning of section 267 or 707(b)) to--
    (1) A member of the expanded affiliated group; or
    (2) A person described in paragraph (i)(2)(iii)(B) of this section. 
See Example 6 of paragraph (j) of this section for an illustration of 
this paragraph (i)(2)(iii)(C)(2).
    (iv) Any other property acquired with a principal purpose of 
avoiding the purposes of section 7874, regardless of whether the 
transaction involves an indirect transfer of property described in 
paragraph (i)(2)(i), (ii), or (iii) of this section. See Example 2 and 
Example 3 of paragraph (j) of this section for illustrations of the 
application of this paragraph (i)(2)(iv).
    (3) An obligation means any fixed or contingent obligation to make 
a payment or provide value without regard to whether the obligation is 
otherwise taken into account for purposes of the Internal Revenue Code. 
An obligation includes, but is not limited to, a debt obligation, an 
environmental obligation, a tort obligation, a contract obligation 
(including an obligation to provide goods or services), a pension 
obligation, an obligation under a short sale, and an obligation under 
derivative financial instruments such as options, forward contracts, 
futures contracts, and swaps. An obligation does not include any 
obligation treated as stock for purposes of section 7874 (see, for 
example, Sec.  1.7874-2(i), which treats certain interests, including 
certain creditor claims, as stock).
    (4) A transfer is, with respect to stock of the foreign acquiring 
corporation, an issuance, sale, distribution, exchange, or any other 
disposition of such stock.
    (j) Examples. The following examples illustrate the application of 
the rules of this section. For purposes of the examples, unless 
otherwise indicated, assume the following facts in addition to the 
facts stated in the examples:
    (1) FA, FMS, FS, and FT are foreign corporations, all of which have 
only one class of stock issued and outstanding;
    (2) DMS and DT are domestic corporations;
    (3) P and R are corporations that may be either domestic or 
foreign;
    (4) PRS is a partnership with individual partners;
    (5) The de minimis ownership exception in paragraph (d)(1) of this 
section does not apply;
    (6) None of the shareholders or partners in the entities described 
in the examples are related persons with respect to each other;
    (7) All transactions described in each example occur pursuant to 
the same plan;
    (8) No property is acquired with a principal purpose of avoiding 
the purposes of section 7874;
    (9) FA, FMS, FS, and FT are tax residents in the same foreign 
country;
    (10) For purposes of determining the ownership fraction, no shares 
of FA stock are excluded from the denominator pursuant to Sec.  1.7874-
7T(b) (which disregards stock attributable to passive assets); and
    (11) For purposes of determining the ownership fraction, no shares 
of FA stock are treated as received by former shareholders of DT 
pursuant to Sec.  1.7874-10T(b) (which disregards certain 
distributions).

    Example 1.  Stock transferred in exchange for marketable 
securities--(i) Facts. Individual A wholly owns DT. PRS transfers 
marketable securities (within the meaning of paragraph (i)(1) of 
this section) to FA, a newly formed corporation, in exchange solely 
for 25 shares of FA stock. Then Individual A transfers all the DT 
stock to FA in exchange solely for 75 shares of FA stock.
    (ii) Analysis. Under paragraph (i)(2)(ii) of this section, the 
marketable securities constitute nonqualified property. Accordingly, 
the 25 shares of FA stock transferred by FA to PRS in exchange for 
the marketable securities constitute disqualified stock described in 
paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of 
this section. Paragraph (c)(2) of this section does not reduce the 
amount of disqualified stock described in paragraph (c)(1)(i) of 
this section because the transfer of FA stock in exchange for the 
marketable securities increases the

[[Page 5397]]

fair market value of the assets of FA by the fair market value of 
the marketable securities transferred. Under paragraph (b) of this 
section, the 25 shares of FA stock transferred to PRS are not 
included in the denominator of the ownership fraction. See also 
section 7874(c)(4). Accordingly, the only FA stock included in the 
ownership fraction is the FA stock transferred to Individual A in 
exchange for the DT stock, and that FA stock is included in both the 
numerator and the denominator of the ownership fraction. Thus, the 
ownership fraction is 75/75.
    Example 2.  Stock transferred in exchange for property acquired 
with a principal purpose of avoiding the purposes of section 7874--
(i) Facts. Individual A wholly owns DT. PRS transfers marketable 
securities (within the meaning of paragraph (i)(1) of this section) 
to FT, a newly formed corporation, in exchange solely for all the FT 
stock. Then PRS transfers the FT stock to FA, a newly formed 
corporation, in exchange solely for 25 shares of FA stock. Finally, 
Individual A transfers all the DT stock to FA in exchange solely for 
75 shares of FA stock. FA acquires the FT stock with a principal 
purpose of avoiding the purposes of section 7874.
    (ii) Analysis. Under paragraph (i)(2)(iv) of this section, the 
FT stock constitutes nonqualified property because a principal 
purpose of FA acquiring the FT stock is to avoid the purposes of 
section 7874. Accordingly, the 25 shares of FA stock transferred by 
FA to PRS in exchange for the FT stock constitute disqualified stock 
described in paragraph (c)(1) of this section by reason of paragraph 
(c)(1)(i) of this section. Paragraph (c)(2) of this section does not 
reduce the amount of disqualified stock described in paragraph 
(c)(1)(i) of this section because the transfer of FA stock in 
exchange for the FT stock increases the fair market value of FA's 
assets by the fair market value of the FT stock. Under paragraph (b) 
of this section, the 25 shares of FA stock transferred to PRS are 
not included in the denominator of the ownership fraction. 
Furthermore, even in the absence of paragraph (i)(2)(iv) of this 
section, the transfer of marketable securities to FT would be 
disregarded pursuant to section 7874(c)(4). Accordingly, the only FA 
stock included in the ownership fraction is the FA stock transferred 
to Individual A in exchange for the DT stock, and that FA stock is 
included in both the numerator and the denominator of the ownership 
fraction. Thus, the ownership fraction is 75/75.
    Example 3.  Stock transferred in exchange for property acquired 
with a principal purpose of avoiding the purposes of section 7874--
(i) Facts. DT is a publicly traded corporation. PRS is a foreign 
partnership that is unrelated to DT. PRS transfers certain business 
assets (PRS properties) to FA, a newly formed foreign corporation, 
in exchange solely for 25 shares of FA stock. The shareholders of DT 
transfer all of their DT stock to FA in exchange solely for the 
remaining 75 shares of FA stock (DT acquisition). None of the PRS 
properties is property described in paragraph (i)(2)(i) through 
(iii) of this section, but FA acquires the PRS properties with a 
principal purpose of avoiding the purposes of section 7874.
    (ii) Analysis. Under paragraph (i)(2)(iv) of this section, the 
PRS properties transferred to FA constitute nonqualified property, 
because FA acquires the PRS properties in a transaction related to 
the DT acquisition with a principal purpose of avoiding the purposes 
of section 7874. Accordingly, the 25 shares of FA stock transferred 
by FA to PRS in exchange for the PRS properties constitute 
disqualified stock described in paragraph (c)(1) of this section by 
reason of paragraph (c)(1)(i) of this section. Paragraph (c)(2) of 
this section does not apply to reduce the amount of disqualified 
stock described in paragraph (c)(1)(i) of this section because the 
transfer of FA stock in exchange for the PRS properties increases 
the fair market value of FA's assets by the fair market value of the 
PRS properties. Accordingly, pursuant to paragraph (b) of this 
section, the 25 shares of FA stock transferred to PRS in exchange 
for the PRS properties are not included in the denominator of the 
ownership fraction. Furthermore, even in the absence of paragraph 
(i)(2)(iv) of this section, the transfer of the PRS properties to FA 
would be disregarded pursuant to section 7874(c)(4). Therefore, the 
only FA stock included in the ownership fraction is the FA stock 
transferred to the former domestic entity shareholders of DT in 
exchange for their DT stock, and that FA stock is included in both 
the numerator and the denominator of the ownership fraction. Thus, 
the ownership fraction is 75/75.
    Example 4.  Stock transferred in exchange for stock of a foreign 
corporation that becomes a member of the expanded affiliated group--
(i) Facts. FT, a publicly traded corporation, forms FA, and then FA 
forms DMS and FMS. FMS merges with and into FT, with FT surviving 
the merger (FMS-FT merger). Pursuant to the FMS-FT merger, the FT 
shareholders exchange their FT stock solely for 100 shares of FA 
stock and FT becomes a wholly owned subsidiary of FA. Following the 
FMS-FT merger, DMS merges with and into DT, also a publicly traded 
corporation, with DT surviving the merger (DT acquisition). Pursuant 
to the DT acquisition, the DT shareholders exchange their DT stock 
solely for the remaining 100 shares of FA stock, and DT becomes a 
wholly owned subsidiary of FA. After the completion of the plan, FA 
wholly owns FT and DT, DMS and FMS cease to exist, and the stock of 
FA is publicly traded.
    (ii) Analysis. Because FT becomes a member of the expanded 
affiliated group that includes FA in a transaction related to the DT 
acquisition, the FT stock does not constitute marketable securities 
(within the meaning of paragraph (i)(1) of this section) and 
therefore does not constitute nonqualified property pursuant to 
paragraph (i)(2)(ii) of this section. Accordingly, no FA stock is 
disqualified stock described in paragraph (c)(1) of this section and 
therefore the FA stock transferred in exchange for the FT stock and 
DT stock is included in the denominator of the ownership fraction. 
Thus, the ownership fraction is 100/200.
    (iii) Alternative facts. The facts are the same as in paragraph 
(i) of this Example 4, except that, instead of undertaking the FMS-
FT merger, FT merges with and into FA with FA surviving the merger 
(FT-FA merger). Pursuant to the FT-FA merger, the FT shareholders 
exchange their FT stock solely for 100 shares of FA stock. At the 
time of the FT-FA merger, FT does not hold nonqualified property and 
has no obligations. Accordingly, FA stock transferred by FA to FT in 
exchange for the property of FT is not disqualified stock described 
in paragraph (c)(1) of this section. Furthermore, pursuant to 
paragraph (c)(2) of this section, the 100 shares of FA stock 
transferred by FT to the shareholders of FT in exchange for their FT 
stock do not constitute disqualified stock described in paragraph 
(c)(1) of this section. Although the FT stock is nonqualified 
property (the FT stock constitutes marketable securities within the 
meaning of paragraph (i)(2)(ii) of this section because the stock of 
FT is publicly traded and FT is not a member of the expanded 
affiliated group that includes FA after the DT acquisition), under 
paragraph (c)(2) of this section, the transfer of FA stock by FT to 
the shareholders of FT neither increases the fair market value of 
the assets of FA nor decreases the liabilities of FA. Accordingly, 
no FA stock is disqualified stock described in paragraph (c)(1) of 
this section and, therefore, the FA stock transferred in exchange 
for the assets of FT and the DT stock is included in the denominator 
of the ownership fraction. Thus, the ownership fraction is 100/200.
    Example 5.  De minimis exception--(i) Facts. Individual A wholly 
owns DT. The fair market value of the DT stock is $100x. PRS 
transfers $96x of cash to FA, a newly formed corporation, in 
exchange solely for 96 shares of FA stock. Then Individual A 
transfers the DT stock to FA in exchange for $96x of cash and 4 
shares of FA stock (DT acquisition).
    (ii) Analysis. Under paragraph (i)(2)(i) of this section, cash 
constitutes nonqualified property. Accordingly, the 96 shares of FA 
stock transferred by FA to PRS in exchange for $96x of cash 
constitute disqualified stock described in paragraph (c)(1) of this 
section by reason of paragraph (c)(1)(i) of this section. 
Furthermore, paragraph (c)(2) of this section does not reduce the 
amount of disqualified stock described in paragraph (c)(1)(i) of 
this section because the transfer of FA stock in exchange for $96x 
of cash increases the fair market value of the assets of FA by $96x. 
However, without regard to the application of paragraph (b) of this 
section and Sec. Sec.  1.7874-7T(b) and 1.7874-10T(b), the ownership 
percentage described in section 7874(a)(2)(B)(ii) would be less than 
5 (by vote and value), or 4 (4/100, or 4 shares of FA stock held by 
Individual A by reason of owning the DT stock, determined under 
Sec.  1.7874-2(f)(2), over 100 shares of FA stock outstanding after 
the DT acquisition). Furthermore, after the DT acquisition and all 
related transactions, Individual A owns less than 5% (by vote and 
value, applying the attribution rules of section 318(a) with the 
modifications described in section 304(c)(3)(B)) of the stock of FA 
and DT (the members of the expanded affiliated group that includes 
FA). Accordingly, the de minimis exception in paragraph (d)(1) of 
this section applies and therefore paragraph (b) of this section 
does not apply to exclude the FA stock transferred to PRS from the

[[Page 5398]]

denominator of the ownership fraction. Therefore, the FA stock 
transferred to Individual A and PRS is included in the denominator 
of the ownership fraction. Thus, the ownership fraction is 4/100.
    Example 6.  Obligation of the expanded affiliated group 
satisfied with stock--(i) Facts. Individual A wholly owns DT. The 
stock of DT held by Individual A has a fair market value of $75x. 
Individual A also holds an obligation of DT with a value and face 
amount of $25x. DT holds property with a value of $100x, and the 
$25x obligation is associated with the property. FA, a newly formed 
corporation, transfers 100 shares of FA stock to Individual A in 
exchange for all the DT stock and the $25x obligation of DT.
    (ii) Analysis. Under paragraph (i)(2)(iii)(A) of this section, 
the $25x obligation of DT constitutes nonqualified property because 
DT is a member of the expanded affiliated group that includes FA, 
and Individual A (the holder of the obligation immediately before 
the domestic entity acquisition and any related transaction) is not 
a member of the EAG after the domestic entity acquisition and all 
related transactions. Thus, the shares of FA stock transferred by FA 
to Individual A in exchange for the obligation of DT constitute 
disqualified stock described in paragraph (c)(1) of this section by 
reason of paragraph (c)(1)(i) of this section. Under Sec.  1.7874-
2(f)(2), Individual A is treated as receiving 75 shares of FA stock 
in exchange for the DT stock (100 x $75x/$100x) and 25 shares of FA 
stock in exchange for the obligation of DT (100 x $25x/$100x). Thus, 
25 shares of FA stock constitute disqualified stock described in 
paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of 
this section. Paragraph (c)(2) of this section does not reduce the 
amount of disqualified stock described in paragraph (c)(1)(i) of 
this section because the transfer of FA stock for the $25x 
obligation increases the fair market value of FA's assets by $25x. 
Therefore, under paragraph (b) of this section, the 25 shares of FA 
stock transferred to Individual A in exchange for the obligation of 
DT are not included in the denominator of the ownership fraction. 
Accordingly, the only FA stock included in the ownership fraction is 
the 75 shares of FA stock transferred to Individual A in exchange 
for the DT stock, and that FA stock is included in both the 
numerator and the denominator of the ownership fraction. Thus, the 
ownership fraction is 75/75.
    (iii) Alternative facts. The facts are the same as in paragraph 
(i) of this Example 6, except that instead of acquiring the stock of 
DT and the $25x obligation of DT, FA acquires the $100x of property 
from DT in exchange solely for 100 shares of FA stock. DT 
distributes 75 shares of FA stock to Individual A in exchange for 
Individual A's DT stock and transfers 25 shares of FA stock to 
Individual A in satisfaction of DT's obligation to Individual A, and 
liquidates. The 25 shares of FA stock transferred by FA to DT in 
exchange for the property of DT and then transferred by DT in 
satisfaction of DT's obligation to Individual A constitute 
disqualified stock described in paragraph (c)(1) of this section by 
reason of paragraph (c)(1)(ii) of this section. Paragraph (c)(2) of 
this section does not reduce the amount of disqualified stock 
described in paragraph (c)(1)(ii) of this section because the 
transfer of FA stock in exchange for the property of DT increases 
the fair market value of FA's assets by $100x (although the amount 
of disqualified stock is limited to 25 shares of FA stock in this 
case). Therefore, under paragraph (b) of this section, the 25 shares 
of FA stock that constitute disqualified stock are not included in 
the denominator of the ownership fraction. Accordingly, only 75 
shares of FA stock are included in the ownership fraction, and that 
FA stock is included in both the numerator and the denominator of 
the ownership fraction. Thus, the ownership fraction is 75/75.
    Example 7.  ``Over-the-top'' stock transfer--(i) Facts. 
Individual A wholly owns DT. Individual B holds all 100 outstanding 
shares of FA stock. Individual C acquires 20 shares of FA stock from 
Individual B for cash, and then FA acquires all of the stock of DT 
from Individual A in exchange solely for 100 shares of FA stock.
    (ii) Analysis. Under paragraph (i)(2)(i) of this section, cash 
constitutes nonqualified property. Accordingly, absent the 
application of paragraph (c)(2) of this section, the 20 shares of FA 
stock transferred by Individual B to Individual C in exchange for 
cash would constitute disqualified stock described in paragraph 
(c)(1) of this section by reason of paragraph (c)(1)(i) of this 
section. Nevertheless, because Individual B's sale of FA stock 
neither increases the assets of FA nor decreases the liabilities of 
FA, such FA stock is not disqualified stock by reason of paragraph 
(c)(2) of this section. Accordingly, paragraph (b) of this section 
does not apply to exclude the 20 shares of FA stock sold by 
Individual B to Individual C, and that FA stock is included in the 
denominator of the ownership fraction. The 100 shares of FA stock 
received by Individual A are the only shares included in the 
numerator of the ownership fraction. Thus, the ownership fraction is 
100/200.
    Example 8. Interaction with internal group restructuring rule--
(i) Facts. P holds 85 shares of DT stock. The remaining 15 shares of 
DT stock are held by Individual A. P and Individual A transfer their 
shares of DT stock to FA, a newly formed corporation, in exchange 
for 85 and 15 shares of FA stock, respectively (DT acquisition), and 
PRS transfers $75x of cash to FA in exchange for the remaining 75 
shares of FA stock.
    (ii) Analysis. Under paragraph (i)(2)(i) of this section, cash 
constitutes nonqualified property. Accordingly, the 75 shares of FA 
stock transferred by FA to PRS in exchange for $75x of cash 
constitute disqualified stock described in paragraph (c)(1) of this 
section by reason of paragraph (c)(1)(i) of this section. 
Furthermore, paragraph (c)(2) of this section does not reduce the 
amount of disqualified stock described in paragraph (c)(1)(i) of 
this section because the transfer of FA stock in exchange for $75x 
of cash increases the fair market value of the assets of FA by $75x. 
Therefore, under paragraph (b) of this section, the 75 shares of FA 
stock transferred to PRS are not included in the denominator of the 
ownership fraction. Although PRS's shares of FA stock are excluded 
from the denominator of the ownership fraction under paragraph (b) 
of this section, under paragraph (h) of this section, such shares of 
FA stock nonetheless are taken into account for purposes of 
determining whether P is a member of the expanded affiliated group 
that includes FA and for purposes of determining whether the DT 
acquisition qualifies as an internal group restructuring. Because P 
holds 48.6% of the FA stock (85/175) after the DT acquisition and 
all transactions related to the DT acquisition, it is not a member 
of the expanded affiliated group that includes FA. In addition, the 
DT acquisition does not qualify as an internal group restructuring 
described in Sec.  1.7874-1(c)(2) because P does not hold, directly 
or indirectly, 80% or more of the shares of FA stock (by vote and 
value) after the DT acquisition and all transactions related to the 
DT acquisition. Therefore, the FA stock held by P (along with the FA 
stock held by Individual A) is included in the numerator and the 
denominator of the ownership fraction. Thus, the ownership fraction 
is 100/100.
    Example 9.  Interaction with loss of control rule--(i) Facts. P 
wholly owns DT. P transfers all of its shares of DT stock to FA, a 
newly formed corporation, in exchange for 49 shares of FA stock (DT 
acquisition), and R transfers marketable securities (within the 
meaning of paragraph (i)(1) of this section) to FA in exchange for 
the remaining 51 shares of FA stock.
    (ii) Analysis. Under paragraph (i)(2)(ii) of this section, the 
marketable securities constitute nonqualified property. Accordingly, 
the shares of FA stock transferred by FA to R in exchange for the 
marketable securities constitute disqualified stock described in 
paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of 
this section. Paragraph (c)(2) of this section does not reduce the 
amount of disqualified stock described in paragraph (c)(1)(i) of 
this section because the transfer of FA stock in exchange for the 
marketable securities increases the fair market value of the assets 
of FA by the fair market value of the marketable securities 
transferred. Therefore, under paragraph (b) of this section, the 
shares of FA stock transferred to R are not included in the 
denominator of the ownership fraction. Although under paragraph (b) 
of this section R's shares of FA stock are excluded from the 
denominator of the ownership fraction, under paragraph (h) of this 
section, such stock is taken into account for purposes of 
determining whether P or R is a member of the expanded affiliated 
group that includes FA. Because P holds 49% of the shares of FA 
stock (49/100), P is not a member of the expanded affiliated group 
that includes FA, and P's FA stock is included in both the numerator 
and the denominator of the ownership fraction. Because R holds 51% 
of the shares of FA stock (51/100), R is a member of the expanded 
affiliated group that includes FA and, before taking into account 
Sec.  1.7874-1(c), R's FA stock would be excluded from the numerator 
and denominator of the ownership fraction under section 
7874(c)(2)(A) and Sec.  1.7874-1(b). However, the DT acquisition 
results in a loss of control described in Sec.  1.7874-1(c)(3)

[[Page 5399]]

because P does not hold, in the aggregate, directly or indirectly, 
more than 50% of the shares of stock (by vote or value) of R, FA, or 
DT after the acquisition. Accordingly, the FA stock held by R would 
be included in the denominator of the ownership fraction under Sec.  
1.7874-1(c)(1). Nevertheless, the FA stock held by R is excluded 
from the denominator of the ownership fraction under paragraphs (b) 
and (h) of this section. Thus, the ownership fraction is 49/49.
    (iii) Alternative facts. The facts are the same as in paragraph 
(i) of this Example 9, except that, in exchange for 51 shares of FA 
stock, R transfers marketable securities (within the meaning of 
paragraph (i)(1) of this section) with a value equal to that of 16 
shares of FA stock and qualified property (within the meaning of 
paragraph (i)(2) of this section) with a value equal to that of 35 
shares of FA stock. Accordingly, 16 of the 51 shares of FA stock 
transferred to R constitute disqualified stock described in 
paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of 
this section, and 35 of such shares do not constitute disqualified 
stock. Paragraph (c)(2) of this section does not reduce the amount 
of disqualified stock described in paragraph (c)(1)(i) of this 
section because the transfer of FA stock in exchange for the 
marketable securities increases the fair market value of the assets 
of FA by the fair market value of the marketable securities 
transferred. Therefore, under paragraph (b) of this section, 16 of 
the 51 shares of FA stock transferred to R are not included in the 
denominator of the ownership fraction. Although 16 of the 51 shares 
of FA stock that are transferred to R are excluded from the 
denominator of the ownership fraction, under paragraph (h) of this 
section, all 51 of R's shares of FA stock are taken into account for 
purposes of determining whether P or R is a member of the expanded 
affiliated group that includes FA. Because P holds 49% of the shares 
of FA stock (49/100), it is not a member of the expanded affiliated 
group that includes FA, and its FA stock is included in both the 
numerator and the denominator of the ownership fraction. Because R 
holds 51% of the shares of FA stock (51/100), it is a member of the 
expanded affiliated group that includes FA and, before taking into 
account Sec.  1.7874-1(c), its FA stock is excluded from the 
numerator and denominator of the ownership fraction under section 
7874(c)(2)(A) and Sec.  1.7874-1(b). However, the DT acquisition 
results in a loss of control described in Sec.  1.7874-1(c)(3) 
because P does not hold, in the aggregate, directly or indirectly, 
more than 50% of the shares of stock (by vote or value) of R, FA, or 
DT after the acquisition. Accordingly, the 51 shares of FA stock 
held by R would be included in the denominator of the ownership 
fraction under Sec.  1.7874-1(c)(1). Nevertheless, the 16 shares of 
FA stock that constitute disqualified stock are excluded from the 
denominator of the ownership fraction under paragraphs (b) and (h) 
of this section. In addition, the 35 shares of FA stock received by 
R that do not constitute disqualified stock are included in the 
denominator. Thus, the ownership fraction is 49/84.
    Example 10.  Stock issued in lieu of assuming associated 
obligation--(i) Facts. Individual A wholly owns DT. The stock of DT 
has a fair market value of $100x. Individual B wholly owns FT, a 
foreign corporation, which conducts two businesses, Business C and 
Business D. Business C comprises property with a gross fair market 
value of $70x and $20x of associated obligations. Business D 
comprises property with a gross fair market value of $45x and $35x 
of associated obligations. Individual A transfers all of the shares 
of DT stock to FA, a newly formed corporation, in exchange for $100x 
of FA stock (DT acquisition). In transactions related to the DT 
acquisition, FA acquires all of the Business C property from FT in 
exchange for $70x of FA stock and then FT transfers $30x of the FA 
stock to its creditors in satisfaction of $30x of its obligations. 
None of the Business C property is nonqualified property.
    (ii) Analysis. Under paragraph (c)(1) of this section by reason 
of paragraph (c)(1)(ii) of this section, the $30x of FA stock 
transferred to FT (the transferee) in exchange for the Business C 
property (the exchanged property) and then transferred by FT in 
satisfaction of $30x of its obligations is disqualified stock, 
except to the extent limited by paragraph (c)(1)(ii)(B) of this 
section. Under paragraph (c)(1)(ii)(B)(1) of this section, the 
proportionate share of obligations associated with the exchanged 
property that is not assumed by FA must be determined. The 
proportionate share of obligations associated with the exchanged 
property is $20x, calculated as $20x (the obligations associated 
with the Business C properties) multiplied by $70x/$70x (the fair 
market value of the exchanged property, $70x, relative to the fair 
market value of all the Business C property, $70x). The 
proportionate share of obligations associated with the exchanged 
property that is not assumed by FA is $20x, calculated as the 
proportionate share of obligations associated with the exchanged 
property ($20x) less the obligations assumed by FA ($0x). Under 
paragraph (c)(1)(ii)(B)(2) of this section, the amount of 
disqualified stock is limited to the proportionate share of 
obligations associated with the exchanged property that is not 
assumed ($20x) multiplied by a fraction, which in this case is $70x/
$70x (the amount of exchanged property that is qualified property, 
$70x, divided by the total amount of exchanged property, $70x). 
Accordingly, $20x of FA stock is disqualified stock under paragraph 
(c)(1) of this section by reason of paragraph (c)(1)(ii) of this 
section. Paragraph (c)(2) of this section does not reduce the amount 
of disqualified stock described in paragraph (c)(1)(ii) of this 
section because the transfer of the FA stock in exchange for the 
exchanged property increases the fair market value of FA's assets by 
$70x (although the amount of disqualified stock is limited to $20x 
of FA stock in this case). Therefore, under paragraph (b) of this 
section, the $20x of FA stock that constitutes disqualified stock is 
not included in the denominator of the ownership fraction. 
Accordingly, only $150x of FA stock is included in the denominator 
of the ownership fraction, calculated as the $100x of FA stock 
received by Individual A plus the $70x of FA stock received by FT 
less the $20x of FA stock that is disqualified stock. Thus, the 
ownership fraction is $100x/$150x. The result would be the same if, 
in transactions related to the DT acquisition, FT instead sold the 
$30x of FA stock for $30x cash and then transferred the cash in 
satisfaction of $30x of its obligations.
    (iii) Alternative facts. The facts are the same as in paragraph 
(i) of this Example 10, except that FA acquires only $42x of the 
Business C property in exchange for $30x of FA stock and the 
assumption of $12x of the obligations associated with the Business C 
property. Under paragraph (c)(1) of this section by reason of 
paragraph (c)(1)(ii) of this section, the $30x of FA stock 
transferred to FT (the transferee) in exchange for the Business C 
property (the exchanged property) and then transferred by FT in 
satisfaction of $30x of its obligations is disqualified stock, 
except to the extent limited by paragraph (c)(1)(ii)(B) of this 
section. Under paragraph (c)(1)(ii)(B)(1) of this section, the 
proportionate share of obligations associated with the exchanged 
property that is not assumed by FA must be determined. The 
proportionate share of obligations associated with the exchanged 
property is $12x, calculated as $20x (the obligations associated 
with the Business C property) multiplied by $42x/$70x (the fair 
market value of the exchanged property, $42x, relative to the fair 
market value of all the Business C property, $70x). The 
proportionate share of obligations associated with the exchanged 
property that is not assumed by FA is $0, calculated as the 
proportionate share of obligations associated with the exchanged 
property ($12x) less the obligations assumed by FA ($12x). 
Accordingly, as a result of the application of paragraph 
(c)(1)(ii)(B)(2) of this section, no FA stock is disqualified stock 
under paragraph (c)(1) of this section by reason of paragraph 
(c)(1)(ii) of this section. As a result, $130x of FA stock is 
included in the denominator of the ownership fraction, calculated as 
the $100x of FA stock received by Individual A plus the $30x of FA 
stock received by FT. Thus, the ownership fraction is $100x/$130x.

    (k) Applicability dates--(1) General rule. Except to the extent 
otherwise provided in paragraph (k) of this section, this section 
applies to domestic entity acquisitions completed on or after September 
17, 2009. Paragraphs (i)(1) and (i)(2)(iv) of this section apply to 
domestic entity acquisitions completed on or after November 19, 2015. 
Paragraph (d)(1)(i) of this section applies to domestic entity 
acquisitions completed on or after April 4, 2016. Paragraphs 
(c)(1)(ii), (d)(1)(ii), (i)(2)(iii), and (i)(3) of this section apply 
to domestic entity acquisitions completed on or after January 13, 2017. 
For domestic entity acquisitions completed before November 19, 2015, 
see Sec.  1.7874-4T(i)(6) and (i)(7)(iv) (the predecessors of 
paragraphs (i)(1) and (i)(2)(iv) of this section) as contained in 26 
CFR part 1 revised as of April 1, 2016. For domestic entity 
acquisitions completed on or after September 22, 2014, and before April 
4,

[[Page 5400]]

2016, see Sec.  1.7874-4T(d)(1)(i) as contained in 26 CFR part 1 
revised as of April 1, 2016. For domestic entity acquisitions completed 
before January 13, 2017, see Sec.  1.7874-4T(c)(1)(ii), (d)(1)(ii), 
(i)(7)(iii) (the predecessor of paragraph (i)(2)(iii) of this section), 
and (i)(8) (the predecessor of paragraph (i)(3) of this section) as 
contained in 26 CFR part 1 revised as of April 1, 2016.
    (2) Transitional rules for domestic entity acquisitions completed 
on or after September 17, 2009, but before January 16, 2014. For 
domestic entity acquisitions completed on or after September 17, 2009, 
but before January 16, 2014, except as provided in paragraph (k)(3) of 
this section, this section shall be applied with the following 
modifications:
    (i) Nonqualified property does not include property described in 
paragraph (i)(2)(iii) of this section.
    (ii) A transfer is limited to an issuance of stock of the foreign 
acquiring corporation.
    (iii) The determination of whether stock of the foreign acquiring 
corporation is described in paragraph (c)(1) of this section is made 
without regard to paragraphs (c)(1)(ii), (c)(2), and (e) of this 
section.
    (iv) Paragraphs (d) and (h) of this section do not apply.
    (3) Election for domestic entity acquisitions completed on or after 
September 17, 2009, and before January 13, 2017. If, pursuant to 
paragraph (k)(1) or (2) of this section, a paragraph of this section 
would not otherwise apply to a domestic entity acquisition completed on 
or after September 17, 2009, and before January 13, 2017 (transition 
period), a taxpayer may elect to apply the paragraph if the taxpayer 
applies the paragraph consistently to all acquisitions completed during 
the transition period. The election is made by applying the paragraph 
to all such acquisitions on a timely filed original return (including 
extensions) or an amended return filed no later than six months after 
January 13, 2017. A separate statement or form evidencing the election 
need not be filed.


1.7874-4T   [Removed]

0
Par. 3. Section 1.7874-4T is removed.

0
Par. 4. Section 1.7874-5 is added to read as follows:


Sec.  1.7874-5   Effect of certain transfers of stock related to the 
acquisition.

    (a) General rule. Stock of a foreign acquiring corporation that is 
described in section 7874(a)(2)(B)(ii) shall not cease to be so 
described as a result of any subsequent transfer of the stock by the 
former domestic entity shareholder or former domestic entity partner 
that received such stock, even if the subsequent transfer is related to 
the domestic entity acquisition.
    (b) Example. The rule of this section is illustrated by the 
following example:

    Example.  (i) Facts. Individual A wholly owns DT, a domestic 
corporation. FA, a newly formed foreign corporation, acquires all of 
the stock of DT from Individual A in exchange solely for 100 shares 
of FA stock. Pursuant to a binding commitment that was entered into 
in connection with FA's acquisition of the DT stock, Individual A 
sells 25 shares of FA stock to B, an unrelated person, in exchange 
for cash. For federal income tax purposes, the form of the steps of 
the transaction is respected.
    (ii) Analysis. Under Sec.  1.7874-2(f)(1), the 100 shares of FA 
stock received by Individual A are stock of a foreign corporation 
(FA) that is held by reason of holding stock in a domestic 
corporation (DT). Accordingly, such stock is described in section 
7874(a)(2)(B)(ii). Under paragraph (a) of this section, all 100 
shares of FA stock retain their status as being described in section 
7874(a)(2)(B)(ii), even though Individual A sells 25 of the 100 
shares in connection with the acquisition described in section 
7874(a)(2)(B)(i) pursuant to the binding commitment. Therefore, all 
100 of the shares of FA stock are included in both the numerator and 
denominator of the ownership fraction.

    (c) Certain transfers involving expanded affiliated group members. 
For rules addressing whether certain stock is treated as held by 
members of the expanded affiliated group for purposes of applying 
section 7874(c)(2)(A) and Sec.  1.7874-1, see Sec.  1.7874-6T.
    (d) Definitions. The definitions provided in Sec.  1.7874-12T apply 
for purposes of this section.
    (e) Applicability dates. This section applies to domestic entity 
acquisitions that are completed on or after January 16, 2014.


Sec.  1.7874-5T   [Removed]

0
Par. 5. Section 1.7874-5T is removed.

0
Par. 6. Section 1.7874-7T is amended by revising paragraph (c)(2) and 
paragraph (h) to read as follows:


Sec.  1.7874-7T   Disregard of certain stock attributable to passive 
assets (temporary).

* * * * *
    (c) * * *
    (2) After the domestic entity acquisition and all related 
transactions, each former domestic entity shareholder or former 
domestic entity partner, as applicable, owns (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) each member of the expanded 
affiliated group.
* * * * *
    (h) Applicability dates. Except as otherwise provided in this 
paragraph (h), this section applies to domestic entity acquisitions 
completed on or after September 22, 2014. Paragraph (c)(2) of this 
section applies to domestic entity acquisitions completed on or after 
January 13, 2017, and paragraphs (c)(1), (d), and (f)(2) and (4) of 
this section apply to domestic entity acquisitions completed on or 
after April 4, 2016. Paragraphs (f)(1)(i)(A)(2) and (f)(1)(i)(D) of 
this section, as well as the portion of paragraph (f)(1)(i)(C) of this 
section relating to property that gives rise to income described in 
section 1297(b)(2)(B), apply to domestic entity acquisitions completed 
on or after November 19, 2015. However, for domestic entity 
acquisitions completed on or after September 22, 2014, and before April 
4, 2016, taxpayers may elect to apply paragraphs (c)(1), (d), and 
(f)(2) and (4) of this section. For domestic entity acquisitions 
completed on or after September 22, 2014, and before January 13, 2017, 
taxpayers may elect to apply paragraph (c)(2) of this section or Sec.  
1.7874-7T(c)(2) as contained in the Internal Revenue Bulletin (IRB) 
2016-20 (see https://www.irs.gov/irb/2016-20_IRB/ar05.html). In 
addition, for domestic entity acquisitions completed on or after 
September 22, 2014, and before April 4, 2016, taxpayers may elect to 
apply paragraph (f)(2) of this section by substituting the term 
``expanded affiliated group'' for the term ``modified expanded 
affiliated group.'' Furthermore, for domestic entity acquisitions 
completed on or after September 22, 2014, and before November 19, 2015, 
taxpayers may elect to apply paragraphs (f)(1)(i)(A)(2) and 
(f)(1)(i)(D) of this section, as well as the portion of paragraph 
(f)(1)(i)(C) of this section relating to property that gives rise to 
income described in section 1297(b)(2)(B).
* * * * *

0
Par. 7. Section 1.7874-10T is amended by revising paragraph (d)(2) and 
paragraph (i) to read as follows:


Sec.  1.7874-10T  Disregard of certain distributions (temporary).

* * * * *
    (d) * * *
    (2) After the domestic entity acquisition and all related 
transactions, each former domestic entity shareholder or former 
domestic entity partner, as applicable, owns (applying the attribution 
rules of section 318(a) with

[[Page 5401]]

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) each member of the expanded affiliated group.
* * * * *
    (i) Applicability date. Except as otherwise provided in this 
paragraph (i), this section applies to domestic entity acquisitions 
completed on or after September 22, 2014. Paragraph (d)(2) of this 
section applies to domestic entity acquisitions completed on or after 
January 13, 2017, and paragraph (d)(1) of this section applies to 
domestic entity acquisitions completed on or after November 19, 2015. 
Paragraph (g) of this section applies to domestic entity acquisitions 
completed on or after April 4, 2016. However, for domestic entity 
acquisitions completed on or after September 22, 2014, and before 
November 19, 2015, taxpayers may elect to apply paragraph (d)(1) of 
this section. For domestic entity acquisitions completed on or after 
September 22, 2014, and before January 13, 2017, taxpayers may elect to 
apply paragraph (d)(2) of this section or Sec.  1.7874-10T(d)(2) as 
contained in the Internal Revenue Bulletin (IRB) 2016-20 (see https://www.irs.gov/irb/2016-20_IRB/ar05.html). In addition, for domestic 
entity acquisitions completed on or after September 22, 2014, and 
before April 4, 2016, taxpayers may elect to determine NOCDs 
consistently on the basis of taxable years, in lieu of 12-month 
periods, in a manner consistent with the principles of this section. 
See paragraph (h)(5) of this section.
* * * * *

0
Par. 8. Section 1.7874-12T is amended by revising the introductory text 
of paragraph (a) to read as follows:


Sec.  1.7874-12T   Definitions (temporary).

    (a) Definitions. Except as otherwise provided, the following 
definitions apply for purposes of this section and Sec. Sec.  1.367(b)-
4T, 1.956-2T, 1.7701(l)-4T, 1.7874-2, 1.7874-2T, 1.7874-4, 1.7874-5, 
and 1.7874-6T through 1.7874-11T.
* * * * *


Sec. Sec.  1.7874-1, 1.7874-6T, 1.7874-7T, 1.7874-9T, and 1.7874-10T   
[Amended]

0
Par. 9. For each provision listed in the table below, removing the 
language in the ``Remove'' column and adding in its place the language 
in the ``Add'' column:

------------------------------------------------------------------------
            Provision                   Remove                Add
------------------------------------------------------------------------
Sec.   1.7874-1(c)(1), second     Sec.   1.7874-4T..  Sec.   1.7874-4
 sentence.
Sec.   1.7874-1(c)(1), second     Sec.   1.7874-      Sec.   1.7874-4(h)
 sentence.                         4T(h).
Sec.   1.7874-6T(g), Example      Sec.   1.7874-      Sec.   1.7874-
 4(iii), first sentence.           4T(i)(7).           4(i)(2)
Sec.   1.7874-7T(b)(1), first     Sec.   1.7874-      Sec.   1.7874-4(b)
 sentence.                         4T(b).
Sec.   1.7874-7T(c)(1)..........  Sec.   1.7874-      Sec.   1.7874-4(b)
                                   4T(b).
Sec.   1.7874-7T(f)(1)(i).......  Sec.   1.7874-      Sec.   1.7874-
                                   4T(i)(7).           4(i)(2)
Sec.   1.7874-7T(f)(2),           Sec.   1.7874-      Sec.   1.7874-4(b)
 introductory text.                4T(b).
Sec.   1.7874-7T(f)(3)(i).......  Sec.   1.7874-      Sec.   1.7874-4(b)
                                   4T(b).
Sec.   1.7874-7T(f)(3)(ii)......  Sec.   1.7874-      Sec.   1.7874-4(b)
                                   4T(b).
Sec.   1.7874-7T(g), Example      Sec.   1.7874-      Sec.   1.7874-
 1(i), penultimate sentence.       4T(i)(7).           4(i)(2)
Sec.   1.7874-7T(g), Example      Sec.   1.7874-      Sec.   1.7874-4(c)
 1(ii), first sentence.            4T(c).
Sec.   1.7874-7T(g), Example      Sec.   1.7874-      Sec.   1.7874-4(b)
 1(ii), first sentence.            4T(b).
Sec.   1.7874-7T(g), Example      Sec.   1.7874-      Sec.   1.7874-
 2(i), last sentence.              4T(i)(7).           4(i)(2)
Sec.   1.7874-7T(g), Example      Sec.  Sec.          Sec.  Sec.
 2(ii), first sentence.            1.7874-4T(b) and.   1.7874-4(b) and
Sec.   1.7874-7T(g), Example      Sec.   1.7874-      Sec.   1.7874-
 3(i), penultimate sentence.       4T(i)(7).           4(i)(2)
Sec.   1.7874-9T(e)(3),           Sec.   1.7874-4T..  Sec.   1.7874-4
 introductory text.
Sec.   1.7874-10T(d)(1),          Sec.  Sec.          Sec.  Sec.
 introductory text.                1.7874-4T(b) and.   1.7874-4(b) and
Sec.   1.7874-10T(f)(3)(iii)(B).  Sec.  Sec.          Sec.  Sec.
                                   1.7874-4T and.      1.7874-4 and
------------------------------------------------------------------------


John Dalrymple,
Deputy Commissioner for Services and Enforcement.
    Approved: December 6, 2016.
Mark J. Mazur
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2017-00643 Filed 1-13-17; 4:15 pm]
 BILLING CODE 4830-01-P