Temporary regulations issued regarding treatment of certain stock of a foreign corporation under Section 7874

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1 23 January 2014 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date Temporary regulations issued regarding treatment of certain stock of a foreign corporation under Section 7874 Executive summary On 17 January 2014, the IRS and the Treasury Department (the Treasury) issued temporary and proposed regulations under Section 7874 (the Temporary Regulations) 1 that provide guidance for determining stock ownership of a foreign acquiring corporation 2 for purposes of the ownership test of Section 7874(a)(2)(B)(ii) (the Ownership Test, as defined below). The Temporary Regulations set forth the rules announced in Notice (the Notice) with certain modifications. Under the Ownership Test, Section 7874 may only apply if the acquired US corporation s shareholders hold a sufficiently large percentage of the foreign acquiring corporation s stock (60% or 80% as described below). Section 7874(c)(2)(B) contains a rule (the statutory public offering rule) that expressly excludes shares issued in a public offering from being considered in computing this ownership percentage. The statutory public offering rule is principally designed to preclude taxpayers from avoiding Section 7874 by engaging in (for example) a unilateral expatriation of a US corporation to a foreign jurisdiction, coupled with a public offering of the stock of the resulting foreign corporation. If the shareholders receiving stock in the public offering were counted for purposes of the Ownership Test, they could dilute the percentage ownership of the legacy US shareholders and thus circumvent Section The Notice essentially extended the statutory public offering rule to private placements. Commentators expressed concern that the Notice was overly broad and could cause Section 7874 to apply to transactions that were, in substance, third-party sale transactions rather than typical inversion structures.

2 Consistent with the Notice, the Temporary Regulations expand the scope of the statutory public offering rule to disregard certain stock of a foreign acquiring corporation received in private placements. The Temporary Regulations also set forth an exclusion rule that limits the statutory public offering rule s application to disqualified stock (as defined below) of the foreign acquiring corporation. Disqualified stock is excluded from the denominator of the ownership fraction (as defined below), which is used to compute the ownership percentage when assessing whether the Ownership Test has been satisfied. The Temporary Regulations also introduce a new de minimis exception to the exclusion rule. This de minimis exception is designed to address commentators concerns about the rules applying to thirdparty sale transactions. Finally, the Temporary Regulations make a number of technical modifications to the Notice, such as expanding the definition of nonqualified property to include certain obligations and debt satisfaction and assumption, clarifying the interaction between the exclusion rule and the expanded affiliated group (the EAG) rules of Section 7874(c)(2) (A), and explaining the effect on the ownership fraction of postacquisition 4 transfers of the foreign acquiring corporation s stock by former shareholders (or partners) of the domestic entity. 5 The Temporary Regulations are generally effective on or after 17 September 2009, the date of the Notice. 6 However, certain provisions of the Temporary Regulations modifying the Notice (listed in Treas. Reg. Section T(k)(2)) are effective prospectively as of 17 January 2014, unless the taxpayer elects to apply such provisions to all acquisitions occurring between 17 September 2009 and 16 January The Temporary Regulations expire on 13 January Detailed discussion A. Background 1. Section 7874 s requirements and the statutory public offering rule The application of Section 7874 depends upon whether a foreign acquiring corporation is treated as a surrogate foreign corporation with respect to a domestic corporation or partnership. Under Section 7874, a foreign acquiring corporation will be treated as a surrogate foreign corporation if the following three tests are met: 7 The foreign acquiring corporation acquires substantially all of the properties held directly or indirectly by a domestic corporation (or that constitute the trade or business of a domestic partnership) (the Acquisition Test) After the acquisition, at least 60% of the stock (by vote or value) of the foreign acquiring corporation is held by the former shareholders of the domestic corporation or partners in the domestic partnership by reason of holding an interest in the domestic corporation or partnership (the Ownership Test) The EAG that includes the foreign acquiring corporation does not have substantial business activities in the foreign country where the foreign acquiring corporation is created or organized compared to the total business activities of the EAG (the Substantial Business Activities Test). 8 If each of these tests of surrogate foreign corporation status are satisfied and the former shareholders (or partners) own less than 80% of the foreign acquiring corporation (by vote or value), the domestic corporation or partnership is treated as an expatriated entity and is subject to Section 7874 s unique taxing regime. 9 If, however, the former shareholders (or partners) own 80% or more of the foreign acquiring corporation, the foreign acquiring corporation will be treated as a domestic corporation for all US federal income tax purposes. 10 The Ownership Test, and its threshold ownership percentages, is determined by means of an ownership fraction with a numerator equal to the amount of shares of the foreign acquiring corporation owned by former shareholders of an acquired domestic corporation 2 International Tax Alert

3 (or partners in a partnership) by reason of their interest in the acquired domestic corporation (or partnership) and a denominator equal to the total amount of shares of the foreign acquiring corporation outstanding immediately after the acquisition. 11 However, under certain circumstances, Section 7874 excludes the stock of a foreign acquiring corporation from the ownership fraction s numerator, the denominator, or both. As outlined above, one such exclusionary rule is the statutory public offering rule, which provides that stock of a foreign acquiring corporation that is sold in a public offering related to the acquisition should not be taken into account for purposes of the Ownership Test. Stock subject to the statutory public offering rule is excluded from the denominator of the ownership faction. 12 The effect of the statutory public offering rule is to reduce the denominator of the ownership fraction, thereby increasing the percentage of the foreign acquiring corporation owned by former shareholders of the acquired domestic corporation by reason of their interest in the domestic corporation, and thus increasing the likelihood that a foreign acquiring corporation will be treated as a surrogate foreign corporation by reason of the Ownership Test. The purpose of the statutory public offering rule is to prevent the avoidance of Section 7874 through a transaction (e.g., a public offering) that will not substantially change the manner in which the domestic entity did business before the acquisition. 2. Notice On 17 September 2009, the IRS and the Treasury issued Notice to announce forthcoming regulations that would modify the statutory public offering rule by both expanding and reducing its scope. According to the Notice, the policy concern addressed by the statutory public offering rule is equally implicated in a private placement. As an illustration, the Notice describes the following transaction: The shareholders of a domestic corporation (DC) transfer all of their stock to a newly formed foreign acquiring corporation (New FCo) in exchange for 79% of the stock of New FCo. In a related transaction, an investor transfers cash to New FCo in exchange for the remaining 21% of the New FCo stock. Because the New FCo stock issued to the investor is not sold in a public offering within the literal meaning of Section 7874(c)(2)(B), the parties take the position that the New FCo stock acquired by the investor is included in the denominator of the ownership fraction. 13 Accordingly, at the end of the transaction, the former shareholders of DC hold only 79% (i.e., an ownership fraction of 79/100) of the stock of New FCo, and thus Section 7874(b) does not apply to treat New FCo as a domestic corporation for US federal income tax purposes. 14 In the view of the IRS and Treasury, an acquisition of the shares of the foreign acquiring corporation for cash, whether through a private placement or a public offering, reduced the ownership faction while effecting no material change on the former business of the domestic entity. At the same time, the Notice identified instances in which the statutory public offering rule could be over-inclusive. For example, a third-party combination transaction between a publicly traded foreign corporation (FT) and a publicly traded domestic corporation (DT) may be structured as a stock transfer by the FT and DT shareholders to a new publicly traded foreign corporation (FA). The FA stock received by the shareholders of FT could arguably be treated as sold in a public offering within the meaning of the statutory public offering rule and thus excluded from the denominator of the ownership fraction. Disregarding the FA stock received by FT shareholders, FA would be treated as a domestic corporation under Section 7874(b) regardless of the amount of FA stock actually owned by former shareholders of DT after the acquisition. In this instance, the statutory public offering rule inappropriately sweeps a genuine business combination into the purview of Section To address these concerns, the IRS and Treasury announced their intention to issue regulations that would modify the statutory public offering rule. The forthcoming International Tax Alert 3

4 regulations would provide that stock of a foreign acquiring corporation issued in exchange for nonqualified property is not taken into account for purposes of the Ownership Test, without regard to whether such stock is publicly traded on the date of issuance or otherwise. Subject to certain exceptions, the term nonqualified property under the Notice meant: (1) cash or cash equivalents; (2) marketable securities as defined in Section 453(f)(2); and (3) any other property acquired in a transaction with a principal purpose of avoiding the purposes of Section Thus, under the Notice, whether stock of a foreign acquiring corporation was taken into account for purposes of the Ownership Test depended on the nature of the property provided in exchange for the stock of the foreign acquiring corporation, rather than on whether such stock was received in a public offering or private placement. B. Temporary Regulations 1. Overview The Temporary Regulations adopt the general approach of the Notice and, with certain modifications and clarifications, formulate an exclusion rule that applies to disqualified stock of the foreign acquiring corporation. Under the exclusion rule, only disqualified stock is treated as stock received in a public offering for purposes of Section 7874(c)(2) (B) and therefore is excluded from the denominator of the ownership fraction. 15 Further, the statutory public offering rule will only apply to exclude stock from the denominator of the ownership fraction if it is disqualified stock Disqualified stock Treas. Reg. Section T(c) defines disqualified stock as stock of the foreign acquiring corporation, whether or not publicly traded, that is transferred in exchange for either: (i) non-qualified property; or (ii) property and, pursuant to the same plan (or series of related transactions), the transferee of that stock subsequently transfers it in exchange for the satisfaction or the assumption of one or more obligations associated with the property exchanged (the associated obligation rule). 17 A transfer is, with respect to stock of the foreign acquiring corporation, an issuance, sale, distribution, exchange, or any other disposition of such stock. 18 a. Associated obligation rule The IRS and Treasury added the associated obligation rule because they believed that taxpayers could seek to circumvent the Ownership Test by altering the manner in which liabilities are treated in an expatriation transaction. The Preamble envisions a transaction in which a domestic corporation owns assets of $100x, subject to liabilities of $25x, and wishes to engage in an expatriation transaction. The Preamble assumes that the transaction will be structured as an asset acquisition in which the domestic corporation transfers its assets to a foreign acquiring corporation in exchange for that corporation s stock and then liquidates and distributes the foreign acquiring corporation stock to the domestic corporation s shareholders. The Preamble notes that, if the foreign acquiring corporation acquires the $100x assets subject to the $25x liabilities, it would issue $75x of stock (equal to the net value of the business), with the result that the shareholders of the domestic corporation would own 100% of the foreign acquiring corporation by reason of their interests in the domestic acquired corporation, thus satisfying the Ownership Test. The Preamble expresses concern, however, that the aforesaid transaction could instead be structured so that the foreign acquiring corporation acquired solely the unencumbered assets for $100x of its stock. The domestic corporation would then use $25x of that stock to satisfy the creditors and distribute $75x to its shareholders. Absent a special rule to exclude the stock received by the creditors, the ownership fraction would be 75/100 (or 75%); thus the Ownership Test would not be met and Section 7874(b) would not apply. The IRS and Treasury believe that the economically similar transactions described above should not lead to disparate treatment under the exclusion rule. Thus, the associated obligation rule excludes for purposes of the Ownership Test the stock of the foreign acquiring corporation transferred 4 International Tax Alert

5 to a person (including the domestic entity) in exchange for property if, pursuant to the same plan (or series of related transactions), the stock is subsequently transferred in exchange for the satisfaction or assumption of an obligation associated with that property. An obligation is associated with property exchanged if, for example, the obligation arose from the conduct of a trade or business in which the property exchanged has been used, regardless of whether the obligation is a non-recourse obligation. 19 b. Increase in net value requirement In response to requests for clarification regarding certain over-the-top transfers of stock, the Temporary Regulations provide that, regardless of the nature of property transferred in exchange for stock, 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. 20 Therefore, stock purchased (in a transaction related to the acquisition described in Section 7874(a)(2)(B)(i)) from a shareholder of the foreign acquiring corporation in exchange for cash (or other nonqualified property) will not constitute disqualified stock because the shareholder-to-shareholder sale of the foreign acquiring corporation s stock has no effect upon the assets or liabilities of the foreign acquiring corporation. 21 Example 6 of the Temporary Regulations illustrates the application of this requirement. Individual A wholly owns DT, a domestic corporation. 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. Generally, the 20 shares of FA stock transferred by Individual B to Individual C in exchange for cash would constitute disqualified stock because it was received for nonqualified property. However, the example concludes that the FA stock is not disqualified stock because Individual B s sale of FA stock neither increases the assets of FA nor decreases the liabilities of FA. Accordingly, the exclusion rule does not apply to Individual B s sale of the 20 shares of FA stock to Individual C, and that FA stock is included in the denominator of the ownership fraction. As a result, the ownership fraction is 100/200 (or 50%). c. Nonqualified property Disqualified stock is stock of the foreign acquiring corporation that is transferred to a person other than the domestic entity in exchange for nonqualified property. 22 The definition of nonqualified property under the Temporary Regulations includes the same categories of property included under the Notice cash and cash equivalents, marketable securities and any property acquired with a principal purpose of avoiding the purposes of Section For this purpose, marketable securities do not include stock of a corporation or an interest in a partnership that becomes a member of the EAG that includes the foreign acquiring corporation in a transaction (or series of transactions) related to the acquisition, unless a principal purpose for acquiring such stock or partnership interest is to avoid the purposes of Section The Temporary Regulations, however, expand the definition of nonqualified property with the addition of disqualified obligations (a term used solely in the Preamble). A disqualified obligation is an obligation of: (i) a member of the EAG that includes the foreign acquiring corporation; (ii) a former owner of the domestic entity; or (iii) a person that, before or after the acquisition, either owns an equity interest in any person described in (i) or (ii) or is related (within the meaning of Section 267 or 707(b)) to any such persons. 25 According to the Preamble, stock received in exchange for a disqualified obligation should be treated similarly to stock received in exchange for cash, cash equivalents and marketable securities because, in each instance, the property transferred will dilute the ownership fraction by increasing the net assets of the foreign acquiring corporation. Moreover, the Temporary Regulations provide that the exclusion rule can also apply to stock of the foreign acquiring International Tax Alert 5

6 corporation that is transferred to a person other than the domestic entity in exchange for the satisfaction or assumption of one or more obligations of the transferor. In this case, the stock of the foreign acquiring corporation is treated as transferred for an amount of cash equal to the fair market value of such stock De minimis exception As outlined above, comments received by the IRS and Treasury recommended that certain transactions that are, in substance, sales should be exempted from the application of the exclusion rule. 27 The quintessential transaction envisioned by those comments involves a taxable acquisition of a domestic corporation by a private equity fund or similar investment entity. If the PE fund wanted to hold the assets through a foreign entity, it would form that entity with cash contributions, which would then fund the taxable acquisition of the domestic corporation. It is typical in such transactions that management of the target is retained and those managers often have equity in the domestic target that is rolled over into the new foreign acquiring corporation. Although that management stock is usually a small percentage of the foreign acquiring corporation, the Ownership Test would be met (typically at the 100% level) by the management s roll-over stock, if the PE fund s cash contribution was disregarded under the Notice. The Preamble outlines the contours of two exceptions recommended by commentators. The first would except stock received in exchange for cash from the exclusion rule when the cash remains in the foreign acquiring corporation and results in a change of ownership in the domestic entity of such a magnitude that the predominant effect of the transaction is that of a sale or joint venture. The second exception to the exclusion rule would apply when the former owners of the domestic entity receive a de minimis amount of the outstanding stock of the foreign acquiring corporation, as would the management in the rollover fact pattern described above. The IRS and Treasury rejected the first sought-after exception in favor of the second de minimis exception. The Temporary Regulations provide that the exclusion rule will not apply if both: (i) the ownership percentage, determined without regard to the exclusion rule, is less than 5% (by vote and value); and (ii) former shareholders (or partners) of the domestic entity, after the acquisition by the foreign acquiring corporation, taking into account all transactions related to the acquisition, own (applying the attribution rules of Section 318(a)), in the aggregate, with the modifications described in Section 304(c)(3)(B)), less than 5% (by vote and value) of the stock (or partnership interests) of any member of the EAG that includes the foreign acquiring corporation. 28 However, the de minimis exception does not apply to disqualified stock that is transferred in a transaction (or series of transactions) related to the acquisition with a principal purpose of avoiding the purposes of Section The de minimis exception is illustrated in Example 4 of the Temporary Regulations: Individual A wholly owns DT, the fair market value of which is $100x. PRS, a partnership, transfers $96x of cash to FA, a newly formed corporation, in exchange solely for 96 shares of FA stock. A then transfers the DT stock to FA in exchange for $96x of cash and 4 shares of FA stock. The FA stock transferred by FA to PRS in exchange for nonqualified property (i.e., the $96x of cash) generally constitutes disqualified stock. Moreover, FA s assets have been increased as a result of this exchange. Thus, the FA stock received by PRS is generally subject to the exclusion rule and therefore removed from the denominator of the ownership fraction for purposes of the Ownership Test. However, without regard to the exclusion rule, Individual A receives less than 5% of the stock of FA by reason of its interest in DT. Furthermore, after the acquisition and all transactions related to the acquisition, Individual A owns less than 5% (by vote and value) of the stock of FA and DT (the members of the EAG that includes FA). Accordingly, the de minimis exception to the exclusion rule applies, and the FA stock transferred to PRS is not excluded from the 6 International Tax Alert

7 denominator of the ownership fraction. Thus, the ownership fraction is 4/100, and FA will not be a surrogate foreign corporation. 4. Interaction with EAG rules of Section 7874(c)(2)(A) Section 7874(c)(2)(A) identifies additional stock to be disregarded for purposes of the Ownership Test. That subparagraph provides that stock held by members of the EAG that includes the foreign acquiring corporation will not be taken into account for purposes of the Ownership Test. Under Treas. Reg. Section (b), the stock of a foreign acquiring corporation held by a member of the EAG is excluded from both the numerator and denominator of the ownership fraction. Notwithstanding the general rule that excludes stock owned by the EAG, Treas. Reg. Section (c)(1) provides that stock owned by the EAG will be included in the denominator (but still not the numerator) of the ownership fraction if the acquisition qualifies as an internal group restructuring or results in a loss of control. An acquisition qualifies as an internal group restructuring if: (i) before the acquisition, 80% or more of the stock (by vote and value) or capital and profits interests, as applicable, of a domestic entity acquired by the foreign acquiring corporation was held directly or indirectly by the corporation that is the common parent of the EAG after the acquisition; and (ii) after the acquisition, 80% or more of the stock (by vote and value) of the foreign acquiring corporation is held directly or indirectly by the common parent. An acquisition results in a loss of control if, after the acquisition, the former shareholders or partners of the domestic entity do not hold, in the aggregate, directly or indirectly, more than 50% of the stock (by vote or value) of any member of the EAG. The effect of the internal group restructuring and loss of control exceptions is to dilute the ownership fraction by reflecting the stock of the foreign acquiring corporation owned by the EAG in the denominator of the ownership fraction, thereby reducing the likelihood that a foreign acquiring corporation will be treated as a surrogate foreign corporation. A comment received by the IRS and Treasury suggested that stock of the foreign acquiring corporation that is disregarded under the exclusion rule should nonetheless be taken into account for purposes of determining whether an entity is a member of an EAG that includes the foreign acquiring corporation under Section 7874(c)(2)(A), as well as for purposes of the internal group restructuring and loss of control exceptions. The comment further suggested that stock that would be included in the denominator under the internal group restructuring and loss of control exceptions should continue to be included even if that stock would otherwise be excluded under the exclusion rule. The IRS and Treasury agreed with the first aspect of the comment on the grounds that the EAG rules and the exclusion rule were intended to operate independently. Thus, Treas. Reg. Section T(h) clarifies that disqualified stock that is excluded from the denominator of the ownership fraction under the exclusion rule is nonetheless taken into account for purposes of determining whether an entity is a member of the EAG for purposes of the EAG rules, as well as whether an acquisition qualifies as an internal group restructuring or results in a loss of control because the IRS and Treasury states that these two rules were intended to operate independently. However, the IRS and Treasury rejected the second aspect of the comment that the internal group restructuring and the loss of control exceptions should effectively trump the exclusion rule again on the grounds that the rules should operate independently. Thus, the Temporary Regulations provide that disqualified stock is excluded from the denominator of the ownership fraction under the exclusion rule, regardless of whether it would otherwise be included in the denominator of the ownership fraction as a result of the internal group restructuring and loss of control exceptions Subsequent transfers of foreign corporation stock The IRS and Treasury received comments requesting clarification regarding the effect upon the International Tax Alert 7

8 Ownership Test of subsequent transfers of stock of the foreign acquiring corporation. The comments questioned whether stock of the foreign acquiring corporation received by former owners of the domestic entity by reason of their interests in that entity should be excluded from the numerator of the ownership fraction if sold in a transaction related to the acquisition. Disregarding the transitory ownership of the foreign acquiring corporation stock for purposes of the Ownership Test would be consistent with step transaction principles as applied in analogous contexts. 31 Based upon a concern that taking such transfers into account could inappropriately reduce the ownership fraction, the IRS and Treasury added Treas. Reg. Section T to clarify that a subsequent transfer of stock of a foreign acquiring corporation under the same plan as the acquisition will not be taken account for purposes of the Ownership Test. Specifically, Treas. Reg. Section T(a) provides that stock of a foreign acquiring corporation that is described in Section 7874(a)(2)(B)(ii) (i.e., stock received by reason of an equity interest a domestic entity that would otherwise be included in the numerator of the ownership fraction) shall not cease to be so described as a result of a subsequent transfer by the shareholder, even if that transfer is related to the acquisition. A former shareholder will be respected as receiving the stock of a foreign acquiring corporation even if the subsequent transfer by the former shareholder occurs under a binding agreement entered into in connection with the acquisition. 32 Implications Few practitioners will be surprised by most of the contents of the Temporary Regulations. In fact, the Temporary Regulations are substantially consistent with the principles outlined in Notice The Temporary Regulations have, however, expanded the reach of the Notice in certain respects, while trying to limit the potential over-inclusiveness of the statutory public offering rule. The Temporary Regulations provide much needed guidance on the broad principles first articulated in the Notice, and introduce several new provisions, including the de minimis exception. While many practitioners may be disappointed at the relatively low 5%-threshold of the de minimis exception, the IRS and Treasury have at least provided relief for the typical management roll-over fact pattern. The Temporary Regulations are also generally consistent with a regulatory trend that is making it more difficult for US taxpayers to feel confident that their crossborder transaction avoids the expanding reach of Section For example, as noted above, the statutory public offering rule has essentially been expanded by the Temporary Regulations to numerous transactions (e.g., private placements), even though cut back in the case of acquisitions of certain foreign target corporations. In addition, many new rules require intensive factual scrutiny, including an assessment of taxpayer intent. For example, the Temporary Regulations add four new regulatory anti-abuse rules (e.g., in the definition of nonqualified property), whose application is predicated upon the taxpayer engaging in a particular transaction or series of transactions with a principal purpose to avoid the purposes of Section Given the relatively low threshold of such tests, taxpayers will need to carefully assess their potential exposure to the various Section 7874 rules that may not apply on their face. Finally, taxpayers may need to determine whether a particular outlier transaction is related to an acquisition by a foreign acquiring corporation described in Section 7874(a)(2)(B)(i), or, in the case of such an acquisition, whether particular liabilities are associated with a trade or business assumed by the foreign acquiring corporation. In sum, while the Temporary Regulations still offer the possibility of being able to engage in a cross-border inversion transaction that avoids Section 7874, successfully navigating all of the rules will continue to pose a significant challenge to most US taxpayers. 8 International Tax Alert

9 Endnotes 1. Treas. Reg. Sections T and -5T. The text of the Temporary Regulations serve as the text for the proposed regulations. 2. See Treas. Reg. Section T(i)(4) C.B See Treas. Reg. Section T(i)(1). 5. See Treas. Reg. Section T(i)(2). 6. The Temporary Regulations do not, contrary to some comments, provide a binding contract exception for transactions that occurred on or after, but pursuant to, agreements entered into before, the date of the Notice. 7. Section 7874(a)(2)(B). 8. The EAG is defined by reference to consolidated return Section 1504(a) affiliation, but includes foreign corporations and applies at a more than 50% level. See Section 7874(c)(1). 9. See, e.g., Section 7874(e). Section 4985 could also apply and result in the imposition of an excise tax on certain shareholders of the domestic entity. 10. Section 7874(b). 11. See also Treas. Reg. Section T(i)(9) ( The ownership fraction is the ownership percentage described in Section 7874(a)(2)(B)(ii), expressed as a fraction. ) 12. Stock received in a public offering (or in a private placement) for cash will never be in the numerator, as only stock received by reason of holding the stock of a domestic corporation (or an interest in a domestic partnership) is included in the numerator. 13. The parties also assert that Section 7874(c)(4), which disregards the transfer of properties or liabilities with a principal purpose of avoiding Section 7874, does not apply to disregard the investor s transfer of cash to New FCo for stock. 14. DC could still potentially be treated as an expatriated entity and subject to Section 7874 because the ownership percentage is greater than 60%. Moreover, the Section 4985 excise tax could also still apply. 15. Treas. Reg. Section T(b). 16. Id. 17. Treas. Reg. Section (c)(1)(i) and (ii). International Tax Alert 9

10 18. Treas. Reg. Section (i)(10). The Temporary Regulations are not limited to issuances of stock by the foreign acquiring corporation. 19. Treas. Reg. Section (c)(1)(ii). 20. Treas. Reg. Section (c)(2). 21. This qualification on the definition of disqualified stock would appear to prevent the exclusion rule from applying to the stock of a foreign acquiring corporation that is sold in a secondary offering that is arguably related to the foreign acquiring corporation s acquisition of the domestic entity. But see Section 7874(c)(4) and Treas. Reg. Section T. 22. Treas. Reg. Section T(c)(1)(i). 23. Treas. Reg. Section T(j)(7)(i), (ii), and (iv). 24. Treas. Reg. Section T(i)(6); see also Treas. Reg. Section T(j), Example Treas. Reg. Section T(j)(7)(iii); see also Treas. Reg. Section T(j), Example Treas. Reg. Section T(e). 27. See, e.g., NYSBA Tax Section Report on Certain Issues Under Section 7874, BNA Tax Core, Volume 10, Number 85 (5 May 2010). 28. Treas. Reg. Section T(d)(1)(i) and (ii). 29. Treas. Reg. Section T(d)(2). 30. See, e.g., Treas. Reg. Section (j), Examples 7 and 8 for the interaction between the EAG rules and the exclusion rule. 31. Cf. Intermountain Lumber v. Commissioner, 65 T.C (1976) and Rev. Rul , C.B. 144 (stock of a transferee corporation subsequently transferred to a person other than a co-transferor pursuant to a binding agreement is disregarded for purposes of the control requirement of Section 351(a)). 32. See Treas. Reg. Section T(b), Example. 33. Cf. Section 269 (disallowance of tax benefits where the principal purpose an acquisition of control is tax evasion or avoidance). 10 International Tax Alert

11 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services Jose Murillo, Washington, DC Paul Pencak, Chicago Steven Surdell, Chicago Gary Scanlon, Chicago Ernst & Young LLP, Transaction Advisory Services Donald Bakke, Washington, DC Brandon Hayes, San Jose International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Craig Hillier, Boston East Central Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Midwest Mark Muktar, Chicago Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City South America Alberto Lopez, New York International Tax Alert 11

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