Treasury and the Internal Revenue Service (IRS) have issued revised temporary regulations under Internal Revenue Code (“Code”) section 7874 concerning the determination of whether a foreign corporation is treated as a surrogate foreign corporation. The regulations primarily affect certain foreign corporations that acquire substantially all of the properties of domestic corporations or partnerships (so-called “inversion” transactions). The regulations replace temporary regulations on surrogate foreign corporations published in 2006 that recently sunset on June 6. Although the temporary regulations are effective June 12, 2009, the regulations provide that they apply to acquisitions completed on or after June 9, 2009.  


Section 7874 will apply when three conditions exist: 1) a U.S. corporation (or partnership) becomes a subsidiary of a foreign corporation or otherwise transfers substantially all of its property to a foreign corporation; 2) the shareholders (or partners) of the U.S. corporation (or partnership) acquire 60 percent or more of the vote or value of the shares of the new foreign parent corporation by reason of their holding stock in the domestic corporation (or interest in the partnership); and 3) the new foreign parent corporation, along with all of its subsidiaries (the expanded affiliated group, or EAG), does not have “substantial business activities” in its country of incorporation when compared with the total business activities of the EAG. In its harshest form (an acquisition of 80 percent or more), section 7874 treats the new foreign parent (the “surrogate foreign corporation”) as a U.S. corporation for all purposes of the Code. In its milder form (an acquisition of between 60 percent and 79 percent), section 7874 denies the use of some tax attributes to offset the inversion gain and certain other income for the succeeding 10-year period.  

Temporary Regulations  

The temporary regulations provide a number of rules designed to clarify and/or modify the previous temporary regulations, including the following:  

  1. modification of the rules related to stock held in a partnership (applies only for purposes of determining whether the ownership condition is satisfied);  
  2. retention and clarification of the rules related to the indirect acquisition of properties (identified transactions in the regulations do not represent an exclusive list of transactions that constitute indirect acquisition; an indirect acquisition of a partnership interest is an indirect acquisition of a proportionate amount of the properties of the partnership);  
  3. retention and modification of the rules related to acquisitions by a foreign acquiring corporation in exchange for stock of a foreign issuing corporation that owns more than 50 percent of the stock of the foreign acquiring corporation after the acquisition (this applies only if both corporations are members of the same EAG; the general rule applies to acquisitions by certain partnerships and acquisitions of a partnership’s properties);  
  4. clarification that the “by reason of” condition is satisfied if stock of a foreign corporation is received in exchange for, or with respect to, stock in a domestic corporation (or an interest in a domestic partnership);  
  5. clarification of when a publicly traded foreign partnership would be treated as a corporation (treating as a foreign corporation any foreign partnership that would, but for section 7704(c), be treated as a corporation at the time of the acquisition or after the acquisition);
  6. modification of the treatment of options and similar interests (treating an option in a domestic corporation (partnership) as stock of the domestic corporation (or an interest in the partnership) with a value equal to the holder’s claim on the equity of the domestic corporation immediately before the acquisition); and  
  7. clarification of when creditors of an insolvent domestic corporation are considered shareholders of the domestic corporation for purposes of determining whether a foreign corporation that acquires substantially all of the properties held by the domestic corporation is treated as a surrogate foreign corporation. Additionally, the temporary regulations provide a number of rules designed to prevent transactions that are viewed as avoiding section 7874.

Acquisitions by multiple foreign corporations

To address acquisitions by multiple foreign corporations intended to avoid Code Sec. 7874, the temporary regulations provide that if, as part of a plan or a series of related transactions, two or more foreign corporations complete, in the aggregate, an acquisition of substantially all the properties of the target domestic corporation (or partnership), then each foreign corporation will be treated as completing the acquisition for purposes of determining whether such a foreign corporation will be treated as a surrogate foreign corporation.

Substantial business activities condition

The temporary regulations do not retain the safe harbor for determining whether the “substantial business activities” condition of Code Sec. 7874(a)(2)(iii) is satisfied, or the examples illustrating the general rule provided by the 2006 temporary regulations. Thus, taxpayers can no longer rely on the safe harbor or the examples; instead, they must apply the general “facts and circumstances” rule to determine whether the substantial business activities condition is satisfied.

Economically equivalent interests

The temporary regulations provide that any interest, including stock or a partnership interest, that is not otherwise treated as stock of a foreign corporation will be treated as stock of the foreign corporation if the following two conditions are satisfied: 1) the interest entitles the holder to distribution rights that are substantially similar to distribution rights held by a shareholder of the foreign corporation and 2) as a result of the first condition, the foreign corporation is treated as a surrogate foreign corporation.

Modification to the internal restructuring exception

An exception from the applicability of section 7874 applies to internal group restructurings of a domestic corporation in which the common parent of the EAG directly or indirectly owned stock representing at least 80 percent (by vote and value) of the corporation both before and after the restructuring. If the exception applies, stock held by an EAG member in the reorganized corporation is excluded from the numerator of the ownership fraction in testing whether section 7874 applies to the restructuring, but included in the denominator of the ownership fraction. The exception also applies for restructurings of domestic partnerships. The ownership thresholds, however, refer to profits and capital interests in the domestic partnership. The new temporary regulations will not apply the exception when, pursuant to the same plan (or a series of related transactions), all or part of the stock of the foreign corporation is transferred outside the EAG that includes the foreign corporation after the acquisition.

The Take Away

The temporary regulations provide some needed clarification that allows taxpayers to determine whether certain transactions will trigger the inversion rules. At the same time, however, the regulations aim to prevent taxpayers from structuring transactions to avoid triggering the inversion rules by expanding the range of transactions that will result in inversion treatment. For example, in at least one instance, the regulations seem to strip taxpayers of objective measures needed to apply the complex inversion rules by doing away with the objective and clear safe harbor tests and related examples, making it difficult for taxpayers to contend that the EAG has a meaningful and bona fide business presence in the relevant foreign country.