Certain Transfers of Domestic Stock or Securities by U.S. Persons to Foreign Corporations

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8702]

RIN 1545-AT42

Certain Transfers of Domestic Stock or Securities by U.S. Persons

to Foreign Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to certain

transfers of stock or securities of domestic corporations by United

States persons to foreign corporations pursuant to the corporate

organization, reorganization, or liquidation provisions of the Internal

Revenue Code. These final regulations modify the rules contained in the

temporary regulations to reflect certain taxpayer comments received in

response to those temporary regulations. This

[[Page 68634]]

action is necessary to provide the public with guidance to comply with

the Tax Reform Act of 1984.

DATES: These regulations are effective January 29, 1997. For dates of

applicability of these regulations, see Sec. 1.367(a)-3(c)(11).

FOR FURTHER INFORMATION CONTACT: Philip L. Tretiak at (202) 622-3860

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations

has been reviewed and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545-1478. Responses to these collections of information

are required in order for U.S. shareholders that transfer stock or

securities in section 367(a) exchanges to qualify for an exception to

the general rule of taxation under section 367(a)(1).

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

The estimated one-time burden per respondent: 10 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,

DC 20224, and to the Office of Management and Budget, Attn: Desk

Officer for the Department of the Treasury, Office of Information and

Regulatory Affairs, Washington, DC 20503.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

On May 16, 1986, temporary and proposed regulations under sections

367 (a) and (d) and section 6038B were published in the Federal

Register (51 FR 17936). These regulations were published to provide the

public with guidance necessary to comply with changes made to the

Internal Revenue Code by the Tax Reform Act of 1984. The IRS and the

Treasury Department later issued Notice 87-85 (1987-2 C.B. 395), which

set forth substantial changes to the 1986 regulations, effective with

respect to transfers occurring after December 16, 1987. A further

notice of proposed rulemaking, containing rules under section 367(a),

as well as under section 367(b), was published in the Federal Register

on August 26, 1991 (56 FR 41993). The 1991 proposed section 367(a)

regulations were generally based upon the positions announced in Notice

87-85, but the regulations made certain modifications to Notice 87-85,

particularly with respect to transfers of stock or securities of

foreign corporations. Subsequently, the IRS and the Treasury Department

issued Notice 94-46 (1994-1 C.B. 356), announcing modifications to the

positions set forth in Notice 87-85 (and the 1991 proposed regulations)

with respect to transfers of stock or securities of domestic

corporations occurring after April 17, 1994.

Most recently, temporary and proposed regulations were published in

the Federal Register on December 26, 1995 (60 FR 66739 and 66771). The

temporary regulations, which are generally effective for transfers

occurring after April 17, 1994, but cease to be effective when the

final regulations take effect, generally incorporated the positions

announced in Notice 94-46, with certain modifications. These final

regulations generally follow the rules set forth in the temporary

regulations, with changes as described below.

Explanation of Provisions

Section 367(a)(1) generally treats a transfer of property

(including stock or securities) by a U.S. person to a foreign

corporation in connection with an exchange described in section 332,

351, 354, 356 or 361 as a taxable exchange unless the transfer

qualifies for an exception to this general rule.

Rules that address transfers of stock or securities of domestic

corporations are contained in the final regulations described herein.

Rules that address transfers of stock or securities of foreign

corporations under section 367(a) are contained in Notice 87-85.

The final regulations retain the general rules set forth in the

temporary regulations, which provide that a U.S. person that exchanges

stock or securities in a U.S. target company (UST) for stock of a

foreign corporation (the transferee foreign corporation (or TFC)) in an

exchange described in section 367(a) will qualify for nonrecognition

treatment if certain reporting requirements are satisfied and each of

the following conditions is met:

(i) U.S. transferors must receive no more than 50 percent of the

voting power and value of the stock of the TFC in the transfer (i.e.,

the 50-percent ownership threshold is not exceeded);

(ii) U.S. officers, directors and 5-percent or greater shareholders

of the U.S. target must not own, in the aggregate, more than 50 percent

of the voting power and value of the TFC immediately after the transfer

(i.e., the control group case does not apply);

(iii) The U.S. person (exchanging U.S. shareholder) either must not

be a 5-percent transferee shareholder immediately after the transfer

or, if the U.S. person is a 5-percent transferee shareholder, must

enter into a 5-year gain recognition agreement (GRA) with respect to

the UST stock or securities it exchanged. (Without such GRA, the

transfer by the 5-percent transferee shareholder will not qualify for

nonrecognition treatment; however, transfer by other U.S. transferors

not subject to the GRA requirement may qualify if all other

requirements are met.); and

(iv) The active trade or business requirement must be satisfied.

If one or more of the foregoing requirements is not satisfied, the

transfer by the U.S. person of stock or securities of a domestic

corporation in exchange for stock of a TFC is taxable under section

367(a).

In response to suggestions from commentators, however, the final

regulations make a number of modifications to the temporary

regulations, principally in two areas: (i) the treatment of transfers

of ``other property'' in the context of the 50-percent ownership

threshold requirement, and (ii) the active trade or business

requirement.

Transfers of ``Other Property''

Under the temporary regulations, if U.S. transferors receive more

than 50 percent of the stock (by vote or value) of the TFC, the 50-

percent ownership threshold is exceeded and the transfer is taxable

under section 367(a)(1). The temporary regulations define a ``U.S.

transferor'' as a U.S. person who transfers (directly, indirectly or

constructively) stock or securities of the U.S. target company or

``other property'' for stock of the TFC in an exchange described in

section 367. Persons who transfer U.S. target company stock or other

property are presumed to be U.S. persons.

The inclusion of ``other property'' in the class of tainted

transferred property was designed to prevent the avoidance of the 50-

percent ownership threshold through ``stuffing'' transactions. For

example, assume that FC, a foreign corporation, and UST, an unrelated

U.S. corporation, seek to combine their

[[Page 68635]]

operations in a new foreign joint venture company (JV). The

shareholders of each company will transfer their respective stock

interests in UST and FC to JV in a transaction that would qualify as a

section 351 exchange unless the transaction was taxable under section

367(a)(1). Assume that FC has all foreign shareholders. The value of

the stock of UST is 550x; the value of the stock of FC is 450x. Because

UST is more valuable than FC, UST's shareholders would receive more

than 50 percent of JV's stock. Consequently, even if the transaction

would otherwise qualify for an exception to the general rule of

taxation under section 367(a)(1), the transaction would be taxable

because the 50-percent ownership threshold would be exceeded. If,

however, a U.S. person (X) contributed at least 100x in cash (or

property) to JV, JV would not issue more than 50 percent of its stock

to the UST shareholders, and, therefore, the 50-percent ownership

threshold would not be exceeded. The temporary regulations, however,

treat X as a U.S. transferor, so that the 50-percent ownership

threshold would be exceeded in this case.

Commentators have pointed out that the term ``other property''

raises issues in the joint venture context that are broader than the

``stuffing'' example described above. Because the term ``other

property'' is broad enough to include stock of a foreign company, the

transfer of UST stock could be taxable under section 367(a)(1) even if

UST were less valuable than the foreign ``target'' company (i.e., in

cases where U.S. transferors would receive less than 50 percent of the

stock of the joint venture company/TFC). Assume similar facts as in the

earlier example, except that FC is widely-held and the shareholders of

UST receive 40 percent of the stock of JV, while the shareholders of FC

receive the remaining 60 percent. No cash or any other property is

transferred to the JV. In such case, if the stock of FC constitutes

``other property,'' UST shareholders would not qualify for an exception

to section 367(a)(1) if they were unable to prove that the U.S.

shareholders of FC, if any, received no more than 10 percent of the

stock of JV in the exchange.

Although the IRS and the Treasury Department remain concerned with

``stuffing'' transactions, the final regulations consider the active

trade or business test to be the primary safeguard for preventing tax-

motivated transactions from qualifying for an exception under these

section 367(a) regulations. In particular, because the active trade or

business test addresses ``stuffing'' transactions that occur within the

36-month period prior to the acquisition, the final regulations

eliminate consideration of transfers of other property with regard to

the 50-percent ownership threshold. Thus, any TFC stock received by

U.S. persons in exchange for transfers of other property will not be

taken into account in determining whether the 50-percent ownership

threshold is exceeded.

Active Trade or Business Test: In General

The final regulations modify the ``active trade or business''

requirement that must be satisfied for a U.S. transferor to qualify for

an exception to the general rule of taxability under section 367(a)(1).

Under the requirement contained in the temporary regulations, no

exception under section 367(a)(1) is available unless (i) the TFC or an

affiliate was engaged in an active trade or business for the entire 36-

month period prior to the exchange (the 36-month test), and (ii) such

business was substantial in relation to the business of the U.S. target

company (the substantiality test). For this purpose, an affiliate is

generally defined by reference to the rules in section 1504(a) (without

the exclusion of foreign corporations).

The active trade or business test under the final regulations

includes (i) a modified 36-month test, (ii) a new anti-avoidance rule

requiring that the transaction not be undertaken with an intention that

the TFC cease its active trade or business, and (iii) a modified

substantiality test. The final regulations make a number of other

modifications and clarifications to the active trade or business test.

For example, the final regulations permit the TFC to consider only an

80-percent owned foreign subsidiary (referred to as a ``qualified

subsidiary''), and not an affiliate, to satisfy the active trade or

business test on its behalf.

Active Trade or Business Test: 36-Month Test and Intent Test

Under the 36-month test contained in the temporary regulations, the

TFC or an affiliate is required to be engaged in an active trade or

business for the entire 36 months immediately preceding the date of the

transfer. Under the final regulations, this test can be satisfied by

acquired businesses that have a 36-month operating history, unless they

are acquired with the principal purpose of satisfying the active trade

or business test.

In addition to the 36-month test, the active trade or business test

in the final regulations contains a requirement that the transaction

not be undertaken with an intention that the TFC cease its active

business. The IRS and the Treasury Department believe that if a TFC

with a 36-month active business history does not intend to maintain

such business, but is only used as a vehicle to acquire the UST, an

``inversion'' transaction rather than a synergy of two businesses has

been effected.

Under the temporary regulations, there is uncertainty as to whether

an affiliate of a newly-formed TFC can satisfy the active trade or

business test on behalf of the TFC for the (36-month) period prior to

the exchange. Subject to a stuffing rule, the final regulations clarify

that, for purposes of determining whether a TFC satisfies the 36-month

test, the TFC may take into account an active business of a company

that is a qualified subsidiary immediately after the transaction, even

if such company was not a qualified subsidiary for all or part of the

36 months prior to the transaction. Thus, for example, if the TFC is a

new foreign joint venture company, it will not be disqualified from

satisfying the active trade or business test solely because its

qualifying active trade or business was engaged in by a qualified

subsidiary whose stock is received in the exchange.

Under the temporary regulations, it is unclear whether a newly-

formed joint venture TFC could satisfy the active trade or business

test if, in the transaction, it received both stock of a UST (from U.S.

transferors) and an active trade or business (i.e., a foreign branch)

that had been operating for at least 36 months prior to the exchange

(from foreign transferors). This uncertainty arose because the active

trade or business test in the temporary regulations required that

either the TFC or an affiliate satisfy the 36-month requirement.

Although the temporary regulations did not intend to establish a

preference for transfers of stock (i.e., affiliates) vis-a-vis assets,

the temporary regulations did not expressly provide that a TFC could

utilize a newly-transferred foreign branch to satisfy the TFC's active

trade or business requirement.

The final regulations clarify that, subject to a stuffing rule, the

TFC may satisfy the active trade or business test if it receives in the

exchange foreign assets that constituted an active trade or business

during such 36-month period.

Active Trade or Business Test: Qualified Subsidiaries

The final regulations permit a TFC to take into account only

qualified subsidiaries, rather than affiliates, to satisfy the active

trade or business test.

[[Page 68636]]

This aspect of the active trade or business test has been narrowed

because the IRS and the Treasury Department do not believe that a TFC

should satisfy the active trade or business exception merely because

its parent company (or an affiliate of the parent company) is engaged

in an active trade or business.

For example, assume that foreign parent (FP), which is engaged in

an active business outside the United States (either directly or

through a subsidiary), forms a foreign subsidiary (FS) and contributes

cash to FS. Shareholders of a U.S. target company (UST) then transfer

all of the stock of UST in exchange for 20 percent of the stock of FS

in a transaction described in sections 368(a)(1)(B) and 367(a). If FS

is permitted to satisfy the active trade or business test by taking

into account FP's business, UST has effectively ``gone offshore'' in an

inversion transaction. Because the shareholders of UST receive stock of

FS (which is the TFC), and not FP, such shareholders will have no

interest in FP's active business. In contrast, if the shareholders

received stock of FP in an exchange described in section 367(a), such

persons would participate in FP's active business, and the active trade

or business test under the final regulations would be satisfied.

Active Trade or Business Test: Partnership Interests

The temporary regulations did not address whether the TFC could

satisfy the active trade or business requirement by taking into account

an interest in a partnership engaged in an active trade or business.

The final regulations permit a TFC (or a qualified subsidiary) to

take into account the active trade or business engaged in outside the

United States by any qualified partnership as there defined.

Active Trade or Business Test: Substantiality Test

Under the temporary regulations, the second prong of the active

trade or business requirement is the substantiality test. The active

trade or business of the TFC is required to be ``substantial'' vis-a-

vis the active trade or business of the UST, but the temporary

regulations do not define substantiality.

The final regulations modify the substantiality requirement. Under

the final regulations, the substantiality test no longer compares the

active trade or business of the TFC vis-a-vis the UST. Instead, it

requires that the entire value of the TFC be at least equal to the

entire value of the UST at the time of the transaction. However, for

this purpose, the value of the TFC may include the value of assets

(including stock) acquired within the 36-month period prior to the

transaction only if (i) such assets were acquired in the ordinary

course of business, or (ii) such assets (or their proceeds) do not

produce and are not held for the production of passive income (as

defined under section 1296(b)), and were not acquired with the

principal purpose of satisfying the active trade or business test. A

special rule applies if the asset acquired by the TFC in the 36-month

period prior to the exchange is stock of a qualified subsidiary or

qualified partnership engaged in an active trade or business. In such

case, the value of the stock or partnership interest may be taken into

account, but must be reduced in accordance with the principles

described above.

When formulating the substantiality test under the final

regulations, the IRS and the Treasury Department considered and

rejected other alternatives considered to be more complex and

burdensome for taxpayers. For example, a comparison of the active

business of the TFC vis-a-vis the active business of the UST for the

36-month period prior to the acquisition, taking into account the

property, payroll and sales of the two companies, was considered and

rejected.

Indirect and Constructive Transfers

One commentator suggested that the IRS clarify the definition of

``U.S. Transferor'' contained in the temporary regulations, which

refers to a U.S. person who transfers ``directly, indirectly or

constructively'' UST stock or other property. The IRS and the Treasury

Department believe that the reference to ``direct, indirect and

constructive'' transfers may have been unclear and, thus, the final

regulations delete such reference. Such technical modification does not

modify the substantive law in which indirect and constructive transfers

may be treated as transfers subject to section 367(a)(1) (see

Sec. 1.367(a)-1T(c)(2) with respect to the ``indirect'' stock transfer

rules; constructive transfers include, but are not limited to, section

367(a) transfers that result from section 304 transactions and section

367(a) transfers that result from a change in classification of an

entity from a foreign partnership to a foreign corporation).

GRA Term

Under the temporary regulations, a 5-percent transferee shareholder

is required to file a GRA. The duration is 5 years if all U.S.

transferors own less than 50 percent of the total voting power and

total value of the TFC stock immediately after the transfer. The

duration of the GRA is 10 years if the U.S. transferors own 50 percent

or more of the TFC stock immediately after the transaction, or if the

5-percent transferee shareholder is unable to prove that all U.S.

transferors own less than 50 percent of the total voting power and

total value of the TFC immediately after the transfer. Thus, in

determining whether a 5- or 10-year GRA is appropriate, the temporary

regulations take into account cross-ownership (i.e., consideration of

stock owned independently of the transaction) by all U.S. transferors,

and contain a presumption that a 10-year GRA is required.

For example, assume that UST shareholders receive 30 percent of the

stock of the TFC in a nonrecognition transaction that qualifies for an

exception under section 367(a). Assume further that one UST

shareholder, X, a U.S. person, transfers stock of UST in the section

367(a) exchange and owns 5 percent of the TFC after the transaction.

Under the temporary regulations, X is required to file a 10-year GRA

unless X can prove that all U.S. transferors in the aggregate own less

than 50 percent of the voting power and value of the TFC immediately

after the transfer (taking into account the 30 percent received in the

transaction by U.S. target shareholders plus any other stock that such

persons may own independently of the transaction). If the companies are

publicly traded or widely held, it is burdensome and may be impractical

for X to rebut the presumption that U.S. transferors own 50 percent or

more of the TFC stock.

In response to comments received and in the interest of

simplification, the final regulations provide that any 5-percent

transferee shareholder that is required to file a GRA upon the transfer

of domestic stock or securities is required to file a 5-year GRA; 10-

year GRAs will no longer be required in the case of 5-percent

transferee shareholders who transfer domestic stock or securities.

Other Areas in Which Comments Were Received

After careful consideration by the IRS and the Treasury Department,

the positions set forth in the temporary regulations were generally not

modified in response to certain comments other than those described

above. For example, the final regulations did not modify: (i) The

amount of stock U.S. transferors could receive without exceeding the

ownership threshold (i.e., not more than 50 percent), (ii) testing the

50-percent ownership threshold at

[[Page 68637]]

the time of the exchange, and (iii) the presumption that all

shareholders of the U.S. target company are U.S. persons.

PLR Option in Limited Instances

The final regulations provide that, in limited instances, the IRS

may consider issuing private letter rulings to taxpayers that (i)

satisfy all of the requirements contained in these regulations, with

the exception of the active trade or business test, or (ii) make a good

faith effort, but are unable to establish non-adverse applicability of

the ownership attribution rules. The IRS and the Treasury Department

are aware that the active trade or business test is mechanical in

nature and, thus, in limited instances, a taxpayer may demonstrate an

ongoing and substantial active trade or business even though it fails

to meet the test set forth in the final regulations. However, in no

event will the IRS rule on the issue of whether a TFC acquired an

active business with the principal purpose of satisfying the 36-month

test and/or the substantiality test.

Other Matters

The IRS and the Treasury Department expect to issue additional

final regulations under section 367(a) to address the transfer of stock

or securities of foreign corporations and other matters contained in

the 1991 proposed regulations not addressed herein. Until the 1991

proposed regulations are finalized, the positions originally announced

in Notice 87-85 will continue to govern the availability of section

367(a) exceptions for transfers of stock or securities of foreign

corporations. See Sec. 1.367(a)-3(d).

Special Analyses

It has been determined that this regulation is not a significant

regulatory action as defined in EO 12866. Therefore, a regulatory

assessment is not required. It is hereby certified that this regulation

does not have a significant economic impact on a substantial number of

small entities. This certification is based on the fact that the number

of U.S. target companies that are acquired by foreign corporations in

nonrecognition transactions subject to section 367(a), and thus are

subject to collection of information, is estimated to be only 100 per

year. Moreover, because these regulations will primarily affect large

shareholders and U.S. multinational corporations with foreign

operations, it is estimated that very few of the 100 transactions will

involve small entities. Thus, a Regulatory Flexibility Analysis under

the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.

Pursuant to section 7805(f) of the Code, the notice of proposed

rulemaking preceding these regulations was submitted to the Small

Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Philip L. Tretiak of

the Office of Associate Chief Counsel (International), within the

Office of Chief Counsel, IRS. However, other personnel from the IRS and

Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.367(a)-3 is added to read as follows:

Sec. 1.367(a)-3 Treatment of transfers of stock or securities to

foreign corporations.

(a) In general. This section provides rules concerning the transfer

of stock or securities by a U.S. person to a foreign corporation in an

exchange described in section 367(a). In general, a transfer of stock

or securities by a U.S. person to a foreign corporation that is

described in sections 351, 354 (pursuant to a reorganization described

in section 368(a)(1)(B)) or section 361 (a) or (b) is subject to

section 367(a)(1) and, therefore, is treated as a taxable exchange,

unless one of the exceptions set forth in paragraph (c) or (d) of this

section or Sec. 1.367(a)-3T(b) applies. For additional rules relating

to an exchange involving a foreign corporation in connection with which

there is a transfer of stock, see section 367(b) and the regulations

under that section. For additional rules regarding a transfer of stock

or securities in an exchange described in section 361 (a) or (b), see

section 367(a)(5) and any regulations under that section.

(b) [Reserved] For further guidance, see Sec. 1.367(a)-3T(b).

(c) Transfers by U.S. persons of stock or securities of domestic

corporations to foreign corporations--(1) In general. Except as

provided in section 367(a)(5), a transfer of stock or securities of a

domestic corporation by a U.S. person to a foreign corporation that

would otherwise be subject to section 367(a)(1) under paragraph (a) of

this section shall not be subject to section 367(a)(1) if the domestic

corporation the stock or securities of which are transferred (referred

to as the U.S. target company) complies with the reporting requirements

in paragraph (c)(6) of this section and if each of the following four

conditions is met:

(i) Fifty percent or less of both the total voting power and the

total value of the stock of the transferee foreign corporation is

received in the transaction, in the aggregate, by U.S. transferors

(i.e., the amount of stock received does not exceed the 50-percent

ownership threshold).

(ii) Fifty percent or less of each of the total voting power and

the total value of the stock of the transferee foreign corporation is

owned, in the aggregate, immediately after the transfer by U.S. persons

that are either officers or directors of the U.S. target company or

that are five-percent target shareholders (as defined in paragraph

(c)(5)(iii) of this section) (i.e., there is no control group). For

purposes of this paragraph (c)(1)(ii), any stock of the transferee

foreign corporation owned by U.S. persons immediately after the

transfer will be taken into account, whether or not it was received in

the exchange for stock or securities of the U.S. target company.

(iii) Either--

(A) The U.S. person is not a five-percent transferee shareholder

(as defined in paragraph (c)(5)(ii) of this section); or

(B) The U.S. person is a five-percent transferee shareholder and

enters into a five-year agreement to recognize gain with respect to the

U.S. target company stock or securities it exchanged in the form

provided in Sec. 1.367(a)-3T(g); and

(iv) The active trade or business test (as defined in paragraph

(c)(3) of this section) is satisfied.

(2) Ownership presumption. For purposes of paragraph (c)(1) of this

section, persons who transfer stock or securities of the U.S. target

company in exchange for stock of the transferee foreign corporation are

presumed to be U.S. persons. This presumption may be rebutted in

accordance with paragraph (c)(7) of this section.

(3) Active trade or business test--(i) In general. The tests of

this paragraph (c)(3), collectively referred to as the

[[Page 68638]]

active trade or business test, are satisfied if:

(A) The transferee foreign corporation or any qualified subsidiary

(as defined in paragraph (c)(5)(vii) of this section) or any qualified

partnership (as defined in paragraph (c)(5)(viii) of this section) is

engaged in an active trade or business outside the United States,

within the meaning of Sec. 1.367(a)-2T(b) (2) and (3), for the entire

36-month period immediately before the transfer;

(B) At the time of the transfer, neither the transferors nor the

transferee foreign corporation (and, if applicable, the qualified

subsidiary or qualified partnership engaged in the active trade or

business) have an intention to substantially dispose of or discontinue

such trade or business; and

(C) The substantiality test (as defined in paragraph (c)(3)(iii) of

this section) is satisfied.

(ii) Special rules. For purposes of paragraphs (c)(3)(i) (A) and

(B) of this section, the following special rules apply:

(A) The transferee foreign corporation, a qualified subsidiary, or

a qualified partnership will be considered to be engaged in an active

trade or business for the entire 36-month period preceding the exchange

if it acquires at the time of, or any time prior to, the exchange a

trade or business that has been active throughout the entire 36-month

period preceding the exchange. This special rule shall not apply,

however, if the acquired active trade or business assets were owned by

the U.S. target company or any affiliate (within the meaning of section

1504(a) but excluding the exceptions contained in section 1504(b) and

substituting ``50 percent'' for ``80 percent'' where it appears

therein) at any time during the 36-month period prior to the

acquisition. Nor will this special rule apply if the principal purpose

of such acquisition is to satisfy the active trade or business test.

(B) An active trade or business does not include the making or

managing of investments for the account of the transferee foreign

corporation or any affiliate (within the meaning of section 1504(a) but

excluding the exceptions contained in section 1504(b) and substituting

``50 percent'' for ``80 percent'' where it appears therein). (This

paragraph (c)(3)(ii)(B) shall not create any inference as to the scope

of Sec. 1.367(a)-2T(b) (2) and (3) for other purposes.)

(iii) Substantiality test--(A) General rule. A transferee foreign

corporation will be deemed to satisfy the substantiality test if, at

the time of the transfer, the fair market value of the transferee

foreign corporation is at least equal to the fair market value of the

U.S. target company.

(B) Special rules. (1) For purposes of paragraph (c)(3)(iii)(A) of

this section, the value of the transferee foreign corporation shall

include assets acquired outside the ordinary course of business by the

transferee foreign corporation within the 36-month period preceding the

exchange only if either--

(i) Both--

(A) At the time of the exchange, such assets or, as applicable, the

proceeds thereof, do not produce, and are not held for the production

of, passive income as defined in section 1296(b); and

(B) Such assets are not acquired for the principal purpose of

satisfying the substantiality test; or

(ii) Such assets consist of the stock of a qualified subsidiary or

an interest in a qualified partnership. See paragraph (c)(3)(iii)(B)(2)

of this section.

(2) For purposes of paragraph (c)(3)(iii)(A) of this section, the

value of the transferee foreign corporation shall not include the value

of the stock of any qualified subsidiary or the value of any interest

in a qualified partnership, held directly or indirectly, to the extent

that such value is attributable to assets acquired by such qualified

subsidiary or partnership outside the ordinary course of business and

within the 36-month period preceding the exchange unless those assets

satisfy the requirements in paragraph (c)(3)(iii)(B)(1) of this

section.

(3) For purposes of paragraph (c)(3)(iii)(A) of this section, the

value of the transferee foreign corporation shall not include the value

of assets received within the 36-month period prior to the acquisition,

notwithstanding the special rule in paragraph (c)(3)(iii)(B)(1) of this

section, if such assets were owned by the U.S. target company or an

affiliate (within the meaning of section 1504(a) but without the

exceptions under section 1504(b) and substituting ``50 percent'' for

``80 percent'' where it appears therein) at any time during the 36-

month period prior to the transaction.

(4) Special rules--(i) Treatment of partnerships. For purposes of

this paragraph (c), if a partnership (whether domestic or foreign) owns

stock or securities in the U.S. target company or the transferee

foreign corporation, or transfers stock or securities in an exchange

described in section 367(a), each partner in the partnership, and not

the partnership itself, is treated as owning and as having transferred,

or as owning, a proportionate share of the stock or securities. See

Sec. 1.367(a)-1T(c)(3).

(ii) Treatment of options. For purposes of this paragraph (c), one

or more options (or an interest similar to an option) will be treated

as exercised and thus will be counted as stock for purposes of

determining whether the 50-percent threshold is exceeded or whether a

control group exists if a principal purpose of the issuance or the

acquisition of the option (or other interest) was the avoidance of the

general rule contained in section 367(a)(1).

(iii) U.S. target has a vestigial ownership interest in transferee

foreign corporation. In cases where, immediately after the transfer,

the U.S. target company owns, directly or indirectly (applying the

attribution rules of sections 267(c) (1) and (5)), stock of the

transferee foreign corporation, that stock will not in any way be taken

into account (and, thus, will not be treated as outstanding) in

determining whether the 50-percent threshold under paragraph (c)(1)(i)

of this section is exceeded or whether a control group under paragraph

(c)(1)(ii) of this section exists.

(iv) Attribution rule. Except as otherwise provided in this

section, the rules of section 318, as modified by the rules of section

958(b) shall apply for purposes of determining the ownership or receipt

of stock, securities or other property under this paragraph (c).

(5) Definitions--(i) Ownership statement. An ownership statement is

a statement, signed under penalties of perjury, stating--

(A) The identity and taxpayer identification number, if any, of the

person making the statement;

(B) That the person making the statement is not a U.S. person (as

defined in paragraph (c)(5)(iv) of this section);

(C) That the person making the statement either--

(1) Owns less than 1 percent of the total voting power and total

value of a U.S. target company the stock of which is described in Rule

13d-1(d) of Regulation 13D (17 CFR 240.13d-1(d)) (or any rule or

regulation to generally the same effect) promulgated by the Securities

and Exchange Commission under the Securities and Exchange Act of 1934

(15 USC 78m), and such person did not acquire the stock with a

principal purpose to enable the U.S. transferors to satisfy the

requirement contained in paragraph (c)(1)(i) of this section; or

(2) Is not related to any U.S. person to whom the stock or

securities owned by the person making the statement are attributable

under the rules of section 958(b), and did not acquire the stock

[[Page 68639]]

with a principal purpose to enable the U.S. transferors to satisfy the

requirement contained in paragraph (c)(1)(i) of this section;

(D) The citizenship, permanent residence, home address, and U.S.

address, if any, of the person making the statement; and

(E) The ownership such person has (by voting power and by value) in

the U.S. target company prior to the exchange and the amount of stock

of the transferee foreign corporation (by voting power and value)

received by such person in the exchange.

(ii) Five-percent transferee shareholder. A five-percent transferee

shareholder is a person that owns at least five percent of either the

total voting power or the total value of the stock of the transferee

foreign corporation immediately after the transfer described in section

367(a)(1). For special rules involving cases in which stock is held by

a partnership, see paragraph (c)(4)(i) of this section.

(iii) Five-percent target shareholder and certain other 5-percent

shareholders. A five-percent target shareholder is a person that owns

at least five percent of either the total voting power or the total

value of the stock of the U.S. target company immediately prior to the

transfer described in section 367(a)(1). If the stock of the U.S.

target company (or any company through which stock of the U.S. target

company is owned indirectly or constructively) is described in Rule

13d-1(d) of Regulation 13D (17 CFR 240.13d-1(d)) (or any rule or

regulation to generally the same effect), promulgated by the Securities

and Exchange Commission under the Securities Exchange Act of 1934 (15

USC 78m), then, in the absence of actual knowledge to the contrary, the

existence or absence of filings of Schedule 13-D or 13-G (or any

similar schedules) may be relied upon for purposes of identifying five-

percent target shareholders (or a five-percent shareholder of a

corporation which itself is a five-percent shareholder of the U.S.

target company). For special rules involving cases in which U.S. target

company stock is held by a partnership, see paragraph (c)(4)(i) of this

section.

(iv) U.S. Person. For purposes of this section, a U.S. person is

defined by reference to Sec. 1.367(a)-1T(d)(1). For application of the

rules of this section to stock or securities owned or transferred by a

partnership that is a U.S. person, however, see paragraph (c)(4)(i) of

this section.

(v) U.S. Transferor. A U.S. transferor is a U.S. person (as defined

in paragraph (c)(5)(iv) of this section) that transfers stock or

securities of one or more U.S. target companies in exchange for stock

of the transferee foreign corporation in an exchange described in

section 367.

(vi) Transferee foreign corporation. A transferee foreign

corporation is the foreign corporation whose stock is received in the

exchange by U.S. persons.

(vii) Qualified Subsidiary. A qualified subsidiary is a foreign

corporation whose stock is at least 80-percent owned (by total voting

power and total value), directly or indirectly, by the transferee

foreign corporation. However, a corporation will not be treated as a

qualified subsidiary if it was affiliated with the U.S. target company

(within the meaning of section 1504(a) but without the exceptions under

section 1504(b) and substituting ``50 percent'' for ``80 percent''

where it appears therein) at any time during the 36-month period prior

to the transfer. Nor will a corporation be treated as a qualified

subsidiary if it was acquired by the transferee foreign corporation at

any time during the 36-month period prior to the transfer for the

principal purpose of satisfying the active trade or business test,

including the substantiality test.

(viii) Qualified partnership. (A) Except as provided in paragraph

(c)(5)(viii)(B) or (C) of this section, a qualified partnership is a

partnership in which the transferee foreign corporation--

(1) Has active and substantial management functions as a partner

with regard to the partnership business; or

(2) Has an interest representing a 25 percent or greater interest

in the partnership's capital and profits.

(B) A partnership is not a qualified partnership if the U.S. target

company or any affiliate of the U.S. target company (within the meaning

of section 1504(a) but without the exceptions under section 1504(b) and

substituting ``50 percent'' for ``80 percent'' where it appears

therein) held a 5 percent or greater interest in the partnership's

capital and profits at any time during the 36-month period prior to the

transfer.

(C) A partnership is not a qualified partnership if the transferee

foreign corporation's interest was acquired by that corporation at any

time during the 36-month period prior to the transfer for the principal

purpose of satisfying the active trade or business test, including the

substantiality test.

(6) Reporting requirements of U.S. target company. (i) In order for

a U.S. person that transfers stock or securities of a domestic

corporation to qualify for the exception provided by this paragraph (c)

to the general rule under section 367(a)(1), in cases where 10 percent

or more of the total voting power or the total value of the stock of

the U.S. target company is transferred by U.S. persons in the

transaction, the U.S. target company must comply with the reporting

requirements contained in this paragraph (c)(6). The U.S. target

company must attach to its timely filed U.S. income tax return for the

taxable year in which the transfer occurs a statement titled ``Section

367(a)--Reporting of Cross-Border Transfer Under Reg. Sec. 1.367(a)-

3(c)(6),'' signed under penalties of perjury by an officer of the

corporation to the best of the officer's knowledge and belief,

disclosing the following information--

(A) A description of the transaction in which a U.S. person or

persons transferred stock or securities in the U.S. target company to

the transferee foreign corporation in a transfer otherwise subject to

section 367(a)(1);

(B) The amount (specified as to the percentage of the total voting

power and the total value) of stock of the transferee foreign

corporation received in the transaction, in the aggregate, by persons

who transferred stock or securities of the U.S. target company. For

additional information that may be required to rebut the ownership

presumption of paragraph (c)(2) of this section in cases where more

than 50 percent of either the total voting power or the total value of

the stock of the transferee foreign corporation is received in the

transaction, in the aggregate, by persons who transferred stock or

securities of the U.S. target company, see paragraph (c)(7) of this

section;

(C) The amount (if any) of transferee foreign corporation stock

owned directly or indirectly (applying the attribution rules of

sections 267(c) (1) and (5)) immediately after the exchange by the U.S.

target company;

(D) A statement that there is no control group within the meaning

of paragraph (c)(1)(ii) of this section;

(E) A list of U.S. persons who are officers, directors or five-

percent target shareholders and the percentage of the total voting

power and the total value of the stock of the transferee foreign

corporation owned by such persons both immediately before and

immediately after the transaction; and

(F) A statement that includes the following--

(1) A statement that the active trade or business test described in

paragraph (c)(3) of this section is satisfied by the transferee foreign

corporation and a description of such business;

(2) A statement that on the day of the transaction, there was no

intent on the

[[Page 68640]]

part of the transferee foreign corporation (or its qualified

subsidiary, if relevant) or the transferors of the transferee foreign

corporation (or qualified subsidiary, if relevant) to substantially

discontinue its active trade or business; and

(3) A statement that the substantiality test described in paragraph

(c)(3)(iii) of this section is satisfied, and documentation that such

test is satisfied, including the value of the transferee foreign

corporation and the value of the U.S. target company on the day of the

transfer, and either one of the following--

(i) A statement demonstrating that the value of the transferee

foreign corporation 36 months prior to the acquisition, plus the value

of any assets described in paragraph (c)(3)(iii)(B) of this section

(including stock) acquired by the transferee foreign corporation within

the 36-month period, less the amount of any liabilities acquired during

that period, exceeds the value of the U.S. target company on the

acquisition date; or

(ii) A statement demonstrating that the value of the transferee

foreign corporation on the date of the acquisition, reduced by the

value of any assets not described in paragraph (c)(3)(iii)(B) of this

section (including stock) acquired by the transferee foreign

corporation within the 36-month period, exceeds the value of the U.S.

target company on the date of the acquisition.

(ii) For purposes of this paragraph (c)(6), an income tax return

will be considered timely filed if such return is filed, together with

the statement required by this paragraph (c)(6), on or before the last

date for filing a Federal income tax return (taking into account any

extensions of time therefor) for the taxable year in which the transfer

occurs. If a return is not timely filed within the meaning of this

paragraph (c)(6), the District Director may make a determination, based

on all facts and circumstances, that the taxpayer had reasonable cause

for its failure to file a timely filed return and, if such a

determination is made, the requirement contained in this paragraph

(c)(6) shall be waived.

(7) Ownership statements. To rebut the ownership presumption of

paragraph (c)(2) of this section, the U.S. target company must obtain

ownership statements (described in paragraph (c)(5)(i) of this section)

from a sufficient number of persons that transfer U.S. target company

stock or securities in the transaction that are not U.S. persons to

demonstrate that the 50-percent threshold of paragraph (c)(1)(i) of

this section is not exceeded. In addition, the U.S. target company must

attach to its timely filed U.S. income tax return (as described in

paragraph (c)(6)(ii) of this section) for the taxable year in which the

transfer occurs a statement, titled ``Section 367(a)--Compilation of

Ownership Statements Under Reg. Sec. 1.367(a)-3(c),'' signed under

penalties of perjury by an officer of the corporation, disclosing the

following information:

(i) The amount (specified as to the percentage of the total voting

power and the total value) of stock of the transferee foreign

corporation received, in the aggregate, by U.S. transferors;

(ii) The amount (specified as to the percentage of total voting

power and total value) of stock of the transferee foreign corporation

received, in the aggregate, by foreign persons that filed ownership

statements;

(iii) A summary of the information tabulated from the ownership

statements, including--

(A) The names of the persons that filed ownership statements

stating that they are not U.S. persons;

(B) The countries of residence and citizenship of such persons; and

(C) Each of such person's ownership (by voting power and by value)

in the U.S. target company prior to the exchange and the amount of

stock of the transferee foreign corporation (by voting power and value)

received by such persons in the exchange.

(8) Certain transfers in connection with performance of services.

Section 367(a)(1) shall not apply to a domestic corporation's transfer

of its own stock or securities in connection with the performance of

services, if the transfer is considered to be to a foreign corporation

solely by reason of Sec. 1.83-6(d)(1).

(9) Private letter ruling option. The Internal Revenue Service may,

in limited circumstances, issue a private letter ruling to permit the

taxpayer to qualify for an exception to the general rule under section

367(a)(1) if--

(i) A taxpayer is unable to satisfy all of the requirements of

paragraph (c)(3) of this section relating to the active trade or

business test of paragraph (c)(1)(iv) of this section, but such

taxpayer meets all of the other requirements contained in paragraphs

(c)(1)(i) through (c)(1)(iii) of this section, and such taxpayer is

substantially in compliance with the rules set forth in paragraph

(c)(3) of this section; or

(ii) A taxpayer is unable to satisfy any requirement of paragraph

(c)(1) of this section due to the application of paragraph (c)(4)(iv)

of this section. Notwithstanding the preceding sentence, in no event

will the Internal Revenue Service rule on the issue of whether the

principal purpose of an acquisition was to satisfy the active trade or

business test, including the substantiality test.

(10) Examples. This paragraph (c) may be illustrated by the

following examples:

Example 1. Ownership presumption. (i) FC, a foreign corporation,

issues 51 percent of its stock to the shareholders of S, a domestic

corporation, in exchange for their S stock, in a transaction

described in section 367(a)(1).

(ii) Under paragraph (c)(2) of this section, all shareholders of

S who receive stock of FC in the exchange are presumed to be U.S.

persons. Unless this ownership presumption is rebutted, the

condition set forth in paragraph (c)(1)(i) of this section will not

be satisfied, and the exception in paragraph (c)(1) of this section

will not be available. As a result, all U.S. persons that

transferred S stock will recognize gain on the exchange. To rebut

the ownership presumption, S must comply with the reporting

requirements contained in paragraph (c)(6) of this section,

obtaining ownership statements (described in paragraph (c)(5)(i) of

this section) from a sufficient number of non-U.S. persons who

received FC stock in the exchange to demonstrate that the amount of

FC stock received by U.S. persons in the exchange does not exceed 50

percent.

Example 2. Filing of Gain Recognition Agreement. (i) The facts

are the same as in Example 1, except that FC issues only 40 percent

of its stock to the shareholders of S in the exchange. FC satisfies

the active trade or business test of paragraph (c)(1)(iv) of this

section. A, a U.S. person, owns 10 percent of S's stock immediately

before the transfer. All other shareholders of S own less than five

percent of its stock. None of S's officers or directors owns any

stock in FC immediately after the transfer. A will own 15 percent of

the stock of FC immediately after the transfer, 4 percent received

in the exchange, and the balance being stock in FC that A owned

prior to and independent of the transaction. No S shareholder

besides A owns five percent or more of FC immediately after the

transfer. The reporting requirements under paragraph (c)(6) of this

section are satisfied.

(ii) The condition set forth in paragraph (c)(1)(i) of this

section is satisfied because, even after application of the

presumption in paragraph (c)(2) of this section, U.S. transferors

could not receive more than 50 percent of FC's stock in the

transaction. There is no control group because five-percent target

shareholders and officers and directors of S do not, in the

aggregate, own more than 50 percent of the stock of FC immediately

after the transfer (A, the sole five-percent target shareholder,

owns 15 percent of the stock of FC immediately after the transfer,

and no officers or directors of S own any stock of FC immediately

after the transfer). Therefore, the condition set forth in paragraph

(c)(1)(ii) of this section is satisfied. The facts assume that the

condition set forth in paragraph (c)(1)(iv) of this section is

satisfied. Thus, U.S. persons that are not five-percent transferee

shareholders will not recognize gain on the exchange of S shares

[[Page 68641]]

for FC shares. A, a five-percent transferee shareholder, will not be

required to include in income any gain realized on the exchange in

the year of the transfer if he files a 5-year gain recognition

agreement (GRA) and complies with section 6038B.

Example 3. Control Group. (i) The facts are the same as in

Example 2, except that B, another U.S. person, is a 5-percent target

shareholder, owning 25 percent of S's stock immediately before the

transfer. B owns 40 percent of the stock of FC immediately after the

transfer, 10 percent received in the exchange, and the balance being

stock in FC that B owned prior to and independent of the

transaction.

(ii) A control group exists because A and B, each a five-percent

target shareholder within the meaning of paragraph (c)(5)(iii) of

this section, together own more than 50 percent of FC immediately

after the transfer (counting both stock received in the exchange and

stock owned prior to and independent of the exchange). As a result,

the condition set forth in paragraph (c)(1)(ii) of this section is

not satisfied, and all U.S. persons (not merely A and B) who

transferred S stock will recognize gain on the exchange.

Example 4. Partnerships. (i) The facts are the same as in

Example 3, except that B is a partnership (domestic or foreign) that

has five equal partners, only two of whom, X and Y, are U.S.

persons. Under paragraph (c)(4)(i) of this section, X and Y are

treated as the owners and transferors of 5 percent each of the S

stock owned and transferred by B and as owners of 8 percent each of

the FC stock owned by B immediately after the transfer. U.S. persons

that are five-percent target shareholders thus own a total of 31

percent of the stock of FC immediately after the transfer (A's 15

percent, plus X's 8 percent, plus Y's 8 percent).

(ii) Because no control group exists, the condition in paragraph

(c)(1)(ii) of this section is satisfied. The conditions in

paragraphs (c)(1)(i) and (iv) of this section also are satisfied.

Thus, U.S. persons that are not five-percent transferee shareholders

will not recognize gain on the exchange of S shares for FC shares.

A, X, and Y, each a five-percent transferee shareholder, will not be

required to include in income in the year of the transfer any gain

realized on the exchange if they file 5-year GRAs and comply with

section 6038B.

(11) Effective date. This paragraph (c) applies to transfers

occurring after January 29, 1997. However, taxpayers may elect to apply

this section in its entirety to all transfers occurring after April 17,

1994, provided that the statute of limitations of the affected tax year

or years is open.

(d) Transfers of stock or securities of foreign corporations. For

guidance, see Notice 87-85 (1987-2 C.B. 395). See Sec. 601.601(d)(2) of

this chapter.

(e) through (h) [Reserved]. For further guidance, see

Sec. 1.367(a)-3T(e) through (h).

Par. 3. In Sec. 1.367(a)-3T, paragraphs (a), (c) and (d) are

revised to read as follows:

Sec. 1.367(a)-3T Treatment of transfers of stock or securities to

foreign corporations (temporary).

(a) [Reserved]. For further information, see Sec. 1.367(a)-3(a).

* * * * *

(c) and (d) [Reserved]. For further information, see Sec. 1.367(a)-

3(c) and (d).

* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 4. The authority for citation for part 602 continues to read

as follows:

Authority: 26 U.S.C. 7805.

Par. 5. Section 602.101, paragraph (c) is amended by revising the

entry for 1.367(a)-3T and adding an entry to the table in numerical

order to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

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

Current OMB

CFR part or section where identified and described control No.

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

* * * * *

1.367(a)-3................................................. 1545-0026

1545-1478

1.367(a)-3T................................................ 1545-0026

* * * * *

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

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: December 11, 1996.

Donald C. Lubick,

Assistant Secretary of the Treasury.

[FR Doc. 96-32375 Filed 12-27-96; 8:45 am]

BILLING CODE 4830-01-U