Foreign income & taxpayers: new rules on treatment of certain stock of a foreign corporation under sec. 7874.

• Author: Rollinson, Marjorie

On September 17, 2009, the IRS issued Notice 2009-78, announcing its intention to issue regulations that will identify certain stock of a foreign corporation that is to be disregarded for determining foreign corporation ownership under the requirements of Sec. 7874. In essence, the notice extends the public offering rule of Sec. 7874(c)(2)(B) to certain private placements.

In the notice, the government outlines its concern about application of the ownership test (under Sec. 7874(a)(2)(B)(ii)) in certain transactions. As one example, the notice describes a transaction in which shareholders of a domestic corporation transfer all their stock to a newly formed foreign corporation for 79% of the stock of the foreign corporation and, in a related transaction, an investor transfers cash to the foreign corporation for the remaining 21% of stock. The government views the investor's acquisition of 21% of the stock (with cash) as inconsistent with the purposes of Sec. 7874. To address the concerns raised by this transaction, the new regulations will provide that if nonqualified property (e.g., cash or marketable securities) is exchanged for stock of a foreign corporation in an acquisition under Sec. 7874, such stock will not be taken into account for purposes of the ownership test.

The notice also describes another transaction in which the shareholders of two publicly traded companies, one foreign and one domestic, transfer all their stock to a newly formed foreign corporation, also publicly traded, solely in exchange for stock of the new foreign corporation. If the new foreign corporation stock received by the shareholders of the old foreign corporation is considered "sold in a public offering," such stock would not be included for purposes of the ownership test. The IRS concludes that this is not the intended result of the statute.

Once issued, the new regulations will apply to acquisitions completed on or after September 17, 2009.

Surrogate Foreign Corporation Test

Under Sec. 7874(a) (2) (B), a foreign corporation will be considered a surrogate foreign corporation if:

* The foreign corporation acquires substantially all the properties that are held directly or indirectly by a domestic corporation (or that constitute the trade or business of a domestic partnership) (acquisition test);

* After the acquisition, at least 60% of the stock (by vote or value) of the foreign corporation is held by the former shareholders of the domestic corporation or...