Foreign reorganization and stock offerings did not create a surrogate foreign corporation

Plain-English summary

A foreign parent planned an F reorganization moving a foreign subsidiary under a newly formed foreign corporation, followed by a private placement and public offering. The IRS ruled that offering shares issued for cash were excluded from the § 7874 ownership fraction, while shares treated as issued for the domestic subsidiary were excluded from both numerator and denominator under the expanded-affiliated-group rule. The resulting ownership fraction was zero over zero, so the new foreign corporation was not a surrogate foreign corporation. The ruling did not decide whether the transaction qualified as an F reorganization and flagged possible FIRPTA consequences.

Ruling snapshot

• Question: Would the proposed foreign reorganization and related stock offerings cause the new foreign corporation to be a surrogate foreign corporation under § 7874?
• Outcome: Approved. The § 7874 ownership test was not satisfied.
• Key authorities: IRC §§ 361, 367, 368(a)(1)(F), 7874, and 1504; Treas. Reg. §§ 1.367(b)-2 and 1.7874-1, -4T, and -5T

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201432002 Third Party Communication: None
Release Date: 8/8/2014 Date of Communication: Not Applicable
Index Number: 367.00-00
Person To Contact:
------------- ----------------, ID No. ----------------
---------------------------- Telephone Number:
------------------------------ ------------------
------------------------ Refer Reply To:
------------------------------------- CC:INTL:B04
PLR-123908-13
Date:
May 1, 2014

                                         Legend

US Co = ----------------------------------------------------------------------
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State A = -------------

Business B = ------------------------------------------------------------------

Foreign Sub 2 = ----------------------------------------------------------------------
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Country C = ------------

Foreign Sub 1 = ----------------------------------------------------------------------
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Country D = ------

FDE3 = ----------------------------------------------------------------------
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Country E = ----------------

FDE 2 = ----------------------------------------------------------------------
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                                 ---------------
                                 ---------------

x% = -----------

y% = -----------

FDE1 = ----------------------------------------------------------------------
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----------------------

Parent = ----------------------------------------------------------------------
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Country F = ---------------------

Country G = ------------

Year 1 = ------

FA = ----------------------------------------------------------------------
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Dear ------------:

This letter responds to your request for rulings dated May 15, 2013, regarding certain
Federal income tax consequences, under the Internal Revenue Code of 1986, as
amended (the “Code”), and the regulations thereunder, of a proposed transaction.
Additional information was received in a letter dated April 23, 2014. The information
provided in that request is summarized below.

The rulings contained in this letter are based on facts and representations submitted by
the taxpayer and accompanied by a penalties of perjury statement executed by an
appropriate party. This office has not verified any of the material submitted in support of
the ruling request. Verification of the information, representations, and other data may
be required as part of the audit process.

SUMMARY OF FACTS

US Co is a State A LLC treated as a domestic corporation for U.S. tax purposes. US
Co is currently constructing a facility in State A in order to conduct Business B.

All the shares of US Co are held by Foreign Sub 2, a Country C entity classified as a
foreign corporation for U.S. tax purposes. All the shares of Foreign Sub 2 are held by
Foreign Sub 1, a Country D entity also classified as a foreign corporation for U.S. tax
purposes. Foreign Sub 1 also holds all the interests in FDE3, a Country E entity
disregarded for U.S. tax purposes. FDE2 holds x% of the outstanding shares of Foreign
Sub 1; the remaining y% of the outstanding shares of Foreign Sub 1 is held by other
investors. FDE2 is a Country C entity disregarded for U.S. tax purposes, and x%
represents a majority interest in the shares of Foreign Sub 1. FDE1, also a Country C
entity disregarded for U.S. tax purposes, holds all the interests in FDE2. Parent, a
Country F entity classified as a foreign corporation for U.S. tax purposes, holds all the
interests in FDE1.

PROPOSED TRANSACTION

In order to help fund the cost of expanding its Business B operations, Parent intends to
conduct stock offerings of Foreign Sub 2. However, based on its own analysis and the
recommendations of its financial advisers, Parent believes the stock offerings would be
better effectuated under Country G law. Accordingly, and in anticipation of the stock
offerings, in year 1 FDE3 formed FA, a Country G corporation.

In order to carry out the stock offerings in Country G, Parent will convert Foreign Sub 2
into FA in what it intends will qualify as a reorganization under section 368(a)(1)(F) of
the Code (“F reorganization”). Specifically,

  1) Foreign Sub 1 will contribute all its shares of Foreign Sub 2 to FDE3;

  2) FDE3 will contribute all the shares of Foreign Sub 2 to FA in exchange for
     additional shares of FA;

  3) Foreign Sub 2 will make an entity classification election pursuant to Treas.
     Reg. § 301.7701-3(c) to be treated as an entity disregarded for U.S. tax
     purposes, effective two days after FDE3’s contribution of the shares of
     Foreign Sub 2 to FA.

After the F reorganization, Parent intends to initiate offerings of FA shares, in exchange
for cash, in the following manner:

  4) A private placement by FA of its only class of common stock (“FA Private
     Placement”) with an unrelated private investor for no more than 20 percent of
     such outstanding stock.

  5) An initial public offering (“FA IPO”) by FA of its only class of common stock on
     a Country G stock exchange. After the FA IPO, the private investor that
     acquired FA shares in the FA Private Placement and the public shareholders

      of FA will together hold no more than 49 percent of the outstanding shares of
      FA.

REPRESENTATIONS

Parent has represented that

   1) Foreign Sub 1’s contribution of the Foreign Sub 2 shares to FA followed by
      the election to treat Foreign Sub 2 as a disregarded entity will qualify as an F
      reorganization.

   2) After the proposed transaction, Foreign Sub 1 has no plan or intention to
      dispose of any of the FA shares it receives pursuant to the F reorganization.

LAW

In an F reorganization of a foreign corporation, there is considered to exist: (i) a transfer
of assets by the foreign transferor corporation to the acquiring corporation in exchange
for stock (or stock and securities) of the acquiring corporation and the assumption by
the acquiring corporation of the foreign transferor corporation’s liabilities; (ii) a
distribution of such stock (or stock and securities) by the foreign transferor corporation
to its shareholders (or shareholders and security holders); and (iii) an exchange by the
foreign transferor corporation’s shareholders (or shareholders and security holders) of
their stock (or stock and securities) for stock (or stock and securities) of the acquiring
corporation. See, e.g., Treas. Reg. § 1.367(b)-2(f).

Section 7874 provides rules for expatriated entities and their surrogate foreign
corporations. An expatriated entity is a domestic corporation (or domestic partnership)
with respect to which a foreign corporation is a surrogate foreign corporation, and any
United States person related to such domestic corporation (or domestic partnership)
(within the meaning of sections 267(b) or 707(b)(1)). Section 7874(a)(2)(A).

A foreign corporation constitutes a surrogate foreign corporation if three conditions are
satisfied. First, the foreign corporation completes, after March 4, 2003, the direct or
indirect acquisition of substantially all of the properties held directly or indirectly by a
domestic corporation. Section 7874(a)(2)(B)(i). Second, after the acquisition at least 60
percent of the stock of the foreign corporation (by vote or value) is held by former
shareholders of the domestic corporation by reason of holding stock in the domestic
corporation. Section 7874(a)(2)(B)(ii). Third, after the acquisition the expanded
affiliated group that includes the foreign corporation does not have substantial business
activities in the foreign country in which, or under the law of which, the foreign
corporation is created or organized, when compared to the total business activities of
the expanded affiliated group. Section 7874(a)(2)(B)(iii). Similar rules apply if a foreign

corporation acquires substantially all the assets of a trade or business of a domestic
partnership.

Where the former shareholders of the acquired domestic corporation hold at least 60
percent, but less than 80 percent, of the stock of the foreign acquirer, the domestic
corporation shall include its inversion gain in its income for the year of the acquisition.
Section 7874(a)(1). The corporation’s inversion gain means:

  [T]he income or gain recognized by reason of the transfer during the
  applicable period of stock or other properties by an expatriated entity, and
  any income received or accrued during the applicable period by reason of
  a license of any property by an expatriated entity--
       (A) as part of the acquisition described in subsection (a)(2)(B)(i), or
       (B) after such acquisition if the transfer or license is to a foreign
           related person.

Section 7874(d)(2). Where the former shareholders of the domestic corporation receive
80 percent or more of the foreign acquiring corporation by reason of their ownership of
the domestic corporation, the foreign acquiring corporation shall be treated as a
domestic corporation for all purposes of the code. Section 7874(b).

Section 7874(c)(1) defines an expanded affiliated group as an affiliated group as
defined in section 1504(a) but without regard to section 1504(b)(3), except that section
1504(a) shall be applied by substituting “more than 50 percent” for “at least 80 percent”
each place it appears.

Under section 7874(c)(2), certain stock of the foreign corporation is not taken into
account in determining ownership under section 7874(a)(2)(B)(ii) (“Ownership
Fraction”): (A) stock of the foreign corporation held by members of the expanded
affiliated group that includes the foreign corporation, and (B) stock of the foreign
corporation sold in a public offering related to the acquisition described in section
7874(a)(2)(B)(i).

In discussing the expanded affiliated group rule in section 7874(c)(2)(A), the General
Explanation prepared by the Joint Committee on Taxation provides:

  [I]f a U.S. parent corporation converts an existing wholly owned U.S.
  subsidiary into a new wholly owned controlled foreign corporation, all
  stock of the new foreign corporation would be disregarded, with the result
  that the transaction would not meet the definition of an inversion under the
  provision.

Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the
108th Congress, (JCS-5-05), at 344 (May 2005).

Treasury Reg. § 1.7874-4T(b) provides that, subject to an exception, disqualified stock
is treated as stock described in section 7874(c)(2)(B) and therefore is not included in
the denominator of the Ownership Fraction. Treasury Reg. § 1.7874-4T(c) defines
disqualified stock to include stock of the foreign acquiring corporation that is transferred
in exchange for nonqualified property. Nonqualified property includes cash. Treas.
Reg. § 1.7874-4T(i)(7)(i).

Treasury Reg. § 1.7874-5T(a) provides that stock of a foreign corporation described in
section 7874(a)(2)(B)(ii) will not cease to be so described as a result of a subsequent
transfer of the stock by the former shareholder that received such stock, even if the
subsequent transfer is related to the acquisition described in section 7874(a)(2)(B)(i).

RULINGS

Based solely on the information and representations submitted in the taxpayer’s ruling
request, we rule as follows:

   1) The FA shares treated as received by Foreign Sub 2 in the section 361(a)
      exchange in connection with the F reorganization will be described in section
      7874(a)(2)(B)(ii) and will not cease to be so described as a result of Foreign
      Sub 2’s section 361(c) distribution of such shares that is deemed to occur as
      a result of the F reorganization. Treas. Reg. § 1.7874-5T(a).

   2) Shares issued by FA pursuant to the FA Private Placement and the FA IPO
      will not be included in the denominator of the Ownership Fraction. Section
      7874(c)(2)(B) and Treas. Reg. § 1.7874-4T(b).

   3) The FA shares treated as issued in exchange for the shares of US Co
      pursuant to the F reorganization will be excluded from both the numerator and
      the denominator of the Ownership Fraction. Section 7874(c)(2)(A) and Treas.
      Reg. § 1.7874-1(b).

   4) The Ownership Fraction will be zero over zero. Accordingly, the requirement
      described in section 7874(a)(2)(B)(ii) will not be satisfied, and FA will not be a
      surrogate foreign corporation within the meaning of section 7874(a)(2)(B).

CAVEATS

Except as expressly provided above, no opinion is expressed concerning the tax
consequences of any aspect of any transaction or item discussed or referenced in this
letter, including whether the reorganization qualifies as a reorganization within the
meaning of section 368(a)(1)(F) of the Code.

Section 897(c)(1)(A)(i) provides that any interest in a domestic corporation is a U.S. real
property interest unless the taxpayer establishes that such corporation was at no time a
U.S real property corporation during the five year period ending on the date of
disposition. Accordingly, unless Foreign Sub 2 establishes that US Co was not a U.S.
real property holding corporation within the five year period ending on the date of the
transfer of the US Co stock, the transfer of the stock of US Co by Foreign Sub 2 to FA is
subject to the rules of section 897(e), section 1.897-6T(b) and section 1445.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

                                  Sincerely,



                                  Charles P. Besecky
                                  Branch Chief, Branch 4
                                  (International)

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