Internal Revenue Bulletin:  2012-28 

July 9, 2012 

T.D. 9592

Substantial Business Activities


DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Temporary Regulations.

SUMMARY:

This document contains temporary regulations regarding whether a foreign corporation has substantial business activities in a foreign country. These regulations affect certain domestic corporations and partnerships (and certain parties related thereto), and foreign corporations that acquire substantially all of the properties of such domestic corporations or partnerships. The text of these temporary regulations serves as the text of the proposed regulations (REG-107889-12) set forth in the notice of proposed rulemaking on this subject also published in this issue of the Bulletin.

DATES:

Effective Date: These regulations are effective on June 12, 2012.

Applicability Date: For date of applicability, see §1.7874-3T(f).

FOR FURTHER INFORMATION CONTACT:

Mary W. Lyons, (202) 622-3860 and David A. Levine, (202) 622-3860 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On June 6, 2006, temporary regulations under section 7874 (T.D. 9265, 2006-2 C.B. 1) were published in the Federal Register (71 FR 32437) concerning the treatment of a foreign corporation as a surrogate foreign corporation (2006 temporary regulations). A notice of proposed rulemaking (REG-112994-06, 2006-2 C.B. 47) cross-referencing the 2006 temporary regulations was published in the same issue of the Federal Register (71 FR 32495). On July 28, 2006, Notice 2006-70, 2006-2 C.B. 252, was published, announcing a modification to the effective date contained in the 2006 temporary regulations. See §601.601(d)(2)(ii)(b). On June 12, 2009, the 2006 temporary regulations and the related notice of proposed rulemaking were withdrawn and replaced with new temporary regulations (2009 temporary regulations), which generally applied to acquisitions completed on or after June 9, 2009. T.D. 9453 (74 FR 27920, 2009-28 I.R.B. 114). A notice of proposed rulemaking cross-referencing the 2009 temporary regulations was published in the same issue of the Federal Register (74 FR 27947, 2009-28 I.R.B. 144). No public hearing was requested or held; however, comments were received. All comments are available at www.regulations.gov or upon request. After consideration of the comments received regarding whether a foreign corporation has substantial business activities in a foreign country, the Internal Revenue Service (IRS) and the Department of the Treasury (Treasury Department) have decided to issue new temporary regulations under §1.7874-3T (2012 temporary regulations) and a new notice of proposed rulemaking that provide guidance regarding this determination. The other portions of the 2009 temporary regulations are finalized in a separate Treasury Decision published elsewhere in this issue of the Bulletin.

Explanation of Provisions

A. General Approach

A foreign corporation is generally treated as a surrogate foreign corporation under section 7874(a)(2)(B) if pursuant to a plan (or a series of related transactions): (i) 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; (ii) after the acquisition at least 60 percent of the stock (by vote or value) of the foreign corporation is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation; and (iii) after the acquisition, the expanded affiliated group that includes the foreign corporation does not have substantial business activities in the foreign country (relevant 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. Similar provisions apply if a foreign corporation acquires substantially all of the properties constituting a trade or business of a domestic partnership.

The 2006 temporary regulations provided that the determination of whether the expanded affiliated group has substantial business activities in the relevant foreign country is based on all the facts and circumstances. The 2006 temporary regulations also provided a safe harbor, which generally was satisfied if at least ten percent of the employees, assets, and sales of the expanded affiliated group were in the relevant foreign country. The 2009 temporary regulations retained the facts and circumstances general rule provided in the 2006 temporary regulations, with certain modifications, but removed the safe harbor.

The IRS and the Treasury Department received comments requesting additional guidance on the level of business activities necessary for an expanded affiliated group to have substantial business activities in the relevant foreign country. One comment suggested providing a new safe harbor, which would require a higher percentage of business activities in the relevant foreign country than was required under the safe harbor included in the 2006 temporary regulations. The comment also recommended different safe harbors depending on the extent of the expanded affiliated group’s business activities in the United States.

After consideration of the comments and the underlying policies of section 7874, the IRS and the Treasury Department believe the facts and circumstances test of the 2009 temporary regulations should be replaced with a bright-line rule describing the threshold of activities required for an expanded affiliated group to have substantial business activities in the relevant foreign country. The IRS and the Treasury Department believe that such a rule will provide more certainty in applying section 7874 to particular transactions than the 2009 temporary regulations and will improve the administrability of this provision.

B. Threshold of Business Activities

The 2012 temporary regulations provide that an expanded affiliated group will have substantial business activities in the relevant foreign country only if at least 25 percent of the group employees, group assets, and group income are located or derived in the relevant foreign country, determined as follows:

1. Group employees

The 2012 temporary regulations set forth two tests, each of which must be satisfied, based on employees of members of the expanded affiliated group (group employees). The first test is calculated as the number of group employees based in the relevant foreign country divided by the total number of group employees determined on the applicable date discussed in section B.4. of this preamble. The second test is calculated as employee compensation with respect to group employees based in the relevant foreign country divided by the total employee compensation with respect to all group employees determined during the one-year testing period.

2. Group assets

The group assets test is calculated as the value of the group assets located in the relevant foreign country divided by the total value of all group assets determined on the applicable date. The term group assets generally means tangible personal property or real property used or held for use in the active conduct of a trade or business by members of the expanded affiliated group. For this purpose, group assets include certain property rented by members of the expanded affiliated group, with the value of such rented property being deemed to be eight times the net annual rent paid or accrued with respect to such property. The IRS and the Treasury Department believe that using an eight-times multiple for this purpose is administrable and consistent with the treatment of rented property for other purposes. See, for example, Uniform Division of Income for Tax Purposes Act, §§10 and 11. In order to constitute group assets, such rented property must satisfy the other applicable requirements for group assets, including that the property is used or held for use in the active conduct of a trade or business.

3. Group income

The group income test is calculated as the group income derived in the relevant foreign country divided by the total group income determined during the one-year testing period. The term group income means gross income of members of the expanded affiliated group from transactions occurring in the ordinary course of business with customers that are not related persons. Group income is considered to be derived in a foreign country only if the customer is located in such country.

4. Applicable date

Section 7874(a)(2)(B)(iii) provides that the determination of whether the expanded affiliated group has substantial business activities is made after the acquisition. However, the IRS and the Treasury Department believe that when the acquisition occurs other than at the end of a month the factors used to determine whether the substantial business activities test is satisfied may not be readily determinable in some cases. Accordingly, the 2012 temporary regulations provide that the number of group employees and the value of group assets can be measured as of the applicable date, which is either the date on which the acquisition is completed or the last day of the month immediately preceding the month in which the acquisition is completed. The applicable date is also used to determine the testing period, which is used in computing group income and employee compensation. When the applicable date is the last day of the month immediately preceding the month in which the acquisition is completed, group employees, employee compensation, group assets, and group income consist of those items or amounts of members that comprise the expanded affiliated group determined at the close of the acquisition date.

C. Attribution from a Partnership

The 2009 temporary regulations provided that for purposes of the substantial business activities test, a member of an expanded affiliated group that holds at least a ten-percent capital and profits interest in a partnership takes into account its proportionate share of all items of the partnership. The IRS and the Treasury Department believe that the policies of section 7874 are better advanced if the treatment of partnerships is made consistent with that of corporations for purposes of applying the substantial business activities test on a group basis. Accordingly, the 2012 temporary regulations provide that the items of a partnership should be taken into account for this purpose only if one or more members of the expanded affiliated group holds, in the aggregate, more than 50 percent (by value) of the interests in the partnership. The IRS and the Treasury Department further believe that, consistent with the treatment of corporations, if this ownership requirement is satisfied, then all the items of the partnership should be taken into account for this purpose.

D. Effective Date

Subject to a transition rule, the 2012 temporary regulations apply to acquisitions completed on or after June 7, 2012.

Special Analyses

It has been determined that that these temporary regulations are not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to the 2012 temporary regulations and because the regulations do not impose a collection of information on small entities, the requirements of the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply. Accordingly, a regulatory flexibility analysis is not required. Pursuant to section 7805(f) of the Code, the 2012 temporary regulations have been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Requests for Comments

The IRS and the Treasury Department are considering to what extent partners of a partnership should be treated as if they were employees solely for purposes of the two tests based on group employees, and specifically request comments on these issues. For information on how to submit comments or request a public hearing, see the section ’’Comments and Requests for a Public Hearing’’ set forth in the notice of proposed rulemaking published elsewhere in this issue of the Bulletin.

Amendments to the Regulations

Accordingly, 26 CFR part 1 is 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 * * *

Section 1.7874-3T is also issued under 26 U.S.C. 7874(c)(6) and (g).* * *

Par. 2. Section 1.7874-3T is added to read as follows:

§1.7874-3T Substantial business activities (temporary).

(a) Scope. This section provides rules regarding whether a foreign corporation has substantial business activities in the relevant foreign country when compared to the total business activities of the expanded affiliated group for purposes of section 7874(a)(2)(B)(iii). Paragraph (b) of this section sets forth the threshold of business activities that constitute substantial business activities. Paragraph (c) of this section describes certain items not to be taken into account as located or derived in the relevant foreign country. Paragraph (d) of this section provides definitions and certain rules of application. Paragraph (e) of this section provides rules regarding the treatment of a partnership in which one or more members of an expanded affiliated group own an interest. Paragraph (f) of this section provides the dates of applicability and expiration.

(b) Threshold of business activities. The expanded affiliated group will have substantial business activities in the relevant foreign country after the acquisition when compared to the total business activities of the expanded affiliated group only if, subject to paragraph (c) of this section, each of the tests described in paragraphs (b)(1) through (b)(3) of this section is satisfied.

(1) Group employees—(i) Number of employees. The number of group employees based in the relevant foreign country is at least 25 percent of the total number of group employees on the applicable date.

(ii) Employee compensation. The employee compensation incurred with respect to group employees based in the relevant foreign country is at least 25 percent of the total employee compensation incurred with respect to all group employees during the testing period.

(2) Group assets. The value of the group assets located in the relevant foreign country is at least 25 percent of the total value of all group assets on the applicable date.

(3) Group income. The group income derived in the relevant foreign country is at least 25 percent of the total group income during the testing period.

(c) Items not to be considered. The following items are not taken into account in the numerator, but are taken into account in the denominator, for each of the tests described in paragraphs (b)(1) through (b)(3) of this section:

(1) Any group assets, group employees, or group income attributable to business activities that are associated with properties or liabilities the transfer of which is disregarded under section 7874(c)(4).

(2) Any group assets or group employees located in, or group income derived in, the relevant foreign country as part of a plan with a principal purpose of avoiding the purposes of section 7874.

(3) Any group assets or group employees located in, or group income derived in, the relevant foreign country if such group assets or group employees, or the business activities to which such group income is attributable, are subsequently transferred to another country in connection with a plan that existed at the time of the acquisition described in section 7874(a)(2)(B)(i).

(d) Definitions and application of rules. The following definitions and rules apply for purposes of this section:

(1) The term acquisition date means the date on which the acquisition described in section 7874(a)(2)(B)(i) is completed.

(2) The term applicable date means either of the following dates, applied consistently for all purposes of this section:

(i) The acquisition date; or

(ii) The last day of the month immediately preceding the month in which the acquisition described in section 7874(a)(2)(B)(i) is completed.

(3) The term employee compensation means all amounts incurred by members of the expanded affiliated group that directly relate to services performed by group employees (including, for example, wages, salaries, deferred compensation, employee benefits, and employer payroll taxes). Employee compensation is determined in U.S. dollars translated, if necessary, using the weighted average exchange rate (as defined in §1.989(b)-1) for the testing period.

(4) The term expanded affiliated group means the affiliated group defined in section 7874(c)(1) determined at the close of the acquisition date. The term member of the expanded affiliated group means an entity included in the expanded affiliated group. A reference to a member of the expanded affiliated group includes a predecessor with respect to such member.

(5) The term group assets means tangible personal property or real property used or held for use in the active conduct of a trade or business by members of the expanded affiliated group, provided such property is owned by members of the expanded affiliated group at the close of the acquisition date. A group asset is considered to be located in the relevant foreign country only if the asset was physically present in such country at the close of the acquisition date and for more time than in any other country during the testing period. All group assets must be valued consistently and on a gross basis (that is, not reduced by liabilities) using either the adjusted tax basis or fair market value determined in U.S. dollars translated, if necessary, at the spot rate determined under the principles of §1.988-1(d)(1), (2), and (4). Tangible personal property or real property that is rented by members of the expanded affiliated group from a person other than a member of the expanded affiliated group is also treated as a group asset, provided such property is used in the active conduct of a trade or business and is being rented by members of the expanded affiliated group at the close of the acquisition date. For purposes of this section, a group asset that is rented is valued at eight times the net annual rent paid or accrued with respect to the property by members of the expanded affiliated group.

(6) The term group employees means employees of members of the expanded affiliated group. A group employee is considered to be based in the relevant foreign country only if the employee spent more time providing services in such country than in any other single country during the testing period.

(7) The term group income means gross income of members of the expanded affiliated group from transactions occurring in the ordinary course of business with customers that are not related persons. Group income is translated into U.S. dollars, if necessary, using the weighted average exchange rate (as defined in §1.989(b)-1) for the testing period. Group income is considered derived in the relevant foreign country only if it is derived from a transaction with a customer located in such country.

(8) The term net annual rent means the annual rent paid or accrued with respect to property, less any payments received or accrued from subleasing such property (or other similar arrangement).

(9) The term related person has the meaning specified in section 954(d)(3), except that section 954(d)(3) is applied by substituting “one or more members of the expanded affiliated group” for “a controlled foreign corporation” and “the controlled foreign corporation” each place they appear.

(10) The term relevant foreign country means the foreign country in which, or under the law of which, the foreign corporation was created or organized.

(11) The term testing period means the one-year period ending on the applicable date.

(e) Treatment of partnerships. For purposes of this section, if one or more members of the expanded affiliated group own, in the aggregate, more than 50 percent (by value) of the interests in a partnership, such partnership will be treated as a corporation that is a member of the expanded affiliated group. Thus, all items of such a partnership are taken into account for purposes of this section. No items of a partnership are taken into account for purposes of this section unless the partnership is treated as a member of the expanded affiliated group pursuant to this paragraph.

(f) Effective/applicability and expiration dates. Except as otherwise provided in this paragraph, this section shall apply to acquisitions that are completed on or after June 7, 2012. For acquisitions completed on or after June 7, 2012, that were either described in a filing with the Securities and Exchange Commission on or before June 7, 2012, or that were subject to a written agreement that was binding on June 7, 2012, and at all times thereafter, taxpayers may apply either the rules in §1.7874-2T(g), as contained in 26 CFR part 1 revised as of April 12, 2012, or the rules set forth in this section. The applicability of this section expires on June 5, 2015.

Steven T. Miller,
Deputy Commissioner for
Services and Enforcement.

Approved June 4, 2012.

Emily S. McMahon,
Acting Assistant Secretary
of the Treasury (Tax Policy).

Note

(Filed by the Office of the Federal Register on June 7, 2012, 4:15 p.m., and published in the issue of the Federal Register for June 12, 2012, 77 F.R. 34785)

Drafting Information

The principal authors of the 2012 temporary regulations are Mary W. Lyons and David A. Levine of the Office of Associate Chief Counsel (International). However, other personnel from the IRS and the Treasury Department participated in their development.

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