Example 1. Stock transferred in exchange for marketable securities—(i) Facts. Individual A wholly owns DT. PRS transfers marketable securities (within the meaning of paragraph (h)(1) of this section) to FA, a newly formed corporation, in exchange solely for 25 shares of FA stock. Then Individual A transfers all the DT stock to FA in exchange solely for 75 shares of FA stock.

(ii) Analysis. Under paragraph (h)(2)(ii) of this section, the marketable securities constitute nonqualified property. Accordingly, the 25 shares of FA stock transferred by FA to PRS in exchange for the marketable securities constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section. Paragraph (c)(2) of this section does not reduce the amount of disqualified stock described in paragraph (c)(1)(i) of this section because the transfer of FA stock in exchange for the marketable securities increases the fair market value of the assets of FA by the fair market value of the marketable securities transferred. Under paragraph (b) of this section, the 25 shares of FA stock transferred to PRS are not included in the denominator of the ownership fraction. See also section 7874(c)(4). Accordingly, the only FA stock included in the ownership fraction is the FA stock transferred to Individual A in exchange for the DT stock, and that FA stock is included in both the numerator and the denominator of the ownership fraction. Thus, the ownership fraction is 75/75.

Example 2. Stock transferred in exchange for property acquired with a principal purpose of avoiding the purposes of section 7874—(i) Facts. Individual A wholly owns DT. PRS transfers marketable securities (within the meaning of paragraph (h)(1) of this section) to FT, a newly formed corporation, in exchange solely for all the FT stock. Then PRS transfers the FT stock to FA, a newly formed corporation, in exchange solely for 25 shares of FA stock. Finally, Individual A transfers all the DT stock to FA in exchange solely for 75 shares of FA stock. FA acquires the FT stock with a principal purpose of avoiding the purposes of section 7874.

(ii) Analysis. Under paragraph (h)(2)(iv) of this section, the FT stock constitutes nonqualified property because a principal purpose of FA acquiring the FT stock is to avoid the purposes of section 7874. Accordingly, the 25 shares of FA stock transferred by FA to PRS in exchange for the FT stock constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section. Paragraph (c)(2) of this section does not reduce the amount of disqualified stock described in paragraph (c)(1)(i) of this section because the transfer of FA stock in exchange for the FT stock increases the fair market value of FA's assets by the fair market value of the FT stock. Under paragraph (b) of this section, the 25 shares of FA stock transferred to PRS are not included in the denominator of the ownership fraction. Furthermore, even in the absence of paragraph (h)(2)(iv) of this section, the transfer of marketable securities to FT would be disregarded pursuant to section 7874(c)(4). Accordingly, the only FA stock included in the ownership fraction is the FA stock transferred to Individual A in exchange for the DT stock, and that FA stock is included in both the numerator and the denominator of the ownership fraction. Thus, the ownership fraction is 75/75.

Example 3. Stock transferred in exchange for property acquired with a principal purpose of avoiding the purposes of section 7874—(i) Facts. DT is a publicly traded corporation. PRS is a foreign partnership that is unrelated to DT. PRS transfers certain business assets (PRS properties) to FA, a newly formed foreign corporation, in exchange solely for 25 shares of FA stock. The shareholders of DT transfer all of their DT stock to FA in exchange solely for the remaining 75 shares of FA stock (DT acquisition). None of the PRS properties is property described in paragraph (h)(2)(i) through (iii) of this section, but FA acquires the PRS properties with a principal purpose of avoiding the purposes of section 7874.

(ii) Analysis. Under paragraph (h)(2)(iv) of this section, the PRS properties transferred to FA constitute nonqualified property, because FA acquires the PRS properties in a transaction related to the DT acquisition with a principal purpose of avoiding the purposes of section 7874. Accordingly, the 25 shares of FA stock transferred by FA to PRS in exchange for the PRS properties constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section. Paragraph (c)(2) of this section does not apply to reduce the amount of disqualified stock described in paragraph (c)(1)(i) of this section because the transfer of FA stock in exchange for the PRS properties increases the fair market value of FA's assets by the fair market value of the PRS properties. Accordingly, pursuant to paragraph (b) of this section, the 25 shares of FA stock transferred to PRS in exchange for the PRS properties are not included in the denominator of the ownership fraction. Furthermore, even in the absence of paragraph (h)(2)(iv) of this section, the transfer of the PRS properties to FA would be disregarded pursuant to section 7874(c)(4). Therefore, the only FA stock included in the ownership fraction is the FA stock transferred to the former domestic entity shareholders of DT in exchange for their DT stock, and that FA stock is included in both the numerator and the denominator of the ownership fraction. Thus, the ownership fraction is 75/75.

Example 4. Stock transferred in exchange for stock of a foreign corporation that becomes a member of the expanded affiliated group—(i) Facts. FT, a publicly traded corporation, forms FA, and then FA forms DMS and FMS. FMS merges with and into FT, with FT surviving the merger (FMS-FT merger). Pursuant to the FMS-FT merger, the FT shareholders exchange their FT stock solely for 100 shares of FA stock and FT becomes a wholly owned subsidiary of FA. Following the FMS-FT merger, DMS merges with and into DT, also a publicly traded corporation, with DT surviving the merger (DT acquisition). Pursuant to the DT acquisition, the DT shareholders exchange their DT stock solely for the remaining 100 shares of FA stock, and DT becomes a wholly owned subsidiary of FA. After the completion of the plan, FA wholly owns FT and DT, DMS and FMS cease to exist, and the stock of FA is publicly traded.

(ii) Analysis. Because FT becomes a member of the expanded affiliated group that includes FA in a transaction related to the DT acquisition, the FT stock does not constitute marketable securities (within the meaning of paragraph (h)(1) of this section) and therefore does not constitute nonqualified property pursuant to paragraph (h)(2)(ii) of this section. Accordingly, no FA stock is disqualified stock described in paragraph (c)(1) of this section and therefore the FA stock transferred in exchange for the FT stock and DT stock is included in the denominator of the ownership fraction. Thus, the ownership fraction is 100/200.

(iii) Alternative facts. The facts are the same as in paragraph (i) of this Example 4, except that, instead of undertaking the FMS-FT merger, FT merges with and into FA with FA surviving the merger (FT-FA merger). Pursuant to the FT-FA merger, the FT shareholders exchange their FT stock solely for 100 shares of FA stock. At the time of the FT-FA merger, FT does not hold nonqualified property and has no obligations. Accordingly, FA stock transferred by FA to FT in exchange for the property of FT is not disqualified stock described in paragraph (c)(1) of this section. Furthermore, pursuant to paragraph (c)(2) of this section, the 100 shares of FA stock transferred by FT to the shareholders of FT in exchange for their FT stock do not constitute disqualified stock described in paragraph (c)(1) of this section. Although the FT stock is nonqualified property (the FT stock constitutes marketable securities within the meaning of paragraph (h)(2)(ii) of this section because the stock of FT is publicly traded and FT is not a member of the expanded affiliated group that includes FA after the DT acquisition), under paragraph (c)(2) of this section, the transfer of FA stock by FT to the shareholders of FT neither increases the fair market value of the assets of FA nor decreases the liabilities of FA. Accordingly, no FA stock is disqualified stock described in paragraph (c)(1) of this section and, therefore, the FA stock transferred in exchange for the assets of FT and the DT stock is included in the denominator of the ownership fraction. Thus, the ownership fraction is 100/200.

Example 5. De minimis exception—(i) Facts. Individual A wholly owns DT. The fair market value of the DT stock is $100x. PRS transfers $96x of cash to FA, a newly formed corporation, in exchange solely for 96 shares of FA stock. Then Individual A transfers the DT stock to FA in exchange for $96x of cash and 4 shares of FA stock (DT acquisition).

(ii) Analysis. Under paragraph (h)(2)(i) of this section, cash constitutes nonqualified property. Accordingly, the 96 shares of FA stock transferred by FA to PRS in exchange for $96x of cash constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section. Furthermore, paragraph (c)(2) of this section does not reduce the amount of disqualified stock described in paragraph (c)(1)(i) of this section because the transfer of FA stock in exchange for $96x of cash increases the fair market value of the assets of FA by $96x. However, without regard to the application of paragraph (b) of this section and §§1.7874-7(b) and 1.7874-10(b), the ownership percentage described in section 7874(a)(2)(B)(ii) would be less than 5 (by vote and value), or 4 (4/100, or 4 shares of FA stock held by Individual A by reason of owning the DT stock, determined under §1.7874-2(f)(2), over 100 shares of FA stock outstanding after the DT acquisition). Furthermore, after the DT acquisition and all related transactions, Individual A owns less than 5% (by vote and value, applying the attribution rules of section 318(a) with the modifications described in section 304(c)(3)(B)) of the stock of FA and DT (the members of the expanded affiliated group that includes FA). Accordingly, the de minimis exception in paragraph (d)(1) of this section applies and therefore paragraph (b) of this section does not apply to exclude the FA stock transferred to PRS from the denominator of the ownership fraction. Therefore, the FA stock transferred to Individual A and PRS is included in the denominator of the ownership fraction. Thus, the ownership fraction is 4/100.

Example 6. Obligation of the expanded affiliated group satisfied with stock—(i) Facts. Individual A wholly owns DT. The stock of DT held by Individual A has a fair market value of $75x. Individual A also holds an obligation of DT with a value and face amount of $25x. DT holds property with a value of $100x, and the $25x obligation is associated with the property. FA, a newly formed corporation, transfers 100 shares of FA stock to Individual A in exchange for all the DT stock and the $25x obligation of DT.

(ii) Analysis. Under paragraph (h)(2)(iii)(A) of this section, the $25x obligation of DT constitutes nonqualified property because DT is a member of the expanded affiliated group that includes FA, and Individual A (the holder of the obligation immediately before the domestic entity acquisition and any related transaction) is not a member of the EAG after the domestic entity acquisition and all related transactions. Thus, the shares of FA stock transferred by FA to Individual A in exchange for the obligation of DT constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section. Under §1.7874-2(f)(2), Individual A is treated as receiving 75 shares of FA stock in exchange for the DT stock (100 x $75x/$100x) and 25 shares of FA stock in exchange for the obligation of DT (100 x $25x/$100x). Thus, 25 shares of FA stock constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section. Paragraph (c)(2) of this section does not reduce the amount of disqualified stock described in paragraph (c)(1)(i) of this section because the transfer of FA stock for the $25x obligation increases the fair market value of FA's assets by $25x. Therefore, under paragraph (b) of this section, the 25 shares of FA stock transferred to Individual A in exchange for the obligation of DT are not included in the denominator of the ownership fraction. Accordingly, the only FA stock included in the ownership fraction is the 75 shares of FA stock transferred to Individual A in exchange for the DT stock, and that FA stock is included in both the numerator and the denominator of the ownership fraction. Thus, the ownership fraction is 75/75.

(iii) Alternative facts. The facts are the same as in paragraph (i) of this Example 6, except that instead of acquiring the stock of DT and the $25x obligation of DT, FA acquires the $100x of property from DT in exchange solely for 100 shares of FA stock. DT distributes 75 shares of FA stock to Individual A in exchange for Individual A's DT stock and transfers 25 shares of FA stock to Individual A in satisfaction of DT's obligation to Individual A, and liquidates. The 25 shares of FA stock transferred by FA to DT in exchange for the property of DT and then transferred by DT in satisfaction of DT's obligation to Individual A constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(ii) of this section. Paragraph (c)(2) of this section does not reduce the amount of disqualified stock described in paragraph (c)(1)(ii) of this section because the transfer of FA stock in exchange for the property of DT increases the fair market value of FA's assets by $100x (although the amount of disqualified stock is limited to 25 shares of FA stock in this case). Therefore, under paragraph (b) of this section, the 25 shares of FA stock that constitute disqualified stock are not included in the denominator of the ownership fraction. Accordingly, only 75 shares of FA stock are included in the ownership fraction, and that FA stock is included in both the numerator and the denominator of the ownership fraction. Thus, the ownership fraction is 75/75.

Example 7. “Over-the-top” stock transfer—(i) Facts. Individual A wholly owns DT. Individual B holds all 100 outstanding shares of FA stock. Individual C acquires 20 shares of FA stock from Individual B for cash, and then FA acquires all of the stock of DT from Individual A in exchange solely for 100 shares of FA stock.

(ii) Analysis. Under paragraph (h)(2)(i) of this section, cash constitutes nonqualified property. Accordingly, absent the application of paragraph (c)(2) of this section, the 20 shares of FA stock transferred by Individual B to Individual C in exchange for cash would constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section. Nevertheless, because Individual B's sale of FA stock neither increases the assets of FA nor decreases the liabilities of FA, such FA stock is not disqualified stock by reason of paragraph (c)(2) of this section. Accordingly, paragraph (b) of this section does not apply to exclude the 20 shares of FA stock sold by Individual B to Individual C, and that FA stock is included in the denominator of the ownership fraction. The 100 shares of FA stock received by Individual A are the only shares included in the numerator of the ownership fraction. Thus, the ownership fraction is 100/200.

Example 8. Interaction with internal group restructuring rule—(i) Facts. P holds 85 shares of DT stock. The remaining 15 shares of DT stock are held by Individual A. P and Individual A transfer their shares of DT stock to FA, a newly formed corporation, in exchange for 85 and 15 shares of FA stock, respectively (DT acquisition), and PRS transfers $75x of cash to FA in exchange for the remaining 75 shares of FA stock.

(ii) Analysis. Under paragraph (h)(2)(i) of this section, cash constitutes nonqualified property. Accordingly, the 75 shares of FA stock transferred by FA to PRS in exchange for $75x of cash constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section. Furthermore, paragraph (c)(2) of this section does not reduce the amount of disqualified stock described in paragraph (c)(1)(i) of this section because the transfer of FA stock in exchange for $75x of cash increases the fair market value of the assets of FA by $75x. Therefore, under paragraph (b) of this section, the 75 shares of FA stock transferred to PRS are not included in the denominator of the ownership fraction. Although PRS's shares of FA stock are excluded from the denominator of the ownership fraction under paragraph (b) of this section, under 1.7874-1(d)(1), such shares of FA stock nonetheless are taken into account for purposes of determining whether P is a member of the expanded affiliated group that includes FA and for purposes of determining whether the DT acquisition qualifies as an internal group restructuring. Because P holds 48.6% of the FA stock (85/175) after the DT acquisition and all transactions related to the DT acquisition, it is not a member of the expanded affiliated group that includes FA. In addition, the DT acquisition does not qualify as an internal group restructuring described in §1.7874-1(c)(2) because P does not hold, directly or indirectly, 80% or more of the shares of FA stock (by vote and value) after the DT acquisition and all transactions related to the DT acquisition. Therefore, the FA stock held by P (along with the FA stock held by Individual A) is included in the numerator and the denominator of the ownership fraction. Thus, the ownership fraction is 100/100.

Example 9. Interaction with loss of control rule—(i) Facts. P wholly owns DT. P transfers all of its shares of DT stock to FA, a newly formed corporation, in exchange for 49 shares of FA stock (DT acquisition), and R transfers marketable securities (within the meaning of paragraph (h)(1) of this section) to FA in exchange for the remaining 51 shares of FA stock.

(ii) Analysis. Under paragraph (h)(2)(ii) of this section, the marketable securities constitute nonqualified property. Accordingly, the shares of FA stock transferred by FA to R in exchange for the marketable securities constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section. Paragraph (c)(2) of this section does not reduce the amount of disqualified stock described in paragraph (c)(1)(i) of this section because the transfer of FA stock in exchange for the marketable securities increases the fair market value of the assets of FA by the fair market value of the marketable securities transferred. Therefore, under paragraph (b) of this section, the shares of FA stock transferred to R are not included in the denominator of the ownership fraction. Although under paragraph (b) of this section R's shares of FA stock are excluded from the denominator of the ownership fraction, under 1.7874-1(d)(1), such stock is taken into account for purposes of determining whether P or R is a member of the expanded affiliated group that includes FA. Because P holds 49% of the shares of FA stock (49/100), P is not a member of the expanded affiliated group that includes FA, and P's FA stock is included in both the numerator and the denominator of the ownership fraction. Because R holds 51% of the shares of FA stock (51/100), R is a member of the expanded affiliated group that includes FA and, before taking into account §1.7874-1(c), R's FA stock would be excluded from the numerator and denominator of the ownership fraction under section 7874(c)(2)(A) and §1.7874-1(b). However, the DT acquisition results in a loss of control described in §1.7874-1(c)(3) because P does not hold, in the aggregate, directly or indirectly, more than 50% of the shares of stock (by vote or value) of R, FA, or DT after the acquisition. Accordingly, the FA stock held by R would be included in the denominator of the ownership fraction under §1.7874-1(c)(1). Nevertheless, the FA stock held by R is excluded from the denominator of the ownership fraction under paragraph (b) of this section and §1.7874-1(d)(1). Thus, the ownership fraction is 49/49.

(iii) Alternative facts. The facts are the same as in paragraph (i) of this Example 9, except that, in exchange for 51 shares of FA stock, R transfers marketable securities (within the meaning of paragraph (h)(1) of this section) with a value equal to that of 16 shares of FA stock and qualified property (within the meaning of paragraph (h)(2) of this section) with a value equal to that of 35 shares of FA stock. Accordingly, 16 of the 51 shares of FA stock transferred to R constitute disqualified stock described in paragraph (c)(1) of this section by reason of paragraph (c)(1)(i) of this section, and 35 of such shares do not constitute disqualified stock. Paragraph (c)(2) of this section does not reduce the amount of disqualified stock described in paragraph (c)(1)(i) of this section because the transfer of FA stock in exchange for the marketable securities increases the fair market value of the assets of FA by the fair market value of the marketable securities transferred. Therefore, under paragraph (b) of this section, 16 of the 51 shares of FA stock transferred to R are not included in the denominator of the ownership fraction. Although 16 of the 51 shares of FA stock that are transferred to R are excluded from the denominator of the ownership fraction, under§1.7874-1(d)(1), all 51 of R's shares of FA stock are taken into account for purposes of determining whether P or R is a member of the expanded affiliated group that includes FA. Because P holds 49% of the shares of FA stock (49/100), it is not a member of the expanded affiliated group that includes FA, and its FA stock is included in both the numerator and the denominator of the ownership fraction. Because R holds 51% of the shares of FA stock (51/100), it is a member of the expanded affiliated group that includes FA and, before taking into account §1.7874-1(c), its FA stock is excluded from the numerator and denominator of the ownership fraction under section 7874(c)(2)(A) and §1.7874-1(b). However, the DT acquisition results in a loss of control described in §1.7874-1(c)(3) because P does not hold, in the aggregate, directly or indirectly, more than 50% of the shares of stock (by vote or value) of R, FA, or DT after the acquisition. Accordingly, the 51 shares of FA stock held by R would be included in the denominator of the ownership fraction under §1.7874-1(c)(1). Nevertheless, the 16 shares of FA stock that constitute disqualified stock are excluded from the denominator of the ownership fraction under paragraph (b) of this section and §1.7874-1(d)(1). In addition, the 35 shares of FA stock received by R that do not constitute disqualified stock are included in the denominator. Thus, the ownership fraction is 49/84.

Example 10. Stock issued in lieu of assuming associated obligation—(i) Facts. Individual A wholly owns DT. The stock of DT has a fair market value of $100x. Individual B wholly owns FT, a foreign corporation, which conducts two businesses, Business C and Business D. Business C comprises property with a gross fair market value of $70x and $20x of associated obligations. Business D comprises property with a gross fair market value of $45x and $35x of associated obligations. Individual A transfers all of the shares of DT stock to FA, a newly formed corporation, in exchange for $100x of FA stock (DT acquisition). In transactions related to the DT acquisition, FA acquires all of the Business C property from FT in exchange for $70x of FA stock and then FT transfers $30x of the FA stock to its creditors in satisfaction of $30x of its obligations. None of the Business C property is nonqualified property.

(ii) Analysis. Under paragraph (c)(1) of this section by reason of paragraph (c)(1)(ii) of this section, the $30x of FA stock transferred to FT (the transferee) in exchange for the Business C property (the exchanged property) and then transferred by FT in satisfaction of $30x of its obligations is disqualified stock, except to the extent limited by paragraph (c)(1)(ii)(B) of this section. Under paragraph (c)(1)(ii)(B)(1) of this section, the proportionate share of obligations associated with the exchanged property that is not assumed by FA must be determined. The proportionate share of obligations associated with the exchanged property is $20x, calculated as $20x (the obligations associated with the Business C properties) multiplied by $70x/$70x (the fair market value of the exchanged property, $70x, relative to the fair market value of all the Business C property, $70x). The proportionate share of obligations associated with the exchanged property that is not assumed by FA is $20x, calculated as the proportionate share of obligations associated with the exchanged property ($20x) less the obligations assumed by FA ($0x). Under paragraph (c)(1)(ii)(B)(2) of this section, the amount of disqualified stock is limited to the proportionate share of obligations associated with the exchanged property that is not assumed ($20x) multiplied by a fraction, which in this case is $70x/$70x (the amount of exchanged property that is qualified property, $70x, divided by the total amount of exchanged property, $70x). Accordingly, $20x of FA stock is disqualified stock under paragraph (c)(1) of this section by reason of paragraph (c)(1)(ii) of this section. Paragraph (c)(2) of this section does not reduce the amount of disqualified stock described in paragraph (c)(1)(ii) of this section because the transfer of the FA stock in exchange for the exchanged property increases the fair market value of FA's assets by $70x (although the amount of disqualified stock is limited to $20x of FA stock in this case). Therefore, under paragraph (b) of this section, the $20x of FA stock that constitutes disqualified stock is not included in the denominator of the ownership fraction. Accordingly, only $150x of FA stock is included in the denominator of the ownership fraction, calculated as the $100x of FA stock received by Individual A plus the $70x of FA stock received by FT less the $20x of FA stock that is disqualified stock. Thus, the ownership fraction is $100x/$150x. The result would be the same if, in transactions related to the DT acquisition, FT instead sold the $30x of FA stock for $30x cash and then transferred the cash in satisfaction of $30x of its obligations.

(iii) Alternative facts. The facts are the same as in paragraph (i) of this Example 10, except that FA acquires only $42x of the Business C property in exchange for $30x of FA stock and the assumption of $12x of the obligations associated with the Business C property. Under paragraph (c)(1) of this section by reason of paragraph (c)(1)(ii) of this section, the $30x of FA stock transferred to FT (the transferee) in exchange for the Business C property (the exchanged property) and then transferred by FT in satisfaction of $30x of its obligations is disqualified stock, except to the extent limited by paragraph (c)(1)(ii)(B) of this section. Under paragraph (c)(1)(ii)(B)(1) of this section, the proportionate share of obligations associated with the exchanged property that is not assumed by FA must be determined. The proportionate share of obligations associated with the exchanged property is $12x, calculated as $20x (the obligations associated with the Business C property) multiplied by $42x/$70x (the fair market value of the exchanged property, $42x, relative to the fair market value of all the Business C property, $70x). The proportionate share of obligations associated with the exchanged property that is not assumed by FA is $0, calculated as the proportionate share of obligations associated with the exchanged property ($12x) less the obligations assumed by FA ($12x). Accordingly, as a result of the application of paragraph (c)(1)(ii)(B)(2) of this section, no FA stock is disqualified stock under paragraph (c)(1) of this section by reason of paragraph (c)(1)(ii) of this section. As a result, $130x of FA stock is included in the denominator of the ownership fraction, calculated as the $100x of FA stock received by Individual A plus the $30x of FA stock received by FT. Thus, the ownership fraction is $100x/$130x.