After the Spin: Preserving Tax-Free Treatment Under Section 355

Article by Herbert N. Beller and Lori E. Harwell

The assistance of John L. Hynes, a Sutherland associate, is gratefully acknowledged. An earlier version of this article was printed in Mergers & Acquisitions: The Monthly Tax Journal, Vol. 2, No. 3 (July 2001). This article has been reprinted in Tax Notes with permission from Panel Publishers.

Table of Contents

I. BACKGROUND

A. Section 355 Transactions

B. Post-Spin Developments

2. TAXABLE STOCK ACQUISITIONS

   A. Device

   1. Post-spin stock dispositions

   2. Non-device factors

      B. Continuity of Interest

   1. How much?

   2. How long?

      C. Section 355(e)

   1. Corporate-level tax

   2. Rebuttable "plan" presumption

   3. Acquisitions after two years

   4. Acquisitions after six months

   5. Facts and circumstances test

   6. Interface with COI/device

   7. Reliance on temporary regulations

3. TAX-FREE STOCK ACQUISITIONS

   A. Device

   B. COI

   C. Section 355(e).

4. OTHER POST-SPIN STOCK TRANSACTIONS

   A. Third-Party Sales

   B. Redemptions

   1. Device

   2. COI/Section 355(e)

      C. Stock Issuances

   1. Device/COI

   2. Section 355(e).

   3. "D" reorganizations.

5. POST-SPIN ASSET TRANSACTIONS

   A. Active Business Considerations

   1. 90% test

   2. 5% test

   3. "Immediately after" requirement.

   4. Tax-free transfers

   B. Continuity of Enterprise

   C. Section 355(e).

6. DEVIATION FROM BUSINESS PURPOSE

   A. Favorable Rulings

   B. Continuing Relationships

7. SUPPLEMENTAL RULINGS

   A. Ruling or Opinion?

   B. Ruling Request Content

   C. Pre-Filing Conferences

   D. Processing Time

   E. Refusal to Rule

8. CONCLUSION

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   This article examines the principal issues that can arise under Section 355 of the Internal Revenue Code in connection with various transactions and other developments following a spin-off or other form of corporate separation. The article also discusses the process for obtaining an opinion of tax counsel or an IRS ruling with respect to such matters.

   I. BACKGROUND

   The ability to achieve a tax-free separation of a controlled subsidiary under Section 355 is one of the few bright spots remaining for corporate tax planners since repeal of the so-called General Utilities doctrine in the mid-1980s. Under the rationale of General Utilities & Operating Co. v. Helvering,1 a corporation could make a liquidating or nonliquidating distribution of appreciated property to shareholders without incurring a corporate-level tax. The Internal Revenue Code generally embraced such treatment for nonliquidating distributions until 1984, and for liquidating distributions until 1986. The statutory reversal of General Utilities in those years (through amendments to Sections 311, 336 and 337) spared only complete liquidations of controlled subsidiaries (under Section 332) and qualifying distributions of controlled subsidiary stock (under Section 355).

   A. Section 355 Transactions.

   All Section 355 transactions involve the distribution by a corporation ("Distributing") of an 80% or more controlling interest in the stock of a subsidiary ("Controlled"). The distributed stock must constitute "control" within the meaning of Section 368(c), i.e., 80% of voting power and 80% of each class of nonvoting stock. In most instances, Distributing owns and distributes 100% of the Controlled stock. Any retention of Controlled stock must be supported by a good business reason, and the retained stock must be disposed of within 5 years under IRS ruling guidelines.2

   A Section 355 distribution typically is either pro rata to all of the Distributing shareholders (a "spin-off") or non-pro rata to some shareholders in redemption of their Distributing stock (a "split-off"). Another, less frequent, variation (a "split-up") involves the complete liquidation of Distributing, with its shareholders receiving the stock of one or more controlled subsidiaries. (The term "spin-off" or "spin" is used in this article as a reference to Section 355 distributions generally, i.e., whether or not pro rata.) If, prior to the spin-off, Distributing transfers an active business or other assets to a newly-formed or previously existing Controlled, the Section 355 distribution is generally considered part of a tax-free divisive reorganization under Section 368(a)(1)(D).

   Apart from the "distribution of control" requirement, all spin-offs must meet several other requirements in order to qualify under Section 355. These include the statutory "device" and "active business" requirements, and the nonstatutory "business purpose," "continuity of interest," and "continuity of business enterprise" requirements. Section 355 qualification results in tax-free treatment to the Distributing shareholders on their receipt of the Controlled stock, and to Distributing as well on any gain inherent in the distributed stock.3 However, in certain circumstances involving significant pre- or post-spin changes in the stock ownership of Distributing or Controlled, corporate-level gain inherent in the distributed Controlled stock may be subject to tax under Section 355(d) or Section 355(e).

   B. Post-Spin Developments.

   The satisfaction of one or more of the Section 355 requirements can sometimes be affected by transactions or other events that occur after the spin-off. Total acquisitions of Distributing or Controlled by unrelated parties typically carry the greatest risk in this regard, especially if the acquisition occurs soon or relatively soon after the spin. More limited changes in the stock ownership or asset composition of Distributing or Controlled can also be problematic, as can changes in business plans or operations that might be viewed as contradicting the asserted business purpose for the spin-off.

   The analysis as to the impact of post-spin developments is largely fact-intensive and tends to focus on two main inquiries: (i) How soon after the spin-off did such developments occur? and (ii) Were such developments planned or otherwise contemplated at the time of the spin-off?

   In many instances, the risk of undoing otherwise available Section 355 treatment is serious enough to dictate not going forward with a proposed post-spin transaction, or at least postponing the transaction. However, if a Section 355 ruling was obtained on the spin-off, it often is possible to obtain a supplemental IRS ruling to the effect that a contemplated transaction or other post-spin development will not adversely affect any of the prior favorable rulings.

   II. TAXABLE STOCK ACQUISITIONS

   Following a spin-off, another corporation or entity may acquire all of the outstanding Distributing or Controlled stock for cash or other nonstock consideration in a taxable transaction. This typically is done through a negotiated purchase, a reverse cash merger or a tender offer (coupled, if necessary, with a minority squeeze-out merger). Such a transaction could render the spin-off taxable at both the shareholder and corporate levels on device or continuity of interest grounds, or result in partial taxation at the corporate level under Section 355(e).

   A. Device.

   Section 355(a)(1)(B) precludes tax-free treatment for spin-off transactions used principally as a "device" for the distribution of the earnings and profits of Distributing or Controlled. The device restriction is intended mainly to prevent shareholder "bailouts" of corporate ordinary income through sales or other capital gain dispositions of stock which allow for recovery of tax basis.4

   1. Post-spin stock dispositions.

   The statute states that "the mere fact" that stock in either Distributing or Controlled is sold or exchanged by all or some of the shareholder-distributees subsequent to the spin-off, "other than pursuant to an arrangement negotiated or agreed upon prior to the (spin-off) shall not be construed to mean that the transaction was used principally as aÖ. device." According to the underlying Treasury regulations (which look to an overall "facts and circumstances" test in applying the device requirement), stock sales or exchanges that are not prearranged are nonetheless considered "evidence of device." Prearranged stock dispositions are considered "substantial evidence."5

   In general, the greater the percentage of stock disposed of, and the closer in time to the spin-off the disposition occurs, the greater the weight that will be accorded the disposition as a factor indicative of device.6 A post-spin stock disposition may be treated as having been effectuated "pursuant to an arrangement negotiated or agreed upon before the distribution," even though enforceable rights to buy or sell did not exist at the time of the spin-off.7 It is sufficient in this regard that the sale was discussed before the spin-off and was "reasonably to be anticipated" by both parties.8

   2. Non-device factors.

   By reason of certain "non-device" factors in the regulations, the disposition may not trigger a device problem even where all or most of the Distributing or Controlled stock changes hands soon after the spin-off. For example, a strong corporate business purpose for the spin-off is generally evidence of non-device.9 Indeed, doing a spin-off for the express purpose of facilitating an acquisition of Distributing or Controlled has long been an acceptable corporate business purpose under Section 355.10 The 1997 enactment of Section 355(e), however, rendered most such transactions not feasible due to stiff corporate-level tax consequences.

   Other non-device indicators include the fact that (i) Distributing is publicly traded and widely held;11 or (ii) the Distributing shareholders consist of one or more domestic corporations that could otherwise exclude the distributed Controlled stock from income as an intercorporate dividend.12 Moreover, apart from these specific regulatory aids, in private letter rulings the Service has blessed post-spin sales of all the stock of Controlled where the decision to sell stemmed from significant changes in business circumstances that arose after the spin-off.13

   B. Continuity of Interest.

   The continuity of interest...