Comments on final regulations under Section 355 relating to corporate separations.

Comments on Final Regulations Under Section 355 Relating to Corporate Separations

On January 4, 1989, the Internal Revenue Service issued final reguations under section 355 of the Internal Revenue Code, relating to corporate separations. The final regulations (T.D. 8238) were published in the Federal Register on January 5, 1989 (54 Fed. Reg. 283), and in the February 21, 1989, issue of the Internal Revenue Bulletin, 1989-8 I.R.B. 5.

The final regulations revise existing regulations that were issued in 1955; amendments to the existing regulations were initially proposed on January 21, 1977 (42 Fed. Reg. 38886) -- more than 12 years before the final regulations were promulgated. For simplicity's sake, the regulations are referred to as the "final regulations"; the 1977 regulations are referred to as the "proposed regulations"; and the 1955 regulations are referred to as the "prior regulations."

GENERAL COMMENTS

Originally enacted as part of the Internal Revenue Code of 1954, section 355 permits the tax-free distribution by one corporation (the distributing corporation) of stock or securities in another corporation (the controlled corporation) to shareholders with respect to their stock or to securities holders in exchange for their securities, if certain conditions are met. Statutory conditions include (i) requirements for control by the distributing corporation and for the active conduct of the business after the distribution, and (ii) a prohibition against the use of the transaction principally as a device for the distribution of earnings and profits. Moreover, although a tax-free reorganization was not a necessary prelude to a tax-free separation, the prior regulations required taxpayers to satisfy certain judicially created restrictions applicable to reorganizations under section 368. specifically, the prior regulations provided:

The distribution by a corporation...will not qualify under section 355 where carried out for purposes not germane to the business of the corporations.... Section 355 contemplates a continuity of the entire business enterprise under modified corporate forms and a continuity of interest in all or part of such business enterprise on the part of those persons who, directly or indirectly, were the owners of the ternprise prior to the distribution or exchange. All the requisites of business and corporate purposes described under 1.368 must be met to exept a transaction from the recognition of gain or loss under this section. Treas. Reg. 1.355-2(c) (1955).

Amendments to the regulations proposed in 1977 generally continued the continuity of interest and business purpose requirements. Prop. Reg. 1.355-2(b) (1977).

Nothwithstanding the long delay in the issuance of the final regulations, TEI commends the IRS for responding to many comments received since the proposed regulations were promulgated 12 years ago. We support, for examples, making the business purpose requirement dependent on whether the distributing corporation may achieve its purpose through a nontraxable transaction. Such a rule is significant clarification and reflects business reality. Moreover, the emphasis on the business purpose of the separation in determining whether the transaction constitutes a "device" under section 355(a)(1)(B) and the articulation of "device" and "nondevice" factors reflect sound policy and provide useful guidance.

TEI questions, however, the underlying validity of certain changes to the business purpose and continuity of interest requirements, as well as the ramifications of certain changes to the section 355 device clause. In addition, changes in the law (particularly the repeal of the General Utilities doctrine) substantially affect the application and interpretation of section 355. We therefore recommend that the regulations be reissued in proposed form to permit taxpayers to respond more formally to these changes. (1)

SPECIFIC COMMENTS

1. Treas. Reg. 1.355-2(b):

Independent Business

Purpose

The prior regulations provided that a distribution would not qualify for tax-free treatment under section 355 where it was carried out for "purposes not germane to the business of the corporations." Treas.Reg. 1.355-2(c) (1955). The proposed regulations explained that this test required a transaction to be carried out for "real and substantial nontax reasons germane to the business of the cororations." Prop. Reg. 1.355-2(b)(1) (1977).

Under the final regulations, "a transaction is carried out for a corporate business purpose if it is motivated, in whole or substantial part, by one or more corporate business purposes." Treas. Reg. 1.355-2(b)(2) (1989)(emphasis added). The final regulations also provide that --

potential for the avoidance of Federal taxes by the distributing or controlled corporation (or a corporation controlled by either) is relevant in determining the extent to wcich an existing corporate business purpose motivated the distribution.

Finally, Treas. Reg. 1.355-2(b)(1) (1989) provides that this test is independent of any other requirement under section 355.

TEI submits that the addition of a requirement that the transaction of motivated "in whole or substantial part" by one or more business purposes is not supported by the legislative history of section 355. In enacting section 355's predecessor in 1951, Congress expressed its intention that business separations would qualify for tax-free treatment "when undertaken for legitimate business purposes." S. Rep. No. 82-781, 82d Cong., 1st Sess. 58 (1951). Congress has never required that the business purpose for the transaction be the sole or predominant reason for the separation.

Nor have the courts required the motivation of the distributing or controlled corporation to be supported "in whole or substantial part by one or more corporate business purposes." For example, in Commissioner v. Wilson, 353F.2d 184, 186-87 (9th Cir. 1966), the court interpreted the business purpose test, as follows:

Congress, in enacting section 355 and its predecessors, was trying to give the business enterprises leeway in readjusting their corporate arrangements to better suit their business purposes. If the rearrangement had that purpose, Congress ws willing to concede them some possible tax advantages. If the reaarangement had no business purpose, let the taxes fall where they might.

Similarly, in Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794, 799 (4th Cir. 1967), the court concluded that a spin-off, followed by a reorganization of the distributing corporation, satisfied section 35 because --

[t]here was a strong business purpose for both the spin off and the merger, and tax avoidance ... was neither a predominant nor a subordinate purpose.

Thus, both Congress and the courts have recognized that, as long as a legitimate business purpose exists, the transaction will qualify under section 355.

We submit that, whereas the language of the proposed regulations ("real and substantial nontax reasons germane to the business of the taxpayer") properly focused the business purpose inquiry, the final regulations unreasonably distend that requirement.

Afacts-and-circumstances test by its nature injects uncertainty into the application of section 355. This is especially the case since the final regulations provide no quantitative analog to its "in whole or substantial part" standard. The regulations seem to contemplate a weighing of the various purposes motivating a transaction, but no guidance is provided on how the balance to be struck would differ under the test set forth from that which would obtain under a "principal" or "predominant" purpose test. (2)

In addition, by providing that the "potential for the avoidance of Federal taxes" is relevant in determining whether the business purpose requirement is satisfied, the final regulations construct a veritable Catch-22: if a transaction is motivated by a substantial nontax reason, the taxpayer will be entitled to the benefits conferred by section 355, but if those benefits -- "the potential for the avoidance of Federal taxes" -- are taken into account, the transaction may be deemed not to be supported by the requisite business purpose. Thus, a standard premised on the "potential for Federal tax avoidance" by the distributing or controlled corporations may disqualify otherwise legitimate section 355 transactions simply because there are significant unrealized gains in the distributed shares that would have been taxed under section 311(b) but for the application of sections 355(c) and 311(a). Nothing in the statute or the case law warrants such a result.

TEI believes that the changes to the business purpose test are unnecessary, will spawn needless uncertainty and confusion, (3) and will operate to deny the benefits of section 355 in respect of transactions comporting with those contemplated by Congress when the statute was enacted. We specifically believe that Example (8) under Treas. Reg. 1.355-2(b)(5) should be revised to provide that the business purpose test is clearly satisfied because the issuance of stock to a key employee under the circumstances was germane to the business. As previously stated, the federal tax savings, in and of itself, should not affect the qualification of the transaction under section 355.

2. Treas. Reg. 1.355-2(c):

Continuity of Interest

Treas. Reg. 1.355-2(c) (1989) continues the separate, independent requirement for continuity of interest set out in the prior regulations. The final regulations, however, "clarify" that definition by requiring --

one or more persons who, directly or indirectly, were the owners of the enterprise prior to the distribution or exchange own, in the aggregate, [to own] an amount of stock establishing a continuity of interest in each of the modified corporate forms in which the enterprise is conducted after the separation (emphasis added). (4)

TEI submits that the final regulations place undue emphasis on the percentage of equity ownership retained by the historic shareholders. Under the prior regulations (Treas. Reg. 1.355-2(c) (1955)), the requisite continuity of interest applied to "all or part of [the original] business enterprise on the part of those who, directly or indirectly, were the owners of the enterprise prior to the distribution or exchange." The proposed regulations continued that rule. Prop. Reg. 1.355-2(b) (1977).

Under the section 368 reorganization rules, (5) continuity of interest has traditionally been found where the shareholders in the acquired corporation retain an aggregate equity interest in the acquiring corporation equal to a substantial percentage of the value of their former holdings. Continuity is measured not by evaluating the shareholders' percentage of ownership in the acquiring corporation, but rather by looking at the value of the stock received by the shareholders and comparing it with the value of the assets transferred to the acquiring corporation. See Helvering v. Minnesota Tea Co., 296 U.S. 378 (1935); John A. Nelson Co. v. Helvering, 296 U.S. 374 (1935); Southwest Natural Gas Co. v. Commissioner, 189 F.2d 332 (5th Cir.), cert. denied, 342 U.S. 860 (1951); Rev. Rul. 66-224, 1966-2 C.B. 114; Rev. Proc. 77-37, 1977-2 C.B. 568. See also Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders 14.11 (5th ed. 1987).

Moreover, the continuity requirement has been deemed satisfied where some shareholders receive only cash, as long as the shareholders as a group receive stock equal to at least 50 percent of the value of the transferred assets. Rev. Rul. 66-224; Rev. Proc. 77-37. See also John A. Nelson Co., supra (continuity found where shareholders received 38 percent of the preferred stock in a reorganization).

TEI is concerned that the mechanical application of the continuity of interest requirement contained in the final regulations could disqualify transactions that are consistent with these long-standing principles. Specifically, the requirement that historic shareholders retain an interest in each of the modified corporate forms could disqualify an otherwise valid section 355 transaction, notwithstanding the owners' retention of an equity interest in substantially all the former combined enterprise's assets. For example, if continuity is not maintained in one of two controlled corporations after the split-up of their parent holding company, the split-up would fail the test in the final regulations even though the tainted controlled corporation represents an insubstantial amount of the value of the former parent. We recommend that, where historic shareholders retain a significant equity interest in the former combined enterprise's assets, the requirement for continuity of interest under section 355 should be considered satisfied.

The final regulations also fail to address when a shareholder's interest ripens into an historic interest for continuity purposes. We suggest this issue could benefit from further study.

Finally, the final regulations do not address unifying reorganizations that are combined with a corporate separation. Such corporate separations have generally qualified under section 355. See Mary Archer W. Morris Trust, supra; Rev. Rul. 75-406, 1975-2 C.B. 125; Rev. Rul. 68-603, 1968-2 C.B. 148. TEI recommends that the IRS clarify that such separations in combination with unifying reorganizations will be treated as satisfying the continuity of interest requirement. (6)

3. Treas. Reg. 1.355-2(d)):

Device for Distribution of

Earnings and Profits

A. General Comments. A transaction cannot qualify under section 355 if it is used principally as a device for the distribution of earnings and profits of the distributing or controlled corporation. The proposed regulations utilized a "facts and circumstances" test for determining whether a transaction had been used as a device. Prop. Reg. 1.355-2(c)(1) (1977). The final regulations list various factors that are evidence of the presence or absence of a device, including (i) the nature and use of the assets of the distributing and controlled corporations, and (ii) whether there has been a pro rata distribution among shareholders or a subsequent sale or exchange. Treas. Reg. 1.355-2(d)(2) (1989). The presence of the specified device factors, however, is not alone controlling. Treas. Reg. 1.355-1(d)(1) (1989).

The final regulations generally provide useful guidance concerning whether a transaction is used as a device for the distribution of earnings and profits. TEI commends the IRS for specifically providing that the presence of a corporate business purpose can negate the evidence of a device. In the comments that follow, we set forth our specific recommendations covering the device test.

b. Excess Business Assets. Treas. Reg. 1.355-2(d)(iv)(B) (1989) provides that the existence of assets not used in a trade or business (as defined in section 355(b)) is evidence of a device (the "excess assets" test). The preamble specifically refers to excess inventory as evidence of a device. 1989-8 I.R.B. at 8 (Feb. 21, 1989).

Under the final regulations, evidence of excess assets will depend in part on the ratio of (i) the value of the assets not used in a qualifying business to (ii) the value of the assets used in such business for each corporation. Different ratios for the distributing and controlled corporations are ordinarily not evidence of a device if the distribution is not pro rata and the difference is attributable to a need to equalize the value of the stock distributed and the value of the stock or securities exchanged. This rule differs from the position taken in the proposed regulations, which focused not on whether there was an imbalance in the amount of nonqualifying assets in each corporation, but on whether there were excess cash, other liquid assets, or non-qualifying businesses. TEI submits that the final regulations represent an unwarranted expansion of the excess assets test.

TEI questions whether any empirical support exists for the notion that a legitimate business enterprise would purposely invest in assets in excess of its business needs in order to avoid dividend taxation. In other words, the regulations seem targeted at chimerical, rather than real, abuses. More importantly, the expanded test raises significant questions. Over what time period is the determination to be made? Can a legitimate expansion of a company's business result in excess assets during the early stages? When does a company have excess inventory? Must a study of market conditions be provided to support inventory levels? TEI suggests that further guidance is needed in this area. In this regard, we note that the final regulations offer no examples of what constitutes "excess assets" and suggest that the regulations be revised to include such examples. (7)

Moreover, TEI believes that the excess assets rule should be circumscribed to reach only those rare situations where a company invests in assets in excess of its business needs to avoid dividend taxation. To avoid the administratively burdensome task of proving a negative -- that they do not hold assets in excess of their business needs -- active corporations should be presumed not to own assets exceeding their business needs (unless such assets constitute cash or cash equivalents).

c. Absence of Earnings and Profits. The final regulations retain the rule that a distribution will ordinarily not be considered to be a device where both the distributing and controlled corporations have no current or accumulated earnings and profits. Treas. Reg. 1.355-2(d)(5)(ii) (1989). Under Treas. Reg. 1.355-2(d)(ii)(C) (1989), however, the distributing corporation will not be considered free of earnings and profits where any distribution of property immediately before the separation would have required recognition of gain resulting in current earnings and profits.

TEI believes that requiring the distributing corporation to hold no appreciated property effectively eliminates the use of this provision as a safe harbor to the device restriction. See I.R.C. 311(b). The vast majority of distributing corporations will have at least one appreciated asset. Therefore, TEI recommends that Treas. Reg. 1.355-2(d)(5)(ii)(C) (1989) be rescinded.

d. Subsequent Sale or Exchange. The final regulations provide that a subsequent sale or exchange of stock pursuant to an arrangement negotiated or agreed upon before the distribution is "substantial" evidence of a device. Treas. Reg. 1.355-2(d)(2)(iii)(E) (1989) further states that if stock is exchanged for stock pursuant to a plan of reorganization and either no gain or loss or only an insubstantial amount of gain is recognized, then the exchange will not be treated as a subsequent sale or exchange.

TEI applauds the Treasury and IRS for rejecting the "bright line" test of the proposed regulations (which provided that if, pursuant to an agreement negotiated before the distribution, 20 percent or more of the stock of the distributing or controlled corporation was to be sold or exchanged after the distribution, the distribution would be considered a device). We suggest, however, that the term "insubstantial" be either defined or illustrated by examples.

CONCLUSION

Tax Executives Institute appreciates this opportunity to present our views on the final regulations relating to corporate separations under section 355. If you have any questions, please do not hesitate to call Paul H. Freischlag, Jr., chair of TEI's Federal Tax Committee, at [phone] or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at [phone].

(1) The IRS appears to recognize that substantial differences exist between the proposed and final regulations. The final regulations have been made applicable only with respect to transactions occurring after February 6, 1989. While TEI applauds the prospective application of the regulations, we believe that the new rules would benefit from further public comment and review before becoming effective.

(2) The "in whole or substantial part" language is presumably different from "real and substantial nontax reasons" for the transaction, but the final regulations do not explicitly address this issue.

(3) The preamble to the regulations confirms that reduction of state and local taxes is a legitimate corporate business purpose (citing Rev. Rul 76-187, 1976-1 C.B. 97). Since many state taxing systems coincide with the federal system, this rule -- the retention of which TEI supports -- seems at odds with the notion that federal tax savings could place an otherwise valid section 355 transaction "beyond the pale."

(4) The examples in Treas. Reg. 1.355-2(c) (1989) treat "enterprise" as including at least the distributing and controlled corporations before the distribution or exchange.

(5) The continuity of interest test contained in the prior regulations followed almost verbatim the test set forth in the section 368 regulations. Compare Treas. Reg. 1.355-2(c) (1955) with Treas. Reg. 1.368-1(b). See also Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders 13.10 at 13-35 (5th ed. 1987) ("The historic relationship between corporate divisions and the reorganizations provisions . . . justifies the assumption that judicial doctrines worked out for corporate reorganizations will be applied with little modification to distributions under 355").

(6) A literal reading of the final regulations suggests that the continuity of interest requirement would not be satisfied if the distributing corporation's shareholders receive 20 percent or less of the acquiring corporation's shares.

(7) Under section 531 a corporation may accumulate earnings to meet the reasonable needs of its business, including working capital and real business contingencies, without being subject to the accumulated earnings tax. See Treas. Reg. 1.357-1 and 1.357-2. The section 355 regulations should clarify that such accumulations do not constitute excess business assets.