The proposed section 355(e) regulations: broadening the traditional notions of what constitutes a plan.

I. Introduction

In 1997, Congress enacted the Taxpayer Relief Act of 1997,(1)(*) which added section 355(e) to the Internal Revenue Code.(2) Under section 355(e), the so-called anti-Morris Trust provision,(3) a distributing corporation will recognize gain if one or more persons acquire, directly or indirectly, 50 percent or more of the stock (measured by vote or value) of the distributing or any controlled corporation as "part of a plan (or series of related transactions)" (hereinafter a "plan") that was in place at the time of the distribution.(4) Section 355(e) also creates a rebuttable presumption that any acquisition occurring two years before or after a section 355 distribution is part of such a plan (hereinafter the "two-year presumption") "unless it is established that the distribution and the acquisition are not pursuant to a plan or series of related transactions."(5) Section 355(e)(5) authorizes the Treasury Department and the Internal Revenue Service to issue regulations "necessary to carry out the purposes" of the legislation.(6)

On August 19, 1999, Treasury and the IRS issued proposed regulations under section 355(e) that provide guidance on what constitutes a plan.(7) The proposed regulations generally treat the test of whether a plan exists as a subjective one that depends ultimately on the intent and expectations of the relevant parties.(8) The proposed regulations rely on a variety of factors to determine whether a plan exists, including the timing of the transactions, the business purpose for the distribution, the likelihood of an acquisition, the intent of the parties, the existence of agreements, understandings, arrangements, or substantial negotiations, and the causal connection between the distribution and the acquisition.(9) Although the proposed regulations provide guidance on the issue of what constitutes a plan, they create significant concerns regarding the scope of section 355(e). Indeed, the proposed regulations may be viewed as going beyond the traditional notions of what constitutes a plan, thus inappropriately expanding the statute.(10)

This article analyzes the proposed section 355(e) regulations and provides recommendations for revising the proposed regulations.(11) Part II describes the proposed regulations in general, Part III analyzes the proposed regulations in the context of several examples, and Part IV sets forth several recommendations to the IRS for amending the proposed regulations.

II. The Proposed Section 355(e) Regulations

A. In General

The preamble to the proposed section 355(e) regulations states that the proposed regulations "provide guidance concerning the interpretation" of a plan. While the proposed regulations provide ways to rebut the two-year presumption, they only implicitly define what constitutes a plan.

Through a series of examples, the proposed regulations seem to interpret the concept of a plan broadly. The preamble to the proposed regulations notes that Congress intended that a plan be interpreted broadly.(12) The IRS points to two specific indications of this intent. First, in contrast to section 355(d), which utilizes the concept of "a person" and applies certain aggregation rules to treat related persons and persons acting in concert as one person, section 355(e) adopts a more expansive approach by referring simply to "one or more persons." Second, the Conference Report provides that public offerings of a sufficient size could trigger section 355(e). This suggests that there does not need to be an identified acquirer on the date of the distribution and that the intent of the acquirer is not necessarily relevant in determining whether there is a plan.(13) For example, the proposed regulations treat a distribution for the purpose of facilitating a public offering by the distributing or controlled corporation of more than 50 percent of its stock as part of a plan for purposes of section 355(e).(14)

In addition to defining a plan broadly, the proposed regulations impose a high burden of proof on the taxpayer to rebut the two-year presumption. The taxpayer must establish that it satisfies the tests set forth in the proposed regulations by "clear and convincing evidence." It is not clear, as a practical matter, what the taxpayer will have to establish to satisfy the clear and convincing standard.(15) Moreover, the rebuttals provided by the proposed regulations purport to be the exclusive means for rebutting the two-year presumption.

As previously mentioned, the proposed regulations rely on a variety of factors to determine the existence of a plan. One factor -- temporal proximity -- is specified by the statute(16) and the proposed regulations reflect the significance of this factor by creating, in effect, a timeline of standards (see the diagram) to rebut the existence of a plan.(17)

B. Post-Spin Rebuttals

1. Introduction

With respect to acquisitions that occur after a section 355 distribution, the distributing corporation may overcome the two-year presumption using one of two alternative tests. These tests are summarized below and are discussed in further detail in Part III.

2. Acquisitions Between Six Months and Two Years After the Distribution

If the acquisition occurs more than six months after the distribution (and there is no agreement, understanding, arrangement, or substantial negotiations at the time of the distribution or within six months thereafter), the distributing corporation may overcome the two-year presumption by establishing that the distribution is motivated in whole or in substantial part by a corporate business purpose other than an intent to facilitate an acquisition (or decrease the likelihood of the acquisition of one or more businesses by separating those businesses from others that are likely to be acquired) (the "General Post-Spin Rebuttal").(18) Thus, the primary focus of the General Post-Spin Rebuttal is the business purpose for the distribution. Because the distribution need only be motivated "in substantial part" by a non-acquisition business purpose, the existence of an acquisition-related business purpose does not automatically preclude the use of the General Post-Spin Rebuttal.(19)

In determining whether the distribution is motivated in whole or substantial part by a non-acquisition business purpose, the intent of the distributing corporation, the controlled corporation, or the controlling shareholders of either the distributing or controlled corporation is relevant.(20)

3. Acquisitions Within Six Months After the Distribution

If a distribution is motivated by an acquisition business purpose, or the acquisition occurs within six months after the distribution, the distributing corporation may overcome the two-year presumption by satisfying a more stringent three-prong test (the "Alternative Post-Spin Rebuttal"). All three prongs must be satisfied.

(a) First Prong

1. Neither the distributing or controlled corporation nor a controlling shareholder of either corporation intends that one or more persons acquire a 50-percent or greater interest in the distributing or controlled corporation (the "First Prong Intent Test").

2. The distribution is not motivated in whole or substantial part by an intention to facilitate an acquisition of an interest in the distributing or controlled corporation (the "First Prong Facilitation Test").

(b) Second Prong

Neither the distributing or controlled corporation nor their controlling shareholders reasonably would have anticipated that it was more likely than not that one or more persons, who would not have acquired the interests if the distribution had not occurred, would acquire a 50-percent or greater interest in the distributing or controlled corporation within two years after the distribution (the "Reasonable Anticipation Prong").

(c) Third Prong

The distribution is not motivated in whole or substantial part by an intention to decrease the likelihood of the acquisition of one or more businesses by separating those businesses from others that are likely to be acquired (the "Hostile Takeover Prong")(21)

The First Prong Intent Test focuses on whether the intended change in ownership totals 50 percent or more. Thus, it is satisfied even if one or more of the relevant parties intends that a distribution facilitate an acquisition, so long as the parties did not intend that there be a 50-percent or greater change in ownership.

The First Prong Facilitation Test, on the other hand, may be satisfied where the parties intend a 50-percent change in ownership as long as the parties did not intend that the distribution facilitate any part of an acquisition.(22) In other words, the distribution must not be motivated by an intent to facilitate an acquisition, which is very similar to the General Post-Spin Rebuttal. Thus, the First Prong Facilitation Test may be satisfied as long as the distribution is not motivated by an acquisition-related business purpose even though the relevant parties may intend a 50-percent change in ownership. As a practical matter, however, it seems difficult to establish a lack of an intent to facilitate an acquisition where a 50-percent change in ownership is intended by the parties.

The Reasonable Anticipation Prong, like the First Prong Intent Test, requires that a relevant party reasonably anticipate an acquisition of the full 50 percent.(23) The Hostile Takeover Prong is similar to the General Post-Spin Rebuttal.(24)

For purposes of applying the Alternative Post-Spin Rebuttal, the tax consequences of section 355(e) are disregarded in determining the intentions and reasonable anticipations of the relevant parties.(25) Absent such a rule, the distributing corporation could argue that it should satisfy the Alternative Post-Spin Rebuttal because it would not be reasonable for a party to act in a manner that would result in section 355(e) liability. Conversely, the IRS could argue that the presence of an indemnity agreement between the distributing and controlled corporations indicates that the parties anticipated section 355(e) liability.(26)

4. Acquisitions More than Two Years After a Distribution

Acquisitions occurring more than two years after a distribution are presumed to be part of a plan only if there is an agreement, understanding, or arrangement concerning the acquisition during the two-year period after the distribution. The distributing corporation may rebut the presumption using the General Post-Spin or Alternative Post-Spin Rebuttals discussed above.(27) There is, however, no negative presumption.

C. Pre-Spin Rebuttals

1. Introduction

With respect to acquisitions that occur within two years before the distribution, the preamble to the proposed regulations states that the most reliable indicators that a plan exists are an intent to make the distribution at the time of the acquisition and a causal connection between the acquisition and the distribution.(28) The preamble notes that where a person becomes a controlling shareholder by acquisition, that person's intention becomes the single best indicator of whether a later distribution is part of a plan.(29) With respect to acquisitions that occur before a section 355 distribution, the distributing corporation may overcome the two-year presumption using one of two alternative tests. These tests are summarized below and discussed in further detail in Part III.

2. Acquisitions Within Two Years Before the Distribution

a. General Rebuttal

The distributing corporation may rebut the two-year presumption with respect to acquisitions within two years before a distribution if it establishes that, at the time of the acquisition, the distributing corporation and its controlling shareholders did not intend to effect a distribution (the "General Pre-Spin Rebuttal").(30) For this purpose, whether a shareholder is "controlling" is determined immediately after the acquisition.(31)

b. Alternative Rebuttal

As an alternative to the General Rebuttal, provided that no person acquiring an interest becomes a controlling shareholder by reason of the acquisition (or becomes a controlling shareholder thereafter during the two-year period beginning on the date of the distribution), the distributing corporation can overcome the two-year presumption by establishing that the distribution would have occurred at approximately the same time and under substantially the same terms regardless of the acquisition (the "Alternative Pre-Spin Rebuttal").(32) For purposes of these tests, a controlling shareholder is defined as a person who, directly or indirectly, or together with related persons, possesses voting power in the distributing or controlled corporation representing a meaningful voice in the governance of the corporation.(33) In the case of a publicly traded corporation, a controlling shareholder is any person who (i) owns five percent or more of any class of stock of the distributing or controlled corporation and (ii) actively participates in the management or operation of the corporation.(34)

3. Acquisitions More than Two Years Before the Distribution

With respect to acquisitions that occur more than two years before a distribution, the presumption shifts in favor of the distributing corporation. Thus, the proposed regulations provide that the acquisition and distribution are presumed not to be part of a plan unless the IRS can establish by clear and convincing evidence that, at the time of the acquisition, (i) the distributing corporation or its controlling shareholders intended to effect the distribution, and (ii) the acquisition resulted in a change in the timing or the terms of the distribution or a person acquiring an interest in that acquisition became a controlling shareholder.(35) In other words, the proposed regulations appear to require the IRS to establish that the taxpayer fails to satisfy both the General and Alternative Pre-Spin Rebuttals in order to treat an acquisition that occurred more than two years before a distribution as part of the same plan.

D. Agreement, Understanding, Arrangement, or Substantial Negotiations

The proposed regulations employ a key phrase "agreement, understanding, arrangement, or substantial negotiations" several times. First, to satisfy the General Post-Spin Rebuttal, the acquisition must have occurred more than six months after the distribution, and there must not have been an agreement, understanding, arrangement, or substantial negotiations concerning the acquisition at the time of the distribution or within six months thereafter.(36) Second, to satisfy the First Prong Intent Test and the Reasonable Anticipation Prong of the Alternative Post-Spin Rebuttal, there can be no intent or reasonable anticipation of a 50-percent acquisition during the two-year period after the distribution (or later pursuant to an agreement, understanding, or arrangement existing at the time of the distribution or within six months thereafter).(37) Third, acquisitions occurring more than two years after a distribution will be considered part of a plan only if there was an agreement, understanding, or arrangement concerning the acquisition at the time of the distribution or within two years thereafter.(38) Fourth, to satisfy the Alternative Pre-Spin Rebuttal, no person acquiring an interest in the pre-spin acquisition may become a controlling shareholder by reason of that acquisition or at any point thereafter and before the end of the two-year period beginning on the date of the distribution (or later pursuant to an agreement, understanding, or arrangement existing at the time of the distribution or within six months thereafter).

Regrettably, however, the proposed regulations do not define the terms "agreement," "understanding," "arrangement," or "substantial negotiations," except to state that the parties do not necessarily have to enter into a binding contract or reach an agreement on all terms in order for an "agreement, understanding, or arrangement" to exist.(39) The preamble notes that an agreement, understanding, arrangement, or substantial negotiations can take place even if the acquirer has not been specifically identified (e.g., a public offering or an auction by an investment banker).(40) Thus, the distributing corporation's unilateral intent may be sufficient to give rise to an agreement, understanding, arrangement, or substantial negotiations. By contrast, in order to establish a business purpose for a spin-off, a taxpayer generally must reveal a specific acquirer or target.(41)

The proposed regulations treat certain options as agreements. If stock is acquired pursuant to an option, the option is treated as an agreement on the date of issuance unless the distributing corporation establishes by clear and convincing evidence that, on the later of the date of the distribution or the date of issuance, the option was not more likely than not to be exercised.(42) The determination of whether an option is more likely than not to be exercised is based on all of the facts and circumstances.(43) For purposes of this rule, the term "option" is defined broadly to include call options, warrants, convertible obligations, the conversion feature of convertible stock, put options, redemption agreements (including rights to cause the redemption of stock), restricted stock, any other instruments that provide for the right or possibility to issue, redeem, or transfer stock, cash settlement options, or any other similar interests.(44) Certain instruments, however, are excluded from the definition of an option unless such instruments are issued, transferred, or listed with a principal purpose of avoiding the application of section 355(e) or the proposed regulations. Excluded instruments consist of certain compensatory options,(45) options that are part of a security arrangement in a typical lending transaction, options that are exercisable only upon death, disability, or mental incompetency, and bona fide rights of first refusal.(46)

E. Aggregation of Acquisitions

The proposed regulations provide that each acquisition of stock of a corporation pursuant to a plan involving a distribution will be aggregated with all other acquisitions of stock pursuant to a plan involving that distribution to determine whether the 50-percent threshold is met.(47) Thus, the appropriate rebuttal is applied separately to each pre-spin acquisition and each post-spin acquisition, and those acquisitions that fail either the pre-spin or post-spin rebuttal tests are aggregated. For example, assume that D plans to distribute its C stock solely to facilitate acquisitions by D. Prior to the distribution, D acquires X (the "X acquisition"). X's shareholders receive 24 percent of D's stock. Six months after the distribution, D acquires Y (the "Y acquisition"). Y's shareholders receive 25 percent of D's stock. Eighteen months after the distribution, D acquires Z (the "Z acquisition"). Z's shareholders receive 26 percent of D's stock.(48) Assume that D is able to rebut the two-year presumption using one of the pre-spin rebuttals with respect to the X acquisition, but is unable to rebut the two-year presumption with respect to the post-spin Y and Z acquisitions. The Y and Z acquisitions are aggregated to determine whether the 50-percent threshold is met. Thus, in this example, 51 percent of D's stock is treated as acquired pursuant to a plan, and section 355(e) applies. Assume instead that D is able to rebut the two-year presumption with respect to the Z acquisition, but not with respect to the X and Y acquisitions. In this case, the X and Y acquisitions are aggregated, and 49 percent of D's stock is treated as acquired pursuant to a plan. Thus, section 355(e) does not apply.

F. Multiple Controlled Corporations

The proposed regulations provide much-needed guidance on how to measure the amount of gain where more than one controlled corporation is distributed, but only one of the corporations is acquired. The proposed regulations clarify that the distributing corporation recognizes gain only with respect to the stock of the distributed controlled corporations that are subject to a 50-percent or greater acquisition.(49) Where the distributing corporation is acquired, however, it must recognize gain on all of the distributed corporations.(50)

III. Analysis of the Proposed Regulations

A. Purpose of Section 355(e)

The legislative history of section 355(e) points to the "abuse" at which the section was aimed. Section 355, which provides an exception to the repeal of the General Utilities doctrine, is intended to permit tax-free restructurings of several businesses among existing shareholders.(51) When new shareholders acquire some or all of either the distributing or controlled corporation, the transaction may no longer look like a mere restructuring, but rather like a sale of a business.(52) A few highly publicized transactions, such as Viacom's spin-off of its cable company to TCI, General Motors' sale of Hughes Electronics to Raytheon, and Walt Disney's sale of its newspaper properties to Knight-Ridder, contained features that Congress considered as more closely resembling a sale. One common feature of "disguised sale" transactions is that the corporation to be acquired borrows money or assumes a large amount of debt and distributes the proceeds of such debt to its parent prior to a spin-off. Upon the subsequent acquisition, the acquiring group inherits the debt of the acquired corporation while the proceeds of such debt are retained by the "selling" group.(53) Another feature common to such transactions is a recapitalization of the acquired corporation where the "old" shareholders' stock is converted from common stock to nonvoting preferred stock or stock with voting rights disproportionate to the value of such stock and the simultaneous issuance of voting common stock to the acquiring corporation.(54)

Congressional concern about disguised sale transactions is reminiscent of the reasons for enacting section 355(d) in 1990 in order to prevent so-called "mirror substitute transactions."(55) Specifically, the legislative history of section 355(d) states that Congress intended to prevent the avoidance of General Utilities repeal and the tax-free disposition of subsidiaries in transactions that resemble sales:

   The provisions for tax-free divisive transactions under section 355 were a
   limited exception to the repeal of the General Utilities doctrine, intended
   to permit historic shareholders to continue to carry on their historic
   corporate businesses in separate corporations. It is believed that the
   benefit of tax-free treatment should not apply where the divisive
   transaction, combined with a stock purchase resulting in a change of
   ownership, in effect results in the disposition of a significant part of
   the historic shareholders' interests in one or more of the divided
   corporations.(56)

Thus, the enactment of section 355(e) can be viewed as Congress' attempt to complete what it started with the enactment of section 355(d). Indeed, in the Administration's budget proposals for fiscal year 1997 and 1998, the anti-Morris Trust provision was proposed as an amendment to section 355(d).(57)

Section 355(e)(5) states that "[t]he Secretary shall prescribe regulations as may be necessary to carry out the purposes of this subsection." To be consistent with the legislative history of section 355(e), the regulations should strive to tax only those distributions that look more like sales of one of the businesses.(58)

B. Exclusivity of the Rebuttals

Section 355(e) provides that acquisitions during the two years before and after a spin-off "shall be treated as pursuant to a plan ... unless it is established that the distribution and the acquisition are not pursuant to a plan or series of related transactions."(59) Thus, the statute clearly contemplates that taxpayers will be permitted to establish that the distribution and the acquisition are not part of a plan. Neither the statute nor the legislative history limits the manner in which the taxpayer may make this showing. The statute seems to contemplate a facts-and-circumstances approach.(60)

Under the proposed regulations, however, the rebuttals discussed above appear to be the exclusive means of overcoming the two-year presumption.(61) Thus, if a distributing corporation is unable to avail itself of one of the rebuttals, section 355(e) applies regardless of whether other facts and circumstances might negate the existence of a plan.

This result is contrary to the language of the statute. Moreover, by imposing an exclusive rule, the proposed regulations expand the scope of an already overly broad statute. As further discussed in Part III.D., the regulations, if promulgated unchanged, will often be useless to taxpayers. Although the IRS may defend the exclusive rebuttals as being more administrable than a facts-and-circumstances approach, that is hardly the case. The rebuttals require inquiries not only into a relevant party's intent but also into what other parties could reasonably anticipate. Moreover, the proposed regulations generally require that the taxpayer prove a negative. No taxpayer can reasonably satisfy such stringent requirements. Consequently, the rebuttals should be reformulated in the final regulations from absolute rules to safe harbors for satisfying the taxpayer's burden of proof.

C. Clear and Convincing Burden of Proof

Section 355(e) and the legislative history are silent concerning the burden of proof imposed on the taxpayer in overcoming the two-year presumption. The proposed regulations require that the taxpayer establish each element of the rebuttals by clear and convincing evidence -- a high standard. The IRS presumably believes that a two-year presumption warrants a burden of proof greater than the usual burden of proof in civil cases (i.e., preponderance of the evidence). Although it is unnecessary to impose a higher burden of proof in cases of statutory presumptions,(62) a number of statutory and regulatory provisions provide that clear and convincing evidence is necessary to overcome a presumption.(63)

The difficulty in satisfying a clear and convincing standard is not the high bar the standard sets, but rather that the rebuttals in the proposed regulations require the distributing corporation to know or anticipate the intent or actions of unrelated third parties, which is impossible to establish by clear and convincing evidence. Presumably, a whole new type of investment banker opinion will be required to satisfy this burden of proof.(64)

D. Post-Spin Acquisitions

1. General Post-Spin Rebuttal

With respect to acquisitions more than six months after a spin-off, the proposed regulations provide a more relaxed presumption than the statute (i.e., six months v. two years). This six-month rule provides greater flexibility for corporate spin-offs. The Treasury and the IRS should be commended for this proposal.(65) As discussed above, the General Post-Spin Rebuttal requires that (i) the distribution be motivated in whole or substantial part by a corporate business purpose (other than an intent to facilitate an acquisition or decrease the likelihood of an acquisition), and (ii) the acquisition occur more than six months after the distribution and that there be no agreement, understanding, arrangement, or substantial negotiations about the acquisition at the time of the distribution or within six months thereafter.(66)

a. Facilitating an Acquisition -- Basic Morris Trust Transaction

   Example 1: P wants to acquire D but does not want C. In order to facilitate
   the acquisition of D by P, D distributes C to its shareholders in a
   transaction otherwise meeting the requirements of section 355. Within six
   months of the distribution, D merges into P, with the D shareholders
   receiving 30 percent of the P stock.

This is the classic Morris Trust transaction. D would not be able to satisfy the General Post-Spin Rebuttal both because the acquisition by P occurs within six months of the distribution and because the purpose of the distribution is to facilitate the acquisition of D by P.

The proposed regulations provide additional examples illustrating business purposes that facilitate an acquisition. In one, the business purpose for the distribution is to facilitate a public stock offering by D of 50 percent of its stock, which D completes within one year after the distribution. Such a business purpose precludes the application of the General Post-Spin Rebuttal.(67) Other tainted business purposes set forth in the proposed regulations include (i) making D or C a more attractive acquisition candidate,(68) (ii) facilitating acquisitions of target companies by D or C,(69) and (iii) facilitating a public offering of 20 percent of the stock of D or C.(70)

Regrettably, the proposed regulations do not limit the phrase "intent to facilitate an acquisition." As a result, a business purpose to facilitate any acquisition, regardless of how small, precludes the use of this rebuttal. Thus, for example, the General Post-Spin Rebuttal cannot be satisfied where the business purpose for the distribution is to issue a five-percent stock interest to key employees or ESOPs. Notwithstanding that these acquisition-related business purposes have long been accepted by the IRS for advance ruling purposes,(71) such business purposes will, as a practical matter, no longer be desirable because taxpayers will likely seek to bring their spin-offs within a non-acquisition business purpose in order to use the General Post-Spin Rebuttal. This is regrettable because a broad interpretation of tainted business purposes is unnecessary to achieve the goals of section 355(e). Facilitating the issuance of stock to key employees or ESOPs simply does not present the disguised sale abuse at which section 355(e) is aimed. Indeed, any business purpose (including an acquisition-related business purpose) that does not involve an intent to facilitate a 50-percent acquisition should be deemed to satisfy the requirements of the General Post-Spin Rebuttal. At a minimum, the General Post-Spin Rebuttal should be modified in the final regulations to require that the business purpose be to facilitate an acquisition of a threshold percentage interest (e.g., greater than 33 percent). Such a rule would permit stock issuances and public offerings that are not structured to result in a 50-percent ownership shift.

Moreover, if there is not a substantial non-acquisition business purpose for a distribution, the General Post-Spin Rebuttal is not available for any post-spin acquisition regardless of whether the acquisition is related to the original acquisition-related business purpose for the distribution. For example, assume that D plans to spin off C for the sole purpose of issuing five percent of its stock to key employees. Immediately after the spin-off, D issues five percent of its stock to its key employees. Eight months after the spin-off, an unrelated party acquires 45 percent of D's stock. D cannot satisfy the General Post-Spin Rebuttal with respect to either acquisition because it did not have a substantial non-acquisition business purpose for the spin-off.(72) This is true even though the second acquisition (the acquisition of D stock by the unrelated party) is completely unrelated to the acquisition-related business purpose (the issuance of C stock to key employees). Because, as discussed below, the alternative three-prong rebuttal is extremely onerous, this result could have a chilling effect on many basic spin-offs.

An acquisition-related business purpose arguably should not preclude application of the General Post-Spin Rebuttal to acquisitions that are unrelated to that business purpose. Thus, if the business purpose for the distribution is to facilitate a public offering of 40 percent of C's stock and an unrelated individual subsequently acquires an additional 10 percent of C's stock, only the 40 percent acquired in the public offering should be considered outside the General Post-Spin Rebuttal. On the other hand, if the business purpose for the distribution is to facilitate a public offering of 40 percent of C's stock, but C ends up issuing 50 percent of its stock in the public offering, the entire 50 percent stock issuance should be outside the General Post-Spin Rebuttal.

Finally, under the proposed regulations a business purpose to facilitate an acquisition of D stock precludes use of the General Post-Spin Rebuttal for a subsequent acquisition of C stock. Representatives from Treasury have informally indicated that this would be corrected in the final regulations.(73)

b. Application of General Post-Spin Rebuttal

   Example 2: D plans to distribute C pro rata to its shareholders. The
   distribution is motivated solely by a non-acquisition business purpose.
   Eighteen months after the spin-off, D merges into P, with the D
   shareholders receiving 30 percent of the P stock.

D will be able to rebut the two-year presumption using the General Post-Spin Rebuttal, because the distribution is motivated solely by a non-acquisition business purpose and the acquisition occurred more than six months after the distribution.(74)

c. Multiple Business Purposes

The proposed regulations provide that the General Post-Spin Rebuttal is satisfied if the distribution is motivated in whole or in substantial part by a non-acquisition corporate business purpose.(75) An intent to facilitate an acquisition or decrease the likelihood of an acquisition is a factor "tending to disprove" that the distribution is motivated in substantial part by a non-acquisition business purpose, but the taxpayer can nonetheless prevail under the General Post-Spin Rebuttal if it establishes by clear and convincing evidence that the distribution is motivated in substantial part by the non-acquisition business purpose.(76) The preamble to the proposed regulations provides that the analysis of whether the non-acquisition business purpose is substantial is similar to analyzing whether there is a corporate business purpose for a distribution in light of the potential avoidance of federal taxes. Thus, the other business purpose must be "real and substantial even in light of the acquisition business purpose."(77) Representatives from Treasury and the IRS have indicated informally that this test is not intended to be a weighing of business purposes; rather, they are looking for a causal connection: Would the distributing corporation undertake the spin-off without the acquisition-related business purpose?(78)

Assume, for example, that D distributes the stock of its controlled subsidiary, C, in order to achieve significant cost savings and, in substantial part, to make D a more attractive acquisition candidate. By providing that the existence of the acquisition-related business purpose tends to disprove that the distribution is motivated in substantial part by the cost savings business purpose, the proposed regulations appear to impose a "heightened" clear and convincing burden of proof on the taxpayer. In other words, not only must the taxpayer rebut the statutory two-year presumption, but it must also rebut a presumption that the acquisition-related business purpose is controlling. If D in this example can establish by clear and convincing evidence that it would undertake the distribution even without the acquisition-related business purpose, D can prevail under the General Post-Spin Rebuttal.

This "but-for" approach seems to require that the non-acquisition business purpose be the primary purpose for the spin-off. Such an approach, however, is inconsistent with the language of the proposed regulations and the preamble, which simply require that the non-acquisition business purpose be "substantial."(79) A but-for approach can also lead to incorrect results in some cases. Assume, for example, that D has a substantial non-acquisition business purpose for the distribution of its C stock. In order to operate its remaining business successfully following the spin-off, D must pay down its debt. To obtain the necessary cash, D anticipates engaging in an equity offering of approximately 20 percent of its stock after the spin-off. D engages in the equity offering shortly after the spin-off. One year later, an unrelated party acquires 30 percent of D's stock. Under the language of the proposed regulations, the General Post-Spin Rebuttal should be available with respect to the second acquisition because D had a substantial non-acquisition business purpose for the spin-off. Under a but-for analysis, however, D likely does not meet the requirements for the General Post-Spin Rebuttal because D could not have undertaken the spin-off without also engaging in the equity offering.

Moreover, a but-for test will also likely cause changes in current advance ruling practices. Taxpayers often have more than one business purpose for a spin-off. Revenue Procedure 96-30, which prescribes conditions for obtaining an advance ruling for spin-off transactions, requires that the taxpayer "[d]escribe in detail each purpose ... for the distribution."(80) The IRS then evaluates separately each business purpose set forth by the taxpayer. In the past, it has not mattered which business purpose was accepted by the IRS. The but-for test in the General Post-Spin Rebuttal, however, will encourage taxpayers to focus on non-acquisition business purposes (even though they will still be required to disclose all business purposes) for the distribution. If the IRS issues section 355(e) rulings, it will presumably be ruling that the non-acquisition business purpose is the primary purpose.

d. Decreasing the Likelihood of an Acquisition -- Hostile Takeovers

As mentioned above, not only does an intent to facilitate an acquisition preclude the use of the General Post-Spin Rebuttal, but an intent to decrease the likelihood of an acquisition of one or more businesses by separating those businesses from others that are likely to be acquired will also preclude use of the General Post-Spin Rebuttal where there is no other substantial non-acquisition business purpose.(81) As a result, taxpayers facing a hostile takeover situation confront a difficult challenge interpreting the meaning of the term "plan."(82) If a distributing corporation distributes a controlled corporation specifically to avoid a hostile takeover (a valid business purpose under Rev. Proc. 96-30(83)), but the distribution does not prevent such a takeover, one could argue that the distributing corporation distributed the controlled corporation with no plan that another party acquire 50 percent or more of the stock of the distributing or controlled corporation. Indeed, the plan is the exact opposite -- to avoid such an acquisition.

Notwithstanding that common sense view, the proposed regulations have specifically adopted a rule that a hostile takeover results in the application of section 355(e).(84) The preamble notes that distributions to decrease the likelihood of an acquisition are often difficult to differentiate from those intended to facilitate an acquisition and should receive the same treatment because both relate to a perceived possibility of an acquisition.(85) Representatives from Treasury and the IRS have, in support of the rule in the proposed regulations, informally noted that, while the Administration's original proposal contained language treating hostile takeovers as unrelated to the distribution,(86) the legislative history of section 355(e) is silent on the matter.

Congress' silence, however, should not be presumed to imply the opposite -- that a distribution to deter a hostile takeover is per se part of a plan. Indeed, in discussing this issue, a senior staff member of the Joint Committee on Taxation stated shortly after enactment of section 355(e) that the legislative history does not include a statement exempting hostile takeovers because it is difficult to determine when a hostile takeover becomes non-hostile -- not because Congress believed that hostile takeovers should be considered part of a plan.(87) The appropriate response to this concern is to provide rules permitting the taxpayer to establish the hostility of the takeover -- not to treat all hostile takeovers as part of a plan.

Moreover, the concern expressed in the preamble -- that it is difficult to differentiate distributions to facilitate acquisitions from those that decrease the likelihood of an acquisition -- is misplaced. Indeed, there are significant differences. A distribution to facilitate an acquisition is part of a plan of the distributing corporation. To utilize acquisition-related business purposes for advance ruling purposes, the taxpayer generally must reveal a specific acquirer or target.(88) Hence, the plan is generally mutual. A hostile takeover, on the other hand, involves a unilateral plan on the part of the hostile acquirer. It not only does not involve the distributing or controlled corporation but it is also unwanted on the part of the distributing or controlled corporation.(89)

The reference to decreasing the likelihood of an acquisition should be deleted from both the General Post-Spin and Alternative Post-Spin Rebuttals. To address Treasury or IRS's concern that a purportedly hostile takeover may actually be friendly, the final regulations could require that the taxpayer demonstrate the presence of other factors, including the imminence of the takeover attempt and the detriment resulting from a successful takeover. These are the factors that the IRS has historically required taxpayers to demonstrate in order to obtain a section 355 ruling where the stated business purpose of a spin-off distributions is to thwart a hostile takeover.(90)

2. Alternative Post-Spin Rebuttal

As discussed above, the Alternative Post-Spin Rebuttal requires that the distributing corporation satisfy a three-prong test: (i) (A) neither the distributing or controlled corporation nor a controlling shareholder of either corporation intend that one or more persons acquire a 50-percent or greater interest in the distributing or controlled corporation (First Prong Intent Test), or (B) the distribution is not motivated in whole or substantial part by an intention to facilitate an acquisition of an interest in the distributing or controlled corporation (First Prong Facilitation Test); (ii) neither the distributing or controlled corporation nor their controlling shareholders reasonably would have anticipated that it was more likely than not that one or more persons, who would not have acquired the interests if the distribution had not occurred, would acquire a 50-percent or greater interest in the distributing or controlled corporation within two years after the distribution (Reasonable Anticipation Prong); and (iii) the distribution is not motivated in whole or substantial part by an intention to decrease the likelihood of the acquisition of one or more businesses by separating those businesses from others that are likely to be acquired (Hostile Takeover Prong).(91) The examples below illustrate the application of the three prongs of the Alternative Post-Spin Rebuttal.

a. Surprise Acquisition

   Example 3: D plans to distribute the stock of C for the purpose of
   facilitating a public offering by C. C issues 20 percent of its stock in a
   public offering one month after the distribution. Neither D, C, nor their
   controlling shareholders intended any further transactions involving D or C
   stock, nor would they reasonably anticipate that it was more likely than
   not that one or more persons would acquire a 50-percent interest in D or C
   within two years who would not have acquired such interest absent the
   distribution. Two months after the distribution, C is approached
   unexpectedly regarding an opportunity to acquire X. Five months after the
   distribution, C acquires X in exchange for 40 percent of the C stock.

Because acquisition of X occurred within six months of the distribution, D will not be able to use the General Post-Spin Rebuttal.(92) The proposed regulations do, however, provide that in the case of a surprise acquisition, the Alternative Post-Spin Rebuttal is satisfied.(93) First, neither D, C, nor their controlling shareholders intended that one or more persons would acquire a 50-percent or greater interest in D or C during the two-year period.(94) Second, neither D, C, nor their controlling shareholders would reasonably have anticipated that it was more likely than not that one or more persons would acquire a 50-percent or greater interest in C. Third, the distribution was not motivated in whole or substantial part by an intention to decrease the likelihood of the acquisition of one or more businesses by separating those businesses from others that are likely to be acquired.(95)

This example appears to represent a relatively simple case of a surprise acquisition, which is properly treated as not part of a plan involving the distribution. Such situations, however, will not be so simple in practice. How must the distributing corporation demonstrate that the acquisition was a surprise? Such a demonstration entails proving a negative -- that C had no prior contact with, or knowledge of the opportunity to acquire, X. As illustrated by the examples below, the Alternative Post-Spin Rebuttal is even more difficult to apply in other situations.

b. Facilitating Acquisitions of Multiple Targets by D

   Example 4: On the advice of an investment banker, D plans to distribute its
   C stock to its shareholders solely to facilitate acquisitions by D. D has
   no specific goals regarding how much D stock will be issued in these
   acquisitions. D and its investment banker have identified X and Y as
   potential acquisition targets. Within six months after the distribution, D
   negotiates with and acquires X. X's shareholders receive 30 percent of D's
   stock. One year after the distribution, D acquires Y. Y's shareholders
   receive 19 percent of D's stock. After the distribution, D and its
   investment banker identify Z as another desirable target. Eighteen months
   after the distribution, D acquires Z. Z's shareholders receive 17 percent
   of D's stock.

D will not be able to satisfy the General Post-Spin Rebuttal with respect to the acquisition of X because the acquisition occurred within six months of the distribution.(96) In addition, D will be unable to satisfy the General Post-Spin Rebuttal with respect to the acquisitions of Y and Z because the sole purpose for the distribution is to facilitate an acquisition of D stock.(97)

To rebut the two-year presumption using the Alternative Post-Spin Rebuttal, D must satisfy the three-prongtest. First, D must establish that, at the time of the distribution, D, C, and their controlling shareholders did not intend that one or more persons would acquire a 50-percent or greater interest. Under the facts of this example, D has no specific goals regarding the amount of D stock to be issued in the acquisitions. D and its investment banker, however, identified X and Y as potential targets, and D subsequently issued 49 percent of its stock in acquiring X and Y. The proposed regulations do not specifically address whether the First Prong Intent Test is satisfied under these facts.(98) Although the proposed regulations provide that a pre-spin acquisition that is part of a plan involving the distribution is counted as an amount intended to be acquired,(99) they do not, with respect to post-spin acquisitions, provide specific guidance about how to calculate the amount intended to be acquired. On the facts, the IRS presumably would consider that at least 49 percent is the amount intended. Consequently, under the circumstances it would be extremely difficult for D to establish the absence of the requisite intent by clear and convincing evidence even though D had no specific goals regarding the amount of stock it would issue.

Second, D must establish that, at the time of the distribution, neither D, C, nor their controlling shareholders would reasonably have anticipated that it was more likely than not that one or more persons would acquire a 50-percent or greater interest in D or C within two years. Similar to the First Prong Intent Test, the proposed regulations do not specifically address whether the Reasonable Anticipation Prong is satisfied under these facts.(100) Presumably, the IRS would analyze the Reasonable Anticipation Prong in a manner similar to the First Prong Intent Test.

Third, the proposed regulations provide that, in this example, D will be able to establish that the distribution was not motivated in whole or substantial part by an intention to decrease the likelihood of an acquisition.(101)

In sum, the proposed regulations do not specifically address whether the Alternative Post-Spin Rebuttal is satisfied where the business purpose for a distribution is to facilitate acquisitions using the distributing corporation's stock, but the distributing corporation has no specific intent or goal to issue 50 percent of its stock in such acquisitions. As a practical matter, however, the distributing corporation is unlikely to be able to satisfy its burden of proof.

c. Investment Banker Advice Received Before Spin-Off is Announced

   Example 5: D consulted with an investment banker regarding an acquisition
   of D. The investment banker advised D that it would be a more attractive
   acquisition candidate if it spun-off C. D distributes C to its shareholders
   to achieve significant nontax cost savings and, in substantial part, to
   maximize the possibility of D's acquisition. At the time of the
   distribution, D has not, directly or indirectly, solicited or received any
   indication of interest from potential acquirers. Seven months after the
   distribution, D engages the investment banker to conduct an auction of D.
   One of the bidders, P, acquires D one year after the distribution.

If D can establish that the distribution was motivated in substantial part by the need to achieve nontax cost savings, D will be able to rebut the two-year presumption using the General Post-Spin Rebuttal.(102) On the other hand, the proposed regulations provide that D will be unable to rebut the two-year presumption using the Alternative Post-Spin Rebuttal, because it will not satisfy either the First Prong Intent Test or the First Prong Facilitation Test.(103) D will not be able to establish that it did not intend that one or more persons would acquire a 50-percent or greater interest in D or that the distribution was not motivated in whole or substantial part by an acquisition-related business purpose.

This example illustrates how the rebuttals apply when D has two substantial business purposes for the distribution -- one acquisition-related and one non-acquisition purpose. If, as recommended in Part III.D.1.c., the final regulations apply the General Post-Spin Rebuttal without a but-for analysis, that test is satisfied as long as the non-acquisition business purpose is substantial. Hence, the General Post-Spin Rebuttal would still apply where there are two substantial business purposes. The First Prong Facilitation Test of the Alternative Post-Spin Rebuttal, on the other hand, cannot apply where the distribution is motivated in substantial part by an acquisition-related business purpose. Thus, the First Prong Facilitation Test automatically does not apply where one of two substantial business purposes is acquisition related. So, in the example above, section 355(e) applies where the acquisition occurs within six months after the distribution, but not where the acquisition occurs more than six months after the distribution. There is no reason for the disparate treatment.

d. Investment Banker Advice Received After Spin-Off is Announced

   Example 6: D, a public company, plans to distribute C pro rata to its
   shareholders. The distribution is motivated by a non-acquisition business
   purpose. After the announcement date, D's investment banker informs D's
   management that there is a lot of interest in new investment in D now that
   it will no longer own C. The investment banker further informed D's
   management that P, a potential acquirer, had expressed an interest in
   acquiring D after the distribution. Five months after the distribution, D
   is acquired by P.

D will not be able to rebut the two-year presumption using the General Post-Spin Rebuttal because the acquisition occurred within six months of the distribution.(104) Moreover, the proposed regulations provide that D will not be able to rebut the two-year presumption using the Alternative Post-Spin Rebuttal because it does not satisfy the Reasonable Anticipation Prong.(105) In other words, D will be unable to establish that, at the time of the distribution, neither D, C, nor their controlling shareholders would reasonably have anticipated that it was more likely than not that one or more persons would acquire a 50-percent or greater interest.

This result is inappropriate and will prevent valid spin-offs. D decided to distribute the stock of C for business purposes completely unrelated to the acquisition and announced its intention to do so. After a spin-off is announced to the public, a distributing corporation is unlikely to back out of it. Yet, since a potential acquirer indicated an interest in D prior to the actual distribution, D is compelled to choose between incurring a substantial corporate-level tax or backing out of the distribution. What if P waited until immediately after the distribution to express its interest to D? Arguably, D would not have reasonably anticipated the acquisition and the Alternative Post-Spin Rebuttal could be used.(106) This disparate treatment makes no sense. This example illustrates that the final regulations should provide that, with respect to public companies, the determination of whether a plan exists (and thus whether the rebuttals are satisfied) should be made at the time distribution is announced.

e. Inadequate Offers to Acquire D

   Example 7: D consulted with its investment banker regarding its long-term
   strategic options, including a sale of C or, alternatively, a separation of
   C's business through a tax-free spin-off. The offers received for the
   acquisition of C were inadequate and rejected by D. Thus, upon the advice
   of D's investment banker, and for a non-acquisition business purpose, D
   distributes C to its shareholders. Within six months after the
   distribution, P acquires C.

D will not be able to rebut the two-year presumption using the General Post-Spin Rebuttal because the acquisition occurred within six months of the distribution.(107) Because D engaged in the spin-off as an alternative to an acquisition and for a non-acquisition business purpose, D should be able to satisfy either the First Prong Intent Test or the First Prong Facilitation Test. Further, D will be able to satisfy the Hostile Takeover Prong. D will not, however, be able to establish that, at the time of the distribution, neither D, C, nor their controlling shareholders would reasonably have anticipated that it was more likely than not that one or more persons would acquire a 50-percent or greater interest who would not have acquired such interests if the distribution had not occurred. D received offers to acquire only C before D distributed the stock of C. Under the proposed regulations, only persons who more likely than not would have acquired an interest in D if the distribution had not occurred are treated as persons who more likely than not would have acquired a proportionate interest in C if the distribution had not occurred.(108) Because P had no intent to acquire D, D will not be able to satisfy the Reasonable Anticipation Prong. If the offers had been to acquire D, however, D may be able to satisfy the Reasonable Anticipation Prong, because it may be able to establish that P would have acquired D if the distribution had not occurred.

f. Hot Market

   Example 8: D distributes C pro rata to its shareholders. The distribution
   is motivated solely by a non-acquisition business purpose. At the time of
   the distribution, although D has not been approached by any potential
   acquirers of C, D would reasonably anticipate that, under current market
   conditions, if C is separated from D, an acquisition of a 50-percent or
   greater interest is more likely than not to occur within two years. C is
   acquired by P within six months after the distribution.

Because the acquisition occurred within six months after the distribution, D cannot use the General Post-Spin Rebuttal to rebut the two-year presumption. Moreover, the proposed regulations provide that D will not be able to rebut the two-year presumption using the Alternative Post-Spin Rebuttal because it will not satisfy the Reasonable Anticipation Prong.(109) D will not be able to establish that, at the time of the distribution, neither D, C, nor their controlling shareholders would reasonably have anticipated that it was more likely than not that one or more persons would acquire a 50-percent or greater interest in the company.

This example illustrates how overbroad the Reasonable Anticipation Prong is. What if the business purpose for the distribution in this example were to satisfy the terms of a court order? The application of section 355(e) seems harsh and unfair under such circumstances. Applied in this manner, the Reasonable Anticipation Prong not only goes well beyond the purpose of section 355(e) but, as discussed below, also ignores traditional notions of what constitutes a plan or series of related transactions. In effect, the Reasonable Anticipation Prong precludes companies in industries that are actively consolidating from undertaking tax-free spin-offs.

The application of familiar step-transaction principles,(110) rather than a sweeping, new reasonable anticipation test, should sufficiently address the concerns of Congress, Treasury, and the IRS without overreaching or unduly expanding the scope of the statute. The whole purpose of the step-transaction doctrine is to determine whether transactions are sufficiently related to one another to treat them as part of a single, planned course of action. Indeed, step-transaction principles have been applied to interpret phrases similar to "plan or series of related transactions" that appear elsewhere in the Code. For example, section 302(b)(2)(D) provides that section 302(b) does not apply to a redemption made pursuant to a "plan the effect of which is a series of redemptions" resulting in a distribution that is not substantially disproportionate. This phrase has been interpreted to incorporate common law step-transaction principles.(111)

The preamble to the proposed regulations provides that the Reasonable Anticipation Prong is intended to reflect (i) the idea that a causal connection between the distribution and the acquisition indicates the presence of a plan and (ii) the idea that the presence of negotiations is not necessary for a plan to exist.(112) First, with respect to the causation factor, the Reasonable Anticipation Prong incorporates a "but-for" analysis -- if the acquisition would not have occurred but for the distribution, then the two are part of the same plan.(113) Even assuming the but-for analysis is appropriate, the proposed regulations improperly focus on the acquisition rather than the distribution. As a result, the distributing corporation must prove a lack of intent on the part of the acquirer. The statutory language, on the other hand, provides that the distribution must be part of a plan (or series of related transactions) pursuant to which one or more persons acquire the requisite 50-percent interest.(114) The statute clearly contemplates that the distribution be the focus of the analysis. Thus, the but-for analysis should consider whether the distribution would have occurred but for the acquisition.(115) Such an analysis properly focuses on the intent of the distributing corporation, controlled corporation, or controlling shareholders. Under such an analysis, the distribution in Example 8 would have occurred regardless of the acquisition; thus, it should not be considered part of the same plan. This statement of the but-for analysis is similar to the mutual interdependence test of the step-transaction doctrine, which asks whether the legal relations created by one transaction would have been fruitless without a completion of the series.(116)

Second, with respect to the necessity of negotiations, the preamble to the proposed regulations reflects a concern that a distributing corporation could attempt to avoid section 355(e) under circumstances that virtually assure an acquisition by arguing that, despite the imminence of an acquisition, effectuating the acquisition was not a motive for the distribution. Hence, Treasury and the IRS rejected any requirement for mutual agreement or negotiations "because Congress intended the statute to apply in situations beyond those in which a distribution is made prior to and as part of an acquisition by a specifically identified acquirer."(117) In support of this conclusion, the preamble notes that the legislative history specifically referred to public offerings as possibly triggering section 355(e) even though presumably no public buyer would have been identified at the time of the distribution.(118)

The expressed concerns, however, simply do not justify a rule as sweeping as the Reasonable Anticipation Prong. Indeed, as suggested by Example 8, section 355(e) may apply not only in the absence of a specifically identified acquirer but also in the absence of any involvement on the part of the distributing or controlled corporation. As such, the proposed regulations lose focus of whose plan is relevant for purposes of section 355(e). The Reasonable Anticipation Prong goes well beyond the statutory language and the purpose of section 355(e) to prevent disguised sales.

The statutory language of section 355(e) provides that the distribution must be part of a plan (or series of related transactions) pursuant to which one or more persons acquire the requisite 50-percent interest.(119) Since (i) the statute contemplates a single plan involving the distribution and acquisition and (ii) the distributing corporation, the controlled corporation, or their controlling shareholders must necessarily be involved in the plan of distribution, one of these relevant parties must, by definition, be involved in the plan of acquisition as well. Indeed, the preamble to the proposed regulations recognizes as much, by stating: "to determine whether a plan of acquisition exists, one must look at all parties to the transaction, including the distributing and controlled corporations and their shareholders, not just the potential acquirers."(120) Focusing on the relevant parties is not inconsistent with the reference to public offerings in the legislative history, because the distributing or controlled corporation will be taking positive action to facilitate the acquisition of its stock by the public. Likewise, other similar transactions, such as private placements or auctions by an investment banker, will continue to fall within this concept of a plan.

g. Hostile Takeover

   Example 9: P announces an intention to acquire D, principally to acquire
   C's business. Due to market conditions, P's available capital, and P's
   success in acquiring other corporations, D would reasonably anticipate that
   an acquisition of a 50-percent or greater interest in D is more likely than
   not to occur within two years. To lower its borrowing costs and in an
   effort to prevent the acquisition of D (by separating it from the more
   attractive C), D distributes the C stock pro rata to its shareholders. P
   acquires C within six months after the distribution.

Because the acquisition occurred within six months after the distribution, D cannot use the General Post-Spin Rebuttal to rebut the two-year presumption.(121) Moreover, the proposed regulations provide that D will not be able to rebut the two-year presumption using the Alternative Post-Spin Rebuttal because it will not satisfy the Hostile Takeover Prong.(122) D will satisfy the First Prong Facilitation Test because the distribution was not motivated by an intention to facilitate an acquisition. Likewise, D will satisfy the Reasonable Anticipation Prong because, at the time of the distribution, neither D, C, nor their controlling shareholders would reasonably have anticipated that it was more likely than not that one or more persons would acquire a 50-percent or greater interest who would not have acquired such interest if the distribution had not occurred. D will not, however, satisfy the Hostile Takeover Prong, because D will not be able to establish that the distribution was not motivated in whole or substantial part by an intention to decrease the likelihood of an acquisition of D by separating it from C, which was likely to be acquired.

As in Example 5, this example illustrates the application of the rebuttals where D has two substantial business purposes for the distribution -- one non-acquisition purpose and one hostile takeover purpose. If, as is recommended above, the General Post-Spin Rebuttal is applied without a but-for analysis, then that test is satisfied as long as the non-acquisition business purpose is substantial. Thus, the General Post-Spin Rebuttal would still apply where there are two substantial business purposes, provided the acquisition occurs more than six months after the distribution. The Hostile Takeover Prong of the Alternative Post-Spin Rebuttal, on the other hand, cannot be satisfied where the distribution is motivated in substantial part by an intention to decrease the likelihood of an acquisition of D by separating it from C. Thus, the Hostile Takeover Prong automatically would not be satisfied where there are two substantial business purposes. Consequently, in the example above, section 355(e) applies where the acquisition occurs within six months after the distribution but not where the acquisition occurs more than six months after the distribution. Again, there is no apparent reason for this disparate treatment. A hostile takeover does not become less hostile by reason of the passage of time. Moreover, this result is extremely harsh and is unnecessary to achieve the objective of section 355(e).

h. Simplification of the Alternative Post-Spin Rebuttal

As drafted, the Alternative Post-Spin Rebuttal is extremely complicated and should be simplified. The First Prong Intent Test requires that the intended change in ownership equal 50 percent or more. This 50-percent threshold is appropriate and consistent with the recommendation in Part III.D.1.a. that the General Post-Spin Rebuttal should be modified to require a business purpose to facilitate a 50-percent acquisition. The First Prong Facilitation Test is, however, unnecessary and should be removed from the Alternative Post-Spin Rebuttal. Furthermore, as noted in Part III.D.2.f., the Reasonable Anticipation Prong of the proposed regulations should be modified to incorporate general step-transaction principles. Finally, as recommended in Part III.D.1.d., the Hostile Takeover Test should be removed from the regulations, which would result in further simplification.

If the recommended changes are incorporated in the final regulations, the Alternative Post-Spin Rebuttal would consist of two prongs: (i) neither the distributing or controlled corporation nor a controlling shareholder of either corporation intended that one or more persons would acquire a 50-percent or greater interest in the distributing or controlled corporation, and (ii) applying general step-transaction principles, the distribution and acquisition should not be stepped together. The revised test would not only be simpler, but it would also be consistent with the intent of the proposed regulations in seeking to impose a higher burden of proof on the distributing corporation with respect to acquisitions occurring within six months of the distribution.

E. Pre-Spin Acquisitions

1. General Pre-Spin Rebuttal

As discussed above, the General Pre-Spin Rebuttal requires that the distributing corporation establish that, at the time of the acquisition, the distributing corporation and its controlling shareholders did not intend to effect a distribution.(123) Thus, the General Pre-Spin Rebuttal focuses on the intent of the distributing corporation and its controlling shareholders to effect the distribution at the time of the acquisition.

a. Public Offering Before Distribution

   Example 10: D does an initial public offering of 50 percent of its stock.
   At the time of the initial public offering, D does not intend to distribute
   the stock of C. One year later, D distributes the stock of C pro rata to
   its shareholders.

The General Pre-Spin Rebuttal is satisfied in this example because D did not intend to effect a distribution of C at the time of the public offering. This result is correct because there is no relationship between the public offering and the distribution.

b. Formation of Intent

   Example 11: D acquires the stock of X, a widely held corporation, in
   exchange for 50 percent of D's stock. None of the X shareholders receiving
   D stock becomes a controlling shareholder of D. Several months later, D
   distributes the stock of C.

Assume that D's acquisition of X occurs after the announcement of the distribution of C. In this case, D clearly intended to effect the distribution at the time of the acquisition; hence, the General Pre-Spin Rebuttal is not available. The proposed regulations address this straightforward case.(124) The proposed regulations, however, are silent with respect to a critical issue: at what point is D's intent to effect a distribution (or acquisition) formed? To illustrate the issue, what if X is acquired while D's management is considering the possibility of a spin-off, but the board of directors has not yet considered the matter? What if the board has considered the spin-off and is studying its feasibility? What if the board has approved the spin-off? Representatives of Treasury and the IRS have informally indicated that mere due diligence with respect to the distribution should not indicate that the requisite intent is formed.(125) It seems that board approval likely indicates intent, but that mere consideration by management or the board and the conduct of feasibility studies and the like should not rise to the level of intent. Establishing these differences by clear and convincing evidence, however, will likely prove difficult.

c. Acquisition Before Announcement of Distribution

   Example 12: A acquires a 10-percent interest in D. Prior to the
   acquisition, and unbeknownst to A, D's board had approved, but had not yet
   announced, a plan to distribute the stock of C pro rata to its
   shareholders. Shortly thereafter, D announces that it will distribute the
   stock of C, and eight months later, D distributes the stock of C. After the
   distribution, a third party acquires 40 percent of the stock of C(126) in a
   transaction related to the distribution.

Because D intended to distribute the stock of C at the time A acquired the D stock, D will not be able to use the General Pre-Spin Rebuttal.(127) Given the proposed regulations' focus on the intent of controlling shareholders, this result makes little sense. The preamble to the proposed regulations states that "if a person becomes a controlling shareholder by acquisition, that person's intention becomes the single best indicator of whether a later distribution was part of a plan."(128) Thus, if A, with full knowledge of the planned distribution, acquired a controlling interest in D, one could say that the acquisition and the distribution are part of A's plan.(129) In this example, however, the proposed distribution had not been announced at the time A became a controlling shareholder. If A did not even know about the distribution and had no influence on D's decision to effect the distribution, how could one say the distribution is part of the same plan as the acquisition? In this case, it seems that the distribution is part of D's plan, and the acquisition is part of A's separate plan. Because section 355(e) requires that the distribution and acquisition be part of a single plan,(130) this result is inappropriate. Hence, the rule should be revised to require that the acquiring shareholder have knowledge of, and involvement with, the distributing corporation's intent to distribute the controlled corporation.

Note that a pre-spin acquisition of the distributing corporation can taint a subsequent acquisition of the controlled corporation. In this example, 40 percent of C is acquired after the distribution as part of a plan. Assume that D is unable to satisfy either the General Pre-Spin or Alternative Pre-Spin Rebuttals with respect to A's acquisition. Because neither acquisition can satisfy the rebuttals, the transactions are aggregated for purposes of determining whether the 50-percent threshold is met.(131) Thus, A's 10-percent acquisition of D and the 40-percent acquisition of C will be aggregated, and the 50-percent threshold will be met. As long as the acquisitions are both related to the distribution, this is true regardless of whether the acquisitions are completely unrelated to one another.(132)

2. Alternative Pre-Spin Rebuttal

As discussed above, the Alternative Pre-Spin Rebuttal requires that the distributing corporation establish that the distribution would have occurred at approximately the same time and under substantially the same terms regardless of the acquisition.(133) Thus, the Alternative Pre-Spin Rebuttal focuses on whether the acquisition had any effect on the timing and terms of the distribution. This rebuttal, however, is unavailable where a person acquiring an interest in the distributing corporation becomes a controlling shareholder.

a. Definition of Controlling Shareholder (Public Company)

   Example 13: D, a public company, announces that it plans to distribute the
   stock of C pro rata to its shareholders. A then acquires 10 percent of D
   voting common stock. Several months later, D distributes the stock of C.
   After the distribution, a third party acquires 40 percent of the stock of C
   in a transaction related to the distribution.

A controlling shareholder in a public company is defined as any person who, directly or indirectly, or together with related persons, owns five percent or more of any class of stock and who actively participates in the management or operation of the corporation.(134) The proposed regulations do not define the phrase "actively participates."(135) An example in the proposed regulations briefly mentions the controlling shareholder rule, but does little to clarify the definition of a controlling shareholder.(136) The example involves the acquisition of an unrelated company, X, by D prior to the distribution. The example states that X's sole shareholder, A, "receives 30 percent of D's stock, becoming a controlling shareholder."(137) Thus, the example assumes, without analysis, that A is a controlling shareholder. Moreover, it is unclear from the facts of the example whether the distributing corporation is a publicly traded or non-publicly traded company. In Example 13, above, it would appear that the acquisition by A of a 10-percent voting stock interest in D, without any participation in D's management or operation, would not make A a controlling shareholder.

What if, in addition to holding a 10-percent interest in D, A were a manager or officer of D? A presumably would satisfy the active participation standard as an active participant in the management of D. What if A just sat on the board of directors of D? Presumably the answer would not change. What if A were a mere employee of D? Would A satisfy the standard as an active participant in the operation of the corporation?

Furthermore, it is unclear from the proposed regulations when a shareholder will be considered to own five percent of a class of stock. What is the effect if, on the facts of the example above, A receives an option to acquire 10 percent of D's stock instead of a direct stock interest? What if A, an employee of D, receives stock that is subject to a substantial risk of forfeiture within the meaning of section 83 and the regulations thereunder? What if A makes a section 83(b) election to include the value of the stock in his or her gross income? Final regulations should clarify the definition of controlling shareholder.

b. Definition of Controlling Shareholder (Non-Public Company)

   Example 14: D has 20 unrelated shareholders, each of which owns five
   percent of the voting stock of D. D announces that it plans to distribute
   the stock of C pro rata to its shareholders. A, who is not related to any
   of D's shareholders, then acquires 5 percent of D voting common stock
   (which dilutes the other shareholders' interests to 4.75 percent). Several
   months later, D distributes the stock of C. After the distribution, a third
   party acquires 45 percent of the stock of C in a transaction related to the
   distribution.

A controlling shareholder in a non-publicly traded company is defined as any person who, directly or indirectly, or together with related persons, possesses voting power in the distributing or controlled corporation "representing a meaningful voice in the governance of the corporation."(138) The proposed regulations do not define what constitutes a "meaningful voice." The same phrase appears, however, in the appendix to Revenue Procedure 96-30 in connection with substantiating the key employee business purpose.(139) In Revenue Procedure 96-30, the IRS states that it will consider whether the voting power represents a meaningful voice on a case-by-case basis, "taking into account factors such as the distribution of voting power among the shareholders, family relationships, and competing economic interests."(140) Presumably, the IRS would apply the same standard for purposes of the Alternative Pre-Spin Rebuttal. Applying this standard to the foregoing example, A's five-percent interest presumably would constitute a meaningful voice because A has the largest outstanding interest. If the other 20 shareholders were related, it is unclear whether A's interest would constitute a meaningful voice.

c. Acquiring Control Within Two Years After the Distribution

   Example 15: D, a public company, announces that it plans to distribute the
   stock of C pro rata to its shareholders. A then acquires three percent of D
   voting common stock. Several months later, D distributes the stock of C.
   Within the two-year period after the distribution, A acquires an additional
   seven percent of D's voting common stock. After the distribution, a third
   party acquires 40 percent of the stock of D in a transaction related to the
   distribution.(141)

The Alternative Pre-Spin Rebuttal does not apply if the acquirer becomes a controlling shareholder by reason of the acquisition or at any point thereafter and during the two-year period following the distribution.(142) In this example, A acquires an additional amount of stock during the two-year period sufficient to make A a controlling shareholder. Thus, the Alternative Pre-Spin Rebuttal would not be available. There is no reason for such an expansive rule. In determining whether a later distribution is part of a plan, the focus of the pre-spin rebuttals is on the intent of the controlling shareholder.(143) A is not a controlling shareholder at the time of the distribution and thus has no influence over the distribution. It should not matter that A acquires a sufficient amount of stock after the distribution to make him or her a controlling shareholder.

Nonetheless, the Treasury and IRS may have a concern that the absence of such a rule could lead to abuse. For example, assume that A wants to acquire a controlling interest, but in order to avoid section 355(e), acquires a three-percent interest before the distribution and acquires an additional seven percent on the day after the distribution. A much more narrow rule could be crafted to address such potential abuses. For example, the Alternative Pre-Spin Rebuttal could be made inapplicable where a person becomes a controlling shareholder by reason of the acquisition or during the two-year period after the distribution by reason of acquisitions that are pursuant to the same plan as the original acquisition.

F. Agreement, Understanding, Arrangement, or Substantial Negotiations

As discussed above, the proposed regulations refer several times to an "agreement, understanding, arrangement, or substantial negotiations."(144) The proposed regulations do not, however, define those terms except to state that the parties do not necessarily have to enter into a binding contract or reach agreement on all terms in order to have an "agreement, understanding, or arrangement."(145)

1. When are Negotiations Substantial?

There is considerable uncertainty in determining when negotiations are substantial. For example, assume that P, a potential acquirer, and D have no negotiations before the distribution, but that within six months after the distribution, P and D discuss the possible benefits of a combination of their operations and engage in due diligence. P and D then merge more than six months after the distribution. Mere due diligence should not constitute substantial negotiations.(146) On the other hand, board approval will likely be considered strong evidence of the existence of an agreement, understanding, or arrangement. As a result, "substantial negotiations" likely fall somewhere between due diligence and board approval in respect of a transaction. Considering the difficulty in defining the term substantial negotiations, the IRS should consider deleting it from the final regulations. An agreement, understanding, or arrangement appears to be broad enough to prevent avoidance of section 355(e) without adding further uncertainty with the introduction of the term "substantial negotiations" in the regulations.

What if P and D engage in substantial negotiations within six months after the distribution, but D ultimately merges with X more than six months after the distribution? Should substantial negotiations with any potential acquirer indicate a plan on the part of the distributing corporation, regardless of whether the party with whom negotiations are conducted is the ultimate acquirer? What if P and D engage in negotiations, but have not yet agreed on price, and D's shareholders ultimately accept P's offer more than six months after the distribution? Whether this latter fact pattern constitutes substantial negotiations likely depends on the significance of the price term to the negotiations and how close P and D are to agreeing on the price. The final regulations should provide guidance about what constitutes substantial negotiations.

2. Breaking Off Negotiations

The proposed regulations do not address whether breaking off negotiations removes the taint of such negotiations. For example, assume that D negotiated with P, a potential acquirer, regarding P's acquisition of D prior to the distribution, but that negotiations are broken off. Negotiations resume later, more than six months after the distribution, and the acquisition is ultimately consummated. If the negotiations are truly broken off, then D should not be precluded from using the General Pre-Spin Rebuttal. The Treasury and IRS may be concerned, however, that negotiations can be temporarily broken off with the understanding that they will be resumed when the six-month period elapses. Notwithstanding the government's concern, this presents a factual issue and the distributing corporation should not be precluded from establishing that the break-off of negotiations was real. For example, what if negotiations with P break off prior to the distribution, but begin with X shortly after the distribution? Assuming that D engaged in no negotiations with X prior to the distribution, the pre-spin negotiations with P should not taint X's negotiations for, and ultimate acquisition of, D.

3. Treatment of Options

As discussed above, the proposed regulations treat certain options as agreements entered into on the date of issuance of the option, unless the distributing corporation establishes by clear and convincing evidence that, on the later of the date of the distribution or the date of issuance of the option, the option is not more likely than not to be exercised.(147)

Thus, an option that is (i) out-of-the-money when issued within two years preceding a spin-off and (ii) in-the-money at the time of the spin-off distribution is considered an agreement even where the option is not actually exercised until more than two years following the distribution. This rule in the proposed regulations makes little sense, because no relevant party (i.e., the distributing corporation, the controlled corporation, or a controlling shareholder of either) has control over the value of an option at the time of the distribution. One or more relevant parties does, however, have control over the issuance of the option. Thus, the determination of whether an option is more likely than not to be exercised should be tested at the time of issuance only.

Under the proposed regulations, the term "option" is defined broadly to include, inter alia, redemption agreements (including rights to cause the redemption of stock).(148) The term thus appears to encompass routine stock repurchase programs undertaken by public companies. This seems to expand the scope of section 355(e) beyond that intended by Congress. Hence, the final regulations should clarify that such repurchase programs will not cause an otherwise tax-flee distribution to be subject to section 355(e).

G. Issues Left Unanswered by the Proposed Regulations

There are several acquisition-related issues, described below, that are not answered by the proposed regulations. Representatives of the Treasury and the IRS have informally indicated that they are working on another set of proposed section 355(e) regulations that will specifically address what constitutes an acquisition. In addition, rules addressing aggregation and attribution (including provisions for public trading of stock) will be included in the next set of proposed regulations.(149)

Such future regulations should make it clear that public trading will not be considered in applying section 355(e). There is simply no way for the distributing and controlled corporations to monitor shares being traded by public shareholders.(150) Moreover, the distributing and controlled corporations are not involved in such acquisitions -- a shareholder sells its stock in the market to a third party. Without an exception, public companies will always be at risk for the application of section 355(e).

Future regulations should also clarify that the exercise of compensatory stock options are disregarded in applying section 355(e).(151) Section 355(e) was simply not intended to reach such acquisitions. Moreover, similar to public trading, the distributing or controlled corporation is not undertaking any positive action to facilitate an acquisition -- the corporation is under a preexisting obligation to issue its stock when the option is exercised.

In addition, acquisitions by a corporation of its own stock pursuant to a redemption or repurchase should be excluded from section 355(e). The resulting increase in the interests of other shareholders should also generally not be considered an acquisition for purposes of section 355(e) because the ownership of the corporation is not shifting to new shareholders. In limited circumstances, however, such an increase in interest may implicate the purposes of section 355(e). This would occur where the redemption is in connection with another prohibited acquisition. For example, assume that individual A acquires 30 percent of the stock of Distributing within two years after the spin-off of Controlled pursuant to a plan. Distributing later redeems enough of its shares to bring A's ownership interest to 50 percent. To address this and other potentially abusive transactions, the regulations could provide an anti-abuse rule similar to that contained in the proposed section 355(d) regulations.(152)

Moreover, guidance should be issued regarding the acquisition of stock by historic shareholders. For example, assume that A, B, and C own 25 percent, 25 percent, and 50 percent, respectively, of Distributing's stock. Distributing distributes the stock of Controlled pro rata to its shareholders. Within two years after the distribution, C sells his 50-percent interest in Controlled to A. Section 355(e)(3)(A)(iv) provides that an acquisition of stock is not taken into account to the extent that the percentage of stock owned by each person owning stock in the corporation immediately before the acquisition does not decrease. This provision seems to adopt a shareholder-by-shareholder approach to determining whether an acquisition occurs. The legislative history of section 355(e), however, provides that the purpose of section 355(e) is to prevent new shareholders from acquiring ownership of a business in connection with a spin-off in a transaction that resembles a disguised sale.(153) Shifts in ownership among historic shareholders do not implicate the purpose behind section 355(e).

IV. Summary

Treasury and the IRS should be commended for proposing a six-month rule that limits the broad application of section 355(e). On balance, however, the proposed regulations are generally not helpful because they exacerbate rather than minimize the problems created by a poorly drafted statute. To improve the regulations, Treasury and the IRS should adopt the following recommendations discussed in this article.

A. General Recommendations

1. The rebuttals provided in the proposed regulations should be recrafted as safe harbors to permit taxpayers to satisfy the burden of proof concerning the absence of a plan. The proposed rebuttals should not constitute the exclusive means to avoid the application of section 355(e).

2. Given the difficulty of proving intent, reasonable anticipation, etc., the burden of proof should be something less than "clear and convincing" evidence.

3. For purposes of applying section 355(e), the regulations should address the following issues, which were left unanswered by the proposed regulations:

* The regulations should clarify that public trading of the stock of the distributing or controlled corporation is not considered.

* The regulations should disregard the exercise of compensatory stock options.

* The regulations should disregard the redemption or repurchase of stock by the distributing or controlled corporation in the open market.

* The regulations should generally disregard the increase in the interests of other share holders that results from a redemption.

* The regulations should provide guidance regarding the acquisition of stock by historic shareholders.

B. General Post-Spin Rebuttal

1. For purposes of the General Post-Spin Rebuttal, an acquisition-related business purpose should taint only those acquisitions related to that purpose. With respect to other unrelated acquisitions, the distributing corporation should be permitted to use the General Post-Spin Rebuttal.

2. The General Post-Spin Rebuttal should be satisfied as long as the distribution is motivated in whole or substantial part by a business purpose other than an intent to facilitate a 50-percent acquisition.(154)

3. The final regulations should clarify that a business purpose to facilitate an acquisition of distributing corporation stock should not preclude use of the General Post-Spin Rebuttal for subsequent acquisitions of controlled corporation stock.

4. Where multiple business purposes exist, the IRS should not apply a but-for analysis to determine whether a distribution is motivated in whole or substantial part by the non-acquisition business purpose.

5. Both the General Post-Spin and Alternative Post-Spin Rebuttals should be modified to remove references to hostile takeovers. To allay government concerns about distinguishing hostile and friendly takeovers, the taxpayer might be required to establish the existence of certain factors to demonstrate that the takeover was, in fact, hostile.

C. Alternative Post-Spin Rebuttal

1. The Alternative Post-Spin Rebuttal should be simplified by deleting the First Prong Facilitation Test.

2. The Reasonable Anticipation Prong should be applied at the time of the announcement of the distribution rather than at the time of the distribution.

3. The Reasonable Anticipation Prong should be replaced with a test that applies step-transaction principles.

4. The Alternative Post-Spin Rebuttal should be simplified by deleting the Hostile Takeover Prong.

D. General Pre-Spin Rebuttal

1. The final regulations should clarify that, for purposes of the General Pre-Spin Rebuttal, mere due diligence regarding the spin-off does not rise to the level of intent that invokes the application of section 355(e).

2. The General Pre-Spin Rebuttal should be modified to provide that an acquiring controlling shareholder must have knowledge of, and involvement with, the distributing corporation's intent to distribute the stock of the controlled corporation.

E. Alternative Pre-Spin Rebuttal

1. The final regulations should clarify the definition of controlling shareholder to provide guidance on (i) the definition of the phrase "actively participates" and (ii) what constitutes a "five-percent shareholder."

2. Under the proposed regulations, the Alternative Pre-Spin Rebuttal does not apply if the acquirer becomes a controlling shareholder at any point during the two-year period after the distribution. This rule should be modified in the final regulations to require that subsequent acquisitions be part of the same plan as the original acquisition.

F. Agreement, Understanding, Arrangement, or Substantial Negotiations:

1. The final regulations should provide guidance on what constitutes "substantial negotiations."

2. For purposes of the definition of "agreement," the determination of whether an option is more likely than not to be exercised should be tested at the time of issuance only.

3. Normal stock repurchase programs should be excluded from the definition of "option."

(*) Notes appear beginning on page 40.

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Notes

(1) Pub. L. No. 105-34 (1997).

(2) Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended.

(3.) In Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966), acq. Rev. Rul. 68-603, 1968-2 C.B. 148, a state bank entered into a merger agreement with a national bank. The state bank had an insurance department, which the national bank did not want to acquire. In order to facilitate the merger, the state bank contributed its insurance department to a newly formed corporation and spun off the corporation to its shareholders. Thus, transactions in which a target company spins off unwanted assets to its shareholders to facilitate an acquisition became known as "Morris Trust" transactions. Such transactions were blessed as tax free under section 355 for more than 30 years until the enactment of section 355(e) in 1997. See, e.g., Rev. Rul. 78-251, 1978-1 C.B. 89; Rev. Rul. 75-406, 1975-2 C.B. 125; Rev. Rul. 72-530, 1972-2 C.B. 212; Rev. Rul. 70-434, 1970-2 C.B. 83. For a discussion of section 355(e), see Mark J. Silverman, et al., The New Anti-Morris Trust and Intragroup Spin Provisions, 49 THE TAX EXECUTIVE 455 (1997).

(4) I.R.C. [subsections] 355(e)(1), (2)(A). The transaction otherwise qualifies as a section 355 transaction. According]y, the recipient shareholders do not recognize gain. All discussions relating to the application of section 355(e) in this article assume that the distribution or distributions of the controlled corporation stock qualify under section 355(a), unless otherwise noted.

(5) I.R.C. [sections] 355(e)(2)(B).

(6) This language gives Treasury and the IRS the authority to interpret the statute and to establish the standards required to demonstrate that a distribution and acquisition are not pursuant to a plan. The legislative history provides guidance about the purpose of the statute, but it does not prevent the Treasury and the IRS from reaching an independent judgment on the meaning of the statute. Indeed, the Treasury and the IRS have exercised similar authority in the past. See, e.g., Prop. Reg. [sections] 1.355-6 (considerably narrowing section 355(d)); Treas. Reg. [sections] 1.338-4 (narrowing the section 338 consistency rules).

(7) The proposed regulations are proposed to apply to distributions that occur after the regulations are published in final form. Preamble to Prop. Reg. [sections] 1.355-7, 64 Fed. Reg. 46,155, 46,160 (1999) (hereinafter the "Preamble").

(8) Preamble, 64 Fed. Reg. at 46,157.

(9) Id.

(10) Section 355(e) is a poorly drafted statute based on flawed principles. So-called Morris Trust transactions have been authorized by the IRS for more than 30 years, and there is no reason to impose a tax on basic Morris Trust transactions. Section 355(e) was aimed at certain abusive transactions that looked more like a sale than a tax-free spin-off. As further discussed in the text at Part III.A., infra, one feature of such "disguised sale" transactions is that the corporation to be acquired borrows money (or assumes a large amount of debt) and distributes (or contributes) the proceeds of such debt to its parent prior to a spin-off. The acquirer often will contribute cash to the acquired entity, which is used to repay the debt. Basic Morris Trust transactions do not contain such features and do not resemble disguised sales.

The Clinton Administration first described the perceived abuse in its 1997 budget proposal and proposed an amendment to section 355(d) to address it. Congress, however, further expanded the proposal. Thus, the statute, along with the proposed regulations, has prevented companies from doing legitimate tax-free spin-offs.

(11) For other detailed analyses of the proposed regulations, see Michael L. Schler, What is a "Plan (or Series of Related Transactions)" Under Section 355(e)?, Tax Forum No. 535 (Oct. 4, 1999); Gordon E. Warnke, The Proposed Section 355(e) Regulations, The New York City Tax Club (Sept. 13, 1999).

(12) Preamble, 64 Fed. Reg. at 46,157.

(13) Id.

(14) See Prop. Reg. [sections] 1.355-7(a)(8), Exs. 1, 9.

(15) Clear and convincing evidence has been described as evidence that need not be beyond a reasonable doubt, but must be stronger than a mere preponderance of the evidence. See Gladden v. Self, 55-1 U.S.T.C. [paragraph] 9,227 (E.D. Ark. 1954). A preponderance of the evidence has been described as the greater weight of evidence, which is sufficient to incline the mind of a fair and impartial juror to one side of the issue rather than the other. See, e.g., White v. United States, 59-2 U.S.T.C. [paragraph] 9,584 (M.D. Ga. 1958); Wissler v. United States, 58-1 U.S.T.C. [paragraph] 9,414 (S.D. Iowa 1958).

(16) See I.R.C. [sections] 355(e)(2)(B); Preamble, 64 Fed. Reg. at 46,157.

(17) Note that the standard with respect to acquisitions that occur more than two years before differs slightly from the standard with respect to acquisitions that occur more than two years after a spin-off. No reason is stated in the preamble to the proposed regulations for the differing standards.

(18) Prop. Reg. [sections] 1.355-7(a)(2)(ii). The parenthetical is intended to reach distributions that are intended to ward off a hostile takeover. See Part III.D.1.d. for a discussion of the application of the General Post-Spin Rebuttal in the context of hostile takeovers.

(19) See Prop. Reg. [sections] 1.355-7(a)(8), Exs. 3, 5. See Part III.D.1.c. for a discussion of the application of the General Post-Spin Rebuttal where both acquisition and non-acquisition business purposes exist for the spin-off.

(20) Prop. Reg. [sections] 1.355-7(a)(2)(ii)(B). The phrase "controlling shareholder" is defined in Prop. Treas. Reg. [sections] 1.355-7(a)(4) and applies for purposes of both the pre-spin and post-spin rebuttals. See Parts III.E.2.a. and b. for a discussion of this definition.

(21) Prop. Reg. [sections] 1.355-7(a)(2)(iii). Note that the General Post-Spin Rebuttal contains language that is similar to both the First Prong Facilitation Test and the Hostile Takeover Prong. See Part III.D.2.c. (comparing the General Post-Spin Rebuttal with the First Prong Facilitation Test) and Part III.D.2.g. (comparing the General Post-Spin Rebuttal with the Hostile Takeover Prong).

(22) See Preamble, 64 Fed. Reg. at 46,158.

(23) Id.

(24) See Part III.D.2.g. for a discussion of the Hostile Takeover Prong.

(25) Prop. Reg. [sections] 1.355-7(a)(2)(ii)(4)(D).

(26)) Preamble, 64 Fed. Reg. at 46,158-59.

(27) Prop. Reg. [sections] 1.355-7(a)(3)(i).

(28) Preamble, 64 Fed. Reg. at 46,159.

(29) Id.

(30) Prop. Reg. [sections] 1.355-7(a)(2)(v)(A).

(31) Id.

(32) Prop. Reg. [sections] 1.355-7(a)(2)(v)(B).

(33) Prop. Reg. [sections] 1.355-7(a)(4).

(34) Id. This definition applies for purposes of both the pre-spin and post-spin rebuttals. See the discussion in the text at Parts III.E.2.a. and b.

(35) Prop. Reg. [sections] 1.355-7(a)(3)(ii).

(36) Prop. Reg. [sections] 1.355-7(a)(2)(ii)(A)(2).

(37) Prop. Reg. [subsections] 1.355-7(a)(2)(iii)(A)(1), (B).

(38) Prop. Reg. [sections] 1.355-7(a)(3)(i).

(39) Prop. Reg. [sections] 1.355-7(a)(5).

(40) Preamble, 64 Fed. Reg. at 46,159. The preamble states that Treasury and the IRS are particularly interested in receiving comments regarding transactions that involve an investment banker and when contacts with such investment banker should be considered an agreement, understanding, or substantial negotiations. Id.

(41) See Rev. Proc. 96-30, 1996-1 C.B. 969, Appendix A, [sections] 2. To utilize acquisition-related business purposes to secure an advance ruling, the taxpayer generally must reveal a specific acquirer or target. For example, where the distribution is to facilitate an acquisition, the taxpayer must identify the acquiring corporation and demonstrate that the acquiring corporation is not related to the taxpayer and will not complete the acquisition unless the distributing and controlled corporations are separated. Id. at Appendix A, [sections] 2.07. The taxpayer must demonstrate the same with respect to a target corporation where the distribution is to facilitate the acquisition of a target corporation by the distributing or controlled corporation. Id. at Appendix A, [sections] 2.08.

(42) Prop. Reg. [sections] 1.355-7(a)(7)(i)(A).

(43) Id. In applying the facts-and-circumstances test, the fair market value of the stock underlying an option is determined by taking into account control premiums and minority and blockage discounts. Id.

(44) Prop. Reg. [sections] 1.355-7(a)(7)(ii).

(45) Compensatory options are excluded from the definition of option only if they are nontransferable within the meaning of Treas. Reg. [sections] 1.83-3(d) and do not have a readily ascertainable fair market value as defined in Treas. Reg. [sections] 1.83-7(b). Prop. Reg. [sections] 1.355-7(a)(7)(iii)(B).

(46) Prop. Reg. [sections] 1.355-7(a)(7)(iii).

(47) Prop. Reg. [sections] 1.355-7(a)(6).

(48) The facts of this example are similar to those in Prop. Treas. Reg. [sections] 1.355-7(a)(8), Ex.5. Although the example mentions the rule that requires aggregation of the acquisitions, it does not fully analyze the rule in the context of the facts of the example.

(49) Prop. Treas. Reg. [sections] 1.355-7(b).

(50) Preamble, 64 Fed. Reg. at 46,160.

(51) H.R. Rep. No. 105-148,, 105 Cong., 1st Sess. 462 (1997) (hereinafter "House Report"); S. Rep. No. 105-33, 105 Cong., 1st Sess. 139 (1997) (hereinafter "Senate Report").

(52) House Report, at 462; Senate Report, at 139-40.

(53) See Joint Committee on Taxation, Description and Analysis of Certain Revenue-Raising Provisions Contained in the President's Fiscal Year 1998 Budget Proposal 51-52 (Mar. 11, 1997) (hereinafter cited as JCT Description of Budget Proposal); Introductory Statement by Chairman Archer, 143 Cong. Rec. E702 (daily ed. Apr. 17, 1997). Note that, unlike the abusive transactions targeted by Congress, the basic Morris Trust transaction does not involve any cashing out of the shareholders' investments and thus does not resemble a sale of the business.

(54) JCT Description of Budget Proposal 51-52. This appears to reflect a feature contained in Viacom's spin-off of its cable company to TCI. The IRS correctly ruled that the transaction qualified as a tax-free spin-off. See P.L.R. 9637043 (June 17, 1996). The only way this transaction may be viewed as a disguised sale is if the preferred stock is viewed as debt and the conversion of common stock to preferred stock is thus treated as a taxable exchange. See, e.g., I.R.C. [sections][sections] 351(g), 354(a)(2)(C).

(55) See also I.R.C. [sections] 337(c). For a more detailed discussion of the purpose of section 355(d), see Mark J. Silverman, et al., The Proposed Section 355(d) Regulations: Narrowing the Scope of an Overly Broad Statute, 26 J. CORP. TAX'N. 271 (2000).

(56) H.R. Rep. No. 101-881, 101st Cong., 2d Sess. 341 (1990).

(57) See Department of the Treasury, General Explanation of the Administration's Proposals (March 1996); Department of the Treasury, General Explanations of the Administration's Revenue Proposals 62 (Feb. 1997).

(58) The recently proposed regulations under section 355(d) provide an excellent example of regulations that implement the purpose behind the statute and narrow an overly broad statute. See Prop. Reg. [sections] 1.355-6; see also Silverman, et al., supra note 55.

(59) I.R.C. [sections] 355(e)(2)(B).

(60) A senior staff member of the Joint Committee on Taxation stated during a meeting of the D.C. Bar Tax Section's Corporation Tax Committee held shortly after enactment of section 355(e) that the legislative history intentionally omitted an explanation of what constitutes a plan, because whether a plan exists will "always be a matter of facts and circumstances." See also New Corporate Laws Beg For Interpretive Regs, 97 TNT 196-2 (Oct. 9, 1997).

(61) This conclusion was confirmed by informal statements made by representatives of Treasury and the IRS during a meeting of the D.C. Bar Tax Section's Corporation Tax Committee on Oct. 7, 1999.

(62) Indeed, some courts have applied a lower standard -- preponderance of the evidence -- in cases of statutory presumptions. See Essick v. Westover, 52-2 U.S.T.C. [paragraph] 10,872 (S.D. Cal. 1952) (requiring a preponderance of the evidence to overcome the presumption in section 2035); Estate of Walton v. Commissioner, 42 B.T.A. 300 (1940) (same). See also I.R.C. [sections] 672(c) (requiring a preponderance of the evidence to overcome the statutory presumption that a related or subordinate party is subservient for purposes of the grantor trust rules).

(63) For example, certain Code sections have both created a presumption and imposed a clear and convincing standard to overcome the presumption. See I.R.C. [sections][sections] 280G(b)(2)(C) (golden parachute payments); 47(d)(3)(D) (measure of progress expenditures for the rehabilitation credit); 613A(b)(3) (definition of "regulated natural gas" for purposes of percentage depletion rules). In addition, several regulatory provisions have created a presumption and imposed a clear and convincing standard to overcome the presumption. See, e.g., Treas. Reg. [sections] 1.897-6T(c)(2) (tax avoidance on U.S. real property interests); Treas. Reg. [sections] 1.881-3(c)(2) (participation by intermediate entity in conduit financing arrangement); Treas. Reg. [sections] 1.675-1(b)(4) (trustee's powers being exercised in a fiduciary capacity); Treas. Reg. [sections] 1.166-6(b)(2) (fair market value of mortgaged property sold); Treas. Reg. [sections] 1.1275-4(b)(4)(i)(B) (comparable yield for contingent payment debt instruments).

(64) It is unclear how the clear and convincing standard will be applied by the IRS where a private ruling has been obtained. For example, assume that a distributing corporation obtains a ruling that a spin-off undertaken for the purpose of cost savings qualities as tax free under section 355. Further assume that 50 percent of the distributing corporation's stock is acquired eight months later. In order to satisfy the General Post-Spin Rebuttal, the distributing corporation must establish by clear and convincing evidence that it had a substantial non-acquisition business purpose. Could the distributing corporation satisfy its burden of proof by pointing to the business purpose accepted in the earlier ruling? Or, is the standard of proof for establishing a corporate business purpose under Revenue Procedure 96-30 something less than clear and convincing so that the IRS may, in essence, reverse its earlier ruling?

(65) As noted in the text infra at Part III.D.1.a., however, the six-month rule is of limited benefit because the proposed regulations interpret acquisition-related business purposes so broadly.

(66) Prop. Reg. [sections] 1.355-7(a)(2).

(67) See Prop. Reg. [sections] 1.355-7(a)(8), Ex.1.

(68) Prop. Reg. [sections] 1.355-7(a)(8), Ex.5. Representatives of the Treasury and the IRS implied during a meeting of the D.C. Bar Tax Section's Corporation Tax Committee on Oct. 7, 1999, that, where the business purpose for the distribution is "fit and focus," one needs to consider the underlying fit to determine whether, in reality, the purpose is to make D or C a more attractive acquisition candidate.

(69) Prop. Reg. [sections] 1.355-7(a)(8), Ex.7.

(70) See Prop. Reg. [sections] 1.355-7(a)(8), Ex.9.

(71) Rev. Proc. 96-30, 1996-1 C.B. 696, Appendix A, [sections] 2.

(72) See Prop. Reg. [sections] 1.355-7(a)(8), Exs. 7, 9.

(73) These statements were made during a recent meeting of the D.C. Bar Tax Section's Corporation Tax Committee on Oct. 7, 1999. See also Sheppard, More Whinging About the Proposed Anti-Morris Trust Rules, 1999 TNT 205-3 (Oct. 22, 1999) (hereinafter cited as "More Whinging").

(74) See Prop. Reg. [sections] 1.355-7(a)(2)(ii).

(75) Prop. Reg. [sections] 1.355-7(a)(2)(ii)(A)(1).

(76) Prop. Reg. [sections] 1.355-7(a)(8), Exs. 3, 5.

(77) Preamble, 64 Fed. Reg. at 46,157.

(78) These statements were made during a meeting of the D.C. Bar Tax Section's Corporation Tax Committee on Oct. 7, 1999. See also More Whinging.

(79) See Prop. Treas. Reg. [sections] 1.355-7(a)(2)(ii)(A)(1).

(80) Rev. Proc. 96-30, 1996-1 C.B. 696, [sections][sections] 4.04(1), (6).

(81) Prop. Reg. [sections] 1.355-7(a)(2)(ii)(A)(1).

(82) For a dialog relating to the problem of hostile takeovers, see Bernard Wolfman, Special Report Put Odd Spin on Section 355(e), 98 TNT 16-107 (Jan. 26, 1998); Mark J. Silverman, et al., Spin-Offs: The Rest of the Story, 98 TNT 26-51 (Feb. 9, 1998); Bernard Wolfman, Setting the Record Straight on ITT/Hilton Case, 98 TNT 31-63 (Feb. 17, 1998); Mark J. Silverman, et al., `Friendly Counterpunching' on Spin-Offs Should Bring IRS Action, 98 TNT 35-94 (Feb. 23, 1998).

(83) 1996-1 C.B. 696.

(84) Prop. Reg. [sections] 1.355-7(a)(2)(ii)(A)(1). See also Preamble, 64 Fed. Reg. at 46,157; Prop. Reg. [sections] 1.355-7(a)(8), Exs. 2, 3. A very similar test applies with respect to the Alternative Pre-Spin Rebuttal, which is discussed below. See Prop. Reg. [sections] 1.355- 7(a)(2)(iii)(C).

(85) Preamble, 64 Fed. Reg. at 46,157.

(86) See Department of the Treasury, General Explanations of the Administration's Revenue Proposals 62 (Feb. 1997).

(87) See A.E. Staley Mfg. Co. v. Commissioner, 97-2 U.S.T.C. (CCH) [paragraph] 50,521 (7th Cir. 1997), rev'g 105 T.C. 166 (1995), where the Tax Court and Seventh Circuit disagreed over whether a transaction was hostile or non-hostile in the context of the deductibility of acquisition costs.

(88) See note 41 supra.

(89) Note that treating a hostile takeover as per se part of a plan cuts both ways. The distributing corporation can spin-off a business with a large built-in gain as a sort of poison pill, hoping that the tax bite will prove to be too much for the hostile acquirer.

(90) See P.L.R. 8930055 (May 3, 1989), revoked P.L.R. 9005070 (Nov. 9, 1989) (because the transaction had not been consummated); P.L.R. 8819075 (Feb. 17, 1988); P.L.R. 8421062 (Feb. 21, 1984).

(91) Prop. Reg. [sections] 1.355-7(a)(2)(iii).

(92) Note that even if C's acquisition of X occurred more than six months after the distribution, C would still be precluded from using the General Post-Spin Rebuttal, because the distribution was motivated solely by an intent to facilitate an acquisition of C's stock in a public offering. See Prop. Reg. [sections] 1.355-7 (a)(2)(ii)(A)(1).

(93) The facts in this example are based on the facts in Prop. Reg. [sections] 1.355-7(a)(8), Ex.9(iii).

(94) Note that the First Prong Intent Test must be relied upon, because the First Prong Facilitation Test is not satisfied where the business purpose for the distribution is to facilitate a public offering.

(95) For these same reasons, the acquisition of 20 percent of C's stock in the public offering should satisfy the Alternative Post-Spin Rebuttal.

(96) Prop. Reg. [sections] 1.355-7(a)(2)(ii)(A)(2).

(97) Prop. Reg. 1.355-7(a)(8), Ex.7(iii). See also Prop. Reg. [sections] 1.355-7 (a)(2)(ii)(A)(1).

(98) The facts in this example are based on the facts in Prop. Reg. [sections] 1.355-7(a)(8), Ex.7(v). Note that the First Prong Intent Test must be relied upon in this example, because the First Prong Facilitation Test is not satisfied where the business purpose for the distribution is to facilitate acquisitions by D.

(99) Prop. Reg. [sections] 1.355-7(a)(2)(iv)(A).

(100) See Prop. Reg. [sections] 1.355-7(a)(8), Ex.7(v). The proposed regulations do provide that a pre-spin acquisition that is part of a plan involving the distribution is counted as an amount reasonably anticipated to be acquired, but they do not address how to calculate the amount reasonably anticipated to be acquired with respect to post-spin acquisitions. Prop. Reg. [sections] 1.355-7(a)(2)(iv)(C).

(101) Prop. Reg. [sections] 1.355-7(a)(8), Ex.7(v).

(102) Prop. Reg. [sections] 1.355-7(a)(8), Ex.5(i).

(103) Prop. Reg. [sections] 1.355-7(a)(8), Ex.5(ii).

(104) Prop. Reg. [sections] 1.355-7(a)(2)(ii)(A)(2).

(105) The facts of this example are based on the facts of Prop. Reg. [sections] 1.355-7(a)(8), Ex.8.

(106) It will still be difficult for D to satisfy the Alternative Post-Spin Rebuttal in the case where P waits until immediately after the distribution because D must prove a negative -- that it did not reasonably anticipate the acquisition.

(107) Prop. Reg. [sections] 1.355-7(a)(2)(ii)(A)(2).

(108) Prop. Reg. [sections] 1.355-7(a)(2)(iv)(B).

(109) See Prop. Reg. [sections] 1.355-7(a)(8), Ex.4.

(110) Courts have developed a number of approaches for dealing with step-transaction issues. Most common are the binding commitment test, the mutual interdependence test, and the end result test. See McDonald's Restaurants of Illinois, Inc. v. Commissioner, 688 F.2d 520 (7th Cir. 1982). Under the binding commitment test, a series of transactions will be stepped together only if at the time that the first step is commenced, there is a binding legal commitment to undertake the subsequent steps. See, e.g., Commissioner v. Gordon, 391 U.S. 83 (1968). Under the mutual interdependence test, a series of transactions will be stepped together if the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series. See, e.g., King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969). Under the end result test, a series of transactions will be stepped together whenever the evidence shows that the parties' intent at the outset was to achieve the particular result, and that the separate steps were all entered into as means of achieving that result. See, e.g., Kuper v. Commissioner, 533 F.2d 152 (5th Cir. 1976).

(111) See Roebling v. Commissioner, 77 T.C. 30 (1981) (holding that the redemption must be "an integrated step in a firm and fixed plan"); Johnston v. Commissioner, 77 T.C. 679 (1981) (same). See also Rev. Rul. 85-14, 1985-1 C.B. 92 (ruling that a plan does not require the existence of an agreement between two shareholders, but rather a shareholder's "design ... to arrange a redemption as part of a sequence of events that ultimately restores" control to such shareholder is sufficient).

Further, the IRS has interpreted the phrase "same plan or arrangement" to incorporate the step-transaction doctrine. See Preamble to the final regulations under sections 704(c)(1)(B) and 737. The regulations address the treatment of a distribution by a partnership of property contributed by a partner. Although the regulations themselves do not incorporate the step-transaction doctrine as the standard for determining whether a distribution was part of the same plan or arrangement, the preamble to these regulations indicates that the IRS considers the step-transaction doctrine to apply.

(112) Preamble, 64 Fed. Reg. at 46,158.

(113) Id.

(114) I.R.C. [sections] 355(e)(2)(A).

(115) See Candace A. Ridgway, Through a Glass, Darkly: Section 355(e) Proposed Regulations in Need of the Guiding Light, 40 TAX MGMT. MEMORANDUM 359, 363-64 (1999) for a discussion of the proposed regulations' but-for analysis.

(116) See, e.g., King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969).

(117) Preamble, 64 Fed. Reg. at 46,158.

(118) Id.

(119) I.R.C. [sections] 355(e)(2)(A).

(120) Preamble, 64 Fed. Reg. at 46,156.

(121) Note that if the General Post-Spin Rebuttal did not apply a but-for analysis, as is recommended in Part III.D.1.c., D would have satisfied the first part of the General Post-Spin Rebuttal because there is a substantial non-acquisition business purpose for the distribution. Prop. Reg. [sections] 1.355-7(a)(2)(ii)(A)(1).

(122) See Prop. Reg. [sections] 1.355-7(a)(8), Ex.2(iii).

(123) Prop. Reg. [sections] 1.355-7(a)(2)(v)(A).

(124) See Prop. Reg. [sections] 1.355-7(a)(8), Exs. 6, 7(iii). If D can establish, however, that the distribution would have occurred at approximately the same time and under substantially the same terms regardless of the acquisition, then D may rebut the two-year presumption using the Alternative Pre-Spin Rebuttal. See Prop. Reg. [sections] 1.355-7(a)(2)(v)(B).

(125) These statements were made during a meeting of the D.C. Bar Tax Section's Corporation Tax Committee on Oct. 7, 1999.

(126) Note that the remaining 10 percent of C's stock is acquired by A in the spin-off of C. Although section 355(e)(3)(A)(ii) does not take into account acquisitions of C stock by reason of holding D stock, the exception does not apply to such an acquisition of C stock if the D stock held before the acquisition was acquired pursuant to a plan. I.R.C. [sections] 355(e)(3) (flush language).

(127) If D can establish that the distribution would have occurred at approximately the same time and under substantially the same terms regardless of the acquisition, then D may rebut the two-year presumption using the Alternative Pre-Spin Rebuttal. See Prop. Reg. [sections] 1.355-7(a)(2)(v)(B).

(128) Preamble, 64 Fed. Reg. at 46,159.

(129) Although the examples in the proposed regulations illustrate only the situation where the acquiring shareholder acquires stock directly from the distributing corporation, presumably the same analysis applies where stock in the distributing corporation is acquired from the current shareholders.

(130) I.R.C. [sections] 355(e)(2)(A).

(131) Prop. Reg. [sections] 1.355-7(a)(6). See Part II.E. for a description of the rule requiring the aggregation of acquisitions for purposes of determining whether the 50-percent threshold has been met.

(132) The statutory language appears to require that each acquisition be related to the distribution. Section 355(e)(2)A) requires that the distribution be part of "a plan (or series of related transactions) pursuant to which 1 or more persons acquire directly or indirectly stock representing a 50-percent or greater interest.... " The statute thus seems to contemplate a single plan involving the distribution.

(133) Prop. Reg. [sections] 1.355-7(a)(2)(v)(B).

(134) Prop. Reg. [sections] 1.355-7(a)(6).

(135) The definition of a controlling shareholder is the same as the definition of a "significant shareholder" for purposes of a public corporation's ability to use the fit and focus business purpose. See Rev. Proc. 96-30, 1996-1 C.B. 696, Appendix A [sections] 2.05(3). The Revenue Procedure also does not define the phrase "actively participates." To be consistent, the regulations should employ the term "significant shareholder."

(136) See Prop. Reg. 1.355-7(a)(8), Ex.7(iii).

(137) Prop. Reg. 1.355-7(a)(8), Ex.7(i).

(138) Prop. Reg. 1.355-7(a)(4).

(139) See Rev. Proc. 96-30, 1996-1 C.B. 696, Appendix A [sections] 2.01(1)(c).

(140) Id.

(141) If P would have acquired 40 percent of C, section 355(e) would not apply, since P's 40-percent acquisition combined with A's three-percent acquisition of C pursuant to the spin-off would not aggregate to 50 percent of the C stock.

(142) Prop. Reg. [sections] 1.355-7(a)(2)(v)(B). Note that if A were already a controlling shareholder as defined in Prop. Treas. Reg. [sections] 1.355-7 (a)(4) at the time A acquired its three-percent interest, the Alternative Pre-Spin Rebuttal would be available because A did not become a controlling shareholder "by reason of the acquisition."

(143) Preamble, 64 Fed. Reg. at 46,159.

(144) See Part II.D.

(145) Prop. Reg. [sections] 1.355-7(a)(5).

(146) Representatives of Treasury and the IRS informally confirmed this conclusion during a meeting of the D.C. Bar Tax Section's Corporation Tax Committee on Oct. 7, 1999. See also Part III.E.1.b. (reaching the same conclusion regarding when intent is formed for purposes of the General Pre-Spin Rebuttal).

(147) Prop. Reg. [sections] 1.355-7(a)(7)(i)(A).

(148) Prop. Reg. [sections] 1.355-7(a)(7)(ii).

(149) These statements were made during a meeting of the D.C. Bar Tax Section's Corporation Tax Committee on Oct. 7, 1999; see also More Whinging, supra note 73; Preamble, 64 Fed. Reg. at 46,156.

(150) This, of course, is less of a concern where the trading occurs with respect to five-percent shareholders, because five-percent shareholders are required to file an applicable Schedule 13 with the Securities and Exchange Commission.

(151) The proposed regulations disregard the issuance of compensatory stock options. See Prop. Reg. [sections] 1.355-7(a)(7)(iii)(B).

(152) Prop. Reg. [sections] 1.355-6(b)(4).

(153) House Report, at 462; Senate Report, at 139-40. See Mark J. Silverman, et al., supra note 3, for a discussion of this provision.

(154) At a minimum, the General Pre-Spin Rebuttal should contain a de minimis rule, permitting acquisition-related business purposes that involve acquisitions of up to a threshold percentage (e.g., greater than 33 percent).

MARK J. SULLIVAN is a partner and chairs the tax and ERISA group at the law firm of Steptoe & Johnson. Mr. Silverman is a frequent speaker at educational programs sponsored by Tax Executives Institutes. LISA M. ZARLENGA is an associate with the firm who focuses on corporate tax issues.