Time is short for spin-offs.

Although few U.S. corporations have spun off foreign subsidiaries (Fortune Brands' spin-off of Gallaher is a notable exception), realigning multinational corporate structures has many benefits. However, a proposed regulation--initially published in 1991 but never finalized--may put a conclusive end to such spin-offs.

Historically, when a domestic corporation sought to spin off a foreign subsidiary, Internal Revenue Code section 1248(f) provided the principal impediment. It says the distributing parent company must include in income (as a dividend) the amount by which the value of the distributed stock exceeds its basis (in the parent's hands) but only to the extent of the earnings and profits accumulated in years when the distributed entity was a controlled foreign corporation. In many cases, this extra income did not translate into a substantial incremental tax liability, because the dividend was accompanied by "deemed paid" foreign tax credits that offset the U.S. tax.

The proposed regulation, however, dramatically ups the ante. Proposed Treasury regulations section 1.367(b)5 provides that, in a distribution otherwise described in section 355, if the distributing corporation is domestic and the distributed entity is foreign, the distributing corporation will recognize gain if the distributee shareholder is an individual and not a U.S. corporation. In light of the ownership profile of most U.S. corporations, this proposed rule, if implemented, would cause the bulk of the appreciation inherent in the stock of a distributed foreign entity to be crystallized at the time of the distribution. The rule would defeat the tax purpose of a spin-off--that is, to allow the distributor to dispose of the spin-off entity tax-free. To the extent the rule applies, it would turn the spin-off into the functional equivalent of a taxable sale of the subsidiary's stock, differing only in the sense that the sale transaction does not generate any cash to defray the resulting tax liability.

Notwithstanding the compelling corporate business objectives of Fortune Brands' spin-off of Gallaher, the transaction probably would not have been undertaken had the proposed regulation been finalized before the deal was concluded. It is likely that most other distributing corporations would reach the same conclusion. These regulations, if finalized in their present form, are slated to become effective for distributions occurring 30 days after they are published in the Federal Register.

Robert Willens, CPA, managing director at Lehman Brothers, New York City.