IRS issues guidance on Sec. 355 active-trade-or-business test.
The notice addresses the continuing applicability of the "holding company" test of Sec. 355(b)(2)(A), as well as the transition rule of Sec. 355(b)(3)(C).
The Tax Increase Prevention and Reconciliation Act of 2005, signed into law May 17, 2006, added Sec. 355(b) (3)(A), providing that, for distributions made after that date and before 2011, a corporation will be treated as meeting the active-trade-or-business requirement of Sec. 355(b)(2)(A) "if and only if such corporation is engaged in the active conduct of a wade or business" For purposes of the new rule, all members of a corporation's separate affiliated group are treated as one corporation. A corporation's separate affiliated group is defined as the affiliated group determined under Sec. 1504(a) as if such corporation were the common parent and Sec. 1504(b) did not apply.
Under Sec. 355(b)(3)(C), the following transactions are excluded from the new rule: those (1) made under an agreement binding on May 17, 2006, and at all times thereafter; (2) described in a ruling request submitted to the IRS before May 18, 2006; and (3) described before May 18, 2006, in a public announcement or in a filing with the Securities and Exchange Commission. However, the distributing corporation may make an irrevocable election not to apply the transition rule to its distributions.
Holding-company test: Sec. 355(b) (2)(A) provides generally that, for Sec. 355(b)(1) purposes, a corporation is treated as being in the active conduct of a trade or business if and only it is engaged in the active conduct of a wade or business, or if substantially all of its assets consist of stock and securities of a corporation controlled by it (immediately after the distribution) that is so engaged. The latter test is referred to as the holding-company test. For this purpose, one corporation is "controlled" by another if the parent owns stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote, and at least 80% of the total number of shares of all other classes.
The continuing applicability of the holding-company test was not clear in light of new Sec. 355(b)(3)(A). However, Notice 2006-81 states that "in light of the restrictive language in [section] 355(b)(3), the Holding Company Test does not apply to any distribution for which [section] 355(b)(3) applies." Thus, when a distributing and/or controlled corporation is not directly active, it must rely on a direct or indirect corporate affiliate (within the meaning of Sec. 1504(a) and without regard to Sec. 1504(b)) to satisfy the requirement. Unlike Sec. 368(c), Sec. 1504(a) requires ownership of stock possessing at least 80% of the total voting power and 80% of the total value. Thus, when an otherwise active subsidiary would not be affiliated within the meaning of Sec. 1504(a) (i.e., in certain high-vote/low-value stock structures), additional restructuring would be required to satisfy the active-wade-or-business requirement.
Transition rule: Corporations desiring tax-free treatment under Sec. 355 and whose transactions are described in the transition rule will not be required to make an affirmative election under Sec. 355(b)(3)(C), provided that their transaction is described in Sec. 355(b) as in effect either before or after May 17, 2006. Those corporations will be deemed to have met the requirements of Sec. 355(b)(2)(A) or (b)(3), as applicable.
However, if the election's purpose is to disqualify the distribution under Sec. 355(a), the corporation must make the election described in Sec. 355(b)(3)(C). This is relevant if the transition rule otherwise applies, and the active-trade-or-business requirement would not be satisfied under Sec. 355(b)(3)(A) but would be met under the holding-company test.
Example 1: A controlled corporation (Controlled) is not engaged directly in an active business, but owns stock in a subsidiary (Sub) that is. Moreover, Controlled's stock in Sub contains 80% of Sub's total voting power, but less than 80% of the total value; an unrelated shareholder owns the remainder of the outstanding Sub stock (with a value in excess of 20%).Thus, Sub is not an affiliate of Controlled under Sec. 1504(a). By electing out of the transition rule, Controlled could not rely on Sub for purposes of the active-trade-or-business test, and Sec. 355(a) would not apply to the distribution transaction.
In contrast, corporations whose transactions are described in the transition rule, but do not desire tax-free treatment under Sec. 355 and require Sec. 355(b)(2)(A) to apply to ensure taxable treatment are not required to file the election, but must report the transaction as taxable. This is relevant if the transition rule applies and the active-trade-or-business requirement would not be satisfied under the holding-company test, but would be satisfied under Sec. 355(b)(3)(A).
Example 2: The facts are the same as in Example 1, except that Controlled owns all of Sub's outstanding stock, plus other assets. These other assets constitute more than 10% of the aggregate fair market value of Controlled's assets. Because the Sub stock constitutes less than 90% of Controlled's assets, the "substantially all" requirement would not be met and the holding-company test would not apply. Thus, Controlled would not be deemed engaged in the active conduct of a trade or business for purposes of qualifying under Sec. 355(a).
To make the election described in Sec. 355(b)(3)(C) (for purposes of disqualifying the distribution under Sec. 355(a)), the distributing corporation may include a statement titled "Election Pursuant to Notice 2006-81 [Insert name and taxpayer identification number (TIN) (if any)], A Distributing Corporation." The statement should provide the names and TINs of the distributing and controlled corporations, and should include a representation that the distributing corporation is eligible to make the election described in the notice and that it elects to have Sec. 355(b)(3) apply to its distribution.
Sec. 355(b)(3)(A) was intended to liberalize the active-trade-or-business requirement and lessen the need for internal restructuring to meet it. It is not clear from either the statute or the legislative history that Congress intended Sec. 355(b)(3)(A) to overrule the holding-company test. Thus, the IRS's and Treasury's statement that Sec. 355(b)(3)(A) trumps the holding-company test is significant. Based on this statement, to meet the active-trade-or-business requirement, a distributing and/or controlled corporation must rely on one or more affiliated corporations; to the extent a corporation is controlled within the meaning of Sec. 368(c) (but not affiliated), additional restructuring would be required.
As to the transition rule, Notice 2006-81 limits the need for an election. Essentially, it requires one only if the purpose is to disqualify the distribution under Sec. 355(a). In contrast, when the transition rule applies and the parties desire to qualify the distribution under Sec. 355(a), an election is not required if the active-trade-or-business requirement would be satisfied under either the holding-company test or the affiliated-group test.
A number of open issues remain, including the scope of the expansion doctrine (and whether a taxable stock acquisition can qualify as an expansion of a historic business).
FROM KIRSTEN SIMPSON, J.D., WASHINGTON, DC
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|Title Annotation:||CORPORATIONS & SHAREHOLDERS|
|Publication:||The Tax Adviser|
|Date:||Jan 1, 2007|
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