Section 355(e): corporate spinoffs.
On August 5, 1999, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning the definition of a "plan" for purposes of Internal Revenue Code section 355(e). TEI's comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is Philip G. Cohen, General Tax Counsel of Unilever United States, Inc. Contributing substantially to the development of TEI's comments was Gregory G. Postian, Associate General Tax Counsel, Unilever United States, Inc. Subsequent to TEI's submission, the IRS on August 19, 1999, promulgated proposed regulations interpreting the phrase "plan (or series of related transactions)" for purposes of section 355(e). See REG-116733-98.
In order to permit a tax-efficient separation or division of one line of business assets from another, section 355 of the Internal Revenue Code accords tax-free treatment to certain distributions by one corporation (the distributing corporation) to its shareholders of the stock or securities in another corporation (the controlled corporation). To address transactions that were perceived as abusing the tax-free status conferred by section 355, Congress added section 355(e) to the Code in The Taxpayer Relief Act of 1997.(1) A number of related provisions and conforming amendments were adopted at the same time, the cumulative effect of which is to revise substantially the conditions for obtaining a tax-free separation -- whether as a spin-off, split-off, or split-up(2) -- of one corporation from another pursuant to section 355. To date, no regulations have been issued under either section 7805(b) or the more specific grant of section 355(e)(5). These comments set forth the Institute's concerns and recommendations in respect of section 355(e), most especially the need for guidance limiting the potentially broad scope of the phrase "plan (or series of related transactions)."
Tax Executives Institute, Inc. is the preeminent association of business tax executives in North America. Our more than 5,000 members represent 2,800 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.
Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by section 355(e).
By combining a tax-free spin-off distribution under section 355 with a subsequent acquisition of either the distributing or controlled corporation by way of one of the methods for taxfree reorganizations (e.g., a statutory merger), a targeted group of assets can be isolated within a corporate group and transferred to a non-group member without incurring a corporate-level tax. That transactional format became commonplace following the IRS's acquiescence in the decision in Mary Archer W. Morris Trust v. Commissioner(3). In Morris Trust, a non-taxable spin-off of a bank's insurance business was followed by a non-taxable merger of the bank with another bank controlled by a new group of shareholders. More recently, the spin-off-and-merger format of Morris Trust transactions was coupled with a pre-distribution borrowing of substantial sums of money by the distributing (or distributed) corporation. Through a pre-arranged sequence of steps, corporate assets were transferred in exchange in part for the assumption of new debt (or a significant shift in existing debt) in a fashion that resembled a leveraged buyout or sale of assets.(4) In response to these transactions, Congress added section 355(e) to the Code to ensure that corporate-level transactions that were considered sufficiently similar to taxable sales or dispositions are treated as such for tax purposes.
Regrettably, the scope of the statutory language in section 355(e) is broader than necessary to thwart the transactions targeted by the legislative changes. In addition, the vague scope of the term "plan (or series of related transactions)" creates substantial uncertainty for taxpayers, which has a chilling effect on legitimate, commercial spin-off transactions. In order to afford taxpayers the guidance necessary to continue to effect tax-free spin-offs under section 355, the IRS and Treasury Department should issue proposed rules under section 355(e) as soon as practicable. To expedite the issuance of such guidance, TEI submits the following comments and recommendations.
Overview of Statutory Provisions
The underlying purpose of section 355 is to permit the tax-free division of pre-existing business arrangements among the historic shareholders.(5) Where a plan exists whereby taxpayers other than the historic shareholders of the distributing corporation will gain control of the controlled or distributed corporation, however, the legislative history of the 1997 Act expresses concern that "the transaction more closely resembles a corporate level disposition" than a rearrangement of continuing interests among existing shareholders(6). As a result, section 355(e) provides that stock or securities in a controlled corporation will not be considered qualifying property for purposes of section 355(c)(2) or section 361(c)(2) if the intended distribution under section 355 is part of a "plan (or series of related transactions)" in which one or more persons acquire directly or indirectly stock representing a 50-percent or greater interest in the distributing or any controlled corporation. Under section 355(e)(2)(B), a plan is presumed to exist where (1) one or more persons, (2) acquire directly or indirectly, (3) stock representing a 50-percent or greater interest in the distributing or any controlled corporation, (4) during the four-year period beginning two years before the spin-off distribution. The presumption can be rebutted where "it is established" that a distribution and a subsequent transaction "are not pursuant to a plan or series of related transactions."(7) (Emphasis added.) Where section 355(e) applies, gain is recognized by the distributing corporation in the amount of the difference between the fair market value of the stock of the distributed subsidiary and the distributing corporation's basis therein.
Definition of a Plan (or Series of Related Transactions)
Crucial to the determination whether a series of transactions within the four-year presumptive period will be collapsed pursuant to section 355(e) is the scope of the phrase "plan (or series of related transactions." This vital link in the statutory regime, however, is undefined. The legislative history adds only that the "plan or arrangement [must be] in existence on the date of distribution."(8) It is unclear whether Congress intended section 355(e) to sweep all sequential corporate transactions effecting a change of control within the presumption of a plan, (i.e., create a statutory per se rule) or whether the statute's scope is more limited. Specifically, the issue is whether the statute should be limited to situations where independent parties to a spin-off transaction are acting in concert before, or at the time of, the spin-off to effect a series of transactions that abuse the underlying purpose of section 355.
In view of the narrow scope of transactions that triggered congressional scrutiny, TEI believes the definition of a "plan (or series of related transactions)" under section 355(e) should be relatively narrow. Indeed, the widely reported transactions that triggered congressional scrutiny involved a substantial amount of predistribution negotiation, coordination, and agreements among the acquiring, distributing, and controlled corporations. In the absence of a narrow definition of the term "plan (or series of related transactions)," the vagueness of the phrase combined with the uncertainty of predicting the likely subsequent actions of independent parties in the two-year period following a spin-off will hinder many non-abusive commercial spin-off transactions. Section 355(e) is especially troubling for public companies effecting a spin-off distribution since neither the distributing nor the controlled companies can predict or control the unilateral, acquisitive actions of another company that may seek to acquire the distributing or distributed companies or predict or control public trading by shareholders.
Recommendations and Discussion
TEI offers the following recommendations to clarify when a series of actions or activities will amount to "a plan (or series of related transactions)" evoking the application of section 355(e). We believe our recommendations will serve the government's interest in curbing perceived abuses of the spin-off provisions, while affording taxpayers and the IRS a reasonable and administrable framework to navigate the complexities and nuances of section 355.
1. Commitment to act required. A plan (or series of related transactions) clearly arises whenever there is a bilateral (or multilateral) commitment to act at the time of a section 355 distribution. In other words, where there is an express or implied agreement, or an understanding in connection with or following a spin-off distribution, between (1) the distributing or controlled corporations and (2) an acquiring corporation, a plan should be presumed to exist. This is the classic Morris Trust transaction at which section 355(e) is directed. Hence, wherever the parties to a transaction operate in concert pursuant to a binding commitment, agreement, or understanding, the presumption of a section 355(e) plan arises. Obversely, where there is no binding commitment, there should be no plan for purposes of section 355(e). Again, the key is the level of predistribution cooperation and negotiation between the acquiring group, on one hand, and the distributing or controlled group, on the other. Mere discussions and financial or strategic analyses (including discussions with outside financial or legal advisers) conducted wholly by the distributing or controlled companies without interaction with another would-be acquiring party should not lead to the conclusion that a plan exists for purposes of section 355(e). Moreover, a mere acknowledgment by the distributing or controlled companies that one or the others may, after the spin-off distribution, be a candidate for acquisition by an independent third-party should not, standing alone, constitute a prohibited plan.
2. Tangible proof of commitments required. The scope of what constitutes an "agreement," "understanding," or "commitment" evoking a determination that a prohibited plan among the parties exists is likely broader than whether a legally enforceable contract exists. For example, certain agreements may be made or tacit understandings reached that make it more likely than not that a subsequent change-in-control transaction is economically compelled. As another example, a non-binding letter of intent (or similar communication) that sets forth in sufficient detail the manner in which a subsequent change in control might occur following a distribution of a controlled company could constitute a plan for purposes of section 355(e).
In the absence of a legally enforceable contract among the parties at the date of the spin-off, the regulations should provide that other concrete evidence or tangible proof demonstrates that a commitment to act or plan exists to effect a change in control of the controlled or distributing company. That evidence may, in its clearest form, be a written document conveying the manifest intentions of the parties to conclude a defined course of action (e.g., a letter of intent) or it may be something less. That "something less" likely includes oral understandings. In the case of an oral understanding or other agreement, other indicia of pre-distribution negotiations, analyses, discussions, and statements of intention, if sufficient in substance and materiality, and communicated directly (or indirectly through intermediaries) to the other party, should warrant a finding of a plan. In other words, predistribution discussions between the distributing (or controlled) corporation and an acquiring company will likely require close scrutiny, but there must be some evidence of concerted action. In dealing with the determination whether a spin-off is a device for the distribution of earnings, Treas. Reg. [sections] 1.355(d)(2)(iii)(D) provides useful language that can be adapted for purposes of determining whether the spin-off is tainted by the existence of a plan. Specifically, the regulation provides that "[i]f a sale or exchange was discussed by the buyer and the seller before the distribution and the [sale or exchange] was reasonably to be anticipated by both parties, the sale or exchange will ordinarily be considered to be pursuant to an arrangement negotiated or agreed upon before the distribution." Whether a subsequent transaction is reasonably to be anticipated by both parties is the linchpin since there are likely a number of issues that reasonably prudent business people would address before consummating a transaction. Moreover, another essential element of a "plan," which is discussed next, is part of this test.
3. Mutuality. Implicit in TEI's recommendation that there be a commitment, understanding, or agreement to find that a "plan (or series of related transactions)" exists is the notion of mutuality or mutual expectations among the parties to the understanding. By definition, the unilateral intentions, actions, analyses, or objectives of one party to a transaction to effect a transfer of control after a spin off should rarely if ever meet the threshold of a prohibited "plan." Hence, a unilateral, hostile, or unsolicited bid by an acquiring corporation should not generally be attributed to the distributing or controlled companies to create a finding that a plan exists unless the target company or companies undertake collaborative steps to facilitate the acquisition. In other words, the recipient of the bid must adopt the acquirer's plan before a section 355(e) plan exists. Hence, an unsolicited offer received prior to a distribution that is rejected by the distributing or controlled companies should not be considered evidence of a "plan" adopted by the distributing or controlled companies.
4. Series of related transactions. A "series of related transactions" may occur either pursuant to a "plan" or as a coincidental matter. But a "plan" in the context of section 355(e) should require a series of preordained or purposeful steps, whether legally or economically compelled. In other words, the key to curbing the abusive transactions that triggered congressional scrutiny lies in a careful definition of the word "plan." Hence, TEI does not believe the parenthetical phrase "series of related transactions" in section 355(e)(2)(A) requires either a separate definition or further elaboration. Any meaningful test that this phrase adds to the statute can be addressed through a proper definition of the word "plan." Indeed, if the phrase were assigned meaning independent of the term "plan," revenue agents may be emboldened to challenge and collapse as "related" any series of sequential transactions notwithstanding that the transactions are unrelated. In order to limit the scope and frequency of unnecessary disputes, we recommend that the government focus on defining the scope of the term "plan" or "plan (or series of related transactions)" without assigning independent meaning to the parenthetical phrase.
5. Overcoming the Statutory Presumption of a Plan. Section 355(e)(2)(B) states that a plan is presumed to exist where one or more persons acquire a 50-percent or greater interest in the distributing corporation or any controlled corporations within the four-year period beginning two years before the date of the spin-off. The presumption can be rebutted where "it is established that the distribution and the acquisition are not pursuant to a plan or series of related transactions."
A. General. The statute and legislative history provide no guidance on how taxpayers may demonstrate the lack of a plan. Proving a negative, however, is inherently more difficult than proving an affirmative proposition. More important, most large companies have corporate development departments (or other employees) whose principal function is to monitor the "fit and focus" of the company's products, divisions, and lines of businesses. That staff continually evaluates whether a company's products or lines of business should be retained, enhanced through strategic business acquisitions or combinations, or sold. Companies are constantly researching and monitoring other companies' products or businesses for possible acquisitions or combinations. Moreover, investment bankers (and other intermediaries) frequently present strategic business proposals and acquisition candidates to company officers. So during the two-year period preceding or following any spin-off transaction, factual evidence will likely exist that most companies contemplated or were presented other possible transactions or combinations. Hence, it will be difficult if not impossible for companies to refute an agent's assertion of the existence of a plan and establish "that a distribution and subsequent acquisition are not pursuant to a plan ...."
TEI recommends that the regulations provide a list of factors that establish that a spin-off and subsequent change-in-control of the distributing or distributed corporations are not part of a plan or series of related transactions. For example, the regulations should include language such as the following: "mere internal discussions or analyses of potential acquisition or business combinations or mere inquiries or expressions of interest in a potential combination (even if expressed to the would-be distributing or distributed corporation) do not, in the absence of other concrete evidence and actions between the parties, establish that a plan exists for purposes of section 355(e)." At a minimum, the unilateral economic or financial analyses or projections of one party (or the receipt of an unsolicited offer) should not constitute evidence of a "plan" between the acquiring and disposing groups.
B. Regulations Should Be Clarified and Safe Harbors Established. Section 355(e)(2)(B) provides a presumption that a plan exists if there is a transfer of control within the four-year period beginning two years before the date of the distribution. Cautious taxpayers will likely plan any change-in-control transactions involving parties to a prior spin-off transaction to occur outside the four-year statutory period. Nonetheless, discussions, negotiations, and planning for the change in control will likely take place within the four-year period. TEI recommends that the regulations clarify that a transfer of control occurring before or after the four-year period beginning two years before the date of the spin-off distribution will not be deemed pursuant to a prohibited plan. In addition, the government should consider providing a safe harbor permitting changes in control within a period of less than the four years specified in the statute where the spin-off distribution is required to effect a government-mandated divestiture, to satisfy a court decree (including transactions effected pursuant to bankruptcy proceedings), or where it can otherwise establish that the spin-off is made necessary by events that are similarly beyond the control of the distributing or controlled corporations.
6. Advance Rulings. Section 355 spin-offs frequently involve rearrangements of long- held business operations of substantial scope and magnitude. As a result, the assets are likely to be substantially appreciated and any corporate-level tax triggered by a violation of section 355(e) will also be substantial. To provide a measure of certainty to the tax treatment of spin-off transactions, the IRS should establish a procedure whereby taxpayers may secure a post-distribution advance ruling that a prohibited plan did not exist. For example, the IRS could adopt an advance ruling policy that section 355(e) will not apply where (1) the taxpayer represents and warrants that there were no agreements or understandings at the date of the distribution between the distributing and controlled corporations, on the one hand, and a would-be acquirer (or its shareholders), on the other, that could reasonably have been expected to lead to a change in control after the spin off, and (2) no change in control occurs within six months of the distribution. Even though the six-month period is shorter than that prescribed by the statute, such a procedure, coupled with a six-month post-distribution review period for the IRS, would provide the taxpayer with a means to establish that there was no plan at the date of the distribution. If a change in control of the distributed corporation actually takes place within the six-month period, however, the safe harbor provided by the ruling would be vitiated.
The Institute's comments were prepared under the aegis of its Federal Tax Committee, whose chair is Philip G. Cohen. If you have any questions, please do not hesitate to call Mr. Cohen at (201) 871-5504, or Jeffery P. Rasmussen of the Institute's professional staff at (202) 638-5601.
(1) Section 1012, Pub. L. No.105-34 (hereinafter "the Act").
(2) Unless otherwise noted, the term "spin-off" includes, in addition to a pro-rata distribution of stock in a controlled corporation, a split-off (or non-pro rata redemption of the distributing corporation's shareholders for stock of the controlled corporation) and a split-up (or a distribution of multiple controlled corporations resulting generally in a liquidation of the distributing corporation.)
(3) 42 T.C. 779 (1964), aff'd, 367 F. 2d 794 (4th Cir. 1966), acq. Rev. Rul. 68-603, 1968-2 C.B. 148.
(4) Such leveraged transactions generally involve multiple steps. First, either the distributing or controlled company borrows money. Next, depending on the form of the transaction as a Morris Trust or reverse-Morris Trust transaction respectively, the unwanted or wanted assets are dropped down into a new subsidiary in tax-free transaction under section 351. The newly acquired debt remains (or is transferred) with the wanted assets and the new company is distributed to the historic shareholders in the spin-off transaction. Finally, the acquiring company acquires the target with the wanted assets (whether the distributing or formerly controlled corporation) in a stock-for-stock exchange.
(5) Staff of the Joint Committee On Taxation, General Explanation of Tax Legislation Enacted in 1997, 105th Cong., 1st Sess. 198 (1997).
(7) Under section 355(e)(2)(C), however, certain plans will be disregarded if, after completion of a plan or series of related transactions, the distributing and all controlled corporations are members of a single affiliated group.
(8) H. Rep. No. 105-48, 105th Cong., 1st Sess. 463; S. Rep. No. 105-33, 105th Cong., 1st Sess. 141.
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|Title Annotation:||IRC section 355(e)|
|Date:||Sep 1, 1999|
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