The recent guidance under section 355 is a significant attempt by the IRS to clarify in a formal way what it historically has been able to do on a case-by-case basis through the private letter ruling process.
Transactions under section 355 of the Internal Revenue Code are effectively the only means to separate two businesses housed in one corporation without triggering corporate-level income. As such, they have attracted significant interest from the Internal Revenue Service (IRS), and, on July 14, the IRS issued proposed Treasury Regulations on the device test and the active trade or business test under section 355. The proposed regulations, if adopted, would formalize the views of the IRS and the Department of the Treasury on several key requirements in section 355 spinoffs.1 In addition to formalizing the IRS’s views, this new guidance is being issued in response to a reduction in the IRS’s ability, due to staffing limitations, to process its traditional private letter ruling program, which addresses many issues associated with section 355 transactions. The proposed regulations provide significant, formula-driven rules to evaluate whether a proposed section 355 spinoff qualifies as tax-free, focusing on the potential violation of the device test and the active trade or business test. It is important to note that the new regulations have only been proposed and are not effective until they are published as final regulations in the Federal Register.
In addition to the proposed regulations, the IRS issued Revenue Procedure 2016-40,2 which addresses certain issues associated with a transaction that can occur prior to a section 355 distribution that results in the distributing corporation obtaining control of the controlled corporation in order to satisfy the control requirements of section 355. It should be noted that section 355 is a very complex, fact-specific area of corporate tax law, and, thus, a complete discussion of the requirements for a tax-free spinoff is beyond the scope of this article. This is an overview of the new guidance, with certain noted key insights as to the potential impact of these rules.
In order for a transaction to be eligible for tax-free treatment under section 355, the transaction cannot have been undertaken for the purpose of distributing corporate profits and/or assets at capital gains rates. This prohibited “device” can occur if investment and liquid assets are separated from operating business assets and then distributed to the shareholders. This effectively allows the shareholders to receive stock of an entity that may have assets not used in a trade or business or assets/activities so closely related to the core business (e.g., single customer for spun-off business is the distributing business or spinning off a building that is 100 percent leased by the distributing company in a triple net lease) as to not be viewed as a viable standalone business, but instead essential to an asset-holding company.
This separation of investment-type assets can have the effect of providing a return of corporate profits that appears to be equivalent to a dividend. Even though capital gains rates and dividend rates are similar under current law, the IRS believes that there is a significant difference with respect to capital gains treatment and dividend treatment because of tax basis issues and the ability of capital gains to offset capital losses. There are several non-device factors that continue to apply. The IRS and Treasury have, however, provided in the proposed regulations situations in which certain facts can outweigh the traditional non-device factors and cause a distribution to be treated as taxable.
Active Trade or Business Test
In order for a transaction to qualify under section 355 as a tax-free spinoff, each of the distributing and controlled corporations must be engaged in an active trade or business that has been conducted for each of the five years prior to the distribution. In order for a business to be considered “active,” there must be income and expenses indicating the operation of a business. Each active business must also have management and operational personnel who conduct the business activities. Thus, the active trade or business test cannot be satisfied with business assets or activities that have been purchased in the last five years (unless the acquisitions are an “expansion” of the existing five-year business). This rule is intended to ensure that each of the newly separated corporations has been conducting a historic business and that newly acquired or investment-type assets are not spun off to the shareholders as a surrogate for a cash dividend or other distribution of assets.
Without the requirement of the five-year active trade or business, a distributing corporation that has excess cash may desire to distribute that cash to its shareholders, but it may not want to do so as a dividend. It could, for example, use the cash to buy a business that might be desired by its shareholders and distribute that business in a newly formed controlled entity in a spinoff, allowing the shareholders to direct the corporate profits of the distributing business and diversify its holdings as if the shareholders received the cash and went out and bought the new business assets that are in the newly formed controlled corporation. This outcome is inconsistent with the congressional intent of section 355, which is to allow a separation of an existing business or businesses to accomplish a corporate business purpose that cannot be accomplished through other nontaxable means. The proposed regulations provide new rules and a minimum threshold that must be met in determining whether the active trade or business test is satisfied.
Proposed Regulations – Nonbusiness Assets
In the proposed regulations, the IRS and Treasury have developed a “per se device test.” This per se test has two prongs, the first being whether the “nonbusiness” assets (a newly defined term under the proposed regulations) of either the distributing or the controlled corporation constitute 66 2/3 percent of the total assets of such corporation. For purposes of this test, cash or liquid assets can be treated as “good” business assets as long as the corporation can demonstrate that such cash and other assets are required by regulatory or other business exigencies to operate one or more businesses of the distributing or controlled corporations. The second prong of the per se test is that the comparison of the nonbusiness assets to the business assets of the distributing and controlled corporations falls within one of three bands of percentage comparisons.3 The rules are intended to identify situations in which the percentage of nonbusiness assets is significant. If a taxpayer meets the two-prong per se test, the distribution would be a per se device and thus not qualify as a tax-free spinoff. If the per se test does not apply, the general device rules would continue to apply to determine if a distribution is motivated by device.
The Proposed Regulations also highlight the fact that, unlike the current view taken by many taxpayers, a strong business purpose cannot “trump” all other device factors. Business purpose is still relevant in the analysis, but a stated business purpose may be required for not only the distribution, but also with respect to the existence of nonbusiness assets held by either the distributing or controlled corporations at the time of the distribution. The proposed regulations also state that the non-device factors cannot be relied on to protect a transaction that avoids the dividend provisions of the Internal Revenue Code upon a sale of either the distributing or controlled corporations after the distribution.4
Proposed Regulations – De Minimis Threshold for Active Trade or Business
The proposed regulations would also add a new section, Treasury Regulations section 1.355-9, that provides rules for determining the minimum percentage of the total assets of both the distributing and the controlled corporations that represent “five-year-active-business assets” (a newly defined term under the proposed regulations). Five-year-active-business assets are those relied on to meet the active trade or business test demonstrating that each of the distributing and controlled corporations has had income and expenses for each of the past five years, indicating that an active trade or business is being conducted. For purposes of this test, certain cash and other assets qualify as five-year-active-business assets if they are used for working capital, regulatory purposes and other necessary business operational exigencies.
In order to satisfy this new test, both the distributing and controlled corporations must have five-year-active-business assets that represent at least 5 percent of the total assets of each relevant corporation (this includes the distributing separate affiliated group [DSAG] and the controlled separate affiliated group [CSAG]). The proposed regulations also include specific information on when the calculation of the percentage of five-year-active-business assets is to be performed5 and how to treat certain assets held by the distributing or controlled corporations, including interests in partnerships and corporate subsidiaries. Importantly, the proposed regulations also include an anti-abuse provision that seeks to prevent an attempt to put in place transitory asset transfers, debt repayments, stock issuances or redemptions, etc., in order to affect the five-year-active-business asset percentage.
Revenue Procedure 2016-40
In order for a transaction to qualify under section 355, the distributing corporation must distribute an amount of stock constituting “control” of the controlled corporation. For this purpose, “control” is defined as ownership of stock of the controlled corporation that holds 80 percent of the combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares outstanding of each other class of stock of the controlled corporation. In order to qualify under section 355, many transactions involve the distributing corporation obtaining control of the controlled corporation through transactions undertaken prior to the distribution. There is a 50-plus-year history of IRS rulings and other guidance on how to correctly obtain control of a controlled corporation as part of a qualifying section 355 distribution, many of which are discussed in Revenue Procedure 2016-40, which was issued on July 15. In light of the positions taken in the historical rulings on the control issue, the IRS has developed two safe harbors. If the safe harbors apply, the IRS will not assert that the transaction in which the distributing corporation obtained controlled lacks substance, which would otherwise cause the distribution to be taxable.
The first safe harbor provides a 24-month rule and applies if no action is taken by the controlled corporation, its board of directors, its management or any of the controlled corporation’s controlling shareholders that would result in an unwind of the transaction in which “control” was obtained.
The second safe harbor allows for an unwind within the 24 months if two conditions are met. The first condition borrows definitions from Treasury Regulations section 1.355-7 and requires that “[t]here is no agreement, understanding, arrangement, or substantial negotiations (within the meaning of § 1.355-7(h)(1)) or discussions (within the meaning of § 1.355-7(h)(6)) concerning the transaction or a similar transaction . . . at any time during the 24-month period ending on the date of the distribution.” The second condition is that no more than 20 percent of the acquiring entity or other party to the transaction involving the controlled corporation is owned by the same persons that own 20 percent or more of the controlled corporation. The IRS specifically states that, if these safe harbors do not apply, no inference as to the qualification of the control requirement should be made. As a result, these safe harbors provide objective protection if met.
This recent guidance under section 355 is a significant attempt by the IRS to clarify in a formal way what it historically has been able to do on a case-by-case basis through the private letter ruling process. However, as the IRS has reduced the number of issues with respect to section 355 that it will continue to rule on due to its stated lack of resources, the importance of providing specific rules and formulas is extremely helpful to taxpayers and tax practitioners. Because of the lack of complete coverage by the IRS private letter ruling program on the issues that arise under a proposed section 355 transaction, many taxpayers seek opinions from their tax counsel prior to undertaking a distribution transaction. These proposed regulations and the revenue procedure are very helpful in obtaining assurance on certain issues associated with section 355 transactions. In addition, the proposed regulations provide a cautionary indication of what the IRS is likely to challenge if distribution transactions go too far outside the stated policies and anti-abuse rules contained in the proposed regulations. Consulting an experienced section 355 tax advisor is recommended to evaluate the potential application of these provisions.