On August 17, 2018, the IRS issued private letter ruling ("PLR") 201833011, in which it ruled on certain aspects of a reorganization proposed by a publicly traded corporate group parent (“Distributing”) that formed “Controlled” to participate in a securities-for-debt exchange involving an investment bank-held debt of Distributing (“Distributing Exchange Debt”), Controlled senior unsecured notes (“Controlled Securities”) and Controlled cash. The PLR contained three rulings: (1) The Controlled Securities will constitute “securities” for purposes of Code section 361(a); (2) No gain or loss will be recognized by Distributing in the Securities-for-Debt Exchange pursuant to section 361(c)(3) other than any (i) deductions attributable to the fact that the Distributing Exchange Debt may be redeemed at a premium, (ii) income attributable to the fact that the Distributing Exchange Debt may be redeemed at a discount, and (iii) interest expense accrued with respect to the Distributing Exchange Debt; and (3) The Controlled Cash will be treated as being distributed by Distributing pursuant to a plan of reorganization for purposes of section 361(b) and section 361(c).
The PLR reflects the IRS's recent change in its ruling policy on section 355 transactions and related issues, including its willingness to issue rulings on the overall federal income tax consequences of divisive reorganizations and other distributions under section 355 as well as various aspects of leveraged spinoff transactions.
By way of background, in a spinoff transaction intended to qualify under section 355, one corporation (Distributing) distributes the stock or securities of a corporation that it controls (Controlled) to its shareholders and/or creditors. Prior to the spin-off, Distributing will typically contribute assets and liabilities to Controlled in exchange for Controlled stock in a transaction intended to qualify as a tax-free reorganization under section 368(a)(1)(D). If properly structured, Controlled can also distribute cash and Controlled securities ("Section 361 Consideration") in the reorganization that Distributing can use to retire existing Distributing debt without gain recognition to Distributing or Controlled ("leveraged spin-off"). Section 361(a), in relevant part, provides that Distributing does not recognize any gain or loss on a transfer of property to Controlled in a reorganization within the meaning of sections 368(a)(1)(D) and 355 if Distributing receives solely stock and securities of Controlled in the exchange. Section 361(b) provides that Distributing will not recognize any gain or loss on the transfer of property to Controlled where Distributing receives other property (in addition to stock and securities) from Controlled in the exchange, and Distributing distributes such other property to Distributing's shareholders. Section 361(b)(3) similarly provides that Distributing will not recognize gain or loss on such a transfer in exchange for stock and securities and other property from Controlled, provided that Distributing distributes the other property to Distributing’s creditors. Section 361(b)(3), however, will only apply to the extent that the sum of the money and the fair market value of other property does not exceed the adjusted basis of the assets transferred, reduced by the amount of the liabilities Controlled assumes. Under section 361(c)(3), Distributing recognizes no gain or loss on the distribution of the stock or securities received from Controlled pursuant to a reorganization described in section 368(a)(1)(D) to its shareholders or creditors as part of the same plan of reorganization.
In Rev. Proc. 2013-3, the IRS expanded its areas under study in which rulings would not be issued on whether either section 355 or section 361 applies to Distributing's distribution of stock or securities of Controlled in exchange for, and in retirement of, any putative debt of Distributing if such distributing corporation debt is issued in anticipation of the distribution. In Rev. Proc. 2013-32, the IRS announced that it would no longer issue rulings on the general federal income tax consequences of spinoff transactions intended to qualify as tax-free under section 355 and instead would only issue spin-off rulings on selected “significant issues."
Prior to 2013, the IRS issued favorable PLRs with respect to leveraged spinoffs. As a condition, taxpayers represented that the sum of Distributing debt exchanged for Controlled securities and repaid with cash from Controlled would not exceed the weighted quarterly average of the Distributing debt for the 12-month period ending on the close of business on the last full business day before the date on which Distributing’s board initially discussed the potential spin-off. In addition, where a financial institution acquired Distributing debt, the IRS applied a "5/14 safe harbor", which required that Distributing debt be held (1) for at least five days before Distributing and the financial institution enter into an agreement to exchange the stock (or securities) of Controlled for the debt and (2) for at least 14 days before the exchange is effected.
However, in Rev. Proc. 2017-38, citing the "interest of sound tax administration," the IRS stated that it would rule on whether section 355 or 361 applies to a corporation’s distribution of stock or securities of a controlled corporation in exchange for, and in retirement of, any putative debt of the distributing corporation, if that debt is issued in anticipation of the distribution. In Rev. Proc. 2017-52, the IRS introduced an 18-month “pilot program”, during which it would issue rulings on the general federal income tax consequences of spinoff transactions intended to qualify as tax-free under section 355, and collateral issues commonly arising in spinoff transactions. Furthermore, on October 3, 2018, the IRS announced that while it is continuing to study the issues relating to assumption and satisfaction of Distributing Debt in divisive reorganizations, it has determined that taxpayers requesting rulings on certain of these issues should follow specified procedures and submit specified representations and related information and analysis (Rev. Proc. 2018-53).
Rev. Proc. 2018-53 contains procedural guidance that taxpayers must follow to the extent the request involves an assumption by Controlled of Distributing debt or satisfaction of Distributing debt with Section 361 Consideration if: (1) Distributing is the obligor of such debt, and (2) the obligation is (a) evidenced by a debt instrument that is not a contingent debt instrument, and (b) by its terms is payable only in money. The revenue procedure outlines representations, information, and analysis that taxpayers should include in their PLR requests. In addition to submitting the usual detailed description of facts and law common to all PLR requests, taxpayers must submit the following fixed set of representations:
- Distributing is in substance the obligor of each Distributing debt that will be assumed or satisfied.
- No holder of Distributing debt that will be assumed or satisfied is a person related to Distributing or Controlled (Related Person).
- The holder of Distributing debt that will be assumed or satisfied will not hold the debt for the benefit of Distributing, Controlled, or any Related Person. A collateral benefit received by Distributing from an arrangement with an intermediary (for example, facilitation of exchanges of Section 361 Consideration for Distributing debt) will not be treated as the intermediary holding Distributing debt for the benefit of Distributing, Controlled, or a Related Person (subject to additional representations that must be submitted).
- Distributing incurred the debt that will be assumed or satisfied (a) before the request for any relevant ruling is submitted and (b) no later than 60 days before the earliest of the following dates: (i) the date of the first public announcement of the Divisive Reorganization or a similar transaction, (ii) the date of the entry by Distributing into a binding agreement to engage in the Divisive Reorganization or a similar transaction, and (iii) the date of approval of the Divisive Reorganization or a similar transaction by the board of directors of Distributing.
- The total adjusted issue price of Distributing debt that will be assumed or satisfied does not exceed the historic average of the total adjusted issue price of (a) Distributing debt owed to persons other than Related Persons and (b) obligations that are evidenced by Non-contingent Debt Instruments and are owed by other members of Distributing's separate affiliated group to persons other than Related Persons.
- There are one or more substantial business reasons for any delay in satisfying Distributing debt with Section 361 Consideration beyond 30 days after the date of the first distribution of Controlled stock and such debt will be satisfied with Section 361 Consideration no later than 180 days after such distribution.
- Distributing will not replace any Distributing debt that will be assumed or satisfied with previously committed borrowing, other than borrowing in the ordinary course of business pursuant to a revolving credit agreement or similar arrangement.
The IRS intentionally kept representations general in order to allow the taxpayers to explain other factors relevant to the transactions. Noticeably absent from the above list of representations is the "5/14 rule." According to Robert Wellen, IRS Associate Chief Counsel (Corporate), a significant purpose of the guidance was to "turn off the 5/14 idea", as part of the IRS's attempt to avoid inserting itself into the mechanics of the transaction. Wellen also emphasized three themes underlying the revenue procedure: (1) the guidance is narrowly focused on fixed leverage transactions (i.e. transactions not involving the assumption or indemnity of contingent liabilities); (2) the IRS is less concerned about the precise mechanics of the transaction, and more concerned with the purpose of the transaction (i.e., allocating Distributing's historical leverage to Controlled under section 361); and (3) with respect to Distributing's historical leverage, the focus is on identifying the amount of debt within the group, and there is less of a concern as to the exact timing of when such debt was incurred (see Guidance on Leveraged Spinoff Rulings Designed for Flexibility, Emily Foster, Tax Notes (Oct. 10, 2018)).