In a recent, taxpayer-friendly private letter ruling, the IRS ruled that a share offering immediately followed by a section 355 distribution would be respected as separate transactions. This ruling addressed a north-south transaction in the context of section 355, an area in which the IRS would not issue rulings from 2013 until 2017, and provided the taxpayer with comfort that the step-transaction doctrine would not be applied to integrate its share offering with its distribution, potentially causing its distribution to fail to qualify for tax-free treatment under section 355.
Summary of Facts
In PLR 201820016 (May 18, 2018), Distributing was a publicly traded corporation that owned foreign and domestic entities, including Controlled. Prior to the transactions, both Distributing and Controlled were engaged in multiple businesses. Distributing had two classes of common stock: (i) Class A shares entitled to “a” vote(s) per share; and (ii) Class B shares entitled to “b” vote(s) per share.
Distributing’s board of directors authorized the issuance of additional shares as part of a share offering (the “Share Offering”) made to all holders of Class A shares and Class B shares (the “Shareholders”) on the record date. Each Shareholder was entitled to pay cash to subscribe for an additional share of Distributing of the same class already held. Only a certain percentage of the Shareholders chose to exercise their subscription rights, and the remaining authorized shares were sold to those Shareholders who applied to further participate in the Share Offering. Distributing used the cash from the Share Offering to reduce its external debt.
Distributing then distributed, on a pro rata basis, shares of Controlled to the Shareholders (the “Distribution”). Distributing’s Class A shareholders received Class A shares of Controlled and Distributing’s Class B shareholders received Class B shares of Controlled. The terms of each class of share in Controlled mirrored the terms of the same class of shares in Distributing.
The IRS ruled that the Share Offering would not prevent the Distribution from otherwise qualifying under section 355. That is, the Share Offering could be disregarded in determining whether the Distribution qualified under section 355.
Background on North-South Transactions in the 355 Context
The taxpayer in PLR 201820016 made a Share Offering to its existing shareholders, i.e., it solicited contributions of cash from its current shareholders, in order to pay down its external debt prior to its spin off of Controlled. An issue can arise, however, when a pre-spin-off transaction involves a contribution of property in exchange for Distributing stock. For example, in Rev. Rul. 80-221, a third party contributed cash to a corporation in exchange for its preferred stock. Later, the corporation distributed property desired by the new preferred shareholder to the new shareholder in redemption of the preferred stock. The IRS disregarded the transitory existence of the preferred stock and treated the overall transaction as a cash sale of the distributed property to the third party for cash.
Similarly, in PLR 201820016, the IRS could treat the Distributing shareholders who acquired additional Class A or Class B shares in the Share Offering as paying cash in exchange for the shares of Controlled stock, as well as the additional Class A or Class B shares (a “north-south transaction”). If more than 20% of the Controlled stock were received in respect of the additional Class A or Class B shares issued in the Share Offering and, hence, treated as acquired for cash under step-transaction principles similar to those applied in Rev. Rul. 80- 221, then the distribution of the Controlled stock would have failed to qualify under section 355(a)(1)(D).
There is, however, a significant difference between the relevant facts of PLR 201820018 and those of Rev. Rul. 80-221; primarily, the Distributing stock acquired in the Share Offering remained outstanding following the spin-off and was not transitory as was the preferred stock in Rev. Rul. 80-221. Despite significant grounds to distinguish the relevant facts of PLR 201820016 and those of Rev. Rul. 80-221, some taxpayers may desire certainty that the IRS would not view their pre-spin off transactions as integrated with the distribution of Controlled.
North-South Once a No-Rule Area
From January 1, 2013 until May 3, 2017, the taxpayer would have been unable to get a ruling that the Share Offering and Distribution would be respected as separate transactions. In Rev. Proc. 2013-2, the IRS announced that north-south transactions were “under study” and no rulings would be issued on whether the contribution and distribution in a north-south transaction would be respected as separate.
Luckily for taxpayers, in 2017, the IRS issued Rev. Rul. 2017-09, which not only removed north-south transactions from the no-rule list, but also provided helpful guidance how the step-transaction doctrine should be applied to north-south transactions. In that ruling, the IRS stated:
The tax treatment of a transaction generally follows the taxpayer's chosen form unless: (1) there is a compelling alternative policy; (2) the effect of all or part of the steps of the transaction is to avoid a particular result intended by otherwise-applicable Code provisions; or (3) the effect of all or part of the steps of the transaction is inconsistent with the underlying intent of the applicable Code provisions.
This articulation of the step-transaction doctrine, applicable to north-south transactions in the context of section 355, seems to provide some deference to the taxpayer’s chosen form in the absence of a contrary policy reason for disregarding the taxpayer’s form. As a subjective standard, it also gives 8 Tax News and Developments July 2018 Baker McKenzie taxpayers a reason to request a ruling to gain certainty that their transactions will be respected as separate transactions.
In PLR 201820016, the IRS provided the taxpayer with certainty that its transactions, the Share Offering and the Distribution, would be respected as separate transactions. This PLR should be welcome news to taxpayers because it shows where a taxpayer undertook reasonable pre-spin-off transactions that involved contributions to Distributing, the IRS was willing to issue a favorable private letter ruling on the north-south issue.