US Treasury regulations that were finalized on October 19 ("Regulations") allow a tax-free spin-off of an affiliated group subsidiary even when the stock of the subsidiary was acquired in a taxable transaction within the prior five year period. The affiliated subsidiary can be acquired from a third party or another affiliated group member, as long as the subsidiary is in the same affiliated group as the distributing corporation at the time of the spin-off. Publication of the Regulations, which adopt the rules in prior Temporary Treasury regulations, gives businesses confirmation that the so-called "hot stock" rules will not be applied to spin-offs of affiliated group members, even though such stock was acquired in a taxable transaction. Taxpayers now have substantial flexibility in structuring a tax-free spin-off.
Generally, a corporation must recognize gain upon the distribution to its shareholders of appreciated property. However, Internal Revenue Code section 355 allows a corporation to carry out a tax-free spin-off of a controlled subsidiary provided, among other restrictions, the subsidiary ("Controlled") was not acquired by the distributing corporation ("Distributing") in a taxable transaction within the five years prior to the distribution (referred to as the "pre-distribution period"). Any Controlled stock that Distributing acquired in the pre-distribution period (referred to as "hot stock") generally is taxable to Distributing to the extent of the gain in the hot stock, and to the recipient shareholder on the value of the hot stock. This provision was intended to prevent Distributing from buying Controlled stock in a taxable transaction with cash simply as a means to transfer the value to its shareholders without incurring tax.
Another requirement of section 355 is that either (A) immediately after the distribution Distributing and Controlled are each engaged in an active trade or business; or (B) immediately before the distribution Distributing's only assets were stock in Controlled corporations, and immediately after the distribution all Controlled corporations are engaged in an active trade or business ("Active Business Requirement"). That trade or business must not have been acquired in a taxable transaction during the pre-distribution period, although the expansion of an existing business in an asset acquisition is disregarded for this purpose.
Statutory Changes Treat a Separate Affiliated Group as One Corporation
In the Tax Increase Prevention and Reconciliation Act of 2005 and the Tax Technical Corrections Act of 2007, Congress introduced, and then amended, the Active Business Requirement to provide that all of the members of a separate affiliated group ("SAG") are treated as one corporation for purposes of determining whether Distributing and Controlled satisfy the Active Business Requirement. Under this rule, if there is an active trade or business located in any member of a corporation's SAG, that corporation is treated as engaged in a business for purposes of meeting the active business requirement. The reason given for the change was to allow corporations to avoid the complicated restructuring sometimes required to transfer an active business into the proper entity to carry out a tax-free spin-off.
Treasury Addresses Inter-Affiliate Transactions
However, when Congress relaxed the Active Business Requirement to allow an active business to be shared between SAG members, it did not address the fact that the stock of the Controlled acquired in a taxable transaction would still constitute "hot stock" subject to the tax upon the spin-off. The Treasury recognized this potential issue, and in December 2008 issued temporary regulations (which were adopted as the form of the Regulations) exempting from the "hot stock" rules the distribution of affiliated group member stock acquired in a taxable transaction within five years . This was done to reconcile the "hot stock" rules fully with the Active Business Requirement. In order to avoid the "hot stock" provisions with respect to such distribution, care must be taken to ensure that Controlled is a member of the separate affiliated group ("SAG") of Distribution at the time of the Distribution, even though control of Controlled may exist under Section 368(c).
Certainty for Separate Affiliated Groups
The promulgation of the Regulations grants assurance to corporations that the freedom given to SAGs will extend to the hot stock spin-off rules. Since the 1986 repeal of the General Utilities doctrine, the ability to carry out a tax-free spin-off under section 355 has been quite valuable. By confirming that an SAG will be treated as a single corporation for purposes of the hot stock rules, the Treasury Department and IRS have made section 355's requirements more coherent and enabled corporations to make acquisitions and conduct inter-group operations with less fear of adverse tax consequences upon a contemplated spin-off.