On September 14, 2015, the Treasury Department (the Treasury) and the Internal Revenue Service (the Service) issued Notice 2015-59 (the Notice), which announces that the Service is studying certain spinoffs where either the controlled corporation (Spinco) or the distributing corporation (Parent) has significant investment assets, has qualifying business assets with a relatively small value, or elects to be a real estate investment trust (REIT). While the Service is studying the issues raised by the targeted types of transactions, the Service will, based on Revenue Procedure 2015-43 released together with the Notice, generally suspend issuing private letter rulings in connection with these types of tax-free spinoffs.1 This is an important announcement as these types of transactions often, but not always, require the receipt of a favorable private letter ruling. In addition, the Notice may affect counsels’ willingness to issue tax opinions in connection with such spinoffs.
Section 3552 provides that, if certain requirements are met, a distribution of the stock of Spinco by a Parent will be tax-free to both the Parent and the Parent’s shareholders. Three of these requirements are central to the Notice. First, before and after the tax-free spinoff, both Parent and Spinco must be engaged in an activity that constitutes an “active trade or business” (ATB). Second, the spinoff must be motivated by a non-tax “corporate business purpose.” And third, the spinoff must not be principally used as a “device” for the distribution of earnings and profits in a tax-favored manner. The Notice states that some taxpayers are taking the position that spin-offs like those targeted satisfy those requirements, but states that the Treasury and Service believe that the targeted transactions might not do so.
Recently, the Service has faced two types of spinoffs. The first type involves pro rata spinoffs in which Parent transfers to Spinco investment assets (such as a minority ownership stake in a publicly traded company) along with an ATB that is tiny (by value and economic significance) when compared with the investment assets in Spinco. This type of spinoff rests on the view that, based on the statutory language of Section 355, Revenue Ruling 73-44 and subsequent private letter rulings, there is no minimum size of the ATB for Section 355 purposes. In addition, in such pro rata spinoffs by widely-held, public companies, taxpayers have taken the position that there is no problem under the so-called “device” or “corporate business purpose” requirements.
The second type of spinoffs targeted by the Service involves spinoffs in which a new REIT election is made by either Parent or Spinco immediately after the spinoffs based on an overall plan. This kind of spinoff is exemplified by the highly publicized, completed spinoff by Penn National Gaming, Inc. (the opco) of its real estate into a new Spinco (the propco) that then elected to be a treated as REIT for U.S. tax purposes. That spinoff received a favorable private letter ruling from the Service. The hallmark of these “opco/propco” REIT spinoffs is that real estate leaves the corporate solution and moves into the favorable REIT tax regime without a toll charge tax. However, unlike most other tax-free spinoffs, in these “opco/propco” REIT spinoffs Parent and Spinco typically remain very closely connected following the spinoff by way of a lease of Spinco’s real estate back to Parent for use in Parent’s operating business. This calls into question whether the separation is sufficiently clear to warrant tax-free treatment under Section 355, particularly in light of the corporate business purpose requirement. In addition, because REITs often use “triple net lease” structures in their operations and “triple net lease” activities do not amount to an ATB under general tax principles, Spincos that intend to elect REIT status in “opco/propco” REIT spinoffs typically face the “tiny ATB” issue because they use a small ATB that they may have in their structures to satisfy the ATB requirement.
In connection with the Notice, Revenue Procedure 2015-43 provides that:
- Investment Assets: The Service will temporarily not issue private letter rulings in respect of any tax issue relating to a Section 355 transaction if, immediately after any such Section 355 transaction, all of the following conditions are met (a) the fair market value of the investment assets of Parent or Spinco, as the case may be, is two-thirds or more of the total fair market value of its gross assets; (b) the fair market value of the gross assets of the ATBs on which Parent or Spinco relies to satisfy the ATB requirement is less than 10 percent of the fair market value of its investment assets; and (c) the ratio of the fair market value of the investment assets to the fair market value of the assets other than investment assets of Parent or Spinco, as the case may be, is three times or more than such ratio for the other corporation (i.e., Spinco or Parent, respectively). This “no rule” policy will not apply to intra-group spinoffs. Special rules apply in determining what constitutes investment assets.
- REIT Spinoffs: The Service will ordinarily not issue private letter rulings in respect of any tax issue relating to a Section 355 transaction if property owned by any Parent or Spinco becomes property of a REIT in a “conversion transaction” (as defined in Treas. Reg. § 1.337(d)-7(a)(2)(ii)) with respect to which no deemed sale election is made and the conversion transaction and the Section 355 transaction are part of a plan. This covers the “opco/propco” REIT spinoff because the REIT election will create the “conversion” transaction.
- Small Value of ATB Assets: The Service will ordinarily not issue private letter rulings in respect of any tax issue relating to any Section 355 transaction if, immediately after such Section 355 transaction, the fair market value of the gross assets of the ATBs on which Parent or Spinco relies to satisfy the ATB requirement is less than five percent of the total fair market value of the gross assets of such corporation. This new rule covers all spinoffs, not just the ones targeted by the Notice.
We have the following initial observations on the Notice:
- Treasury and the Service have not expressly taken a stand on the transactions that they deem questionable from a tax policy point of view. Accordingly, it is possible that, in the absence of a statutory change caused by Congress, nothing will change from the current state of the law as a result of the announced study. However, it is also possible that the Service will issue new Treasury Regulations amending long standing Treasury Regulations under Section 355 to implement the findings and conclusions of the study. The Notice does not specify that any such Treasury Regulations would have an effective date that relates back to the date of the issuance of the Notice.
- The Notice indicates that one particular focus of the Service is the business purpose requirement. This casts doubt on whether the Service believes that certain transactions do not satisfy the business purpose requirement under existing Treasury Regulations or whether the Service believes that new Treasury Regulations should be amended to restrict the corporate business purpose requirement.
- Treasury and Service identify Section 355(g) as the main policy reason for their uneasiness with the specified types of spinoffs described above. Section 355(g) was enacted in 2008 to curb certain cash rich splitoffs, by limiting the amount of cash-like investment assets Spinco may have, thereby indirectly providing for a minimum size of the ATB. However, Section 355(g) is very narrowly drafted and does not apply to pro rata spinoffs. It appears that the Service questions whether the old interpretations of the ATB requirement, allowing for a tiny ATB, should be reinterpreted in light of Section 355(g) because it is not readily apparent why a pro rata spinoff should have more leeway in respect of the use of cash-like investment assets than a non-pro rata spinoff.
- Given that the Service has announced that it will generally not issue any private letter rulings in the “opco/propco” REIT spinoffs, taxpayers will have to consider completing such transactions on the strength of tax opinions only. It will remain to be seen whether the issuance of the Notice will adversely affect counsels’ willingness to give strong tax opinions on these kinds of transactions.
- The Service indicated that tax-free spinoffs of REITs by REITs are not the concern of the Notice.
- We expect that the Service will receive numerous comments, making it difficult to predict the final conclusions of the announced study and the specific action items, if any, that may follow from the study.