A great amount of uncertainty now surrounds potential business separation transactions taking the form of spin-offs. This uncertainty is largely the result of increased scrutiny by the Internal Revenue Service (IRS) of certain spin-offs involving large amounts of cash or marketable securities and smaller active trade or business assets.

The IRS has recently announced its intention to give further study to such transactions and to suspend certain advance rulings during this study period - a position that is directly impacting planned spin-off transactions.  In addition, new federal legislation has just been enacted making a REIT generally ineligible to participate in a tax-free spin-off involving a taxable C corporation. Is your company considering a potential spin-off? Here's what you need to know.  

The Background

Section 355 of the Internal Revenue Code provides that if certain requirements are satisfied, a corporation may distribute the stock of a controlled subsidiary to its shareholders without the distributing corporation or its shareholders recognizing taxable income. In order to qualify for this tax free treatment, a “spin-off” transaction must meet a number of requirements, including that (i) both the distributing and spun-off entities must be engaged in an active trade or business (the “active trade or business requirement”); (ii) the spin-off must be motivated by a non-tax business purpose (the “business purpose requirement”); and (iii) the spin-off must not be principally used as a device for the distribution of earnings and profits (the “device requirement”). 

Critical Changes

Recently the IRS issued Notice 2015-59 and Revenue Procedure 2015-43, which announced that where either the distributing or spun-off entity has (i) significant investment assets; (ii) qualifying business assets with a relatively small value; or (iii) elects to be treated as a real estate investment trust (REIT) following the spin-off, the transaction may fail to satisfy one or all of the active trade or business, business purpose, or device requirements (or the other requirements necessary for a tax-free spin-off).
Although the IRS previously took the position that it would not rule on a spin-off transaction unless at least five percent of the total value of each of the distributing and controlled companies was comprised of an “active business,” it abandoned that position some years back, requiring only that each of the companies be engaged in some active business. Revenue Procedure 2015-43 resurrected the previously abandoned five percent active trade or business requirement by providing that the IRS will no longer provide an advance ruling (absent “unique and compelling circumstances”) on any issue involved in a proposed spin-off if the active trade or business of either the distributing or spun-off company is less than five percent of the total fair market value of its gross assets. The new guidance also indicated that the IRS is studying certain spin-offs where either the distributing or spun-off entity has a substantial amount of investment assets and will temporarily suspend the issuance of private letter rulings in this context until the study is complete.
As part of the same guidance, the IRS indicated that it would ordinarilynot provide an advance ruling on spin-offs where a new REIT or RIC election will be made by either the distributing or spun-off entity as part of a plan with the spin-off. The guidance indicated that because REITs typically have a relatively small percentage of qualifying active-business assets and REIT spin-off transactions can involve retention of control over the REIT’s assets through long-term lease arrangements, these transactions (and similar transactions involving RICs) raise concerns under the active trade or business, business purpose and device requirements.

Since the release of the IRS guidance, Congress included a provision in its year-end spending and tax legislation that addresses the issues raised by the IRS regarding REIT spin-offs (H.R. 2029, the “act”).  The act provides that non-REIT corporations will no longer be able to spin off REITs in a tax-free transaction (including non-REIT corporations that elect REIT status within 10 years following the spin-off).  However, REITs will be able to spin off another REIT or a  taxable REIT subsidiary (TRS) (or portions thereof) held for at least three years (and otherwise meeting the active trade or business requirement that the business had been conducted for five years prior to the spin-off). The act also clarifies that the exception for spin-offs of TRSs would apply if a TRS were held through a partnership so long as the spin-off otherwise met the requirements for tax-free treatment (which, among other things, would require that the REIT own at least 80 percent of the partnership for the three-year period).  The act includes a transition rule permitting tax-free spin-offs for transactions described in a ruling request submitted on or before December 7, 2015, so long as the request had not been withdrawn, issued or denied as of that date.

The Fallout

The new IRS guidance has thrown planned spin-offs involving a relatively small percentage of active business assets into an area of significant uncertainty, as taxpayers await the conclusion of the IRS study in this area and the subsequent release of further IRS guidance. In addition, the action by Congress to preclude tax-free treatment of certain REIT spin-offs changes the operating environment for those in the real estate industry (or existing corporations considering dividing into a REIT and a non-REIT).

One of the most high profile transactions impacted by the new IRS position has been Yahoo’s planned spin-off of its 15 percent stake in Alibaba Group. Although it previously announced its intention to go forward with the spin-off despite the IRS’s position that it would not provide an advance ruling on the transaction, Yahoo announced earlier this month that it would no longer pursue the spin-off, amid reported investor concerns with the tax risks involved. Yahoo has announced that it now plans to pursue a spin-off of its core business while retaining its stake in Alibaba.

What To Do

While some spin-off transactions are moving forward, cash-rich spin-offs remain an area in which taxpayers should move forward only with great caution, particularly until the IRS finalizes its thinking in this area. Moreover, any planned spin-off involving a REIT should be reevaluated in light of the latest action by Congress and any future guidance issued by the IRS that may add further context as to how such transactions will be treated.