The basic idea of a spinoff and its close cousin, a split-off, is simple. Just recall your high school biology class in which you studied the division of one cell into two cells. The idea is that if a whole company breaks itself into two pieces, and the sum of the two pieces equals the whole, and the same people own the two pieces as owned the whole, nothing has occurred that would justify taxation at either the company level or the shareholder level. Most of us can envision factual circumstances in which that conclusion seems absolutely right and other circumstances in which it seems very wrong. It is the attempt to define the good and bad circumstances that has occupied Congress, Treasury, and the IRS over the years. Spinoffs first entered the tax law in the 1920s.1 The point I will try to develop in this report is that despite the accumulation of piles of restrictions on spinoffs over the years, they are still tax friendly—in some cases remarkably so. I will not cover all the tax aspects of spinoffs, which would take a treatise, or even all the friendly tax aspects of spinoffs, but rather will focus on recent developments and particular areas of current interest in which this friendliness is apparent.
Part I will discuss specific aspects of the IRS’s current ruling policy. Part II will discuss the flexibility surrounding the 80-percent-by-vote test of section 355(a)(1)(A).2 Part III will discuss debt exchanges and other similar transactions that are used in connection with spinoffs and contain a monetization element. Part IV will discuss some aspects of the device prohibition that exists in relation to spinoffs, and particularly the related function test and its applicability to overlapping officers and boards of directors.
Ruling Policy of the IRS
Taxpayers for many years have sought letter rulings from the IRS on spinoff transactions with a greater frequency than on other reorganization transactions.3 Spinoffs are complex transactions from a commercial standpoint, and there is usually sufficient time to obtain a ruling. Because of the volume of spinoff rulings, the IRS is adept at handling them and tends to be understanding of the timelines involved in public spinoff transactions. Still, it came as a pleasant surprise in September 2005 when the IRS announced that it will ‘‘endeavor’’ to issue letter rulings on spinoff transactions within 10 weeks from receipt of the request.4 Based on a fairly thorough (but not entirely scientific) analysis,5 it appears that rulings issued since the announcement have been dated, on average, about 17 weeks from the date of the ruling request. The average drops to about 14 weeks if one excludes from the calculation rulings in which it appears that the taxpayer did not ask for a 10-week ruling.6 It seems that the IRS is not exactly meeting the 10-week goal, but it is doing pretty well. The 10-week ruling policy7 has been an extraordinary success from the standpoint of taxpayers, and it represents a remarkably customer-friendly approach for the IRS. Even when the period stretches a bit beyond 10 weeks, the time that it now takes to obtain a spinoff ruling is well within the timeline of any public spinoff.
In a more modest but nonetheless notable gesture of friendliness, the IRS in May 2009 included spinoffs in a procedure that allow it to issue rulings on parts of an integrated transaction without ruling on the larger transaction.8 Those rulings have been issued.9 However, that one can get a full ruling in about 10 weeks makes the prospect of a selective ruling less attractive.
The 80-Percent-by-Vote Test
Section 355(a)(1)(A) requires that the distributing company ‘‘control’’ the controlled company immediately before the distribution. Section 368(c) provides that the term ‘‘control’’ means stock possessing at least 80 percent of the total combined voting power of all classes of voting and at least 80 percent of the total number of shares of all classes of nonvoting stock of the corporation. This means that the controlled corporation immediately before the spinoff can have two classes of stock, one of which is held by the public and one of which is held by the distributing corporation. As long as the distributing corporation’s class has at least 80 percent of the vote, the distributing corporation can distribute that stock in a tax-free spinoff regardless of its value. In 1969 the IRS ruled that a parent could recapitalize its stock in a subsidiary to increase its vote to 80 percent, while not affecting its value, which was less than 80 percent, and then immediately spin off the subsidiary having met the control requirement.10 This of course is what the statute literally sanctions when it requires only that the distributing company control the controlled company ‘‘immediately before the distribution.’’11 The IRS also relied on section 355(b)(2)(C), which provides that for purposes of the active business requirement, control can be acquired within the applicable five-year period preceding the spinoff as long as it is not acquired in a transaction in which gain or loss is recognized in whole or in part.12
The 1969 ruling emphasized that the approved recapitalization into high-vote stock was neither transitory nor illusory, and that was because the realignment of voting control was ‘‘permanent.’’13 The concern that the vote of the high-vote stock be real, rather than transitory, is fairly obvious. If the controlled corporation in the 1969 ruling had recapitalized itself immediately following the spinoff to eliminate the high-vote stock that enabled the spinoff, it would be easy to say that the short time in which the high vote existed had no substance.14 It seems relatively clear that the 1969 ruling meant permanent not in a come-hell-or-high-water sense, but rather in the step transaction sense—that is, that there was no plan or intention to change the high-vote structure. The IRS has issued a handful of private letter rulings over the years in which there was no plan or intention to change the high-vote structure at the time of the spinoff, but such a plan developed later and the change was blessed by the IRS.15
The McDonald’s Corp. spinoff of Chipotle Mexican Grill Inc. illustrates the establishment of a high-vote structure to facilitate a spinoff, and the eventual unwind of that structure at a time safely past the spinoff. McDonald’s in January 2006 recapitalized its subsidiary, Chipotle, with class A low-vote and class B high-vote shares, and Chipotle then offered the low-vote shares to the public in an initial public offering.16 In October 2006 McDonald’s split off the class B shares under section 355.17 Each class of shares carried approximately half the value of Chipotle.18 In December 2009 the class B shares were converted back to common shares after that conversion was approved by a vote of the shareholders, and since then Chipotle has had only one class of shares outstanding.19 That timing seems relatively safe from a step transaction standpoint; the unwind was more than three years after the split-off and took place under an intervening shareholder vote.20
What if there is not the three-plus years between spinoff and unwind that existed with Chipotle? What if, in fact, there is a plan or intention at the time of the spinoff to unwind the high-vote structure? In June 2008 MetLife Inc. announced that it would split off its approximately 52 percent stock interest in Reinsurance Group of America Inc. (RGA).21 The split-off occurred in September 2008, shortly after RGA’s recapitalization of its stock into two classes, with the high-vote stock owned by MetLife and destined for distribution in the splitoff. 22 The proxy statement/prospectus stated:
RGA presently expects that, following the divestiture, the RGA board of directors will consider submitting to a shareholder vote a proposal to convert the dual-class structure adopted in the recapitalization into a single class structure. The approval of the conversion would require approval by the holders of a majority of each class of common stock represented in person or by proxy and entitled to vote at the RGA special meeting. There is, however, no binding commitment by the RGA board of directors to, and there can be no assurance that the RGA board of directors will, consider proposing a conversion or resolve to submit such a proposal to RGA shareholders. If submitted, there can be no assurance that the RGA shareholders would approve the conversion.23
This is close enough to a plan or intention to alarm most tax professionals. Obviously, the envisioned intervening board of director’s action and shareholder votes provide some comfort, but I would dare say not enough for a conservative public company. The IRS itself had provided the comfort to MetLife and RGA, however, in a private letter ruling that was received by MetLife before the announcement of the transaction.24 The ruling recited language that was similar to that of the proxy statement/prospectus.25 The taxpayer represented that ‘‘Controlled’’ had no legally binding obligation to propose to collapse the two classes of common stock after the split-off, and the IRS ruled, without caveat or qualification relevant to this issue, that the split-off was tax free under section 355.26 RGA was actually split off by MetLife on September 12, 2008.27 On November 25, 2008, only two and a half months later, RGA shareholders approved, and the company implemented, a collapse of the two classes into one class of class A common stock.28
It is understood that the IRS’s primary rationale in taking this stance stems from the enactment of section 355(e) in 1997. In Rev. Rul. 98-27,29 the IRS stated in effect that section 355(e) preempts the area on what post-spinoff transactions are good and bad and that as a result, it will not apply the step transaction doctrine to any subsequent restructuring of the controlled corporation, even if prearranged.30 It is not clear on its face that the unwind of a high-vote structure is the type of restructuring that was intended to be blessed in Rev. Rul. 98-27, and it seems unlikely that such an unwind is the type of perceived abuse that was intended by Congress to be policed by section 355(e) itself. As support for its broad holding, Rev. Rul. 98-27 cited equally broad language from the conference report to the Taxpayer Relief Act of 1997:
The House bill does not change the present-law requirement under section 355 that the distributing corporation must distribute 80 percent of the voting power and 80 percent of each other class of stock of the controlled corporation. It is expected that this requirement will be applied by the Internal Revenue Service taking account of the provisions of the proposal regarding plans that permit certain types of planned restructuring of the distributing corporation following the distribution, and to treat similar restructurings of the controlled corporation in a similar manner. Thus, the 80-percent control requirement is expected to be administered in a manner that would prevent the tax-free spin-off of a less-than-80-percent controlled subsidiary, but would not generally impose additional restrictions on post-distribution restructurings of the controlled corporation if such restrictions would not apply to the distributing corporation.31
The final sentence literally supports an application of the holding of Rev. Rul. 98-27 to a post spinoff unwind of high-vote stock.32 However, section 355(e) is focused on a classic step transaction issue: whether a subsequent acquisition will be stepped together with a spinoff for purposes of determining whether the 80-percent-voting-stock requirement was met by the spinoff. This was the question presented in Commissioner v. Morris Trust.33 In the Morris Trust facts, however, the spinoff is obviously real and the subsequent merger also is obviously real.34 If a distributing company owned high-vote stock in a controlled company that was old and cold, then spun that controlled company off, and then eliminated the control by a recapitalization of the high-vote stock, one might view this as analogous to the Morris Trust step transaction issue. In contrast, when the high-vote stock is created on the eve of spinoff and eliminated shortly thereafter, a question more troublesome than the classic step transaction question arises: whether the existence of the high-vote stock was transitory. In applying the broad words of Rev. Rul. 98-27 to that issue, the IRS may have gone further than it needed to remain true to section 355(e) and its legislative history.
Debt Exchanges and Similar Transactions
I started this report with an analogy to a single cell dividing into two cells. That analogy may fit (at least roughly) a spinoff in which the only outstanding interest in the distributing company is stock, and the only interest of the controlled company that is distributed is its stock. In fact, most distributing companies have debt that is outstanding and spinoffs are frequently used, at least in part, to apply a portion of the value of the controlled company to satisfy debt of the distributing company. This is referred to by many as a monetizing spinoff.
In a basic monetizing spinoff that involves a D reorganization, the distributing corporation (Distributing) first contributes assets to a new subsidiary (Controlled) in exchange for all the stock of Controlled and debt of Controlled.35 (It is the Controlled debt that tees up the monetization.) In the stock portion of the second step, Distributing distributes the stock of Controlled to the shareholders of Distributing. These two steps, considered in the aggregate, qualify as a reorganization under section 368(a)(1)(D).36 Section 361(a) provides that Distributing does not recognize gain or loss on the receipt of Controlled stock. Distributing also does not recognize gain or loss on the receipt of Controlled’s debt under section 361, but the provisions that apply to the debt turn on the type of debt issued by Controlled. Section 361(a) controls as long as the debt qualifies as ‘‘securities.’’37 If the debt fails to qualify as securities, section 361(b)(1)(A) will still provide nonrecognition treatment to the extent that the debt is distributed in pursuance of the plan of reorganization. Section 355(a)(1)(A) ordinarily allows only stock or securities to be distributed under the plan of reorganization, but section 361(b)(3) allows the nonsecurity debt to be distributed to any creditor, and not necessarily a holder of Distributing securities.38 There is one important distinction for Distributing between the receipt and distribution of a Controlled security and the receipt and distribution of Controlled debt that is not a security. If the Controlled debt is not a security, section 361(b)(3) provides that Distributing has a tax-free transaction only to the extent that the value of the debt does not exceed the tax basis of the assets transferred by Distributing to Controlled. If the Controlled debt is a security,39 there is no limitation; Distributing can transfer zero-basis assets to Controlled in exchange for Controlled stock and Controlled securities and distribute those securities in the spinoff without recognizing gain.40
Regarding the distribution of Controlled stock, Distributing does not recognize any gain under section 361(c)(1).41 Regarding the distribution of Controlled debt, whether a security or not, Distributing will not have to recognize gain or loss on the distribution under section 361(c)(1) and (c)(3), because the debt in either case will be characterized as ‘‘qualified property.’’42
Finally, there is the tax treatment to Distributing’s debt holder to be considered.43 It is at this point that the monetization occurs, and it occurs via the exchange by Distributing of Controlled debt for its outstanding debt. If the Controlled debt and the Distributing debt both qualify as securities, the exchanging holder will not recognize gain on the receipt of the Controlled securities to the extent that Distributing securities are surrendered in the exchange, as long as the aggregate principal amount of the Distributing securities surrendered equals or exceeds the aggregate principal amount of Controlled securities received.44
The above example assumes that a historic creditor of Distributing actually exchanges debt of Distributing for debt of Controlled. Such a debt-for-debt exchange by a creditor may not be realistic for several practical reasons. In many spinoffs, for example, the debt of Controlled is more speculative than the debt of Distributing, and the type of holder that holds Distributing debt may not be the same type of holder that would want to hold Controlled debt.45 Enter the investment banker and another friendly IRS policy. In the early 1980s, the debt of many corporations was trading at a discount, and there was a wave of stock-for-debt exchanges designed to qualify as such under section 108 as it then existed.46 This meant that there