On May 3, the Internal Revenue Service (the IRS) issued Revenue Ruling 2017-09 (the “Ruling”), which helpfully clarifies that the separate steps of a typical “north-south” spinoff transaction will be respected, and announced that it would once again issue private letter rulings on north-south transactions.
In a north-south spinoff transaction, a shareholder contributes property to a corporation and the corporation distributes the stock of another subsidiary to the shareholder in a transaction that is intended to be a tax-free spinoff. If the contribution and distribution are treated as separate steps, then the distribution would qualify as tax-free under section 355 but if the steps are combined under the “step transaction doctrine” so that the contribution is received in exchange for the distribution, the distribution would be taxable.
The IRS had issued private letter rulings respecting the separate steps until January 2013, when it stopped issuing the rulings and announced that it was reconsidering the issue.
The Ruling resolves the issue and quite possibly alters the application of the step transaction doctrine going forward.
The Ruling, under the facts set forth under Situation 1, spells out the paradigmatic case of a “north-south” transaction. A parent corporation (P) owns all the stock of a subsidiary (D), which in turn owns all the stock of its controlled subsidiary (C). P and C have engaged in separate active businesses for the requisite five years, but D does not conduct its own active business. Although D wants to spin C off to P, it needs its own separate active business to meet the requirements of Section 355. For the purpose of meeting this requirement, P contributes its separate active business to D in exchange for additional shares of D stock. At some point thereafter, D distributes all the C stock to P in a transaction intended to be a tax-free spinoff.
The issue considered by the IRS in 2013 is whether the contribution of the P business assets to D should be stepped together with the distribution of (some of) the stock of C by D, and thus a portion of the C shares distributed by D would actually be treated as being exchanged (in a taxable exchange) by D for the business assets contributed by P. Such a recharacterization would have several negative consequences: taxable gain recognized on the business assets and the C shares deemed sold, and, in fact, the possible inapplicability of Section 355 itself to the entire transaction (including the C shares that are still treated as being distributed by D). This would occur if more than 20% of the C shares are caught by the “north-south” recharacterization. In this case, the distribution as a whole would not satisfy the Section 355 requirement that an amount of stock constituting “control” (i.e., 80%) of C be distributed.
The Ruling, however, makes it clear that the two transactions will not be stepped together, without many caveats or other restrictions that would significantly limit the Ruling’s applicability. Thus, it seems that in most spinoff transactions, the “north-south” issue should no longer be a problem. The Ruling, therefore, is a welcome clarification with respect to one long-standing area of concern in the tax-free spinoff area.
But perhaps of more interest is the approach the Ruling takes to the step transaction doctrine. Rather than one of the more common formulations for the step transaction doctrine used in the past, the Ruling adopts a somewhat new, and potentially very beneficial, formulation suggested in part by the Tax Section of the New York State Bar Association in a 2013 report. In particular, the Ruling states that 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 formulation focuses on the taxpayer’s chosen form and substantive policy considerations underlying the applicable Code provisions with respect to a series of transactions rather than applying a mechanical test. It appears that the IRS intends the formulation to apply generally (although the Ruling is limited to the specific facts described in it).
At the very least, the Ruling clears up the long-standing concerns with the “north-south” issue in tax-free spinoffs. At the very most, the Ruling reflects a new IRS approach to the step transaction doctrine that could apply generally. We may have to wait to see how far reaching the Ruling is intended to be—whether the IRS will apply the Ruling’s formulation in other fact patterns, or whether the IRS reverts to one of the earlier formulations of the doctrine.