The Internal Revenue Service (IRS) recently released guidance on certain “north-south” spinoff transactions. Generally, a “north-south” transaction consists of a transfer of property from a shareholder to a corporation close in time with a related transfer of property from the corporation to the shareholder. Rev. Rul. 2017-9 (Ruling) discusses the tax consequences of two such transactions involving tax-free spinoffs. In each case, the proper treatment hinges on whether the steps should be respected as separate transactions or recast as an integrated whole. Though the IRS answers this question differently in the two situations analyzed, its reasoning in each departs somewhat from the traditional step-transaction doctrine.
In this situation, a parent corporation, P, owns all of the stock of a distributing corporation, D, which in turn owns all of the stock of a controlled corporation, C. At the time of the transactions, P and C have conducted Businesses A and B, respectively, for more than five years. On Date 1, P transfers all of the assets and activities of Business A, which have a fair market value of $25X, to D in exchange for additional D stock. On Date 2, D transfers all of the stock of C, which has a fair market value of $100X, to P. The purpose of the transfer on Date 1 was to ensure that D was conducting an active trade or business at the time of the transfer on Date 2, as required for the distribution to qualify as tax-free under IRC § 355.
If the transfers on Dates 1 and 2 are considered separately, then no gain will be recognized. The Date 1 transfer fits neatly within the bounds of IRC § 351, which provides that no gain or loss is recognized when a shareholder contributes property to a corporation solely in exchange for stock of the corporation. The Date 2 transfer would qualify for nonrecognition as a tax-free spinoff under IRC § 355. IRC § 355(a) provides that no gain or loss is recognized when a corporation distributes to its shareholders a controlling block of the stock or securities of a corporation it controls immediately before the distribution. IRC § 355(b) specifies that, to qualify for nonrecognition, both the distributing corporation and the controlled corporation must be engaged in an active trade or business immediately following the distribution. Under IRC § 368(c), “control” means the ownership of 80% of the corporation’s stock.
Conversely, if the two transfers are considered parts of a single transaction, then gain will be recognized. The transaction will be considered an exchange of the Business A assets for a block of C stock worth $25X (the value of the assets) and a transfer of the remaining $75X of C stock from D to P. The exchange will be taxed as a sale or exchange of property under IRC § 1001. IRC § 355(a) will not apply to the distribution of the $75X of C stock because it represents only 75% of C’s stock, less than the required 80% control.
The IRS determined that the two transfers would be respected as separate transactions in this situation. It stated that the form of a transaction generally controls its tax treatment, unless: (1) there is a compelling alternative policy; (2) the effect of all or part of the steps of the transaction avoids a particular result intended by otherwise-applicable rules; or (3) the effect of all or part of the steps of the transaction is inconsistent with the underlying intent of the applicable rules. It also suggests that if a step does not implicate these three exceptions, it will be considered to have “independent significance” and will be treated as a separate transaction.
The IRS noted that IRC §§ 351, 355 and 368 were intended to allow for the nonrecognition of gain when transfers achieve the continued ownership of property in corporate form and found that the structure contemplated in this situation achieved that result. It also highlighted IRC § 355(b)(2)(C) and (D), which deny nonrecognition treatment to distributions of stock when the distributing corporation has acquired its active trade or business in a taxable transaction within the preceding five years. In this situation, D acquires Business A from P in a nonrecognition transaction, indicating that the transfer of property to D is consistent with with the purposes of IRC §§ 355(b)(2)(C) and (D). The IRS also implied that because this situation aligns with the purposes of the applicable provisions, it is irrelevant that the Date 1 transfer is motivated by the taxpayer’s desire to attain nonrecognition treatment under IRC § 355(a) for its planned Date 2 spinoff.
Eversheds Sutherland Observation: This reasoning does not reference the typical step-transaction doctrine, which is an offshoot of the broad substance-over-form principle. The step-transaction doctrine is generally applied using one of three tests that examine the taxpayer’s legal obligations, the interdependence of the steps, and the taxpayer’s intentions regarding the entire series of transactions. The IRS asserts that the taxpayer’s intent to produce a favorable tax result is irrelevant even though the IRS has previously found that multiple related, purportedly tax-free transactions should be collapsed into a single transaction under traditional step-transaction principles. It is not clear how the three factors discussed in this ruling will fit into the broader framework of the step-transaction doctrine.
In this situation, a parent corporation, P, owns all of the stock of a distributing corporation, D, which in turn owns all of the stock of a controlled corporation, C. At the time of the transactions, D and C have conducted Businesses A and B, respectively, for more than five years. On Date 1, C distributes $15X of cash and property with a fair market value of $10X to D, which D retains. On Date 2, D transfers property with a fair market value of $100X and a basis of $20X to C and distributes all of the stock of C to P in a transaction qualifying as a reorganization under IRC §§ 368(a)(1)(D) and 355. The Ruling states that the Date 1 transfer was effected pursuant to the plan of reorganization.
If the Date 1 and Date 2 transactions are considered separately, the Date 1 transfer would be treated as a distribution to D under IRC § 301. No gain would be recognized to D on the Date 2 transfer pursuant to IRC § 361(a), which provides for nonrecognition treatment when a corporation, in connection with a reorganization, exchanges property solely for the stock or securities of another corporation that is also a party to the reorganization. A transaction is a reorganization under IRC § 368(a)(1)(D) if the taxpayer corporation transfers assets to a controlled corporation and, pursuant to the plan of reorganization, distributes the stock or securities of the controlled corporation in a transaction that qualifies for nonrecognition under IRC § 355 (among other provisions). In this case, D distributes assets to C, which it controls, then transfers the stock of C to P in a transaction that qualifies for nonrecognition under IRC § 355.
On the other hand, if all of the transfers on Date 1 and Date 2 are treated as steps of one integrated transaction, then the amount distributed from C to D on Date 1 will be considered “boot” in the IRC § 368(a)(1)(D) reorganization rather than a dividend or other distribution under IRC § 301. Pursuant to IRC § 361(b), a corporation that receives boot in a reorganization is required to recognize gain to the extent of the amount of boot received and retained. A corporation does not recognize gain on any boot that it distributes to its shareholders or creditors. D would therefore recognize gain on the property transferred to C up to the value of the cash and property it received from C in the Date 1 distribution because D did not distribute such cash and property.
The IRS determined that, in this situation, the steps should be viewed as a single integrated transaction because they were taken pursuant to a plan of reorganization. It cited Estates of Bell v. Comm’r, T.C.M. 1971-285, to stand for the proposition that the boot rules are the “exclusive measure of dividend income provided by Congress where money is distributed to shareholders as an incident of a reorganization.” It also seemed to rely on language elsewhere in § 361 referring broadly to distributions related to the plan of reorganization to implicitly broaden the meaning of “exchange” as used in § 361(b).
Eversheds Sutherland Observation: In this situation, the IRS again analyzes whether a multistep deal should be recast as a single transaction primarily by referring to the legislative intent underlying the relevant tax rules. Because it was stipulated as a matter of fact that the Date 1 distribution was made pursuant to a plan of reorganization, the Ruling offers no guidance on the factors that may cause a step to be considered part of such a plan. Additionally, though the IRS determined that the steps in this transaction should be integrated, it made no reference to the typical step-transaction doctrine and did not indicate whether the factors that would have been relevant under the traditional tests impacted its analysis in this situation.
Rev. Rul. 2017-9 is binding only on those taxpayers who enter into transactions that are identical or substantially identical to the ones described. As such, the ruling does not address several tax issues that may be implicated in similar transactions. For example, when cash or other liquid assets are transferred between the distributing and controlled corporations before a spinoff, the “device” prohibition can prevent the transaction from receiving nonrecognition treatment under IRC § 355 in certain circumstances. However, more guidance on these issues may be forthcoming because Rev. Rul. 2017-9 also lifts the no-rule policy in respect of significant issues relating to north-south transactions.