This advisory briefly discusses the recently issued regulations under section 355(e) of the Internal Revenue Code of 1986, as amended (the "Code") with particular emphasis on the "rebuttal" rules contained therein as they apply to changes in control of either the distributing or controlled corporation subsequent to a spin-off.
Introduction
Section 355 of the Code generally provides that, if a corporation distributes to its shareholders stock of a corporation which it controls immediately before the distribution and certain other conditions are met, neither the distributing corporation nor its shareholders recognize gain or loss. One of the purposes of those other conditions is to limit the circumstances in which either the distributing or controlled corporation can undergo changes of control in conjunction with a distribution that qualifies for corporate and shareholder level nonrecognition under section 355. Nevertheless, prior to the enactment of section 355(e) of the Code, it was possible for such changes to occur, for example, in the context of the Morris Trust case described below, while qualifying for tax-free treatment under section 355.
Morris Trust Case
In Commissioner v. Mary Archer W. Morris Trust, 697 F.2d 794 (4th Cir. 1966) ("Morris Trust"), the distributing corporation ("Distributing") was engaged in two businesses: banking and insurance. Distributing transferred the insurance business to a new corporation and spun off the stock of the new corporation to its shareholders. Distributing then merged, for valid, nontax business reasons, with another bank. The court determined that the continuity of stockholder interest requirement was satisfied because the historic shareholders of Distributing received 54 percent of the stock of the merged corporation, and, as a result, the transfer was a nontaxable spin-off. The perception became that, due to the lack of a continuing interest by the historic shareholders, the Morris Trust rule was being used as a device to transfer unwanted corporate assets without incurring a tax at the corporate level.
Enactment of Section 355(e)
Section 355(e), added to the Code in 1997, provides for gain recognition if a distributing corporation distributes the stock of a controlled corporation and the distribution "is part of a plan (or series of related transactions) pursuant to which one or more persons acquire directly or indirectly" a 50 percent or greater equity interest in either the distributing or the controlled corporation. In addition, if one or more persons acquire such a 50 percent equity interest during the four-year period that begins two years before the distribution and ends two years after the distribution, the acquisition is "treated as pursuant to" such a plan "unless it is established that the distribution and the acquisition are not pursuant to a plan or series of related transactions."
Proposed Regulations
Proposed regulations, issued on August 24, 1999, provide guidance concerning "presumption" that 50 percent changes in ownership within two years are part of a plan.
General Rebuttal
For acquisitions occurring within two years after a distribution, the presumption may be rebutted by establishing that: (i) the distribution was motivated in whole or substantial part by a corporate business purpose (other than an intent to facilitate an acquisition or decrease the likelihood of the acquisition of one or more businesses by separating those businesses from others that are likely to be acquired) and (ii) the acquisition occurred more than 6 months after the distribution and there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition at the time of the distribution or within 6 months thereafter. Thus, in this general rebuttal, the proposed regulations rely on corporate business purpose as a key factor indicating whether a distribution and an acquisition are part of a plan.
Alternative Rebuttal
Where general rebuttal cannot be satisfied, acquisitions are subject to greater scrutiny and will be considered part of a plan unless taxpayers satisfy a more stringent rebuttal. Unlike the general rebuttal, a nonacquisition business purpose alone is not sufficient under the alternative rebuttal. Rather, taxpayers must satisfy all prongs of a three-prong test.
The first prong of the alternative rebuttal may be satisfied in either of two ways. The distributing corporation must establish either that (i) at the time of the distribution, the distributing corporation, the controlled corporation, and their controlling shareholders did not intend that one or more persons would acquire a 50 percent or greater interest in the distributing or any controlled corporation during the statutory presumption period (or later pursuant to an agreement, understanding, or arrangement existing at the time of the distribution or within 6 months thereafter) or (ii) the distribution was not motivated in whole or substantial part by an intention to facilitate an acquisition of an interest in the distributing or controlled corporation.
Under the second prong of the alternative rebuttal, the distributing corporation must establish that, at the time of the distribution, neither the distributing corporation, the controlled corporation, nor their controlling shareholders reasonably would have anticipated that it was more likely than not that one or more persons would acquire a 50 percent or greater interest in the distributing corporation or the controlled corporation within two years after the distribution (or later pursuant to an agreement, understanding, or arrangement existing at the time of the distribution or within 6 months thereafter) who would not have acquired such interests if the distribution had not occurred. This prong is referred to as the "reasonable anticipation" test.
The third prong of the alternative rebuttal reiterates the requirement in the general rebuttal. The distributing corporation must establish that the distribution was not motivated in whole or substantial part by an intention to decrease the likelihood of the acquisition of one or more businesses by separating those businesses from others that are likely to be acquired.
Discussion
Prior to the proposed regulations, most tax lawyers believed that the determination of whether a "plan" existed properly depended upon the level of predistribution discussions or negotiations between the distributing or controlled corporation and the acquiring corporation. A plan might also exist if the distributing or controlled corporation itself intended to issue 50 percent new stock in an acquisition for cash. Under this view, in the absence of any such discussions or intent, no plan would exist.
However, the proposed regulations interpret the scope of a plan in a much more expansive manner. Commentators believe that the alternative rebuttal test cannot be met unless the distributing corporation can prove that the spin-off does not make an acquisition of either party more likely to occur compared to the potential for such an acquisition absent the spin-off. Because this may be an impossible hurdle to overcome, taxpayers will most likely not rely on the alternative rebuttal and will rely only on the general rebuttal.
A good illustration of this is contained in Example 5 of the regulations. In that example, a parent effected a spin-off for a valid non-tax business purpose. However, at the same time, the parent believed it would become a more attractive acquisition candidate if the spin-off were undertaken. One year after the spin-off, the anticipated acquisition took place, although it was not undertaken pursuant to an agreement in place during the six months following the spin-off. The example concludes that the presumption can be rebutted under the general rebuttal rule if it could be shown that the spin-off was in substantial part motivated by the nonacquisition business purpose. Nevertheless, the alternative rebuttal was not satisfied because the distributing corporation could not establish that, at the time of the spin-off, it did not intend that one or more persons would acquire the requisite 50 percent interest during the two-year period referred to in the statute.
This example is particularly relevant in the high-tech area where the value of one segment of a corporate entity can be enhanced by a spin-off. Consequently, care should be taken not to run afoul of the new regulations.
Conclusion
Section 355(e) of the Code provides that a distribution of stock of a controlled corporation will be taxable if the distribution and the acquisition of stock are part of a "plan (or series of related transactions), with a presumption for acquisitions of stock within two years before or after the distribution. Under the proposed regulations, there may be many situations where a plan is deemed to exist even though no plan exists under what might be considered common usage of that term. Most significantly, a plan will often exist even though, at the time of the distribution, the distributing and controlled corporation have had no contact with any potential acquiring corporation and have no plan to issue 50 percent of their own stock after the distribution. Careful consideration must, therefore, be given to the general and alternative rebuttal requirements where any spin-off transaction is under consideration, and such consideration is equally important even if no change of control is currently contemplated.
Kevin C. Jones is an associate with the law firm of Buchanan Ingersoll and is a member of the Tax Group. Buchanan Ingersoll's Tax Group advises publicly held and private business entities, affluent individuals and families, and key executives in a full range of tax, employee benefits and dispute resolution matters at federal, state and local levels. We also counsel clients in the areas of wealth preservation and business succession planning. For more information, contact Tax Group Chairman Francis A. Muracca, II, at 412-562-3950 or by email at muraccafa@bipc.com.