New Temporary Regulations Under Code Section 355(e): the Problems With Planning Spin-offs

• Publication year: 2002
• Pages: 71
• Citation: Vol. 31 No. 2 Pg. 71

31 Colo.Law. 71 Colorado Lawyer 2002.

2002, March, Pg. 71. New Temporary Regulations Under Code Section 355(e): The Problems With Planning Spin-offs

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71

Vol. 31, No. 2, Pg. 71

The Colorado Lawyer
March 2002
Vol. 31, No. 3 [Page 71]

Specialty Law Columns
Tax Tips
New Temporary Regulations Under Code § 355(e): The Problems With Planning Spin-offs
by Nathaniel T. Trelease
C2002 Nathaniel T. Trelease

This column is sponsored by the CBA Taxation Law Section to provide timely updates and practical advice on federal state, and local tax matters of interest to Colorado practitioners

This month's article was written by Nathaniel T Trelease, Denver, a tax attorney and founder of an online company - (720) 937-9930, ntrelease@webcredenza.com.

Recently issued temporary Treasury Regulations under Code § 355(e) are substantial improvements over the proposed regulations they replace. Still, there is risk of planning a spin-off in conjunction with a merger or acquisition, which this article highlights in the context of the new temporary Treasury Regulations.

Corporations spin off portfolio businesses for a variety of reasons, including the desire to facilitate acquisitions, prepare for public offerings of stock, enhance their ability to raise capital, and reduce operating or legal risks. Tax-free divestments of businesses under the Internal Revenue Code ("Code")1 have become more difficult in recent years and have brought renewed attention to and increased pressure on the use of Code § 355, the principal provision governing spin-offs.

In August 2001, the IRS issued new temporary regulations under Code § 355(e) ("Temporary Regs"). As discussed in this article, the Temporary Regs mark a significant improvement over the problematic and widely criticized first set of proposed regulations.

Spin-Offs

Subject to various requirements, a corporation may divest itself of unwanted businesses through a tax-free spin-off2 under Code § 355. However, the process becomes significantly more complicated when a spin-off is planned in conjunction with a pre- or post-spin acquisition. In one transaction format, the distributing corporation ("D") places the assets of the business it seeks to divest into a controlled corporation ("C")3 and then distributes the stock of C to D's shareholders. Subsequently, D or C may be acquired by an unrelated corporation ("P").

Where the following statutory requirements of Code § 355 and the non-statutory tests developed by the courts are satisfied, the spin-off is accomplished without taxation at either the corporate or shareholder level. The statute generally requires that:

1) D distribute either all of its stock in C, or enough stock to constitute "control"4 of C, and the retention of C stock by D does not have as one of its principal purposes the avoidance of federal tax;5

2) the distribution of C stock be "with respect to" its stock;6

3) D and C be actively engaged in a trade or business immediately after the transaction;7 and

4) the transaction not be "principally" used as a device for the distribution of the earnings and profits of D, C, or both.8

Compliance with the statutory requirements alone is insufficient to qualify a transaction for nonrecognition treatment under the Code.9 The transaction also must satisfy the following non-statutory requirements, among which there may be substantial overlap: (1) the transaction must have a substantial non-tax corporate business purpose;10 (2) pre-spin shareholders of D and C must maintain a post-distribution continuity in both corporations;11 and (3) post-spin, D and C must maintain a continuity of business enterprise.12

Format of Morris Trust

In tax law, the most famous example of a post-spin acquisition of D came in the Fourth Circuit case of Commissioner v. Mary Archer W. Morris Trust,13 where a national bank desired to acquire a local bank but could not do so while the local bank owned an insurance business. The local bank divested its insurance business through a spin-off and was subsequently acquired by the national bank. The Internal Revenue Service ("IRS") challenged the transaction on several grounds, but the court held that the transaction was valid and resulted in nonrecognition of gain. Thus a "Morris Trust" transaction generally refers to the pre- or post-spin acquisition of D or C by P.

Congress perceived certain Morris Trust-type transactions as devices for the tax-free sale of portfolio businesses in violation of the purpose, if not the text, of Code § 355 after the complete repeal of the General Utilities doctrine.14 (This doctrine had held that a corporation generally did not recognize gain or loss on the distribution of appreciated property to its shareholders.) In high profile cases, D leveraged C, retained the proceeds from the financing, and then accomplished a spin-off of encumbered C.15 In effect, D sold C for cash in a disguised sale and without the imposition of tax.

In 1997, to combat this perceived abuse, Congress amended Code § 355 to add subsection (e). Instead of focusing on the pre- and post-spin leverage involved in a transaction, Code § 355(e) focuses on changes in ownership control. It imposes a tax at the corporate level (but not at the shareholder level) on distributions: (1) that are part of a "plan" or "series of related transactions" (together, a "plan"); and (2) pursuant to which one or more persons, directly or indirectly, acquire a 50 percent or greater interest in either D or C. A plan is presumed to exist if the 50 percent or greater interest is acquired any time within a four-year period, beginning two years before and ending two years after the spin-off.16

New Anti-Morris Trust Temporary Regulations

Due to substantial confusion about the scope of Code § 355(e), the Temporary Regs attempt to bring greater clarity and certainty to this area of practice. The Temporary Regs have their roots in two sets of proposed regulations, one set issued in August 1999 ("August Proposed Regs");17 the other in January 2001 ("January Proposed Regs").18

The August Proposed Regs were widely criticized and ultimately withdrawn. They were replaced by the January Proposed Regs, which contained several significant features more favorable to taxpayers. Among these were making the list of "plan" factors broader and non-exclusive; focusing on D and C in determining intent, instead of on P; and giving weight to whether the second transaction (either the acquisition or the spin-off) would have occurred regardless of the first transaction.19

On August 3, 2001, the IRS issued the Temporary Regs,20 which, except for two changes,21 are identical to the January Proposed Regs. The Temporary Regs apply to spin-offs occurring after August 3, 2001. The Temporary Regs do not define what constitutes a plan. Instead, they outline a series of factors that tend to indicate the existence or non-existence of a plan encompassing both a spin-off and an acquisition of D or C. These factors have the effect of broadly defining the concept of a...