The proposed section 355(e) regulations: broadening the traditional notions of what constitutes a plan.

• Author: Silverman, Mark J.
• Position: IRS regulations under IRC section 355(e

1. Introduction

   In 1997, Congress enacted the Taxpayer Relief Act of 1997,(1)(*) which added section 355(e) to the Internal Revenue Code.(2) Under section 355(e), the so-called anti-Morris Trust provision,(3) a distributing corporation will recognize gain if one or more persons acquire, directly or indirectly, 50 percent or more of the stock (measured by vote or value) of the distributing or any controlled corporation as "part of a plan (or series of related transactions)" (hereinafter a "plan") that was in place at the time of the distribution.(4) Section 355(e) also creates a rebuttable presumption that any acquisition occurring two years before or after a section 355 distribution is part of such a plan (hereinafter the "two-year presumption") "unless it is established that the distribution and the acquisition are not pursuant to a plan or series of related transactions."(5) Section 355(e)(5) authorizes the Treasury Department and the Internal Revenue Service to issue regulations "necessary to carry out the purposes" of the legislation.(6)

   On August 19, 1999, Treasury and the IRS issued proposed regulations under section 355(e) that provide guidance on what constitutes a plan.(7) The proposed regulations generally treat the test of whether a plan exists as a subjective one that depends ultimately on the intent and expectations of the relevant parties.(8) The proposed regulations rely on a variety of factors to determine whether a plan exists, including the timing of the transactions, the business purpose for the distribution, the likelihood of an acquisition, the intent of the parties, the existence of agreements, understandings, arrangements, or substantial negotiations, and the causal connection between the distribution and the acquisition.(9) Although the proposed regulations provide guidance on the issue of what constitutes a plan, they create significant concerns regarding the scope of section 355(e). Indeed, the proposed regulations may be viewed as going beyond the traditional notions of what constitutes a plan, thus inappropriately expanding the statute.(10)

   This article analyzes the proposed section 355(e) regulations and provides recommendations for revising the proposed regulations.(11) Part II describes the proposed regulations in general, Part III analyzes the proposed regulations in the context of several examples, and Part IV sets forth several recommendations to the IRS for amending the proposed regulations.

2. The Proposed Section 355(e) Regulations

   1. In General

      The preamble to the proposed section 355(e) regulations states that the proposed regulations "provide guidance concerning the interpretation" of a plan. While the proposed regulations provide ways to rebut the two-year presumption, they only implicitly define what constitutes a plan.

      Through a series of examples, the proposed regulations seem to interpret the concept of a plan broadly. The preamble to the proposed regulations notes that Congress intended that a plan be interpreted broadly.(12) The IRS points to two specific indications of this intent. First, in contrast to section 355(d), which utilizes the concept of "a person" and applies certain aggregation rules to treat related persons and persons acting in concert as one person, section 355(e) adopts a more expansive approach by referring simply to "one or more persons." Second, the Conference Report provides that public offerings of a sufficient size could trigger section 355(e). This suggests that there does not need to be an identified acquirer on the date of the distribution and that the intent of the acquirer is not necessarily relevant in determining whether there is a plan.(13) For example, the proposed regulations treat a distribution for the purpose of facilitating a public offering by the distributing or controlled corporation of more than 50 percent of its stock as part of a plan for purposes of section 355(e).(14)

      In addition to defining a plan broadly, the proposed regulations impose a high burden of proof on the taxpayer to rebut the two-year presumption. The taxpayer must establish that it satisfies the tests set forth in the proposed regulations by "clear and convincing evidence." It is not clear, as a practical matter, what the taxpayer will have to establish to satisfy the clear and convincing standard.(15) Moreover, the rebuttals provided by the proposed regulations purport to be the exclusive means for rebutting the two-year presumption.

      As previously mentioned, the proposed regulations rely on a variety of factors to determine the existence of a plan. One factor -- temporal proximity -- is specified by the statute(16) and the proposed regulations reflect the significance of this factor by creating, in effect, a timeline of standards (see the diagram) to rebut the existence of a plan.(17)

   2. Post-Spin Rebuttals

      1. Introduction

         With respect to acquisitions that occur after a section 355 distribution, the distributing corporation may overcome the two-year presumption using one of two alternative tests. These tests are summarized below and are discussed in further detail in Part III.

      2. Acquisitions Between Six Months and Two Years After the Distribution

         If the acquisition occurs more than six months after the distribution (and there is no agreement, understanding, arrangement, or substantial negotiations at the time of the distribution or within six months thereafter), the distributing corporation may overcome the two-year presumption by establishing that the distribution is motivated in whole or in 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) (the "General Post-Spin Rebuttal").(18) Thus, the primary focus of the General Post-Spin Rebuttal is the business purpose for the distribution. Because the distribution need only be motivated "in substantial part" by a non-acquisition business purpose, the existence of an acquisition-related business purpose does not automatically preclude the use of the General Post-Spin Rebuttal.(19)

         In determining whether the distribution is motivated in whole or substantial part by a non-acquisition business purpose, the intent of the distributing corporation, the controlled corporation, or the controlling shareholders of either the distributing or controlled corporation is relevant.(20)

      3. Acquisitions Within Six Months After the Distribution

         If a distribution is motivated by an acquisition business purpose, or the acquisition occurs within six months after the distribution, the distributing corporation may overcome the two-year presumption by satisfying a more stringent three-prong test (the "Alternative Post-Spin Rebuttal"). All three prongs must be satisfied.

         (a) First Prong

      1. Neither the distributing or controlled corporation nor a controlling shareholder of either corporation intends that one or more persons acquire a 50-percent or greater interest in the distributing or controlled corporation (the "First Prong Intent Test").

      2. The distribution is not motivated in whole or substantial part by an intention to facilitate an acquisition of an interest in the distributing or controlled corporation (the "First Prong Facilitation Test").

         (b) Second Prong

         Neither the distributing or controlled corporation nor their controlling shareholders reasonably would have anticipated that it was more likely than not that one or more persons, who would not have acquired the interests if the distribution had not occurred, would acquire a 50-percent or greater interest in the distributing or controlled corporation within two years after the distribution (the "Reasonable Anticipation Prong").

         (c) Third Prong

         The distribution is 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 (the "Hostile Takeover Prong")(21)

         The First Prong Intent Test focuses on whether the intended change in ownership totals 50 percent or more. Thus, it is satisfied even if one or more of the relevant parties intends that a distribution facilitate an acquisition, so long as the parties did not intend that there be a 50-percent or greater change in ownership.

         The First Prong Facilitation Test, on the other hand, may be satisfied where the parties intend a 50-percent change in ownership as long as the parties did not intend that the distribution facilitate any part of an acquisition.(22) In other words, the distribution must not be motivated by an intent to facilitate an acquisition, which is very similar to the General Post-Spin Rebuttal. Thus, the First Prong Facilitation Test may be satisfied as long as the distribution is not motivated by an acquisition-related business purpose even though the relevant parties may intend a 50-percent change in ownership. As a practical matter, however, it seems difficult to establish a lack of an intent to facilitate an acquisition where a 50-percent change in ownership is intended by the parties.

         The Reasonable Anticipation Prong, like the First Prong Intent Test, requires that a relevant party reasonably anticipate an acquisition of the full 50 percent.(23) The Hostile Takeover Prong is similar to the General Post-Spin Rebuttal.(24)

         For purposes of applying the Alternative Post-Spin Rebuttal, the tax consequences of section 355(e) are disregarded in determining the intentions and reasonable anticipations of the relevant parties.(25) Absent such a rule, the distributing corporation could argue that it should satisfy the Alternative Post-Spin Rebuttal because it would not be reasonable for a party to act in a manner that would result in section 355(e) liability. Conversely, the IRS could argue that the presence of an indemnity agreement between the distributing and controlled...