Comments on final regulations under Section 355 relating to corporate separations.

• Author: Nitschke, David F.
• Position: Filed by Tax Executives Institute with Department of the Treasury and IRS on July 25, 1989

Comments on Final Regulations Under Section 355 Relating to Corporate Separations

On January 4, 1989, the Internal Revenue Service issued final reguations under section 355 of the Internal Revenue Code, relating to corporate separations. The final regulations (T.D. 8238) were published in the Federal Register on January 5, 1989 (54 Fed. Reg. 283), and in the February 21, 1989, issue of the Internal Revenue Bulletin, 1989-8 I.R.B. 5.

The final regulations revise existing regulations that were issued in 1955; amendments to the existing regulations were initially proposed on January 21, 1977 (42 Fed. Reg. 38886) -- more than 12 years before the final regulations were promulgated. For simplicity's sake, the regulations are referred to as the "final regulations"; the 1977 regulations are referred to as the "proposed regulations"; and the 1955 regulations are referred to as the "prior regulations."

GENERAL COMMENTS

Originally enacted as part of the Internal Revenue Code of 1954, section 355 permits the tax-free distribution by one corporation (the distributing corporation) of stock or securities in another corporation (the controlled corporation) to shareholders with respect to their stock or to securities holders in exchange for their securities, if certain conditions are met. Statutory conditions include (i) requirements for control by the distributing corporation and for the active conduct of the business after the distribution, and (ii) a prohibition against the use of the transaction principally as a device for the distribution of earnings and profits. Moreover, although a tax-free reorganization was not a necessary prelude to a tax-free separation, the prior regulations required taxpayers to satisfy certain judicially created restrictions applicable to reorganizations under section 368. specifically, the prior regulations provided:

The distribution by a corporation...will not qualify under section 355 where carried out for purposes not germane to the business of the corporations.... Section 355 contemplates a continuity of the entire business enterprise under modified corporate forms and a continuity of interest in all or part of such business enterprise on the part of those persons who, directly or indirectly, were the owners of the ternprise prior to the distribution or exchange. All the requisites of business and corporate purposes described under 1.368 must be met to exept a transaction from the recognition of gain or loss under this section. Treas. Reg. 1.355-2(c) (1955).

Amendments to the regulations proposed in 1977 generally continued the continuity of interest and business purpose requirements. Prop. Reg. 1.355-2(b) (1977).

Nothwithstanding the long delay in the issuance of the final regulations, TEI commends the IRS for responding to many comments received since the proposed regulations were promulgated 12 years ago. We support, for examples, making the business purpose requirement dependent on whether the distributing corporation may achieve its purpose through a nontraxable transaction. Such a rule is significant clarification and reflects business reality. Moreover, the emphasis on the business purpose of the separation in determining whether the transaction constitutes a "device" under section 355(a)(1)(B) and the articulation of "device" and "nondevice" factors reflect sound policy and provide useful guidance.

TEI questions, however, the underlying validity of certain changes to the business purpose and continuity of interest requirements, as well as the ramifications of certain changes to the section 355 device clause. In addition, changes in the law (particularly the repeal of the General Utilities doctrine) substantially affect the application and interpretation of section 355. We therefore recommend that the regulations be reissued in proposed form to permit taxpayers to respond more formally to these changes. (1)

SPECIFIC COMMENTS

1. Treas. Reg. 1.355-2(b):

   Independent Business

   Purpose

   The prior regulations provided that a distribution would not qualify for tax-free treatment under section 355 where it was carried out for "purposes not germane to the business of the corporations." Treas.Reg. 1.355-2(c) (1955). The proposed regulations explained that this test required a transaction to be carried out for "real and substantial nontax reasons germane to the business of the cororations." Prop. Reg. 1.355-2(b)(1) (1977).

   Under the final regulations, "a transaction is carried out for a corporate business purpose if it is motivated, in whole or substantial part, by one or more corporate business purposes." Treas. Reg. 1.355-2(b)(2) (1989)(emphasis added). The final regulations also provide that --

   potential for the avoidance of Federal taxes by the distributing or controlled corporation (or a corporation controlled by either) is relevant in determining the extent to wcich an existing corporate business purpose motivated the distribution.

   Finally, Treas. Reg. 1.355-2(b)(1) (1989) provides that this test is independent of any other requirement under section 355.

   TEI submits that the addition of a requirement that the transaction of motivated "in whole or substantial part" by one or more business purposes is not supported by the legislative history of section 355. In enacting section 355's predecessor in 1951, Congress expressed its intention that business separations would qualify for tax-free treatment "when undertaken for legitimate business purposes." S. Rep. No. 82-781, 82d Cong., 1st Sess. 58 (1951). Congress has never required that the business purpose for the transaction be the sole or predominant reason for the separation.

   Nor have the courts required the motivation of the distributing or controlled corporation to be supported "in whole or substantial part by one or more corporate business purposes." For example, in Commissioner v. Wilson, 353F.2d 184, 186-87 (9th Cir. 1966), the court interpreted the business purpose test, as follows:

   Congress...