Final section 355(e) plan regulations - the final chapter in the saga.

• Author: Silverman, Mark J.

1. Background

   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)" (referred to herein as 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 "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) authorizes Treasury and the Internal Revenue Service to issue regulations "necessary to carry out the purposes" of the legislation. (6)

   Section 355(e) was enacted in response to several high profile leveraged Morris Trust transactions occurring during 1996 and 1997 that more closely resembled sales, including Telecommunication, Inc.'s acquisition of Viacom's cable business, Raytheon's acquisition of General Motors' military electronics business, and Knight Ridder's acquisition of Disney's newspaper business. These transactions generally involved borrowing a large sum of cash and separating the proceeds of the debt from the obligation to repay the debt so that the corporation to be acquired retained the liability. Immediately after the distribution of Controlled, either Distributing or Controlled (holding the liability) would effectively be acquired. Significantly, these transactions involved prearranged acquisitions, the terms of which had been agreed upon between Distributing and/or Controlled and the acquirer before the distribution. The legislative history similarly points to the following "abuse" at which section 355(e) was aimed:

   The Committee believes that section 355 was intended to permit the tax-free division of existing business arrangements among existing shareholders. In cases in which it is intended that new shareholders will acquire ownership of a business in connection with a spin off, the transaction more closely resembles a corporate level disposition of the portion of the business that is acquired. (7) The term "plan" as used in section 355(e) should be interpreted in light of this purpose.

   The Treasury and IRS have been struggling to provide guidance on how to establish that a distribution and acquisition are not part of a plan. On April 19, 2005, after four previous attempts to issue guidance in this area, final plan regulations were issued. These regulations represent the final chapter in what had been an ongoing saga. Over the past six years, the Treasury and IRS have considered numerous comments from practitioners and have modified the regulations as appropriate. As a result, the plan regulations have evolved from an extremely rigid set of rules that defined plan broadly to include the intent of either party without regard to whether there had been any bilateral discussions or negotiations to a very administrable set of rules that reflect both the purpose of section 355(e) and business realities.

   Following a summary of the first four sets of regulations, this article analyzes the changes made by the final set of regulations.

2. Evolution of Plan Regulations

   On August 19, 1999, the Treasury and IRS issued proposed regulations under section 355(e) that provided guidance as to what constitutes a plan (the "1999 proposed regulations"). (8) The 1999 proposed regulations created a complicated series of elements that the distributing corporation had to establish to rebut the two-year presumption. The particular rebuttal that applied depended upon when the acquisition occurred relative to the distribution. Not only were the rebuttals the exclusive means of overcoming the two-year presumption, but the taxpayer also had to establish that it satisfied the rebuttals by a high burden of proof--clear and convincing evidence. As a result, the 1999 proposed regulations expanded the scope of an already overbroad statute. (9)

   On December 29, 2000, the Treasury and IRS withdrew the 1999 proposed regulations, (10) and issued new proposed regulations in their place (the "2000 proposed regulations"). (11) The 2000 proposed regulations adopted a facts-and-circumstances approach, which is consistent with the statute. (12) The 2000 proposed regulations contained six safe harbors that, when applicable, obviated a facts-and-circumstances analysis. (13) If the safe harbors were not satisfied, the 2000 proposed regulations contained a list of nonexclusive factors to consider in determining whether or not there is a plan. (14) Finally, the 2000 proposed regulations deleted references to a clear and convincing standard of proof. (15)

   On August 2, 2001, the Treasury and IRS issued temporary regulations under section 355(e) (the "2001 temporary regulations"). (16) The 2001 temporary regulations were identical to the 2000 proposed regulations, except that the 2001 temporary regulations reserved section 1.355-7(e)(6) (suspending the running of any time period prescribed in the regulations during which there is a substantial diminution of risk of loss under the principles of section 355(d)(6)(B)) and reserved on Example 7 (concluding that multiple acquisitions of target companies using Distributing stock were part of a plan, regardless of whether targets were identified at the time of the spinoff, where the purpose for the spin-off was to make such acquisitions). The 2001 temporary regulations were issued in response to numerous comments that immediate guidance was needed. (17) Nevertheless, the preamble to the 2001 temporary regulations states, "The IRS and Treasury will continue to devote significant resources to analyzing the comments and, in the near future, expect to issue additional guidance regarding the interpretation of the phrase 'plan (or series of related transactions)." (18)

   On April 23, 2002, Treasury and the Service issued revised temporary regulations to amend the 2001 temporary regulations (the "2002 temporary regulations"). (19) Although the 2002 temporary regulations retained the overall facts-and-circumstances approach of the 2000 proposed regulations and 2001 temporary regulations, they further tightened up the definition of plan by focusing on whether there were bilateral discussions between the acquirer and Distributing or Controlled. In so doing, the 2002 temporary regulations more clearly carried out the purposes of section 355(e), reflected practical business considerations, and provided a great deal more certainty to taxpayers and the government. (20)

   Finally, on April 19, 2005, the Treasury and IRS issued final regulations, adopting the 2002 temporary regulations with certain amendments (hereinafter referred to as the "final plan regulations"). (21) The final plan regulations are effective for distributions occurring after April 19, 2005. The 2002 temporary regulations continue to apply to distributions after April 26, 2002, and before the effective date of the final regulations; however, taxpayers may apply the final regulations in whole, but not in part, to such distributions. (22)

3. Discussion of Final Section 355(e) Plan Regulations

   1. Summary of Final Plan Regulations and Significant Changes Made to the 2002 Temporary Regulations

      In general, whether a distribution and acquisition are part of a plan is determined based on all the facts and circumstances. (23) The regulations set forth a number of nonexclusive factors that tend to show the presence or absence of a plan. (24) The weight to be given each of the facts and circumstances depends on the particular case. (25) The regulations also provide several safe harbors that, if satisfied, preclude a finding of plan without the necessity of weighing the facts and circumstances. (26) There are also certain operating rules that apply for purposes of the entire regulation. (27)

      The most significant change made by the 2002 temporary regulations, which is retained by the final plan regulations, was the addition of a "super safe harbor" for post-distribution acquisitions not involving a public offering. The super safe harbor provides that a post-distribution acquisition can be part of a plan only if there was an agreement, understanding, arrangement, or substantial negotiations (28) regarding the acquisition or a similar acquisition (29) at some time during the two-year period ending on the date of the distribution. (30) This rule is referred to as the super safe harbor, because if its requirements are satisfied, there is no need to look at the other safe harbors or perform a facts-and-circumstances analysis. The importance of the super safe harbor is that it generally requires bilateral negotiations on significant economic terms, which provides more certainty to taxpayers and the government by eliminating ongoing strategic planning, including preliminary discussions or purely internal discussions, from the definition of plan.

      The problem with the 2002 temporary regulations was that the rules governing pre-distribution acquisitions and public offerings were much less clear. This was remedied in large part in the final regulations. With respect to pre-distribution acquisitions, the final plan regulations modify and expand the one safe harbor that applies to pre-distribution acquisitions and adopt a new safe harbor for acquisitions before pro rata distributions. With respect to public offerings, which did not have the benefit of any safe harbor in the 2002 temporary regulations, the final plan regulations adopt a safe harbor to govern pre-distribution public offerings. The final plan regulations also clarify the definition of public offering and provide guidance on when an...