The fourth time's a charm: new temporary section 355(e) regulations provide helpful guidance to taxpayers.

• Author: Silverman, Mark J.
• Position: Anti-Morris Trust provision - Internal Revenue Code

1. Background

   In 1997, Congress enacted the Taxpayer Relief Act of 1997 (TRA 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 referred to 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)

   The language of section 355(e) is deceptively broad and offers no real guidance to taxpayers. There is an obvious disconnect between the apparent breadth of section 355(e) and the provision's legislative history, which clearly indicates that the statute was intended to prevent tax-free disguised sales. Section 355(e) does, however, authorize Treasury and the Internal Revenue Service to issue regulations "necessary to carry out the purposes" of the legislation. Treasury and the IRS have been struggling to reconcile the purposes of the statute with its overbroad language, and their latest attempt seems to have achieved this goal. On April 23, 2002, Treasury and the IRS issued their fourth set of regulations to define "plan." (6) Following a summary of the first three attempts to define plan, this article discusses the purpose of section 355(e) and then analyzes the new temporary regulations.

2. Evolution of Plan Regulations

   On August 19, 1999, Treasury and the IRS issued proposed regulations under section 355(e) (7) that provided guidance on what constitutes a plan (the "1999 proposed regulations"). 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 broad statute. (8)

   On December 29, 2000, Treasury and the IRS withdrew the 1999 proposed regulations, (9) and issued new proposed regulations in their place (the "2000 proposed regulations"). (10) The 2000 proposed regulations adopted a facts-and-circumstances approach, which is consistent with the statute. (11) The 2000 proposed regulations contained six safe harbors that, when applicable, obviated a facts-and-circumstances analysis. (12) 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. (13) Finally, the 2000 proposed regulations deleted references to a clear and convincing standard of proof. (14)

   On August 2, 2001, Treasury and the IRS issued temporary regulations under section 355(e) (the "2001 temporary regulations"). (15) 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 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 spin-off, where 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. (16) 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).'" (17)

   Finally, on April 23, 2002, Treasury and the IRS issued revised temporary regulations to amend the 2001 temporary regulations (the revised temporary regulations are hereinafter referred to as "the temporary regulations"). Although the temporary regulations retain the overall facts-and-circumstances approach of the 2000 proposed regulations and 2001 temporary regulations, they tighten the definition of plan by focusing on whether there were bilateral discussions between the acquirer and Distributing or Controlled. In so doing, the temporary regulations carry out the purposes of section 355(e), reflect practical business considerations, and provide a great deal more certainty to taxpayers and the government.

3. History and Purpose of Section 355(e) as it Relates to Plan

   A senior staff member of the Joint Committee on Taxation stated during a meeting of the D.C. Bar Tax Section's Corporation Tax Committee held shortly after the enactment of section 355(e) that the legislative history intentionally omitted an explanation of what constitutes a plan. (18) The staff member further stated that whether a plan exists will "always be a matter of facts and circumstances." (19) Nonetheless, the history of section 355(e) does provide some insight on what is meant by a plan.

   In 1996-1997, several companies undertook high-profile leveraged Morris Trust transactions 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. These transactions drew the attention of lawmakers, who quickly set out to shut them down.

   On February 6, 1997, the Clinton Administration, as part of its 1998 budget proposal, proposed anti-Morris Trust legislation to be included in section 355(d). (20) The Administration's proposal would have specifically excluded acquisitions of stock that were "unrelated" to the distribution. For this purpose, a transaction would be treated as unrelated if it were not "pursuant to a common plan or arrangement that includes the distribution." (21) Thus, public trading of the stock in either Distributing or Controlled would be disregarded, even if the trading occurred in contemplation of the distribution. (22) Similarly, a hostile acquisition of Distributing or Controlled after the distribution would be disregarded. A friendly acquisition, however, would generally be considered related to the distribution if it were "pursuant to an arrangement negotiated (in whole or in part) prior to the distribution," even if it were subject to certain conditions (e.g., shareholder approval) at the time of the distribution. (23)

   The Joint Committee on Taxation, in its analysis of the Administration's proposal, suggested that the reason for the proposal was the "considerable publicity" surrounding transactions involving significant shifts in debt and creation of stock classes having voting rights disproportionate to the value of the stock, specifically citing the Viacom/TCI and GM/Hughes/Raytheon transactions. (24) The Joint Committee also stated:

   In those cases in which it is intended that the ownership of a business will change in connection with a spin-off, it is argued that the tax-free provisions of section 355 should not apply at the corporate level, but rather the distributing corporation should be viewed as having disposed of a corporation and thus should not be exempt from tax at the corporate level. (25) Acting Assistant Secretary for Tax Policy Donald C. Lubick reiterated the Administration's concern over disguised sales while testifying before Congress:

   If a corporation has two businesses and wants to dispose of one in exchange for shares of another corporation, that cannot be done directly under the reorganization provisions. Indeed, arrangements have been made for the use of Section 355, which allows divisive split-ups of corporate holdings to the shareholders of the corporation. One of those is carried out, and then the shares are immediately disposed of to a third party corporation. In that case, the corporation avoids gain at the corporate level on the disposition of its assets. (26) On April 17, 1997, Representative Bill Archer, Chairman of the House Ways and Means Committee, introduced legislation to restrict the use of section 355. (27) Senator William Roth, Chairman of the Senate Finance Committee, and Senator Daniel Moynihan, Ranking Minority Member of the Senate Finance Committee, introduced identical legislation on the same date (collectively the "Archer/Roth/Moynihan bill"). (28) Similar to the Administration's proposal, the Archer/Roth/Moynihan bill required recognition of corporate-level gain if either Distributing or Controlled was acquired. In their joint statement introducing the Archer/Roth/Moynihan bill, the legislators made it clear that the purpose for the bill was to shut down prearranged transactions similar to the highly publicized disguised sale transactions:

   Several recent news reports described corporate acquisition transactions in which one corporation distributes the stock of one (or more) of its...