New proposed section 355(e) regulations: a vast improvement.

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

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 (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) further authorizes the Department of Treasury and the Internal Revenue Service to issue regulations "necessary to carry out the purposes" of the legislation.

On August 24, 1999, Treasury and the IRS issued proposed regulations under section 355(e) that provided guidance on what constitutes a plan (the 1999 proposed regulations).(6) 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 on 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.(7)

On January 2, 2001, Treasury and the IRS withdrew the 1999 proposed regulations,(8) and issued new proposed regulations in their place (the 2001 proposed regulations).(9) The 2001 proposed regulations adopt a facts-and-circumstances approach, which is consistent with the statute.(10) The 2001 proposed regulations contain six safe harbors that, when applicable, obviate a facts-and-circumstances analysis.(11) If the safe harbors are not satisfied, the 2001 proposed regulations contain a list of nonexclusive factors to consider in determining whether or not there is a plan.(12) Finally, the 2001 proposed regulations delete references to a clear and convincing standard of proof.

The 2001 proposed regulations represent a vast improvement over the 1999 proposed regulations. There are, however, still areas that need clarification. This article summarizes the 2001 proposed regulations and discusses a few areas that need clarification. An in-depth analysis of the 2001 proposed regulations is beyond the scope of this article.

Summary of 2001 Proposed Section 355(e) Regulations

1. Safe Harbors

   The 2001 proposed regulations contain six safe harbors.(13) If an acquisition and distribution fall within one of the safe harbors, then they are not treated as part of a plan, and the distributing corporation need not apply the facts-and-circumstances test.

   1. Business Purpose Safe Harbors

      1. Safe Harbor I -- Non-Acquisition Business Purpose

         (i) In general.

         Safe Harbor I provides that a distribution and an acquisition occurring after the distribution are not part of a plan if: (i) the acquisition occurred more than six months after the distribution (and there was no agreement, understanding, arrangement, or substantial negotiations(13A) before a date that is six months after the distribution), and (ii) the distribution was motivated in whole or substantial part by a business purpose other than a business purpose to facilitate an acquisition.(14)

         Safe Harbor I refers to a business purpose other than to facilitate an acquisition. Thus, the safe harbor appears to be inapplicable in the following situation: D distributes C to facilitate an acquisition of D by X. Negotiations between D and X subsequently break down. One year after the spin-off, Y acquires C. Because there was a business purpose to facilitate an acquisition (i.e., the acquisition of D by X), Safe Harbor I does not apply.(15) Similarly, an intent to facilitate any acquisition, however small, precludes the use of Safe Harbor I. For example, a spin-off to enable key employees to purchase five percent of the stock of the controlled corporation would not fall within Safe Harbor I.

         Safe Harbor I precludes an agreement, understanding, arrangement, or substantial negotiations concerning the acquisition before a date that is six months after the distribution.(16) Thus, if substantial negotiations occurred several years before the distribution, Safe Harbor I would be unavailable. As a practical matter, however, this rule is limited by the reference to the acquisition -- the negotiations must occur with respect to the acquisition that actually occurred.(17)

         (ii) Multiple business purposes.

         Where there are two business purposes for a distribution one acquisition and one non-acquisition -- the distributing corporation must show that the non-acquisition business purpose was substantial. The preamble to the 2001 proposed regulations states that analyzing whether a non-acquisition business purpose is substantial is similar to analyzing whether there is a corporate business purpose for a distribution in light of the potential avoidance of federal taxes; the non-acquisition business purpose thus must be real and substantial even in light of the acquisition business purpose.(18) In discussing the 1999 proposed regulations, representatives from Treasury and the IRS had informally indicated that this test was intended to be a but-for analysis: Would the distributing corporation have undertaken the spin-off without the acquisition business purpose?(19) Presumably, since the language of the rule has not changed, the but-for analysis continues to apply with respect to the 2001 proposed regulations.

         The 2001 proposed regulations contain certain operating rules that deem or create an acquisition business purpose (specifically, reasonable certainty, internal discussions, and hostile takeovers), all of which are discussed below. The preamble states that these operating rules apply in determining whether the non-acquisition business purpose is substantial.(20) Thus, if the stated business purpose for a spin-off is cost savings, but an acquisition business purpose is deemed under the operating rules, the distributing corporation must do the but-for analysis. This appears to be true even if the distributing corporation obtained a private letter ruling relying solely on the cost savings business purpose.(21)

         (a) Operating rule 1 -- reasonable certainty The first business purpose operating rule is that reasonable certainty that an acquisition will occur is evidence of an acquisition business purpose. Thus, in the case of a post-spin acquisition, if it is reasonably certain that within six months after the distribution an acquisition would occur, an agreement, understanding, or arrangement would exist, or substantial negotiations would occur regarding an acquisition, then there is evidence of an acquisition business purpose.(22) In the case of a pre-spin acquisition, if it is reasonably certain that within six months after the acquisition a distribution would occur (or an agreement, understanding, arrangement, or substantial negotiations would occur), then there is evidence of an acquisition business purpose. In addition, if the acquisition occurs after the public announcement of the distribution, the public announcement is itself evidence of an acquisition business purpose.(23)

         Regarding the reasonable certainty rule, the preamble states:

         The rule regarding reasonable certainty is necessary to implement section 355(e) because where a taxpayer was reasonably certain that an acquisition would occur, that acquisition was likely to be taken into account in determining whether to effect a distribution. While the IRS and the Department of Treasury believe that reasonable certainty (even where no discussions with potential acquirers have occurred) is relevant in determining whether a plan exists, it should be noted that this concept is significantly modified from the 1999 proposed regulations. This operating rule will apply only in cases where there was a strong possibility that, within 6 months after the distribution, an acquisition would occur....(24) Thankfully, the reasonable certainty test appears much narrower and much less complicated than the reasonable anticipation test of the 1999 proposed regulations.(25) In addition, the reasonable certainty test plays a diminished role in the 2001 proposed regulations; it provides evidence of a factor, rather than being an exclusive test. It is not clear, however, who bears the burden of proving reasonable certainty. Must the IRS first assert that an acquisition that occurred was reasonably certain, or must the taxpayer in all cases produce evidence that the acquisition was not reasonably certain?

         The difference between the reasonable anticipation test and the reasonable certainty test is illustrated most clearly by comparing the hot market examples of the 1999 and 2001 proposed regulations. Under the 1999 proposed regulations, if a distributing corporation spun off a controlled corporation in a hot market, so that it was reasonable to anticipate that the controlled corporation would be acquired, section 355(e) applied.(26) Under the 2001 proposed regulations, however, reasonable certainty that the controlled corporation would be acquired is evidence of an acquisition business purpose. If an actual acquisition does not occur for six months, the distributing corporation may avoid section 355(e). If the acquisition does occur within six months, the distributing corporation may still avoid section 355(e) if it can satisfy the facts-and-circumstances analysis.(27)

         Regarding the...