Significant recent developments.

• Author: Bakke, Don W.
• Position: Most significant tax legislation

EXECUTIVE SUMMARY

The TIPRA made significant changes to the Sec. 355 spinoff rules.

* Several regulations were issued and amended on a range of issues.

* The IRS obtained a victory in Coltec Industries, Inc., applying the economic-substance doctrine to disallow a large capital loss.

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This article summarizes selected income tax developments during the past year affecting corporations, including those that file consolidated returns. Since the last update (1) (approximately one year ago), the most significant tax legislation enacted was the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), signed into law on May 17, 2006. For corporate taxpayers, the most significant TIPRA changes are the amendments to the Sec. 355 spinoff rules. Those changes--as well as other selected administrative and case law developments--discussed below.

TIPRA Changes to Sec. 355

Under Sec 355, if a corporation (the distributing corporation) distributes to a shareholder with respect to its stock, or to a security holder in exchange for its securities, solely stock or securities of a corporation (the controlled corporation) that it controls immediately before the distribution, no gain or loss is recognized to such shareholder or security holder. The distribution may also qualify for nonrecognition at the corporate level, under Sec. 355(c) or 361(c). This statutory provision--popularly thought of as enabling tax-flee spinoffs--contains a number of requirements that must be satisfied, and the TIPRA enlarged the list.

Under the TIPRA, new Sec. 355(b)(3) amends the active-trade-or-business requirement, while new Sec. 355(g) provides an exclusion from Sec. 355 for distributions involving qualified investment companies.

Modification of Active-Business Definition

To qualify for nonrecognition treatment, both the distributing corporation and the controlled corporation must, immediately after the distribution, be engaged in the active conduct of a trade or business, among other requirements. Under Sec. 355(b)(2)(A), a corporation is treated as engaged in the active conduct of a trade or business only if it is directly engaged in the active conduct of a trade or business, or "substantially all" (2) of its assets consist of stock and securities of a corporation controlled by it that is so engaged.

Following the TIPRA amendment, for distributions made after May 17, 2006 and before 2011, all members of a corporation's separate affiliated group are treated as one corporation for purposes of the active-conduct test. For this purpose, a corporation's separate affiliated group is the affiliated group, determined under Sec. 1504(a) as if such corporation (e.g., the distributing or controlled corporation) were the common parent and Sec. 1504(b) did not apply. Transition rules are provided for certain corporations seeking to rely on the old standard of direct satisfaction or meeting the holding--company requirement. (3)

New Sec. 355(b)(3) is intended to liberalize the active-wade-or-business requirement. By permitting a corporation to rely on the business of a lower-tier affiliate for purposes of the requirement, Sec. 355(b)(3) effectively introduces a lookthrough rule. Thus, for distributions occurring before 2011, corporations not directly engaged in business operations will not be subject to the "substantially all" requirement. Rather, the active-business requirement will be satisfied if at least one corporate affiliate (whether domestic or foreign) is engaged in a five-year active wade or business.

Exclusion

The TIPRA also added new Sec. 355(g), providing that Sec. 355 (and the portion of Sec. 356 that relates to Sec. 355) does not apply to any distribution that is a part of a transaction, if (1) either the distributing or the controlled corporation is a disqualified investment corporation immediately after the transaction and (2) any person that did not hold a 50%-or-greater interest (by vote or value, determined using the Sec. 318 attribution rules) immediately before the transaction, holds such an interest immediately after the transaction in a disqualified investment corporation.

A disqualified investment corporation is any distributing or controlled corporation if the aggregate fair market value (FMV) of the corporation's investment assets is: (1) 2/3 or more of the FMV of all assets of the corporation, for distributions after the end of the one-year period beginning on May 17, 2006; and (2) for distributions during such one-year period, 3/4 or more of the FMV.

Investment assets include (1) cash; (2) stock or securities; (3) interest in a partnership; (4) any debt instrument or other evidence of debt; (5) any option, forward or futures contract, notional principal contract or derivative; (6) foreign currency; or (7) any similar asset. Exceptions exist for assets used in the active conduct of certain lending or finance, banking and insurance businesses. An exception also exists for securities marked-to-market.

Investment assets do not include stock, securities, debt instruments, options, forward or futures contracts, notional principal contracts or derivatives issued by a 20%-controlled entity. This is a corporation whose stock is at least 20% owned (by vote and value), directly or indirectly, by the distributing or controlled corporation. Under a lookthrough rule, a distributing or controlled corporation is treated as owning its ratable share of the assets of any 20%-controlled entity.

In addition, partnership interests and debt instruments issued by a partnership are not investment assets if one or more of the partnership's wades or businesses are taken into account by the distributing or controlled corporation for purposes of the Sec. 355(b) active-wade-or-business requirement. Under a lookthrough rule, the distributing or controlled corporation is treated as owning its ratable share of the partnership's assets.

The amendments are generally effective after May 17, 2006, but a transition rule excludes distributions pursuant to a transaction (1) made under an agreement binding on that date, and at all times thereafter; (2) described in a ruling request submitted...