On July 14, 2016, the Internal Revenue Service (the “IRS”) and the Department of Treasury issued proposed regulations (the “Proposed Regulations”) under section 355 of the Internal Revenue Code of 1986, as amended (the “Code”), that provide new rules on the so-called device test (the “Proposed Device Rules”) and the active trade or business (“ATB”) requirement (the “Proposed ATB Rules”), both relating to the ability of a spin-off to qualify as a tax-free transaction for the distributing corporation and its shareholders. These Proposed Regulations are the product of concerns that the IRS raised last year when it announced that private letter rulings no longer would be issued on section 355 distributions involving small ATBs and substantial non-business assets. (Coverage on the no-rule announcement can be found here).
Among other things, the Proposed Device Rules add a per se rule under which a spin-off is deemed to be a device in certain circumstances where the spin-off involves a disproportionate amount of non-business assets being held by either the distributing or spun-off corporation. Correspondingly, the Proposed ATB Rules set a de minimis level of 5% of the fair market value of a corporation’s gross assets under which a business would not qualify as an ATB for purposes of section 355. Taxpayers currently considering a spin-off transaction may take some comfort that these rules are prospective only upon promulgation of final Treasury regulations and provide fairly generous grandfather rules. On the other hand, the IRS notes that it is still considering additional regulations under section 337 of the Code to address broader concerns related to the General Utilities repeal, and the IRS has stated in the preamble to the Proposed Regulations that it believes the rules in the Proposed Regulations are consistent with Congressional intent and existing case law.
Section 355 of the Code allows a distributing corporation (“Distributing”) to distribute the stock of a controlled corporation (“Controlled”) to Distributing shareholders in a tax-free transaction. Two of the requirements for a distribution to qualify for such treatment under Code section 355 are:
- The distribution cannot be used principally as a device for the distribution of the earnings and profits of Distributing or Controlled; that is, as the non-taxable equivalent of a cash dividend (the “Device Test”); and
- Immediately after the distribution, Distributing and Controlled must each be engaged in an ATB, and the ATB must have been actively conducted throughout the five-year period ending on the date of the distribution and cannot have been acquired, directly or indirectly, within such five-year period in a taxable transaction (the “ATB Requirement”).
Long-standing Treasury regulations providing guidance on the Device Test set forth a number of factors that must be examined in determining whether a distribution is used principally as a device to distribute earnings and profits. Some factors are considered to be evidence of device and some are considered to be evidence of non-device. As relevant here, the factors include the nature and use of the assets of Distributing and Controlled, including whether the assets are used in an ATB, and whether there is a valid corporate business purpose for the distribution.
Historically, there has been no minimum size requirement for an ATB set forth in the Code or Treasury regulations. Nevertheless, for many years, the IRS had ruling procedures under which the ATB typically was required to represent at least 5% of the total assets of each of Distributing and Controlled in order to obtain a favorable private letter ruling on a spin-off. Such ruling procedure was abandoned in 2003, and while tax advisors often looked upon the former 5% threshold as a form of safe harbor in advising clients thereafter, the IRS was willing to consider and issue private letter rulings where the ATB was significantly smaller in size.
II. The Proposed Device Rules
In the preamble to the Proposed Regulations, the IRS notes that the potential for a device exists if Distributing or Controlled own a large percentage of assets not used in business operations compared to its total assets or if Distributing’s and Controlled’s percentages of non-business assets differ to a substantial extent. To address these concerns, the Proposed Device Rules would modify the factors of the Device Test, as well as add a per-se device rule (the “Per Se Device Rule”).
A. The Device Test Factors
The Proposed Regulations would amend existing provisions on two of the factors that are examined in determining whether a spin-off is being used as a device. First, in the “nature and use” factor of current Treasury regulations, ownership of substantial investment assets is evidence of a device. The Proposed Regulations would re-focus this factor on a comparison of business assets versus non-business assets, rather than the seemingly narrower analysis of investment assets (i.e., as some non-business assets, such as land, may not be viewed as investment assets). To that end, the Proposed Regulations would add the following definitions:
- “Business” is the active conduct of a trade or business without regard to the five-year period and certain other requirements.
- “Business Assets” are gross assets used in one or more Businesses, including a reasonable amount of cash used for working capital, assets required (by binding commitment or legal requirement) to be held for exigencies or regulatory purposes related to the Business or to secure or otherwise provide for a financial obligation reasonably expected to arise from a Business, and assets held to implement a binding commitment to expend funds to expand or improve a Business.
- “Non-Business Assets” are all other assets, and generally includes stock and partnership interests.
The larger the percentage of the fair market value of Distributing’s or Controlled’s total assets that is comprised of Non-Business Assets, the stronger the evidence of device. If the percentage of the fair market value of Non-Business Assets of each of Distributing and Controlled is less than 20%, then the ownership of Non-Business Assets ordinarily is not evidence of device. In contrast, a difference between Distributing’s and Controlled’s Non-Business Asset percentages is evidence of a device, and the larger the difference, the stronger the evidence of device. Such a difference, however, ordinarily will not be evidence of device if the difference is less than 10 percentage points, or alternatively if the difference is due to a need to equalize the value of stock and securities of Controlled distributed with the stock and securities of Distributing exchanged in a non-pro rata split-off. The operating rules discussed below apply in determining the fair market value of Non-Business Assets and Business Assets.
In addition to modifying the “nature and use” factor, the Proposed Regulations also would modify the “corporate business purpose” factor. Current Treasury regulations recognize that a strong business purpose for a spin-off can be evidence of non-device that mitigates against unfavorable device factors, such as the presence of Non-Business Assets. In the preamble to the Proposed Regulations, however, the IRS indicated that taxpayers perhaps were relying too heavily on the significance of business purpose when substantial Non-Business Assets are present in a spin-off. Thus, under the Proposed Regulations, if the corporate business purpose for a spin-off is related to separating Non-Business Assets from Business Assets, such purpose will not be considered evidence of a non-device unless the business purpose involves an exigency that requires an investment or other use of the Non-Business Assets in a Business of either Distributing or Controlled.
B. The Per Se Device Rule
Under the Per Se Device Rule, a spin-off can be considered to be a device to distribute earnings and profits per se where substantial Non-Business Assets are involved, with the result that the spin-off will fail to qualify for tax-free treatment unless the transaction is ordinarily not considered to be a device. The Per Se Device Rule is met if (1) Distributing or Controlled or both have Non-Business Assets with a fair market value that constitutes two-thirds or more of the fair market value of their total assets (the “First Per Se Prong”) and (2) the percentage of the fair market value of the Non-Business Assets of Distributing and Controlled vary substantially from each other (the “Second Per Se Prong”). The First Per Se Prong is straightforward (and generally adopts the threshold under the statutory prohibition against “cash-rich split-offs" under Section 355(g) of the Code), whereas the Second Per Se Prong requires one of three scenarios to occur.
1. Operating Rules
To determine the percentage of Non-Business Assets, the operating rules measure the fair market value of a corporation’s assets under generally accepted tax principles, reduced (but not below adjusted tax basis) by certain liabilities that would give rise to a deduction. Fair market value is determined as of one of the following dates: (1) immediately before the distribution; (2) any date within the 60-day period before the distribution; (3) on the date of an agreement with respect to the distribution that was binding on Distributing; and (4) on the date of a public announcement or filing with the Securities and Exchange Commission (the “SEC”) with respect to the distribution. Distributing and Controlled must be consistent in the valuation date and in the manner of valuing assets.
These operating rules also adopt in part the separate affiliated group (“SAG”) concept from the active trade or business requirement in determining what assets constitute Business Assets and what assets constitute Non-Business Assets. Members of the SAG (generally determined by 80% control) with respect to which Controlled is the common parent would be treated as a single corporation, as would the members of the SAG with Distributing as the common parent (excluding Controlled and its SAG). Therefore, inter-company obligations and inter-company stock ownership would be disregarded in calculating the Non-Business Asset percentages.
Partnership interests generally are treated as Non-Business Assets under the Proposed Regulations. If, however, the corporation is considered to be engaged in the active conduct of a trade or business conducted by the partnership under existing IRS guidance, by reason of the size of its ownership interest or participation or both, then the fair market value of the corporation’s partnership interest is allocated between Business Assets and Non-Business Assets in the same proportion as the fair market value of the partnership’s Business Assets and Non-Business Assets. Similarly, stock owned by Distributing and Controlled, other than stock in a member of its SAG, generally is treated as a Non-Business Asset, but if a corporation would be part of Distributing’s or Controlled’s SAG if the control test was 50% (rather than 80%), then the fair market value of the stock in such corporation will be allocated between Business Assets and Non-Business Assets in the same manner as a partnership interest.
The Proposed Regulations also provide for some exceptions and relief from the Per Se Device Rule. Specifically, the Per Se Device Rule would not apply to a distribution of Controlled to a corporation or corporations that, in the absence of the application of Code section 355, would be entitled to a dividends received deduction. Furthermore, the Per Se Device Rule would not apply to the list of transactions ordinarily not considered as a device under current Treasury regulations, which include distributions in which Distributing and Controlled have no accumulated or current earnings and profits and certain distributions that would constitute redemptions qualifying for capital gain (rather than dividend) treatment but for qualification instead under Code section 355.
2. First Per Se Prong & Second Per Se Prong
As mentioned, the First Per Se Prong is a simple calculation as to whether the Non-Business Assets of Distributing, Controlled or both equal or exceed 66 2/3% of their total assets. The Second Per Se Prong compares the percentage of Non-Business Assets of Distributing and Controlled and establishes three bands in which differing percentages can result in per se violation of the device test. According to the preamble of the Proposed Regulations, these bands are a nod to the inherent difficulties of valuing assets and determining which assets are Business Assets, and the bands are an alternative to requiring taxpayers to make exact determinations.
In the first band, if Distributing’s or Controlled’s percentage of Non-Business Assets is 66 2/3% or more but less than 80%, then the distribution meets the Second Per Se Prong if the other corporation’s percentage of Non-Business Assets is less than 30%. In the second band, if Distributing’s or Controlled’s percentage of Non-Business Assets is 80% or more but less than 90%, then the distribution meets the Second Per Se Prong if the other corporation’s percentage of Non-Business Assets is less than 40%. Finally, in the third band, if Distributing’s or Controlled’s percentage of Non-Business Assets is 90% of more, than the distribution meets the Second Per Se Prong if the other corporation’s percentage of Non-Business Assets is less than 50%.
III. ATB Requirement
The Proposed ATB Rules address the IRS’s concerns raised last year that a distribution involving a relatively small ATB should not qualify for tax-free treatment under Code section 355. Therefore, the Proposed ATB Rules set a bright line rule that the percentage of the fair market value of the ATB assets of each of Distributing and Controlled must constitute 5% or more of the fair market value of their respective gross assets.
The operating rules for making these determinations are similar to those described above in the discussion of the Proposed Device Rules. The relevant comparison, however, is ATB assets (meaning gross assets used in an ATB that meets the five-year period of the ATB Requirement) to the total assets of each of Distributing and Controlled. Like the Business Asset definition, ATB assets can include cash needed for working capital, assets required (by binding commitment or legal requirement) to be held for exigencies or regulatory purposes related to the ATB or to secure or otherwise provide for a financial obligation reasonably expected to arise from an ATB, and assets held to implement a binding commitment to expend funds to expand or improve an ATB. Similarly, the SAG rules and the rules with respect to partnership interests also apply to the Proposed ATB Rules with respect to determining the percentage of ATB assets. Finally, the Proposed ATB Rules include a special rule in cases where Distributing or Controlled is considered to be engaged in an ATB conducted by a partnership, whereby the fair market value of the corporation's interest in the partnership will be allocated between ATB assets and Non-ATB assets in the same proportion as the proportion of the fair market values of the ATB assets and Non-ATB assets of the partnership.
IV. Anti-Abuse Rules
Both the Proposed Device Rules and the Proposed ATB Rules contain anti-abuse rules. Under these rules, any transaction or series of transactions undertaken with a principal purpose of affecting the relevant percentage under the Proposed Device Rules or the Proposed ATB Rules would not be given effect. Such transactions include changes in the form of asset ownership, the issuance, assumption or repayment of indebtedness or other obligations, or the issuance or redemption of stock. The anti-abuse rule will not apply to a non-transitory acquisition or disposition of assets, other than from or to a person whose stock would be attributed to Distributing or Controlled under applicable Code provisions providing for attribution of ownership (other than by option ownership), or to a non-transitory transfer of assets between Distributing and Controlled.
V. Effective Date
The Proposed Regulations are prospective, meaning that they will not be effective until published as final Treasury regulations In addition, the Proposed Regulations contain fairly generous grandfather rules. Specifically, the Proposed Regulations will not apply to any distribution that is:
- made pursuant to an agreement, resolution, or other corporate action that is binding on or before the date on which Proposed Regulations are finalized;
- described in a public announcement or filing with the SEC on or before the date on which the Proposed Regulations are finalized; or
- described in a ruling request submitted to the IRS on or before July 15, 2016.
VI. Comment Period.
Taxpayers wishing to comment on the Proposed Regulations have until October 13, 2016, to submit such comments.
This update is intended only to provide a general summary of certain tax provisions and not to constitute tax advice for any particular situation or taxpayer. If you have any questions about any of these tax provisions or their applicability to your particular circumstances, please contact any of the authors of this update.