PRACTISING LAW INSTITUTE
TAX STRATEGIES FOR CORPORATE ACQUISITIONS,
DISPOSITIONS, SPIN-OFFS, JOINT VENTURES,
FINANCINGS, REORGANIZATIONS AND
RESTRUCTURINGS 2012
“Spin-Offs”: The Anti-Morris Trust and
Intragroup Spin Provisions
By
Mark J. Silverman
Steptoe & Johnson LLP
Washington, D.C.
Copyright © 2012 Mark J. Silverman, All Rights Reserved
-iTABLE OF CONTENTS
Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations,
advice (if any) relating to federal taxes that is contained in this communication (including
attachments) is not intended or written to be used, and cannot be used, for the purpose of (1)
avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or
recommending to another party any plan or arrangement addressed herein.
Page
I.
II.
III.
IV.
INTRODUCTION ............................................................................................................ 1
DESCRIPTION OF THE STATUTE AND ITS HISTORY ............................................ 2
A.
Description of Statutory Language ....................................................................... 2
1.
Section 355(e) -- The Anti-Morris Trust Provision .................................. 3
2.
Section 355(f) -- Intragroup Distribution Provision ................................. 6
3.
“Control Immediately After” Provision .................................................... 7
B.
History of the Statute ............................................................................................ 8
1.
Administration’s Budget Proposal ............................................................ 8
2.
Archer/Roth/Moynihan Bill ...................................................................... 9
3.
House Bill ............................................................................................... 12
4.
Senate Bill ............................................................................................... 14
5.
Taxpayer Relief Act of 1997................................................................... 15
6.
Technical Corrections ............................................................................. 17
ISSUES AND ANALYSIS ............................................................................................. 18
A.
Purpose of Section 355(e) and (f) ....................................................................... 18
B.
Operation of Section 355(e) ................................................................................ 21
1.
Base Case ................................................................................................ 21
2.
Distributions That Are “Part of a Plan” .................................................. 22
3.
One or More Persons “Acquire Directly or Indirectly” Stock ................ 37
4.
The Distributing or “Any” Controlled Corporation ................................ 42
5.
Exceptions to Section 355(e) .................................................................. 44
6.
Successors and Predecessors................................................................... 51
7.
Regulatory Authority Under Section 355(e) ........................................... 59
C.
Operation of Section 355(f) ................................................................................ 60
1.
In General................................................................................................ 60
2.
Section 358(g) Regulations ..................................................................... 63
D.
Control and Step-Transaction Issues .................................................................. 72
1.
Control .................................................................................................... 72
2.
The Step-Transaction Doctrine ............................................................... 73
3.
The Step-Transaction Doctrine and Section 355(e) ................................ 78
RECOMMENDATIONS ................................................................................................ 81
“Spin-offs”
The Anti-Morris Trust and Intragroup Spin Provisions
Mark J. Silverman and Lisa M. Zarlenga, Steptoe & Johnson, LLP1
I.
INTRODUCTION
Since the repeal of the General Utilities doctrine in 1986,2 one of the only ways in
which corporations may distribute appreciated property to their shareholders without recognizing
corporate-level gain is through the use of spin-off type transactions under section 355 of the
Internal Revenue Code.3 Often, corporations undertake such spin-offs to dispose of unwanted
businesses in preparation for a tax-free acquisition by another corporation. For more than 30
years, these so-called “Morris Trust” transactions were blessed as tax free under section 355,4
provided the requirements of section 355 were met. Not anymore. The Taxpayer Relief Act of
1997 (the “Act”)5 added section 355(e) and (f), which severely limit these transactions.
1
Andrew J. Weinstein, former Of Counsel at Steptoe & Johnson LLP, co-authored this
article.
2
In General Utilities and Operating Co. v. Helvering, 296 U.S. 200 (1936), the Supreme
Court held that corporations could distribute appreciated property to their shareholders tax free.
The Tax Reform Act of 1986 repealed the General Utilities doctrine, adding section 311(b) to the
Internal Revenue Code. Section 311(b) imposes a corporate-level tax on the distribution of
appreciated property to shareholders, as if the corporation sold such property for its fair market
value.
3
Unless otherwise indicated, all section references are to the Internal Revenue Code of
1986, as amended.
4
Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966), acq. Rev.
Rul. 68-603, 1968-2 C.B. 148. See also Rev. Rul. 78-251, 1978-1 C.B. 89; Rev. Rul. 75-406,
1975-2 C.B. 125; Rev. Rul. 72-530, 1972-2 C.B. 212; Rev. Rul. 70-434, 1970-2 C.B. 83.
5
Pub. L. No. 105-34 (1997).
-2-
This article analyzes sections 355(e) and 355(f) and other related changes that
were made by the Act as well as regulatory guidance that has been issued to implement these
provisions. Part II describes the provisions and their history, Part III analyzes the language of
the statute in the context of several examples and in light of the legislative history, and Part IV
provides suggested recommendations to Congress and to Treasury regarding what issues require
additional guidance.
II.
DESCRIPTION OF THE STATUTE AND ITS HISTORY
Following is a brief description of the statutory language and the history of these
provisions. The statutory language raises many issues, which will be discussed in Part III.
A.
Description of Statutory Language
On August 5, 1997, President Clinton signed the Act. Section 1012 of the Act
amended section 355 to place additional restrictions on the acquisition and disposition of the
stock of the distributing or controlled corporations. Section 1012 of the Act contains four basic
provisions: (i) an anti-Morris Trust provision,6 which is contained in section 355(e); (ii) an
intragroup distribution provision, which is contained in section 355(f), (iii) a related provision
contained in section 358(g) authorizing the Department of the Treasury (the “Treasury”) to issue
basis adjustment regulations under section 358; and (iv) a modified control provision, which
amends sections 351(c) and 368(a)(2)(H).
6
Ironically, newly enacted section 355(e) would not apply to the facts of the Morris Trust
case, because the distributing corporation’s shareholders in Morris Trust retained a 50-percent or
greater interest in the distributing corporation following the acquisition.
-31.
Section 355(e) -- The Anti-Morris Trust Provision
Under section 355(e), the anti-Morris Trust provision, 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 that was in place at the time of the distribution.7 The
distributing corporation recognizes gain equal to the “built-in” gain in the controlled corporation
stock held by the distributing corporation.8 However, no adjustment to the basis of the stock or
assets of either corporation is allowed by reason of the gain recognition.9 The statute also creates
a rebuttable presumption that any acquisition occurring two years before or after a section 355
distribution is part of such a plan.10 For purposes of determining whether one or more persons
has acquired a 50-percent interest, the section 318(a)(2) attribution rules generally apply (without
regard to the 50-percent threshold of section 318(a)(2)(C)), and the aggregation rules of section
355(d)(7)(A) apply so that all related persons are treated as one person.11 Moreover, except as
7
Code § 355(e)(1), (2)(A). The transaction otherwise qualifies as a section 355
transaction. Accordingly, the recipient shareholders do not recognize gain. All discussions
relating to the application of section 355(e) in this article assume that the distribution or
distributions of the controlled corporation stock qualify under section 355(a), unless otherwise
noted.
8
Section 355(e)(1) provides that stock in the controlled corporation shall not be treated as
qualified property under section 355(c)(2). The amount of gain is measured by the stock of the
controlled corporation, regardless of whether the distributing or controlled corporation is
acquired. Any gain recognized is treated as long-term capital gain. H.R. Conf. Rep. No. 105220, at 528, 531 (1997) (hereinafter “Conference Report”).
9
Conference Report, at 531-32.
10
11
Code § 355(e)(2)(B).
Code § 355(e)(4)(C). The relevance of the aggregation rules is discussed infra
note 103.
-4-
provided in regulations, if a successor corporation in an A, C, or D reorganization acquires the
assets of the distributing or any controlled corporation, the shareholders (immediately before the
acquisition) of the successor corporation are treated as if they acquired stock in the corporation
whose assets were acquired.12 In short, section 355(e) essentially eliminated Morris Trust-type
transactions and overturned more than 30 years of well-settled tax law.
The statute does, however, include several exceptions. For example, certain
acquisitions are not taken into account for purposes of the anti-Morris Trust provision.13
1. The acquisition of stock in the controlled corporation by the
distributing corporation;
2. The acquisition of stock in a controlled corporation by reason
of holding stock in the distributing corporation;
3. The acquisition of stock in any successor corporation of the
distributing corporation or controlled corporation by reason of
holding stock in such distributing or controlled corporation; and
4. The acquisition of stock in the distributing corporation or any
controlled corporation to the extent that the percentage of stock
owned directly or indirectly in such corporation by each person
owning stock in such corporation immediately before the
acquisition does not decrease.14
These exceptions apply only if the stock owned prior to the acquisition was not acquired as part
of a plan to acquire a 50-percent or greater interest in either the distributing or controlled
corporation.15
12
Code § 355(e)(3)(B).
13
Code § 355(e)(3)(A)(i)-(iv).
14
See discussion of the technical correction to this provision in Part II.B.6., infra.
15
Code § 355(e)(3)(A).
-5-
In addition, a plan (or series of related transactions) will not cause gain
recognition under section 355(e) if, immediately after the completion of the plan or transaction,
the distributing and controlled corporations are members of the same affiliated group.16 The
provision also does not apply to a distribution that would otherwise be subject to section 355(d),
or a distribution pursuant to a title 11 or similar case.17
The anti-Morris Trust provision further authorizes Treasury to issue regulations
necessary to carry out the purposes of the legislation, including regulations (i) providing rules
where there is more than one controlled corporation, (ii) treating two or more distributions as one
distribution, and (iii) providing rules similar to the substantial diminution of risk rules of section
355(d)(6) where appropriate for purposes of the legislation.18 In addition, it extends the statute
of limitations with respect to gain recognized under section 355(e), so that the statute does not
expire until three years from the date the taxpayer notifies the Internal Revenue Service (the
“Service”) that the distribution occurred.19
For purposes of the anti-Morris Trust provision, any reference to a distributing or
controlled corporation also refers to any predecessor or successor of the corporation.20 Section
Code § 355(e)(2)(C). For this purpose, the term “affiliated group” is defined without
regard to whether the corporations are includible corporations as defined in section 1504(b) (e.g.,
foreign corporations, insurance companies, or tax-exempt organizations). Id.
16
17
Code § 355(e)(2)(D), (4)(B).
18
Code § 355(e)(5). The Internal Revenue Service has issued proposed, temporary, and
recently final regulations under section 355(e), which address the issue of what constitutes a plan
or series of related transactions within the meaning of section 355(e). These regulations are
discussed in Part III.B.2., infra.
19
Code § 355(e)(4)(E).
20
Code § 355(e)(4)(D).
-6-
355(e) generally applies to distributions after April 16, 1997, unless certain transition rules
apply.21
2.
Section 355(f) -- Intragroup Distribution Provision
Under section 355(f), the intragroup distribution provision, section 355, in its
entirety, does not apply to any distribution of stock from one member of an affiliated group
(whether or not the group files a consolidated return) to another member of such group, if the
distribution is part of a plan or series of related transactions to which section 355(e) applies.22
Section 1012(b)(2) of the Act also added section 358(g) to the Code, which authorizes Treasury
to issue regulations to provide adjustments to the basis of group members’ stock (whether or not
section 355(e) applies) in order to reflect the proper treatment of intragroup distributions.23 The
intragroup distribution provision applies to distributions after April 16, 1997, unless certain
transition rules apply.24
21
Act § 1012(d)(1), (3). In general, the amendments do not apply to any distribution
pursuant to a plan involving an acquisition occurring after April 16, 1997, if such acquisition is
(i) made pursuant to an agreement that was binding on such date and at all times thereafter, (ii)
described in a ruling request submitted to the Service on or before such date, or (iii) described in
a public announcement or in a filing with the Securities and Exchange Commission on or before
such date. Act § 1012(d)(3).
22
Code § 355(f). Section 355(f) specifically provides that all of section 355(e), including
the exceptions therein, applies in determining whether the intragroup distribution provisions
apply. Id.
23
Code § 358(g). In general, Congress was concerned that affiliated corporations could
manipulate their outside bases through the use of tax-free intragroup distributions. See
discussion of purposes of section 355(e) and (f) infra Part III.A.
24
Act § 1012(d)(1), (3). For a description of the transition rule, see supra note 20.
-73.
“Control Immediately After” Provision
Prior to its change by the Internal Revenue Service Restructuring and Reform Act
of 1998 (the “Reform Act”), Section 1012(c) of the Act also relaxed the rule under sections 351
and 368(a)(1)(D) for determining control immediately after a section 355 transaction. Under the
provision, shareholders receiving stock in a controlled corporation were treated as controlling the
controlled corporation immediately after the distribution if they held stock representing greater
than a 50-percent interest by vote and value of such controlled corporation.25 The former rule
required 80 percent of the vote and 80 percent of each class of nonvoting stock as required by
section 368(c). However, the statute did not change the section 355 requirement that the
distributing corporation distribute 80 percent of the voting power and 80 percent of each other
class of stock of the controlled corporation in the transaction.26 The change in the control test
generally applied to transfers after August 5, 1997.27
In 1998, the Reform Act replaced the new 50-percent control test with a provision
that states that if the requirements of section 355 are met, the fact that the shareholders of the
distributing corporation dispose of part or all of their controlled corporation stock will not be
taken into account for purposes of determining whether the transaction qualifies under section
368(a)(1)(D).28 Thus, the 80-percent control test in section 368(c) again applies to divisive
25
Code §§ 351(c), 368(a)(2)(H).
See H.R. Rep. No. 105-148, at 464 (1997) (hereinafter “House Report”); S. Rep. No.
105-33, at 142 (1997) (hereinafter “Senate Report”).
26
27
28
Act § 1012(d)(2).
Code § 368(a)(2)(H)(ii) (prior to amendment by the Tax and Trade Relief Extension
Act of 1998).
-8-
section 368(a)(1)(D) transactions. The Tax and Trade Relief Extension Act of 1998 (the
“Extension Act”) contained a further technical correction of section 368(a)(2)(H)(ii), providing
that the fact that the controlled corporation issues additional stock will not be taken into account
for purposes of determining whether the transaction qualifies under section 368(a)(1)(D).29
B.
History of the Statute
1.
Administration’s Budget Proposal
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).30 The proposal
would have required the distributing corporation (but not its shareholders) to recognize gain on
the distribution of the stock of the controlled corporation, unless the direct and indirect
shareholders of the distributing corporation, as a group, continued to own at least 50 percent of
the total vote and value of both the distributing and controlled corporations at all times during the
four-year period beginning two years before and ending two years after the distribution.31
In determining whether shareholders retain the requisite ownership of both
corporations throughout the four-year period, acquisitions or dispositions of stock that are
“unrelated” to the distribution would be disregarded. A transaction would be treated as unrelated
if it were not “pursuant to a common plan or arrangement that includes the distribution.”32 Thus,
29
Code § 368(a)(2)(H)(ii).
30
This proposal first appeared, in substantially identical form, in the Clinton
Administration’s 1997 budget proposal, which was publicized in early 1996. See Department of
the Treasury, General Explanation of the Administration’s Proposals (Mar. 1996).
Department of the Treasury, General Explanations of the Administration’s Revenue
Proposals, at 62 (Feb. 1997) (hereinafter Treasury Explanation of Revenue Proposals).
31
32
Id.
-9-
for example, public trading of the stock in either the distributing or controlled corporation would
be disregarded, even if the trading occurred in contemplation of the distribution.33 Similarly, a
hostile acquisition of the distributing or controlled corporation after the distribution would be
disregarded – but a friendly acquisition 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.34
2.
Archer/Roth/Moynihan Bill
On April 17, 1997, Bill Archer, Chairman of the House Ways and Means
Committee, introduced legislation in the House of Representatives to restrict the use of section
355. 35 William Roth, Chairman of the Senate Finance Committee, and Daniel Moynihan,
Ranking Minority Member of the Senate Finance Committee, introduced identical legislation in
the Senate on the same date (collectively the “Archer/Roth/Moynihan bill”).36 Although the bill
was similar to the President’s budget proposal in that it required recognition of corporate-level
gain if either the distributing or controlled corporation was acquired, it differed in several
important respects.
33
Id. at 62-63.
34
Id.
35
H.R. 1365, 105th Cong. (1997).
36
S. 612, 105th Cong. (1997).
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First, the proposal would have been added as a new subsection (e) to section 355,
rather than as an addition to section 355(d).37 Under section 355(e), as proposed by the bill, if a
distribution were “part of a plan (or series of related transactions) pursuant to which a person
acquires stock representing a 50-percent or greater interest in the distributing corporation or any
controlled corporation (or any successor of either),” corporate-level gain would be recognized.38
The import of the move from subsection (d) to subsection (e) was to make clear that an
acquisition of the distributing or controlled corporation was not limited to “purchase”
transactions as defined in section 355(d).39 To coordinate the two subsections, the bill contained
a provision that section 355(e) would not apply to any distribution to which section 355(d)
applied.
Second, the bill did not limit corporate-level gain recognition to the distributing
corporation. Rather, the bill provided that if the distributing corporation were acquired, gain
would be recognized by the controlled corporation equal to the amount of gain that the
distributing corporation would have recognized had it sold its assets for their fair market value
immediately after the distribution. Conversely, if the controlled corporation were acquired, gain
would be recognized by the distributing corporation equal to the amount of gain that the
37
H.R. 1365, § 1(a); S. 612, § 1(a).
38
The attribution rules of section 355(d)(7) would apply to treat two or more persons
acting pursuant to a plan or arrangement as one person.
The introductory statement of Chairman Archer stated that “[w]hether a corporation is
acquired would be determined under rules similar to those of present-law section 355(d), except
that acquisitions would not be restricted to ‘purchase’ transactions.” 143 Cong. Rec. E702 (daily
ed. Apr. 17, 1997) (hereinafter Introductory Statement by Chairman Archer).
39
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distributing corporation would have recognized had it sold the stock of the controlled corporation
for its fair market value on the date of the distribution.40
Third, prohibited acquisitions were not limited to those occurring during the fouryear period beginning two years before the distribution. Instead, if the distribution of the
controlled corporation were part of a plan or series of related transactions pursuant to which a
person acquired a 50-percent or greater interest in either the distributing or controlled
corporation, gain would be recognized. There was a rebuttable presumption that such an
acquisition was pursuant to a plan or series of related transactions, however, if the acquisition
occurred during the four-year period beginning two years before the distribution. Thus, although
a plan was presumed to exist during the four-year period, a plan was not limited to the four-year
period.
Fourth, a prohibited acquisition could occur with respect to the distributing or
controlled corporation, or any successor thereof.
Fifth, the bill authorized Treasury to prescribe regulations necessary to carry out
the purposes of the subsection, including regulations (i) providing for the application of section
355(e) where there is more than one controlled corporation, (ii) treating two or more
distributions as one distribution, and (iii) providing for rules suspending the four-year period
where stock is subject to a substantial diminution of risk.
40
The reason for this change was that these transactions were viewed as sales of the
distributing or controlled corporation. Thus, if the controlled corporation were acquired, the gain
would be measured by the stock of the controlled corporation; if the distributing corporation
were acquired, the gain would be measured by the assets of the distributing corporation. See
Introductory Statement by Chairman Archer, supra note 38.
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Sixth, the bill extended the statute of limitations for the assessment of any
deficiency attributable to gain recognized as a result of a prohibited acquisition to three years
from the date the taxpayer notifies the Service that the distribution occurred. Such a deficiency
could be assessed within the three-year period, notwithstanding other provisions of law that
would otherwise prevent assessment.
Finally, the bill added a new subsection (f) to section 355,41 an extremely broad
intragroup distribution provision, which did not appear in any form in the President’s proposal.
Subsection (f) provided that section 355, in its entirety, would not apply to the distribution of
stock from one member of an affiliated group filing a consolidated return to another member of
such group. The provision also required Treasury to issue regulations providing for proper
adjustments for the treatment of such distributions, including adjustments to stock basis and
earnings and profits.
The bill would apply to distributions made after April 16, 1997, unless certain
transition rules applied.42
3.
House Bill
On June 26, 1997, the House of Representatives passed a modified version of the
Archer/Roth/Moynihan bill (the “House bill”).43 The House bill provided for a broader class of
41
H.R. 1365, § 1(b); S. 612, § 1(b).
42
The transition rules were essentially the same as those ultimately enacted. See supra
note 20 for a description of the transition rules.
43
H.R. 2014, 105th Cong. § 1012 (1997). Section 1012 of H.R. 2014 was identical to
Chairman Archer’s mark as well as the House Ways and Means Committee version. Thus, the
changes discussed in this part were actually incorporated in Chairman Archer’s mark, and the
bill passed through the House without change.
- 13 -
potential acquirers. The House bill’s version of section 355(e) still provided for corporate-level
gain recognition if a 50-percent or greater interest of either the distributing or controlled
corporation is acquired pursuant to a plan or series of related transactions. However, instead of
the acquisition being by “a person,” as provided in the Archer/Roth/Moynihan bill, a prohibited
acquisition could be made under the House bill by “1 or more persons . . . directly or indirectly.”
The House bill also broadened the class of potential acquirees. The Archer/Roth/Moynihan bill
provided that a prohibited acquisition could occur with respect to “the distributing corporation or
any controlled corporation (or any successor).” The House bill, on the other hand, deleted the
parenthetical reference to successor and added a new provision stating that “for purposes of this
subsection, any reference to a controlled corporation or a distributing corporation shall include a
reference to any predecessor or successor of such corporation.”
In addition, the House bill added some new provisions. First, the House bill
added a provision treating the acquisition of assets by a successor corporation in an A, C, or D
reorganization (or any other transaction specified in Treasury regulations) as an acquisition of
stock by the shareholders of such successor corporation. Although Chairman Archer’s
introductory statement to the Archer/Roth/Moynihan bill noted that “[i]t is anticipated that
certain asset acquisitions would be treated as stock acquisitions,”44 no such provision was
included in that bill.
44
Introductory Statement by Chairman Archer, supra note 38.
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Second, while the House bill retained the exception for acquisitions of stock in
any controlled corporation by reason of holding stock in the distributing corporation, it added
three new exceptions for certain acquisitions, all of which appear in the final Act.
Third, the House bill modified the attribution rule for purposes of determining
whether an acquisition has occurred. Rather than apply the entity attribution rules of section
318(a)(2) without regard to the 50-percent threshold in section 318(a)(2)(C), as in the
Archer/Roth/Moynihan bill, the House bill applied section 355(d)(8)(A), which incorporates
section 318(a)(2), but attributes stock owned by a corporation to its shareholder only if the
shareholder owns 10 percent of the corporation.
Finally, the House bill added a provision amending the “control” requirement of
sections 351 and 368(a)(1)(D) where the distributing corporation contributes appreciated assets
to the controlled corporation in connection with the section 355 distribution. Under the proposal,
the distributing corporation’s shareholders need only hold more than 50 percent of the vote and
value of the controlled corporation’s stock following the distribution, as opposed to 80 percent of
the vote and 80 percent of each class of nonvoting stock as currently required by section
368(c).45
4.
Senate Bill
On June 27, 1997, the Senate approved a different version of the H.R. 2014
containing amendments to section 355 (the “Senate bill”). The Senate bill followed the House
45
H.R. 2014, § 1012(c). The House Ways and Means Committee Report notes that the
bill does not change the present-law requirement under section 355 that the distributing
corporation must distribute 80 percent of the voting power and 80 percent of each class of
nonvoting stock of the controlled corporation. House Report, at 464.
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bill with respect to the anti-Morris Trust provision,46 but it modified the intragroup distribution
provision.47 The Senate bill would make section 355 inapplicable to a distribution of stock
within an affiliated group, regardless of whether the group files a consolidated return, but only if
the distribution is part of a plan or series of related transactions that is described in section
355(e). In addition, similar to the House bill and the Archer/Roth/Moynihan bill, the Senate bill
authorized Treasury to issue regulations providing for proper basis adjustments with respect to
group members’ stock. Unlike the House bill and the Archer/Roth/Moynihan bill, however, this
authorization was not mandatory.
5.
Taxpayer Relief Act of 1997
Section 1012 of the Act, as described above, essentially followed the Senate bill
with certain modifications.
First, the Act modified the measurement and timing of gain recognition under
section 355(e), so that regardless of whether the distributing or controlled corporation is
acquired, gain is recognized by the distributing corporation immediately before the distribution,
as measured by the appreciation in the stock of the controlled corporation.48
46
Thus, all of the provisions discussed in Part II.B.3. supra apply equally to the Senate
bill.
As with the House bill, the Senate bill was identical to Chairman Roth’s mark as well as
the Senate Finance Committee version. Thus, the changes discussed in this part were actually
incorporated in Chairman Roth’s mark, and the bill passed through the Senate without change.
47
48
See Code § 355(e)(1). Thus, gain is not measured by reference to the entity acquired.
This is similar to the approach taken in section 355(d) and in the Clinton Administration’s
budget proposal. See supra notes 29-30 and accompanying text.
- 16 -
Second, the Act added a new exception for situations where the distributing and
all controlled corporations are members of a single affiliated group immediately after the
completion of the plan or transactions.49 In addition, the Act modified the continuing control
exception to provide that an acquisition does not require gain recognition if the same persons
own more than 50 percent of the stock of the distributing corporation or any controlled
corporation, directly or indirectly (rather than merely indirectly as in the House and Senate bills),
before and after the acquisition.50
Third, the Act modified the attribution rule for purposes of determining whether
an acquisition has occurred. The Act retained the application of the entity attribution rules of
section 318(a)(2). However, rather than apply the 10-percent threshold of section 355(d)(8)(A)
for purposes of attributing stock ownership from a corporation, as in the House and Senate bills,
the Act provides that the corporate entity attribution rules of section 318(a)(2)(C) apply without
regard to the 50-percent threshold.51
Finally, the Act clarified that section 355(f) applies with respect to an intragroup
distribution only if section 355(e) in its entirety applies.52
49
Code § 355(e)(2)(C).
50
Code § 355(e)(3)(A)(iv). But see discussion of the technical correction to this provision
in Part II.B.6., infra.
51
See Code § 355(e)(4)(C)(ii). This was the same language that appeared in the
Archer/Roth/Moynihan bill.
52
See Code § 355(f); Conference Report, at 534. Although the Senate bill provided that
section 355(f) applies only if the distribution is part of a plan or series of related transactions
described in section 355(e)(2)(A)(ii), the Act clarified that in determining whether an acquisition
is described in section 355(e)(2)(A)(ii), all the provisions of section 355(e) are applied. Thus, if
the acquisition would otherwise fall within an exception to section 355(e), it is not subject to
(cont. on next page)
- 17 6.
Technical Corrections
The Reform Act addressed two of the provisions in section 355(e). First, it
modified the language of section 355(e)(3)(A) to clarify that the acquisitions described in
subsections (i) through (iv) are not taken into account in determining whether there has been an
acquisition of a 50-percent or greater interest in a corporation. Other transactions that are part of
a plan or series of related transactions, however, could result in a prohibited acquisition.53
Second, the Reform Act changed the language of the continuing control exception of section
355(e)(3)(A)(iv).54 Instead of providing that an acquisition does not require gain recognition “if
shareholders owning directly or indirectly stock possessing” more than 50 percent of the vote
and value “in the distributing or any controlled corporation before such acquisition own directly
or indirectly stock possessing such vote and value in such distributing or controlled corporation
after such acquisition,” the exception reads as follows:
(A) Except as provided in regulations, the following acquisitions
shall not be taken into account in applying paragraph (2)(A)(ii):
(iv) The acquisition of stock in the distributing corporation or any
controlled corporation to the extent that the percentage of stock
owned directly or indirectly in such corporation by each person
owning stock in such corporation immediately before the
acquisition does not decrease.
section 355(f). Conference Report, at 534.
S. Rep. No. 105-174, 105th Cong., 2d Sess 174 (Apr. 22, 1998) (hereinafter “1998
Senate Report”).
53
54
Without a technical correction to section 355(e)(3)(A)(iv), a literal reading of the
exception would except every transaction from the application of section 355(e). See discussion
of this exception infra Part III.B.5.b.(iv).
- 18 III.
ISSUES AND ANALYSIS
A.
Purpose of Section 355(e) and (f)
The legislative history of section 355(e) points to the “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.55
A few highly publicized transactions, such as Viacom’s spin-off of its cable company to TCI,
General Motors’ sale of Hughes Electronics to Raytheon, and Walt Disney’s sale of its
newspaper properties to Knight-Ridder, contained features that caused the transaction to more
closely resemble a sale. For example, one feature of such “disguised sale” transactions is that the
corporation to be acquired borrows money or assumes a large amount of debt and distributes the
proceeds of such debt to its shareholder or shareholders prior to a spin-off. Thus, upon the
subsequent acquisition, the acquiring group inherits the debt of the acquired corporation, while
the proceeds of such debt are retained by the “selling” group.56 Another feature that has
appeared in such transactions is a recapitalization of the interests of the old shareholders of the
acquired corporation, converting their stock from common stock to nonvoting preferred stock or
55
House Report, at 462 (emphasis added); Senate Report, at 139-40 (emphasis added).
56
See Joint Committee on Taxation, Description and Analysis of Certain RevenueRaising Provisions Contained in the President’s Fiscal Year 1998 Budget Proposal, at 51-52
(Mar. 11, 1997) (hereinafter JCT Description of Budget Proposal); Introductory Statement by
Chairman Archer, supra
note 38.
- 19 -
stock with voting rights that are disproportionate to the value of such stock, and the simultaneous
issuance of voting common stock to the acquiring corporation.57
Congress’ concern over “disguised sale” transactions is reminiscent of its reasons
for enacting section 355(d) in 1990. Congress enacted section 355(d) in order to prevent socalled “mirror transactions.”58 The legislative history of section 355(d) states that Congress
intended to prevent the avoidance of the General Utilities repeal and the tax-free disposition of
subsidiaries in transactions that resemble sales:
The provisions for tax-free divisive transactions under section 355
were a limited exception to the repeal of the General Utilities
doctrine, intended to permit historic shareholders to continue to
carry on their historic corporate businesses in separate
corporations. It is believed that the benefit of tax-free treatment
should not apply where the divisive transaction, combined with a
stock purchase resulting in a change of ownership, in effect results
in the disposition of a significant part of the historic shareholders’
interests in one or more of the divided corporations.59
Thus, the enactment of sections 355(e) and 355(f) can be seen as an attempt to complete what
Congress had started when it enacted section 355(d). In fact, in the Administration’s budget
proposals for fiscal year 1997 and 1998, the Morris Trust repeal provision was included as an
amendment to section 355(d).60 By referring to “new shareholders” acquiring interests in
connection with a spin-off, the legislative history of section 355(e) makes it clear that Congress
was concerned with new shareholders coming in – not with ownership shifts among historic
57
JCT Description of Budget Proposal, supra note 55, at 51-52.
58
See also Code § 337(c).
59
H.R. Rep. No. 101-881, at 341 (1990) (emphasis added).
60
See supra 29 and accompanying text.
- 20 -
shareholders. It is important to note, however, that neither section 355(e) nor section 355(d)
impose a shareholder-level tax – both sections impose only corporate-level taxes.
In addition, Congress was concerned that affiliated corporations could manipulate
their outside bases through the use of tax-free intragroup distributions. For example, Congress
was concerned that under the consolidated return regulations,61 it is possible to eliminate an
excess loss account (“ELA”)62 of a lower tier subsidiary, which creates the potential for the
subsidiary to leave the group without recapture of the ELA, even though the group benefited
from the losses or distributions in excess of basis that lead to the existence of the ELA.63
Moreover, Congress was concerned that the basis allocation rules of section 358(c) could result
in inappropriate shifts of basis as a result of intragroup distributions. Section 358(c) currently
requires that a shareholder’s stock basis in its stock of the distributing corporation be allocated
after a section 355 distribution between the stock of the distributing and controlled corporations
in proportion to their relative fair market values. As explained in the Conference Report:
If a disproportionate amount of asset basis (as compared to value)
is in one of the companies (including but not limited to a shift of
value and basis through a borrowing by one company and
contribution of the borrowed cash to the other), present law rules
under section 358(c) can produce an increase in stock basis relative
61
See Treas. Reg. § 1.1502-19(g), Ex. 3.
62
An ELA is generally created when a subsidiary corporation that is a member of a
consolidated group makes a distribution or incurs a loss that is deducted by the group that
exceeds the parent corporation’s basis in the stock of the subsidiary. Id. § 1.1502-19(a)(2)(i).
Such ELAs are treated as negative basis for purposes of the Code and are generally required to
be recaptured in certain circumstances, such as when the subsidiary leaves the group. Id.
§ 1.1502-19(a)(2)(ii), (b). However, such ELAs disappear, and are not required to be recaptured,
in certain cases where there is an intragroup spin-off. See id. § 1.1502-19(g), Ex. 3.
63
See House Report, at 462; Senate Report, at 141; Conference Report, at 535.
- 21 to asset basis in one corporation, and a corresponding decrease in
stock basis relative to asset basis in the other company.64
B.
Operation of Section 355(e)
1.
Base Case
As noted above in Part II.A.1., section 355(e) applies if there is a section 355
distribution that is part of a plan pursuant to which a person or persons acquires, directly or
indirectly, stock representing at least a 50-percent interest in the distributing corporation or any
controlled corporation.
Example 1: A publicly traded corporation (“D”) owns all the stock
of a controlled corporation (“C”). D has an adjusted basis in its C
stock of $100, and the fair market value of its C stock is $150. In
order to facilitate an acquisition of D by a third corporation (“P”),
D distributes its C stock to its shareholders. Within two years, P
acquires all the stock of D in a section 368(a)(1)(B) reorganization,
with the shareholders of D receiving 40 percent of the stock of P in
exchange for their D stock.
Under the facts of Example 1, D recognizes gain under section 355(e) in the amount of $50 (the
amount of D’s gain in its C stock), because the distribution of C was part of a plan under which P
acquired a 50-percent or greater interest in D.65
The above example seems to be the type of transaction that Congress intended to
tax. However, these simplified facts do not address the numerous issues that arise in interpreting
section 355(e). For example, what is a “plan?” What is a “related” transaction? What does
64
65
Conference Report, at 535; see also House Report, at 462; Senate Report, at 141.
If P had instead acquired C, the Service will not apply the step-transaction doctrine to
reorder the steps of the transaction, as it had in the past. See Rev. Rul. 70-225, 1970-1 C.B. 80,
obsoleted, Rev. Rul. 98-44, 1998-2 C.B. 315, and Rev. Rul. 96-30, 1996-1 C.B. 36, obsoleted,
Rev. Rul. 98-27, 1998-1 C.B. 1159; see also Rev. Proc. 96-39, 1996-2 C.B. 300, and Rev. Proc.
97-3, § 5.17, 1997-1 C.B. 507, both of which were repealed by Rev. Proc. 97-53, 1997-2 C.B.
528. See discussion in Part III.D. infra.
- 22 -
“acquire” mean? What does the phrase “any controlled corporation” mean? These questions are
not easily answered.
2.
Distributions That Are “Part of a Plan”
a.
What is a “Plan (or Series of Related Transactions)?”
Section 355(e) will only apply to a distribution that is part of a “plan” pursuant to
which a person or persons acquire a 50-percent or greater interest in the distributing or any
controlled corporation. A question thus arises as to what constitutes a plan.66 The language of
section 355(e) is deceptively broad and offers no real guidance to taxpayers. 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 enactment of section 355(e) that the
legislative history intentionally omitted an explanation of what constitutes a plan.67 The staff
member further stated that whether a plan exists will “always be a matter of facts and
circumstances.”68
There is an obvious disconnect between the apparent breadth of section 355(e)
and the legislative history of section 355(e), which clearly indicates that the statute was intended
to prevent tax-free disguised sales. Section 355(e) does, however, authorize Treasury and the
Service to issue regulations “necessary to carry out the purposes” of the legislation. Treasury
The Senate Report uses the phrase “plan or arrangement.” Senate Report, at 140
(emphasis added). However, the significance of the term “or arrangement” in the legislative
history is unclear.
66
67
See New Corporate Laws Beg For Interpretive Regs, 97 TNT 196-2 (Oct. 9, 1997)
(hereinafter “New Corporate Laws”).
68
Id.
- 23 -
and the Service have been struggling to reconcile the purposes of the statute with its overly broad
language, and their most recent attempts seem to have achieved this goal. On April 18, 2005,
Treasury and the Service issued their fifth set of regulations to define plan69 and on November
22, 2004, they issued proposed regulations to define predecessor and successor.70
On August 19, 1999, Treasury and the Service issued the first set of proposed
regulations under section 355(e) that provided guidance as to what constitutes a plan (the “1999
proposed regulations”).71 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 overly broad statute.72
The 1999 proposed regulations received a great deal of criticism, and on
December 29, 2000, Treasury and the Service withdrew the 1999 proposed regulations,73 and
69
70
71
T.D. 9198, 70 Fed. Reg. 20279-291 (2005).
Prop. Treas. Reg. § 1.355-8, 69 Fed. Reg. 67,873 (2004).
1999 Prop. Treas. Reg. § 1.355-7, 64 Fed. Reg. 46,155, 46,160 (1999).
72
We discussed the 1999 proposed regulations in detail in Mark J. Silverman & Lisa M.
Zarlenga, The Proposed Section 355(e) Regulations: Broadening the Traditional Notions of
What Constitutes a Plan, 52 TAX EXEC. 20 (2000).
73
66 Fed. Reg. 76 (2001).
- 24 -
issued new proposed regulations in their place (the “2000 proposed regulations”).74 The 2000
proposed regulations adopted a facts-and-circumstances approach, which is consistent with the
statute.75 The ultimate factual determination was the intent of the distributing corporation, the
controlled corporation, and their respective controlling shareholders (collectively the “relevant
parties”). In general, a distribution and acquisition would be treated as part of a plan under the
2000 proposed regulations if the relevant parties intended, on the date of the first transaction, that
the second transaction occur.76
The 2000 proposed regulations contained six safe harbors that, when applicable,
obviated the need to perform the facts-and-circumstances analysis.77 If the safe harbors were not
satisfied, the 2000 proposed regulations contained a list of nonexclusive factors to consider in
74
1999 Prop. Treas. Reg. § 1.355-7, 66 Fed. Reg. 66 (2001).
75
See 2000 Prop. Treas. Reg. § 1.355-7(b)(1). Section 355(e)(2)(B) provides that
acquisitions during the two years before and after a spin-off “shall be treated as pursuant to a
plan . . . unless it is established that the distribution and the acquisition are not pursuant to a plan
or series of related transactions.” Thus, the statute clearly contemplates that taxpayers will be
permitted to establish that the distribution and the acquisition were not part of a plan. Neither the
statute nor the legislative history limits the manner in which the taxpayer may make this
showing. The statute seems to contemplate a facts-and-circumstances approach.
76
2000 Prop. Treas. Reg. § 1.355-7(b)(1). The 2000 proposed regulations looked to the
relevant parties’ intent to that an acquisition or a “similar acquisition” occur. The 2000 proposed
regulations made it clear that the reference to “similar” does not mean identical – “the actual
acquisition and the intended acquisition may be similar even though the identity of the person
acquiring stock of Distributing or Controlled (acquirer), the timing of the acquisition or the terms
of the actual acquisition are different from the intended acquisition.” 2000 Prop. Treas. Reg. §
1.355-7(b)(2). Nonetheless, the scope of “similar acquisition” was not entirely clear.
77
2000 Prop. Treas. Reg. § 1.355-7(f).
- 25 -
determining whether or not there is a plan.78 Finally, the 2000 proposed regulations deleted
references to a clear and convincing standard of proof.79
On August 2, 2001, Treasury and the Service issued temporary regulations under
section 355(e) (the “2001 temporary regulations”).80 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.81 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
78
2000 Prop. Treas. Reg. § 1.355-7(d)(2), (3).
79
We discussed the 2000 proposed regulations in detail in Mark J. Silverman & Lisa M.
Zarlenga, New Proposed Section 355(e) Regulations – A Vast Improvement, 53 TAX EXEC. 55
(2001).
80
81
66 Fed. Reg. 40,590 (2001).
Even before the 2001 temporary regulations were issued, however, the Service
appeared to apply the principles of the 2001 proposed regulations when issuing private letter
rulings. See P.L.R. 200125044 (Mar. 22, 2001); P.L.R. 200115001 (Apr. 28, 2000); P.L.R.
200128038 (Apr. 16, 2001); P.L.R. 200131003 (Apr. 10, 2001).
- 26 -
future, expect to issue additional guidance regarding the interpretation of the phrase ‘plan (or
series of related transactions).’”82
On April 23, 2002, Treasury and the Service issued revised temporary regulations
to amend the 2001 temporary regulations (the “2002 temporary regulations”).83 The 2002
temporary regulations were generally effective for distributions occurring after April 26, 2002. 84
For distributions occurring prior to that date, taxpayers could have applied the 2002 temporary
regulations retroactively. Any retroactive application of the 2002 temporary regulations must
have been made, however, in whole and not in part. If the distribution occurred after August 3,
2001 (the effective date of the 2001 temporary regulations) but before April 26, 2002, the 2001
temporary regulations applied if the taxpayer did not apply the 2002 temporary regulations.85
Although the 2002 temporary regulations retained the overall facts-andcircumstances approach of the 2000 proposed regulations and 2001 temporary regulations, they
shifted the focus from the intent of the relevant parties to the existence of bilateral discussions
between the acquirer and the relevant parties. Thus, a mere expectation that the distributing or
controlled corporation may have been acquired (e.g., operation in a consolidating market) was no
longer sufficient to be regarded as a plan. By changing the focus, the 2002 temporary
82
66 Fed. Reg. at 40,590.
83
We discussed the 2002 temporary regulations in detail in Mark J. Silverman & Lisa M.
Zarlenga, The Fourth Time’s a Charm – New Temporary Section 355(e) Regulations Provide
Helpful Guidance to Taxpayers, 54 TAX EXEC. 238 (2002).
84
Temp. Treas. Reg. § 1.355-7T(k).
85
Id.
- 27 -
regulations carried out the purposes of section 355(e), reflected practical business considerations,
and provided a great deal more certainty to taxpayers and the government.
The most significant change made by the 2002 temporary regulations was the
addition of a “Super Safe Harbor”: a post-distribution acquisition could be part of a plan only if
there was an agreement, understanding, arrangement, or substantial negotiations86 regarding the
86
Like the 2001 temporary regulations, the 2002 temporary regulations stated that
whether an agreement, understanding, or arrangement existed depended upon the facts and
circumstances—the parties did not necessarily have to enter into a binding contract or reach an
agreement on all significant economic terms. Temp. Treas. Reg. § 1.355-7T(h)(1)(i). Unlike the
2001 temporary regulations, however, the 2002 temporary regulations provided some muchneeded guidance as to what constitutes “substantial negotiations”:
Substantial negotiations in the case of an acquisition (other than involving a public
offering) generally require discussions of significant economic terms, e.g., the exchange
ratio in a reorganization, by one or more officers, directors, or controlling shareholders of
Distributing or Controlled, or another person or persons with the implicit or explicit
permission of one or more officers, directors, or controlling shareholders of Distributing
or Controlled, with the acquirer or a person or persons with the implicit or explicit
permission of the acquirer.
Temp. Treas. Reg. § 1.355-7T(h)(1)(ii) (emphasis added). The final regulations (described
below) retain this definition and provide additional guidance on what constitutes an agreement,
understanding, or arrangement:
(i) An agreement, understanding, or arrangement generally requires either -(A) an agreement, understanding, or arrangement by one or more officers or directors
acting on behalf of Distributing or Controlled, by controlling shareholders of
Distributing or Controlled, or by another person or persons with the implicit or explicit
permission of one or more of such officers, directors, or controlling shareholders, with
the acquirer or with a person or persons with the implicit or explicit permission of the
acquirer; or
(B) an agreement, understanding, or arrangement by an acquirer that is a controlling
shareholder of Distributing or Controlled immediately after the acquisition that is the
subject of the agreement, understanding, or arrangement, or by a person or persons
with the implicit or explicit permission of such acquirer, with the transferor or with a
person or persons with the implicit or explicit permission of the transferor.
(cont. on next page)
- 28 -
acquisition or a similar acquisition87 at some time during the two-year period ending on the date
of the distribution. The Super Safe Harbor, which is retained by the final regulations, provides a
bright-line test. If the requirements for the Super Safe Harbor are satisfied, there is no need to do
a facts-and-circumstances analysis. The existence of an agreement, understanding, arrangement,
or substantial negotiations during the two-year period tends to show that the distribution and
acquisition were part of a plan, but such showing may still be rebutted using the safe harbors or
the facts-and-circumstances approach. The Super Safe Harbor does not apply in the case of
public offerings or with respect to pre-spin acquisitions.88
The final chapter of the plan regulations came on April 18, 2005, when the 2002
temporary regulations were made final (hereinafter the 2005 regulations are referred to as the
Treas. Reg. § 1.355-7(h)(1)(i). The final regulations also clarify that in the case of an acquisition
by a corporation, substantial negotiations require discussions with one or more officers,
directors, or controlling shareholders of the acquiring corporation. Treas. Reg. § 1.3557(h)(1)(v).
The 2002 temporary regulations narrowed the definition of “similar acquisition.” The
2002 temporary regulations provided that, in general, an actual acquisition will be similar to
another potential acquisition “if the actual acquisition effects a direct or indirect combination of
all or a significant portion of the same business operations as the combination that would have
been effected by such other potential acquisition.” Temp. Treas. Reg. § 1.355-7T(h)(8). An
acquisition was not similar if the ultimate owners of the business operations of the actual
acquirer were substantially different from the ultimate owners of the business operations of the
potential acquirer. Id. In the case of a single public offering, an actual acquisition may be
similar to another acquisition, even though there were changes in the terms, class, or price of
stock being offered, the size or timing of the offering, or the participants in the offering. Id. The
final regulations retain the rule and further provide that where more than one public offering
occurs, the second public offering cannot be similar to the actual acquisition unless the purpose
is similar and it occurs close in time to the first public offering. Treas. Reg. §1.355-7(h)(13)(ii)
87
88
Temp. Treas. Reg. § 1.355-7T(b)(2).
- 29 -
“final plan regulations”).89 Although the 2002 temporary regulations were favorably received by
practioners, they were viewed as too harsh with respect to pre-spin acquisitions and public
offerings. The final plan regulations address these criticisms and extend the bilateral focus to
pre-spin acquisitions and public offerings. The final plan regulations adopt two new safe harbors
for pre-spin acquisitions--one for an acquisition before the first disclosure event regarding the
distribution,90 and one for acquisitions before pro rata distributions but after the public
announcement of the distribution, as long as there were no discussions with the acquirer
regarding the distribution.91 The final plan regulations also adopt a safe harbor for pre-spin
public offerings that occur before the first disclosure event or public announcement of the
distribution.92
The final plan regulations are effective for distributions occurring after the regulations are
published in the Federal Register. 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.
89
We discussed the 2005 final plan regulations in detail in Mark J. Silverman & Lisa M.
Zarlenga, Anti-Morris Trust Plan Regulations: The Final Chapter In the Saga, 57 TAX
EXECUTIVE 604 (Nov.-Dec. 2005), reprinted in 110 TAX NOTES 967 (Feb. 28, 2006).
90
Treas. Reg. §1.355-7(d)(4). A disclosure event is defined to include any
communication by an officer, director, controlling shareholder, or employee of the distributing or
controlled corporation or a corporation related to the distributing or controlled corporation, or an
outside advisor of those persons to the acquirer or any other person regarding the distribution.
Treas. Reg. §1.355-7(h)(5).
91
Treas. Reg. §1.355-7(d)(5).
92
Treas. Reg. §1.355-7(d)(6).
- 30 -
A hostile takeover presents a peculiar problem in interpreting the meaning of the term
“plan.”93 If a distributing corporation distributes a controlled corporation specifically to avoid a
hostile takeover (a valid business purpose under Rev. Proc. 96-30),94 but the distribution does not
prevent such a takeover, one could argue that the distributing corporation distributed the
controlled corporation with no plan that another party would acquire 50 percent or more of the
stock of the distributing or controlled corporation. In fact, its plan was the exact opposite – to
avoid such an acquisition. Factual difficulties arise, however, when trying to determine whether
an acquisition is hostile or non-hostile. Indeed, in discussing this issue, a senior staff member of
the Joint Committee on Taxation stated during the above-mentioned meeting of the D.C. Bar Tax
Section’s Corporation Tax Committee that the legislative history does not include a statement
exempting hostile takeovers, because it is difficult to determine when a hostile takeover becomes
non-hostile.95 The final plan regulations generally resolve this issue in favor of treating a hostile
93
Indeed, this issue was raised in Hilton Hotels Corp. v. ITT Corp., 978 F. Supp. 1342 (D.
Nev. 1997). The ITT case arose out of a transaction where ITT planned to spin off its hotel and
casino business, a business that Hilton has been trying to acquire through a hostile takeover. In
an affidavit filed with the court, Professor Bernard Wolfman noted that the hostile acquisition
“safe harbor” that was in the Administration’s original proposal had been eliminated, and thus,
“[g]iven this legislative history, the pre-distribution pendency of the Hilton offer, and Hilton’s
expressed desire to acquire the . . . business in particular, there is a likelihood that a postdistribution acquisition by Hilton of [the subsidiary] would be deemed part of a ‘plan’ or ‘series
of related transactions.’” Id. As described in Part III.B.2.b., below, this analysis seems
incorrect, as an acquirer’s plan alone should not constitute a “plan.” In support of this
conclusion, see Affidavit of Lewis R. Steinberg in same matter.
94
95
1996-1 C.B. 696.
Id. See A.E. Staley Mfg. Co. v. Commissioner, 97-2 U.S.T.C. (CCH) ¶ 50,521 (7th Cir.
1997), rev’g 105 T.C. 166 (1995), where the Tax Court and Seventh Circuit conflicted over
whether a transaction was hostile or non-hostile, in the context of the deductibility of acquisition
costs. The Administration’s original proposal had stated that “a hostile acquisition of the
distributing or controlled corporation commencing after the distribution will be disregarded.”
See Treasury Explanation of Revenue Proposals, supra note 30, at 62.
- 31 -
takeover as part of a plan if the distributing corporation engaged in discussions with a potential
acquirer.96
Whose Plan is Relevant?
In addition to the question of what constitutes a plan, it must also be determined
whose plan is relevant. Does the plan have to be the plan of the distributing or controlled
corporation? Is the plan of the distributing corporation alone sufficient, or do multiple parties
need to be involved in the plan? Can the plan be the plan of a shareholder or multiple
shareholders? Can the plan be the plan of the acquiring entity? Can the plan be the plan of one
of the distributing or controlled corporation’s officers or directors? What about the plan of an
investment banker facilitating a distribution and acquisition?
The language in section 355(e) does not address these issues. However, logic
would seem to dictate that the relevant plan can be either the plan of the distributing corporation,
the controlled corporation (including officers or directors entitled to act on behalf of either
corporation), or “significant” shareholders of the distributing corporation. Because Congress
apparently passed the legislation in order to tax distributions that are part of related acquisitions,
the relevant plan should include the plan of the decision maker(s) involved in carrying out the
distribution, most notably the distributing corporation. Since the distributing corporation’s
“significant” shareholders have influence over the transactions entered into by the distributing
corporation, it would seem logical that such shareholders’ plan would also be relevant in addition
to the plan of the distributing and controlled corporations. The acquiring corporation’s plan
96
See Treas. Reg. § 1.355-7(c)(2).
- 32 -
should not be relevant, since such acquirer, acting alone, has no direct influence over the
distribution.97
The 2001 temporary regulations adopted this view and provided that the intent of
the distributing corporation, the controlled corporation, or the controlling shareholders of the
distributing or controlled corporation (i.e., the relevant parties) is relevant for purposes of section
355(e).98 Nonetheless, it was still unclear whether a joint plan of two or more persons was
necessary, or whether the plan of a single person was sufficient.99 The final plan regulations
continue to focus on the relevant parties. By requiring bilateral negotiations, the final plan
regulations clarify that the plan must generally be a joint plan of a relevant party and the
acquirer.
97
This is consistent with the analysis of Rev. Proc. 96-30, 1996-1 C.B. 36, which appears
to require that a plan of two or more persons (i.e., the plan of either the distributing corporation
or the controlled corporation, and the plan of the acquiring corporation) is necessary in order to
establish a business purpose to facilitate an acquisition of or by the distributing or controlled
corporation.
Likewise, in the context of a hostile acquisition, the intent of the hostile acquirer to
acquire the target should not be relevant, unless either the distributing corporation or the
controlled corporation participates in the plan. See supra note 87, referring to the affidavits of
Bernard Wolfman and Lewis R. Steinberg submitted in the Hilton Hotels Corp. v. ITT Corp.
case.
98
See 2001 Temp. Treas. Reg. § 1.355-7T(b)(1). The regulations define a controlling
shareholder as any person who, directly or indirectly, possesses voting power representing a
meaningful voice in the governance of the corporation. In a publicly traded corporation, a
controlling shareholder is any person who owns five percent or more of any class of stock and
who actively participates in the management or operation of the corporation. Treas. Reg. §
1.355-7(h)(3).
99
market).
See, e.g., 2001 Temp. Treas. Reg. § 1.355-7T(m), Exs. 2 (substituted acquirer) & 5 (hot
- 33 b.
Four-Year Presumption
Under section 355(e), a plan is presumed to exist if a person or persons acquire 50
percent or more of the distributing or any controlled corporation during the four-year period
beginning two years before the distribution, unless it is established otherwise. Thus, the statute
creates a rebuttable presumption if there is an acquisition within two years before or after the
distribution. Furthermore, although the presumption does not apply beyond two years before or
after the distribution, acquisitions beyond the four-year period still may be part of a plan, and
thus may fall within section 355(e).
A number of questions arise when analyzing the four-year presumption. For
instance, what evidence will be required to establish that there is no plan in order to overcome
the presumption? The House and Senate Reports merely state that taxpayers may avoid gain
recognition within the four-year period if they show that an acquisition “was unrelated to the
distribution.”100 Will a representation that a plan did not exist suffice? What if there is an
intervening event within the four-year period? Will that fact alone overcome the presumption?
Is there an obligation to notify the Service or file an amended return if there is an acquisition
within the two-year period following the distribution?101
Senate Report, at 141; House Report, at 463. Note that the Administration’s proposal
contained similar language, and stated that hostile takeovers and public trading among
shareholders would be treated as unrelated to the distribution. Treasury Explanation of Revenue
Proposals, supra note 30, at 62. See Part II.B.1. supra.
100
101
Section 355(e)(4)(E) seems to answer this question. It states that the three-year statute
of limitations for assessment of deficiencies attributable to section 355(e) does not begin to run
until the taxpayer notifies the Secretary that a distribution subject to section 355(e) has occurred.
Thus, if a taxpayer does not notify the Service of an acquisition occurring within the four-year
period, the Service may raise the section 355(e) issue in any future year. However, it seems that
one would have to litigate the substantive section 355(e) issue before deciding whether the
statute of limitations has run, because the duty to notify only applies if section 355(e) applies.
(cont. on next page)
- 34 -
The final plan regulations provide guidelines for overcoming the four-year
presumption. The regulations provide that whether a distribution and acquisition are part of a
plan is determined based on all the facts and circumstances.102 The final plan regulations contain
nine safe harbors,103 including safe harbors for public trading, compensatory stock acquisitions
and acquisitions by retirement plans, and acquisitions occurring more than a certain period of
time before or after the distribution.104 Moreover, the Super Safe Harbor provides a bright-line
The Service should issue guidance explaining what methods of notice will be required in order to
begin the running of the statute of limitations.
102
Treas. Reg. § 1.355-7(b)(1).
103
The 2002 temporary regulations only contained 7 safe harbors. See Temp. Treas. Reg.
§ 1.355-7T(d).
104
Reg. § 1.355-7(d). Specifically, the nine safe harbors are:
1. (i) The distribution was motivated in whole or substantial part by a business purpose other
than a business purpose to facilitate an acquisition of the acquired corporation, and (ii) the
acquisition occurred more than six months after the distribution (and there was no agreement,
understanding, arrangement, or substantial negotiations concerning the acquisition or a
similar acquisition during the period that begins one year before and ends six months after
the distribution);
2. (i) The distribution was not motivated by a business purpose to facilitate the acquisition or a
similar acquisition, (ii) the acquisition occurred more than six months after the distribution
(and there was no agreement, understanding, arrangement, or substantial negotiations
concerning the acquisition or a similar acquisition during the period that begins one year
before and ends six months after the distribution), and (iii) no more than 25 percent of the
stock of the acquired corporation was either acquired or subject to an agreement,
understanding, arrangement, or substantial negotiations during the period that begins one
year before and ends six months after the distribution;
3. There was no agreement, understanding, arrangement, or substantial negotiations concerning
the acquisition or a similar acquisition at the time of the distribution or within one year after
the distribution;
4. The acquisition occurs before the first disclosure event regarding the distribution, but only if
the acquirer is not a controlling or 10-percent shareholder of the acquired corporation and the
aggregate acquisitions represent less than 20 percent of the stock of the acquired corporation.
(cont. on next page)
- 35 -
test that a post-distribution acquisition can be part of a plan only if there was an agreement,
understanding, arrangement, or substantial negotiations regarding the acquisition or a similar
acquisition during the two-year period before the distribution.105 If an acquisition and
distribution fall within the Super Safe Harbor or 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.
For purposes of applying the facts-and-circumstances test, the final plan regulations provide a list
of nonexclusive factors to consider in demonstrating the existence of a plan – five plan factors
and six non-plan factors.106 The factors consider discussions with a potential acquirer, the
business purpose for the distribution, whether the acquisition was unexpected, and whether the
5. The acquisition occurs after the public announcement of the distribution and there were no
discussions by the distributing or controlled corporation with the acquirer on or before such
announcement, but only if the acquirer is not a controlling or 10-percent shareholder of the
acquired corporation and the aggregate acquisitions represent less than 20 percent of the
stock of the acquired corporation.
6. The public offering occurs before the first disclosure event or public announcement regarding
the distribution.
7. An acquisition of stock listed on an established market if, immediately before or after the
transfer, none of the transferor, transferee, and any coordinating group of which either the
transferor or transferee is a member is: (i) the acquired corporation; (ii) a corporation
controlled by the acquired corporation; (iii) a member of a controlled group of corporations
of which the acquired corporation is a member; (iv) a controlling shareholder of the acquired
corporation; or (v) a 10-percent shareholder of the acquired corporation;
8. An acquisition of stock by an employee, director, or independent contractor of the
distributing corporation, controlled corporation, or a related person in connection with the
performance of services in a transaction to which section 83 or section 421(a) applies; and
9. An acquisition of stock by a retirement plan of an employer that qualifies under section
401(a) or 403(a).
105
Treas. Reg. § 1.355-7(b)(2).
106
Treas. Reg. § 1.355-7(b)(3), (4).
- 36 -
distribution would have occurred at the same time and in similar form regardless of the
acquisition.107 The weight given to each factor depends on the particular case, and the existence
of a plan is not determined merely by comparing the number of plan and non-plan factors.108
107
Specifically, the plan factors are: (i) in the case of a post-distribution acquisition (not
involving a public offering), at some time during the two-year period ending on the date of the
distribution, there was an agreement, understanding, arrangement, or substantial negotiations
regarding the acquisition or a similar acquisition; (ii) in the case of a post-distribution acquisition
involving a public offering, at some time during the two-year period ending on the date of the
distribution, there were discussions by the distributing or controlled corporation with an
investment banker regarding the acquisition or a similar acquisition; (iii) in the case of a predistribution acquisition (not involving a public offering), at some time during the two-year period
ending on the date of the acquisition, there were discussions by the distributing or controlled
corporation with the acquirer regarding a distribution, or the acquirer intends to cause a
distribution and, immediately after the acquisition, can meaningfully participate in the decision
regarding whether to make a distribution; (iv) in the case of a pre-distribution acquisition
involving a public offering, at some time during the two-year period ending on the date of the
acquisition, there were discussions by the distributing or controlled corporation with an
investment banker regarding a distribution; (v) in the case of either a pre- or post-distribution
acquisition, the distribution was motivated by a business purpose to facilitate the acquisition or a
similar acquisition. Treas. Reg. § 1.355-7(b)(3).
The non-plan factors are: (i) in the case of a post-distribution acquisition involving a
public offering, during the two-year period ending on the date of the distribution, there were no
discussions by the distributing or controlled corporation with an investment banker regarding the
acquisition or a similar acquisition; (ii) in the case of any post-distribution acquisition, there was
an identifiable, unexpected change in market or business conditions occurring after the
distribution that resulted in the acquisition that was otherwise unexpected at the time of the
distribution; (iii) in the case of a pre-distribution acquisition (not involving a public offering),
during the two-year period ending on the date of the acquisition, there were no discussions by the
distributing or controlled corporation with the acquirer regarding a distribution, except where the
acquirer intends to cause a distribution and, immediately after the acquisition, can meaningfully
participate in the decision regarding whether to make a distribution; (iv) in the case of any predistribution acquisition, there was an identifiable, unexpected change in market or business
conditions occurring after the acquisition that resulted in a distribution that was otherwise
unexpected; (v) in the case of either a pre- or post-distribution acquisition, the distribution was
motivated in whole or substantial part by a corporate business purpose other than a business
purpose to facilitate the acquisition or a similar acquisition; (vi) in the case of either a pre- or
post-distribution acquisition, the distribution would have occurred at approximately the same
time and in similar form regardless of the acquisition or a similar acquisition. Treas. Reg. §
1.355-7(b)(4).
- 37 -
The final plan regulations represent a vast improvement over the 1999 proposed
regulations. The application of a facts-and-circumstances analysis, while it may not always
result in a great deal of certainty, was clearly contemplated by the statute. The Super Safe
Harbor and the safe harbors simplify the regulations by providing exceptions to deal with more
straightforward situations.
3.
One or More Persons “Acquire Directly or Indirectly” Stock
a.
Definition of “Acquire”
In order for section 355(e) to apply, one or more persons must “acquire,” directly
or indirectly, stock representing a 50-percent or greater interest in the distributing or any
controlled corporation. What does the term “acquire” include? The Conference Report states
that whether a corporation is acquired “is determined under rules similar to those of present law
section 355(d), except that acquisitions would not be restricted to ‘purchase’ transactions.”109
Section 355(d)(5) defines purchase as any acquisition, except carryover basis
transactions and any transactions under sections 351, 354, 355, or 356. Because the legislative
history explicitly states that the term “acquire” is not restricted to purchase transactions, it seems
clear that any carryover basis transaction, including section 351, 354, 355, and 356 transactions,
is included in the term “acquire,” unless specifically excluded by statute or regulation.110 It is
108
Treas. Reg. § 1.355-7(b)(1).
109
Conference Report, at 528.
110
It is unclear whether certain transactions, such as gifts or bequests, are intended to be
included in the term “acquire.” Gifts and bequests to family members arguably should be
excluded from application of section 355(e). For example, suppose D, a corporation, spins off a
wholly owned subsidiary (“C”) one month before D’s sole shareholder (“A”) dies. Assume that
A’s interest in D and C is bequeathed to A’s spouse (“B”). Has B “acquired” D or C? Under the
aggregation rules of sections 355(e)(4)(C)(i) and 355(d)(7)(A), related persons are treated as one
(cont. on next page)
- 38 -
not clear whether transactions that result in an increase in voting power or value of stock held by
certain shareholders, such as redemptions, recapitalizations, or stock conversions, constitute
acquisitions for purposes of section 355(e).111
person. Under section 267(b)(1) and (c)(4), related persons include members of a family,
including spouses. Thus, one can argue, A and B are treated as one person, and section 355(e)
should not apply.
On the other hand, an argument can be made that the reference in section 355(e)(4)(C)(i)
to section 355(d)(7)(A) intended the phrase “‘[f]or purposes of this subsection” in section
355(d)(7)(A) to mean section 355(d) and not section 355(e). In the context of section 355(d), the
aggregation rule applies to treat two or more acquirers as a single person. If section
355(e)(4)(C)(i) is read in a similar context, the aggregation rule would not apply to treat A and B
as one person. However, if the aggregation rule is interpreted in this way, there would be no
need for it in section 355(e), because section 355(e)(2)(A)(ii) already states that “one or more
persons” may acquire the 50-percent or greater interest, as opposed to “any person” as in section
355(d)(2).
Nonetheless, section 355(e), as originally drafted, applied only to “a person” acquiring a
50-percent or greater interest in the distributing or any controlled corporation. Therefore, it may
be the case that Congress inadvertently left the aggregation rule of section 355(e)(4)(C)(i) in the
final bill after the operating rules were changed. The Service has ruled privately that the transfer
of stock to a shareholder’s estate, from the estate to a trust pursuant to the estate plan, and to a
beneficiary pursuant to the estate plan did not constitute a section 355(e) plan. P.L.R.
200125044 (Mar. 22, 2001). Hopefully, the Service will address this issue in published
guidance.
The Service and the courts appear to treat such shifts in ownership as “acquisitions.”
See, e.g., McLaulin v. Commissioner, 276 F.3d 1269 (11th Cir. 2001) (concluding that an
increase in ownership of a non-redeemed shareholder constituted an acquisition for purposes of
section 355(b)(2)(D)(ii) under the ordinary meaning of the term); Younker Brothers, Inc. v.
United States, 318 F. Supp. 202 (S.D. Iowa 1970) (concluding that an increase in ownership of a
non-redeemed shareholder constituted an acquisition of control for purposes of section 269);
Rev. Rul. 57-144, 1957-1 C.B. 123 (ruling that a redemption resulted in an acquisition for
purposes of section 355(b)(2)(D)); P.L.R. 200125044 (Mar. 22, 2001) (ruling that a stock
repurchase program was not part of a plan for purposes of section 355(e), implying that it was an
acquisition); P.L.R. 200048030 (Aug. 30, 2000) (taxpayer represented that in measuring whether
the 50-percent limitation has been violated, the change in voting rights effected by the
recapitalization of Controlled will be treated as an acquisition by Distributing and/or its
shareholders of voting stock in Controlled); P.L.R. 200046001 (Nov. 17, 1999) (taxpayer
represented that several specific acquisitions, including a recapitalization of Controlled common
stock into two classes of stock with identical rights except for voting power and Distributing’s
(cont. on next page)
111
- 39 b.
Looking Through to the Ultimate Shareholders
Under the facts of Example 1, above, P has obtained 50 percent or more of the
value of D, and thus P has “acquired” D. Section 355(e) applies.
Example 2: Same facts as Example 1, except that in the B
reorganization, the shareholders of D receive 60 percent of the
stock of P in exchange for their D shares.
Technically, a person (P)112 has acquired a 50-percent or greater interest in the distributing
corporation (D). Thus, section 355(e) appears to apply. However, the historic D shareholders
retain, albeit indirectly, a 50-percent or greater interest in D. Clearly, Congress intended that
section 355(e) not apply to such a situation.113
The attribution rules in section 355(e), in conjunction with the exception in
section 355(e)(3)(iv), appear to alleviate this problem. Section 355(e)(4)(C)(ii) provides that the
attribution rules of section 318(a)(2) apply (without regard to the 50-percent value threshold in
section 318(a)(2)(C)) in determining whether a person holds stock in a corporation for purposes
of section 355. Thus, D’s historic shareholders would be treated as owning 60 percent of the D
stock, and the P shareholders would be treated as owning 40 percent of the D stock. If this is the
case, the exception in section 355(e)(3)(A)(iv) would apply, because D’s historic shareholders
stock repurchase program, would not aggregate to result in a 50-percent or greater acquisition of
Distributing stock); P.L.R. 199910026 (Dec. 10, 1998) (taxpayer represented that several specific
acquisitions, including the conversion of preferred stock into common stock, which resulted in a
shift of voting power, and Distributing’s stock repurchase program would not aggregate to result
in a 50-percent or greater acquisition of Distributing stock).
Section 7701(a)(1) states that the term “person” includes “an individual, a trust, estate,
partnership, association, company or corporation.”
112
113
Section 355(e)(3), which provides exceptions to the application of section 355(e),
appears to assume that the persons to test under section 355(e) are the ultimate owners.
- 40 -
would hold more than 50 percent of the vote and value in D before and after the acquisition.114
Accordingly, section 355(e) should not apply.115 However, the statute is poorly drafted. Section
355(e) does not explicitly state that, under the attribution rules, one must look to the ultimate
owners instead of the acquiring entity itself in applying section 355(e). Hopefully, the Service
will clarify this issue in published guidance.
c.
50-Percent or Greater Interest
Under sections 355(e)(4)(A) and 355(d)(4), a “50-percent or greater interest”
means stock possessing at least 50 percent of the total combined voting power of all classes of
voting stock, or at least 50 percent of the total value of shares of all classes of stock. Thus, there
is an acquisition to which section 355(e) applies if a person or persons acquires 50 percent or
more of the vote or value of the stock of the controlled or distributing corporation.116
How does the 50-percent rule apply to market trading by shareholders of publicly
traded corporations in anticipation of a distribution and acquisition? Are arbitrageurs who
anticipate an acquisition and buy stock in the distributing corporation included in the term “one
or more persons?” If so, would all market trading in anticipation of such distribution and
acquisition count toward the 50-percent threshold? The Treasury’s Explanation of the
Administration’s initial proposal in February 1997 stated that “public trading of the stock of
114
See Part III.B.5.b.(iv) infra for a more detailed discussion of section 355(e)(3)(A)(iv).
115
Code § 355(e)(2)(A)(ii).
116
Conference Report, at 528. In the General Motors / Raytheon deal that received so
much press, the Raytheon shareholders acquired 20 percent of the vote and 70 percent of the
value of a spun-off General Motors subsidiary. If this transaction had occurred after the effective
date of section 355(e), it would be taxed under section 355(e), because Raytheon’s receipt of 70
percent of the value of the subsidiary would constitute an acquisition.
- 41 -
either the distributing or controlled corporation is disregarded, even if that trading occurs in
contemplation of the distribution.”117 It is unclear why this provision was not included in the
final Act. However, the final plan regulations contain a safe harbor for public trading if neither
the buyer nor the seller is a controlling or ten-percent shareholder.118 Even before the 2002
temporary regulations (and the 2001 proposed regulations) were issued, the Service issued
favorable private letter rulings involving publicly traded companies, thus implying that section
355(e) does not apply to public trading.119
d.
Directly or Indirectly
Given the application of the attribution rules to section 355(e), why did Congress
need to add the phrase “directly or indirectly” to section 355(e)(2)(A)(ii)? If the Service applies
the attribution rules to look through to the ultimate owners, its seems that the phrase “directly or
indirectly” is unnecessary.120 It is possible that Congress intended the phrase to expand upon the
attribution rules. There is no legislative history, however, to support such a view.
117
Treasury Explanation of Revenue Proposal, supra note 30, at 62.
118
Treas. Reg. § 1.355-7(d)(7). See supra note 97 for a list of the safe harbors.
119
See, e.g., P.L.R. 200025001 (July 9, 1999); P.L.R. 199909027 (Dec. 2, 1998); P.L.R.
9819048 (Feb. 2, 1998).
120
In addition, if a person owns an interest in a corporation indirectly due to the
attribution rules, section 355(e) should not apply if such person acquires an equal interest in the
corporation directly.
- 42 4.
The Distributing or “Any” Controlled Corporation
a.
Spin-off of Multiple Controlled Corporations
Section 355(e) applies to distributions that are part of a plan pursuant to which
one or more persons acquire stock representing a 50-percent or greater interest in “the
distributing corporation or any controlled corporation.”
Example 3: A publicly traded corporation (“D”) owns all the stock
of two controlled corporations (“S” and “C”). In order to facilitate
an acquisition by a third corporation (“P”), D distributes its S stock
and its C stock to its shareholders. Within two years, P acquires all
the stock of S (but not C) in a section 368(a)(1)(B) reorganization,
with the shareholders of S receiving 40 percent of the stock of P in
exchange for their S stock.
Is D taxed under section 355(e) on the gain in both its S stock and its C stock, or only on the gain
in its S stock?121 Clearly, D will be taxed on the gain in its S stock under section 355(e).
However, is the distribution of C a distribution that is part of a plan pursuant to which one or
more persons acquire stock representing a 50-percent or greater interest in the distributing
corporation or any controlled corporation? There would seemingly be no need to use the word
“any” (instead of “the”) before “controlled corporation” if section 355(e) were not intended to
apply to the distribution of C.
However, under section 355(e)(1), if there is a distribution to which 355(e)(2)(A)
applies, any stock “in the controlled corporation” is treated as non-qualified property.122 Is C
“the” controlled corporation for purposes of applying section 355(e)(1)? There appears to be no
121
No such question appears to arise if D, as opposed to S, were acquired. Section 355(e)
would apply to tax the gain in both the S stock and the C stock.
122
See Code § 355(c)(2).
- 43 -
policy reason for taxing the gain in the C stock. No one has acquired a 50-percent interest in
either D or C.
Under section 355(e)(5), the Service is required to issue regulations as may be
necessary to carry out the purposes of section 355(e), including regulations providing for the
application of section 355(e) where there are multiple controlled corporations.123 The final plan
regulations address this issue. They appropriately provide that the distributing corporation only
recognizes the gain on the stock of the distributed controlled corporation that was acquired.124 If
the distributing corporation is acquired, however, the final plan regulations provide that the
distributing corporation must recognize gain on all of the distributed controlled corporations.125
b.
Acquisitions of Subsidiaries That are Not Distributed
Example 4: A publicly traded corporation (“D”) owns all the stock
of two controlled corporations (“S” and “C”). D distributes its C
stock to its shareholders. Within two years, P acquires from D all
the stock of S in a section 368(a)(1)(B) reorganization. D receives
40 percent of the stock of P in exchange for its S stock.
Is S “any controlled corporation?” If S is deemed to be a controlled corporation, section 355(e)
will apply, because there is a distribution that is part of a plan in which P acquired 50 percent or
more of a controlled corporation (S).
An analysis of section 355(a) leads to the conclusion that S should not be treated
as a controlled corporation. Under section 355(a), no gain or loss is recognized if a corporation
See Part III.B.7. infra for a more detailed discussion of the Service’s regulatory
authority under section 355(e).
123
124
Treas. Reg. § 1.355-7(f).
125
Id.; see also Preamble to 2001 proposed regulations, 66 Fed. Reg. 66, 69 (2001).
- 44 -
distributes to a shareholder “solely stock or securities of a corporation (referred to in this section
as ‘controlled corporation’) which it controls immediately before the distribution.”126 Thus,
section 355(a) clearly refers to the term “controlled corporation” in the context of a corporation
that is distributed to shareholders. The final plan regulations confirm this conclusion.127
Since S in the example is not distributed to shareholders, it does not constitute
“any controlled corporation” for purposes of section 355(e)(2)(A)(ii). Thus, section 355(e)
should not apply to Example 4, because there was no acquisition of the distributing corporation
or any controlled corporation.
5.
Exceptions to Section 355(e)
a.
Exception to “Plan”
As discussed above in Part II.A.1., there are several exceptions to section 355.
Section 355(e)(2)(C) provides that a plan (or series of related transactions) will not cause gain
recognition if, immediately after the completion of the plan or transaction, the distributing and all
controlled corporations are members of the same affiliated group. For this purpose, the term
“affiliated group” is defined without regard to whether the corporations are includible
corporations as defined in section 1504(b). Thus, for example, a tax-exempt organization, life
insurance company, foreign corporation, real estate investment trust, or a regulated investment
company are considered members of the affiliated group for purposes of determining whether the
distributing and controlled corporations are in the same affiliated group.128
126
Code § 355(a)(1)(A).
127
Treas. Reg. § 1.355-7(h)(2).
Section 1012 of the Act contains several references to “affiliated group;” however, the
(cont. on next page)
128
- 45 Example 5: A publicly traded corporation (“D”) owns all the stock
of a controlled corporation (“C”), a foreign corporation. A third
corporation (“P”) acquires all the stock of D in a section
368(a)(1)(B) reorganization, with the shareholders of D receiving
40 percent of the stock of P in exchange for their D stock. As part
of the plan of reorganization, D distributes the stock of C to P.
Even though the distribution of C stock is part of a plan in which the ownership of the group has
changed, D is not required to recognize gain under section 355(e), because D, C, and P will
remain members of an affiliated group immediately after the completion of the plan. The fact
that C is a foreign corporation is disregarded in determining affiliated group status.129
b.
Exceptions to “Acquisition”
Section 355(e)(3)(A) provides that certain acquisitions are not considered
acquisitions for purposes of section 355(e).130 These exceptions apply only if the stock owned
prior to the acquisition was not acquired as part of a plan to acquire a 50-percent or greater
interest in either the distributing or controlled corporation.
definitions are not consistent. Affiliated group is defined broadly (i.e., without regard to whether
the corporations are includible corporations as defined in section 1504(b)) for purposes of both
(i) the exception to plan where the distributing and controlled corporations are members of the
same affiliated group immediately after the distribution, and (ii) Treasury’s regulatory authority
with respect to distributions within affiliated groups under section 358(g). Code
§§ 355(e)(2)(C), 358(g). On the other hand, section 355(f), which removes distributions within
affiliated groups from section 355, defines affiliated group more narrowly (i.e., as defined in
section 1504(a)). Code § 355(f). Congress presumably intended to grant Treasury broad
regulatory authority (hence, the broad definition of affiliated group). The reason for the narrow
definition in the rule and the broad definition in the exception is not clear, but it appears to be
drafted to the taxpayer’s advantage.
129
130
See Conference Report, at 532 (Ex. 1).
Note that the Reform Act clarified the language of section 355(e)(3)(A) so that the
excepted acquisitions “shall not be taken into account in applying” section 355(e)(2)(A)(ii),
rather than “shall not be treated as described” in section 355(e)(2)(A)(ii), thus excepting only
those interests described. See description of Reform Act supra Part II.B.6.
- 46 (i)
Acquisition of Controlled Stock by Distributing
Corporation
Section 355(e)(3)(A)(i) provides that section 355(e) does not apply to the
acquisition of stock in the controlled corporation by the distributing corporation. Thus, for
example, the receipt of stock of a newly formed controlled corporation in a section 351 exchange
or a D reorganization in connection with a spin-off of the controlled corporation will not trigger
gain recognition under section 355(e).131
(ii)
Acquisition of Controlled Stock by Shareholders of Distributing
Corporation
Section 355(e)(3)(A)(ii) provides that section 355(e) does not apply to the
acquisition of stock in a controlled corporation by reason of holding stock in the distributing
corporation. Thus, for example, if the distributing corporation engages in a “split-off”
transaction in which a shareholder of the distributing corporation that did not own 50 percent of
the stock of the distributing corporation before the transaction ends up owning all of the stock of
the controlled corporation, section 355(e) will not be triggered.132
The exception does not address the effect of the shareholders that end up owning all of
the stock of the distributing corporation after the split-off. Is their increased ownership in the
distributing corporation an “acquisition” within the meaning of section 355(e)? Certainly,
Congress did not intend to trigger section 355(e) in this case. The imposition of a tax by reason
of the increased ownership by the distributing corporation’s remaining shareholders would
render the exception in section 355(e)(3)(A)(ii) ineffective. In addition, as discussed above in
131
See Conference Report, at 533.
132
See Conference Report, at 533.
- 47 -
Part III.A., the purpose of section 355(e) was to prevent disguised sales to new shareholders.
Accordingly, an increase in ownership among historic shareholders should not constitute an
acquisition for purposes of section 355(e). The Service should clarify this in published guidance.
(ii)
Acquisition of Successor Stock by Shareholders of
Distributing Corporation
Section 355(e)(3)(A)(iii) provides that section 355(e) does not apply to the
acquisition of stock in any successor corporation of the distributing corporation or controlled
corporation by reason of holding stock in such distributing or controlled corporation.
Example 6: A publicly traded corporation (“D”) owns all the stock
of a controlled corporation (“C”). In order to facilitate an
acquisition by a third corporation (“P”), D distributes its C stock to
its shareholders. Within two years, D merges into P in a section
368(a)(1)(A) reorganization, with the shareholders of D receiving
60 percent of the stock of P.
Because D’s assets were apparently acquired by a successor corporation,133 P, in an A
reorganization, section 355(e)(3)(B) provides that the shareholders of P are treated as having
acquired the stock of D. Thus, the distribution seemingly was part of a plan pursuant to which
one or more persons, P’s shareholders, acquired at least 50 percent of the stock of D. Thus,
section 355(e) would seem to apply. However, D’s shareholders acquired stock in a successor
corporation, P, by reason of holding stock in D. As noted above, such stock is not taken into
account for purposes of applying section 355(e).134 As a result, only 40 percent of the stock of D
was acquired within the meaning of section 355(e), so no gain is recognized by D.135
133
See Part III.B.6. infra for an analysis of what the term “successor” means.
134
Code § 355(e)(3)(A)(iii).
135
If P acquired the D stock in a B reorganization, would it be considered a successor
(cont. on next page)
- 48 (iii)
Continuing Control Exception
(a)
As Enacted in Section 355(e)(3)(A)(iv)
Prior to the Reform Act, section 355(e)(3)(A)(iv) provided that section 355(e)
does not apply to the “acquisition of stock in a corporation if shareholders owning directly or
indirectly stock possessing” more than 50 percent of the vote and value in either “the distributing
or any controlled corporation before such acquisition own directly or indirectly stock possessing
such vote and value in such distributing or controlled corporation after such acquisition.”
Literally read, this exception seems to prevent application of section 355(e), because in a typical
Morris Trust transaction, there will be no change in the ownership of the corporation holding the
“unwanted” assets.
The Conference Report, however, makes clear Congress’ intent. It states that
“[t]he conference agreement clarifies that an acquisition does not require gain recognition if the
same persons own 50 or more of both corporations, directly or indirectly . . . before and after the
acquisition and distribution . . . .” Thus, the shareholders must own the requisite interest in both
the acquiring corporation and either the distributing or controlled corporation (whichever is not
acquired). Congress’ use of the disjunctive in section 355(e)(3)(A)(iv) was a technical error.
The examples used in the Conference Report confirm this conclusion.136
within the meaning of section 355(e)(3)(A)(iii) – or does this exception apply only to asset
acquisitions? In the case of a stock acquisition, the continuing control exception in section
355(e)(3)(A)(iv), discussed immediately below, may apply.
In addition, the Staff of the Joint Committee on Taxation stated in its “Blue Book” on
the Act that, despite the technical language of section 355(e)(3)(A)(iv), Congress’ intention was
that “the acquisition of stock in the distribution corporation or any controlled corporation is
disregarded to the extent that the percentage of stock owned directly or indirectly in such
corporation by each person owning stock in such corporation immediately before the acquisition
does not decrease.” Joint Committee on Taxation, General Explanation of Tax Legislation
(cont. on next page)
136
- 49 Example 7: Individual A owns all the stock of a corporation
(“D”), and D owns all the stock of a controlled corporation (“C”).
In order to facilitate an acquisition by a third corporation (“P”),
which is also owned entirely by A, D distributes its C stock to A.
Within two years, D merges into P in a section 368(a)(1)(A)
reorganization.
The Conference Report concludes that this is not an acquisition that requires gain recognition,
because A owns, directly or indirectly, all of the stock of both P (the successor to D) and C
before and after the merger.137
(b)
The Reform Act
i)
General Application
The Reform Act addresses the flaw in section 355(e)(4)(A)(iv) by restating the
exception as follows:
(A) Except as provided in regulations, the following acquisitions
shall not be taken into account in applying paragraph (2)(A)(ii):
(iv) The acquisition of stock in the distributing corporation or any
controlled corporation to the extent that the percentage of stock
owned directly or indirectly in such corporation by each person
owning stock in such corporation immediately before the
acquisition does not decrease.
While this provision appears to clarify that the former shareholders of the acquired corporation
must maintain a continuing interest in both the acquiring and the retained corporations, it does so
at the cost of even more complexity. The interests have to be calculated for each individual
shareholder.
Enacted in 1997, at 200-201 (“1997 Blue Book”). The Staff also noted that a technical
correction may be needed in order to reflect this intention. Id.
Conference Report, at 533 (Ex. 2). If, instead of A’s owning 100 percent of both P and
D before the acquisition, 20 different individuals owned five-percent interests in both P and D,
the exception would still apply. Id. at 534 (Ex. 3).
137
- 50 Example 8: Individual A owns 10 percent of the stock of a
corporation (“D”), and D owns all the stock of a controlled
corporation (“C”). There are nine other 10-percent shareholders of
D. A also owns 100 percent of the stock of a third corporation
(“P”). In order to facilitate an acquisition by P, D distributes its C
stock to its shareholders. Within two years, P (worth 900x)
acquires all the stock of D (worth 100x after the spin-off) in a
section 368(a)(1)(B) reorganization. After the reorganization, each
of the former D shareholders (except A) owns one percent of the
stock of P, and A owns 91 percent of the stock of P.
In determining whether a 50-percent or greater interest in D has been acquired under the Reform
Act, the interest of each of the continuing shareholders is disregarded only to the extent there has
been no decrease in such shareholder’s direct or indirect ownership. Thus, the 10-percent
interest of A and the one-percent interest of each of the other former shareholders of D are not
counted. The remaining 81 percent ownership of P following the merger (i.e., the decrease of
nine percent in the interests of each of the nine former shareholders other than A) is counted.
Therefore, a 50-percent or greater interest in D has been acquired.138
ii)
Impact of Shareholder-by-Shareholder
Approach
One very important change in the language of the Reform Act is the reference to
the ownership interest of “each person,” as opposed to “shareholders.”139 Consider the effect of
the Reform Act on the following example.
138
1998 Senate Report, at 174-175; 1997 Blue Book, at 201.
Section 355(e)(3)(A)(iv), as enacted, excepted an “acquisition of stock in a corporation
if shareholders owning directly or indirectly stock possessing” more than 50 percent of the vote
and value of the distributing or controlled corporation before and after the acquisition.
(Emphasis added). The Reform Act modifies this language to provide that an acquisition is
excepted to the extent that the percentage ownership of “each person owning stock in [the
distributing or controlled] corporation immediately before the acquisition does not decrease.”
(Emphasis added).
139
- 51 Example 9: Individuals A and B own 10 percent and 90 percent,
respectively, of the stock of a corporation (“D”). D owns all the
stock of a controlled corporation (“C”). The fair market value of
the C stock is $100. D distributes its C stock to its shareholders, A
and B. Thus, immediately after the distribution, A owns 10
percent of the stock of C and B owns 90 percent. Within two
years, as part of the same plan, A invests 200x in C, increasing A’s
ownership interest in C to 70 percent (and decreasing B’s
ownership interest to 30 percent).
A has acquired more than 50 percent of the stock of C as part of a plan, thus triggering section
355(e). Because A and B own all of the stock of C both before and after the acquisition, the
exception in section 355(e)(3)(A)(iv) of the statute, as originally enacted, would seem to apply.
However, applying the language of the Reform Act, it would appear that only 10 percent of A’s
interest and 30 percent of B’s interest are not counted for purposes of determining whether an
acquisition has occurred. The remaining 60 percent of C’s stock would be considered acquired,
thus triggering section 355(e). As discussed above in Part III.A., the purpose of section 355(e)
was to tax disguised sales to new shareholders. The application of the technical correction in this
example seems contrary to this intent.
6.
Successors and Predecessors
Section 355(e)(4)(D) provides that for purposes of section 355(e), any reference
to a controlled corporation or a distributing corporation “shall include a reference to any
predecessor or successor of such corporation.” Unfortunately, this phrase is defined neither in
section 355 nor in its legislative history. On November 22, 2004, the Service issued proposed
regulations providing long-awaited definitions of “predecessor” and “successor.”140 The
140
Prop. Treas. Reg. § 1.355-8, 69 Fed. Reg. 67,873 (2005). For a more in-depth look at
these proposed regulations, see Lisa M. Zarlenga & Kevin Spencer, Who Preceeds and Who
Succeeds: Proposed Section 355(e)(4)(D) Regulations, 2005 TNT 74-52 (Mar. 14, 2005).
- 52 -
proposed regulations adopt the same basic section 381 approach utilized elsewhere in the Code.
However, the approach has been modified somewhat to more closely follow the assets being
spun off. Although at first blush the proposed regulations appear unnecessarily complex, the
approach of the proposed regulations appropriately tailors the definitions of predecessor and
successor to the purposes of section 355(e).
a.
Definition of “Predecessor”
Consistent with other definitions of predecessor and successor found elsewhere in the
Code and regulations, the measuring stick for the proposed regulations is whether there has been
a section 381 transaction. The proposed regulations then add a gloss to the definition of
predecessor that limits the definition to transactions that implicate the purposes behind section
355(e). The proposed regulations provide separate definitions of predecessor for the distributing
and controlled corporation, focusing largely on predecessors of the distributing corporation,
because predecessors of the controlled corporation do not raise section 355(e) concerns. The fact
that a corporation is a predecessor does not automatically trigger section 355(e) – it also must be
determined whether there has been a 50-percent or greater acquisition of the predecessor as part
of the same distribution plan. The proposed regulations provide for separate testing of the
distributing corporation and its predecessor in determining whether such an acquisition has
occurred and provide special gain limitation rules depending on which entity is acquired.
(i)
Definition of Predecessor of the Distributing Corporation
To determine if a corporation is a predecessor of the distributing corporation, the
proposed regulations provide two tests that focus on what happens to the assets transferred to the
- 53 -
distributing corporation. Specifically, the tests are designed to identify transactions in which
there is a separation of the predecessor’s assets.
Under the first test, a corporation is a predecessor of the distributing corporation if,
before the distribution, it transfers property to the distributing corporation in a section 381
transaction (referred to by the proposed regulations as the “combining transfer”), but only if
(i) the distributing corporation transfers some, but not all, of the property to the controlled
corporation (or a predecessor of the controlled corporation) (referred to by the proposed
regulations as the “separating transfer”), and (ii) the controlled corporation’s basis in the
transferred assets is the same as the distributing corporation’s basis in the assets prior to the
transfer.141
Example 10: Shareholder X owns 100 percent of P corporation
and shareholder Y owns 100 percent of D corporation. P merges
into D in a section 368(a)(1)(A) reorganization. D then contributes
in a section 368(a)(1)(D) reorganization one of the former P assets
to its wholly owned subsidiary, C, for additional C stock and then
distributes C to its shareholders pro rata.
Because P transferred property to D in a section 381 transaction and D transferred some, but not
all of the former P property to C, there has been a separation of P’s assets. Therefore, P is
considered a predecessor of D.142
Under the second test, a corporation is a predecessor of the distributing corporation if it
transfers property to the distributing corporation, including stock of the controlled corporation, in
a section 381 transaction (i.e., the combining transfer), and thereafter, the distributing
141
Prop. Treas. Reg. § 1.355-8(b)(1)(i).
142
See Prop. Treas. Reg. § 1.355-8(g), Ex. 1.
- 54 corporation does not transfer all of that property (other than the controlled corporation stock) to
the controlled corporation (i.e., the separating transfer).143
Example 11: Shareholder X owns 100 percent of P corporation
and shareholder Y owns 100 percent of D corporation. P owns 35
percent of C corporation, and D owns the remaining 65 percent of
C. P merges into D in a section 368(a)(1)(A) reorganization. As a
result of the merger, D owns 100 percent of C. D then distributes
C to its shareholders pro rata.
Because P transferred property to D, including stock of C, in a section 381 transaction, and D did
not transfer all of that property to C, there has been a separation of P’s assets (i.e., the C stock
from P’s other assets). Therefore, P is considered a predecessor of D.144
By limiting the definition of predecessor to combining transfers that occur before the
distribution, the proposed regulations avoid a technical glitch that could lead to some anomalous
results.
Example 12: D owns all the stock of a controlled corporation, C.
D distributes its C stock to its shareholders. As part of a plan, P, a
small corporation, merges into D in a section 368(a)(1)(A)
reorganization, with the shareholders of P receiving two percent of
the stock of D.
Only two percent of D’s stock was acquired by P shareholders in the merger; thus, section 355(e)
should not apply. However, if the term “predecessor” were defined to include corporations
merging into the distributing corporation after the distribution, the predecessor rule could operate
143
Prop. Treas. Reg. § 1.355-8(b)(1)(ii).
144
See Prop. Treas. Reg. § 1.355-8(g), Ex. 2.
- 55 -
to trigger section 355(e) in this example, because D’s shareholders acquired a 50-percent or
greater interest in P, a predecessor to D.
(ii)
Special Gain Limitation Rules
The proposed regulations provide special rules limiting the amount of gain to be
recognized by the distributing corporation where there is a 50-percent or greater acquisition of
either the distributing corporation or the predecessor of the distributing corporation, but not both.
If there is a 50-percent or greater acquisition of both the distributing corporation and the
predecessor, then the entire gain inherent in the controlled corporation’s stock is recognized.
The gain limitation rules focus on which assets are being separated and, therefore, are consistent
with the purpose of section 355(e) to deny tax-free treatment where a division of a corporation’s
assets is coupled with a planned 50-percent or greater acquisition of the distributing or controlled
corporation.
If there is a 50-percent or greater acquisition of a predecessor of the distributing
corporation, the distributing corporation’s gain is limited to the gain that the predecessor of the
distributing corporation would have otherwise recognized if, immediately before the distribution,
the predecessor contributed the property that was transferred to the controlled corporation in the
separating transfer and any stock of the controlled corporation transferred to the distributing
corporation in the combining transfer to a newly formed, wholly owned corporation in a section
- 56 -
351 transaction, and sold the subsidiary’s stock to a third party for cash equal to its fair market
value.145
If there is a 50-percent or greater acquisition of the distributing corporation and the
acquisition(s) occur in the combining transfer, the amount of gain recognized by the distributing
corporation is limited to the excess, if any, of the amount described in sections 355(c)(2) or
361(c)(1), as applicable (which is essentially the distributing corporation’s built-in gain in its
controlled corporation stock), less the amount of gain that the distributing corporation would
have recognized if there had been a 50-percent or greater acquisition of a predecessor of the
distributing corporation but not the distributing corporation (which is the amount calculated upon
the deemed section 351 transaction and stock sale under Prop. Treas. Reg. § 1.355-8(e)(2)).146
What if the distributing corporation and the predecessor are of equal size, so that the
combining transfer results in a 50-percent acquisition of each company? It would appear that the
distributing corporation’s entire built-in gain in its controlled corporation stock is recognized.
This places a significant amount of pressure on the valuation of the distributing corporation and
145
Prop. Treas. Reg. § 1.355-8(e)(2)(i). Because gain is measured immediately before
the distribution, any post-merger appreciation (or depreciation) in the predecessor’s assets (other
than the controlled corporation stock) will increase (or decrease) the gain limitation. Similarly,
any basis adjustments to the property will affect the gain limitation. For example, if the
distributing corporation recognizes gain on the divisive section 368(a)(1)(D) reorganization by
reason of receiving boot, the resulting increase in the basis of the asset in the controlled
corporation’s hands will reduce the amount of the gain limitation. Further, any assets purchased
after the combining transaction are treated as the distributing corporation’s assets and do not
affect the predecessor’s gain limitation.
146
Prop. Treas. Reg. § 1.355-8(e)(3).
- 57 -
the predecessor, because the gain will be limited if more than 50-percent of either corporation is
acquired.
(ii)
Definition of Predecessor of the Controlled Corporation
The proposed regulations contain a definition of a predecessor of the controlled
corporation, but only for certain limited purposes.147 Specifically, the definition of a predecessor
of the controlled corporation applies only for purposes of determining whether a corporation is a
predecessor of the distributing corporation, calculating the gain limitation where a predecessor of
the distributing corporation is acquired, and applying a special affiliated group rule.148 For these
limited purposes, a corporation that transfers property to the controlled corporation in a section
351 transaction will be treated as a predecessor of the controlled corporation. An acquisition of a
predecessor of the controlled corporation cannot therefore trigger section 355(e) gain
147
The preamble to the proposed regulations explains that generally the controlled
corporation will not be able to transfer property it receives in a section 381 transaction to the
distributing corporation tax-free, see section 311(b) (except when the controlled corporation is,
itself, a distributing corporation in a section 355 transaction). Thus, the concern that was present
with respect to the distributing corporation’s ability to separate its or a predecessor’s property
tax-free is generally not present with the controlled corporation.
148
Prop. Treas. Reg. § 1.355-8(b)(2). The special affiliated group rule clarifies the
application of the affiliated group exception to section 355(e) in the context of predecessors and
successors. Section 355(e)(2)(C) provides that section 355(e) will not apply if, immediately after
the planned distribution and acquisition, the distributing and all controlled corporations are
members of a single affiliated group (as defined in section 1504 without regard to subsection (b)
thereof). The proposed regulations provide that for purposes of applying this exception, a
predecessor of the distributing or controlled corporation will be treated as continuing in existence
following the combining transfer, and the distributing or controlled corporation will be treated as
continuing in existence following a transfer of property to a successor. Prop. Treas. Reg.
§ 1.355-8(f).
- 58 -
b.
Definition of “Successor”
The proposed regulations define a “successor” more traditionally as a corporation to
which the distributing or controlled corporation transfers property in a section 381 transaction
after the distribution of the controlled corporation.149 The proposed regulations thus create sort
of a timeline -- section 381 transfers between the distributing corporation can result in a
predecessor, while section 381 transfers after the distribution can result in a successor.
Prop. Treas. Reg. § 1.355-8(a) restates the rule in section 355(e)(4)(D) that references to
the distributing or controlled corporation include references to any predecessor or successor of
such corporation, but presumably the definitions in the proposed regulations apply for purposes
of all of section 355(e). Section 355(e) contains two other references to “successor”
corporations. Section 355(e)(3)(A)(iii) excludes from section 355(e) acquisitions of stock in any
successor corporation of the distributing or controlled corporation by reason of holding stock or
securities of the distributing or controlled corporation (the “successor exception”). Section
355(e)(3)(B) treats the acquisition of assets by a successor of the distributing or controlled
corporation in a reorganization under section 368(a)(1)(A), (C), or (D) as an acquisition of stock
of the distributing or controlled corporation (the “asset rule”).
Example 13: A publicly traded corporation, “D,” owns all the
stock of a controlled corporation, “C”. D distributes its C stock to
its shareholders. Immediately thereafter, D merges into S in a
149
Prop. Treas. Reg. § 1.355-8(c)(1). The Service appropriately decided not to treat a
partnership or corporation to which the distributing or controlled corporation transfers assets as a
successor. Such a rule would have added substantial complexity as it would have required
measuring the ownership changes of the distributing or controlled corporation as well as each
entity to which it transferred assets. By limiting the definition of successor to require a section
381 transaction, the prior entity no longer exists and there is only one entity to monitor.
- 59 section 368(a)(1)(A) reorganization with the shareholders of D
receiving 60-percent of the S stock.
S is a successor to D under the proposed regulations, because after the distribution, D transfers
property to S in a 381 transaction. Assuming that the successor definition applies for purposes of
all of section 355(e), then S is also a successor for purposes of the successor exception and the
asset rule. As a result, under the asset rule, S’s shareholders are treated as acquiring 40-percent
of D’s stock, and under the successor exception, the acquisition by D’s shareholders of the S
stock is ignored. Thus, there has only been a 40-percent acquisition of D and section 355(e) does
not apply. If this were not the case, you could end up with the bizarre result that D’s
shareholders are treated as acquiring 60-percent of S, a successor of D, and section 355(e) would
always apply to a merger into a successor because there will always be a 50-percent or greater
acquisition of either the distributing/controlled corporation or the successor.
7.
Regulatory Authority Under Section 355(e)
Section 355(e)(5) grants Treasury authority to prescribe regulations as may be
necessary to carry out the purposes of section 355(e), including regulations (i) providing for the
application of section 355(e) where there is more than one controlled corporation, (ii) treating
two or more distributions as one distribution where necessary to prevent the avoidance of such
purposes, and (iii) providing for the application of rules similar to section 355(d)(6) where there
has been a substantial diminution of risk. As discussed above, regulations providing guidance on
the definition of “plan (or series of related transactions)” have been issued and regulations
providing guidance on the definition of “predecessor” and “successor” have been proposed.
Regulations dealing with these other issues, however, are anticipated in the future. What types
of transactions should the regulations address?
- 60 -
Treasury’s regulatory authority under section 355(e)(5) also extends to providing
rules treating two or more distributions as one distribution where necessary to prevent the
avoidance of the purposes of section 355(e). When should such rules apply? Will the rules
apply to distributions of more than one controlled corporation, or more than one distribution of
the same controlled corporation? What transactions should be targeted to prevent the avoidance
of section 355(e)?
In addition, Treasury’s regulatory authority under section 355(e)(5) extends to
providing rules similar to section 355(d)(6) in situations where a shareholder’s risk of loss with
respect to its stock is substantially diminished. Section 355(d)(6) provides that the relevant
holding period is suspended in any period during which the shareholder’s risk of loss is
substantially diminished by a transaction such as an option or a short sale. Presumably,
Congress was focusing on the four-year presumption period in providing such regulatory
authority. However, given the fact that the four-year period is only a presumption (unlike the
five-year holding period in section 355(d)), and section 355(e) applies to any distribution that is
part of a plan or series of related transactions regardless of whether it occurs within the four-year
period, such regulations seem unnecessary.
C.
Operation of Section 355(f)
1.
In General
As described in Part II.A.2., section 355(f) provides that section 355 will not
apply to intragroup distributions that are part of a plan (or series of related transactions)
described in section 355(e)(2)(A)(ii). In addition, section 355(f) will only apply if section 355(e)
- 61 -
applies.150 Thus, if one of the exceptions in section 355(e)(3)(A) applies so that section
355(e)(2)(A)(ii) does not apply, section 355(f) does not apply as well. The examples below
explain the operation of section 355(f).151
Example 14: A publicly traded corporation (“D”) owns all the
stock of a subsidiary corporation (“S”), which in turn owns all the
stock of a controlled corporation (“C”). D, S, and C are members
of the same affiliated group. In order to facilitate an acquisition by
a third corporation (“P”), S distributes its C stock to D, and D then
distributes its C stock to its shareholders. Within two years, P
acquires all the stock of D in a section 368(a)(1)(B) reorganization,
with the shareholders of D receiving 40 percent of the stock of P in
exchange for their D stock.
Section 355(e) applies to P’s acquisition of D. Thus, the following results occur:
1. Under section 355(f), section 355 will not apply to the distribution by S of its C stock, and
thus the distribution will be a taxable distribution.152
150
See Conference Report, at 534.
151
See Part III.C.2. infra for a discussion of particular issues related to section 355(f).
152
What if C were a newly formed corporation, and S contributed assets to C
immediately prior to distributing its C stock? Would the contribution of assets to C constitute a
section 368(a)(1)(D) tax-free reorganization? Because section 355 will not apply to the
distribution by S of its C stock due to section 355(f), there may not be a distribution under
sections 354, 355, or 356, as required by section 368(a)(1)(D). However, there is a section 355
distribution of the C stock by D to its shareholders (even though section 355(e) will apply to
place a corporate tax on the distribution). Will the “disconnect” between the contribution of the
assets to C and the section 355 distribution of C by D to its shareholders make the contribution of
assets by S to C taxable? Because the literal language of section 368(a)(1)(D) merely states that
section 368(a)(1)(D) applies if “stock or securities of the corporation to which the assets are
transferred are distributed in a transaction which qualifies under section 354, 355, or 356,” one
can argue that the distribution by D of the C stock to its shareholders under section 355 satisfies
this requirement. Thus, the contribution of assets by S to C would be a tax-free D
reorganization.
Furthermore, the contribution of assets by S to C should qualify as a section 351
transaction. Section 351(c)(1) states that in determining control for purposes of section 351, “the
fact that any corporate transferor distributes part or all of the stock in the corporation which it
receives in the exchange to its shareholders shall not be taken into account.” This rule applies
(cont. on next page)
- 62 2. S will recognize deferred intercompany gain as if it had sold its C stock on the date of the
distribution (and such gain will be triggered into income upon D’s distribution of its C stock
to its shareholders). D will receive a taxable dividend, which is eliminated under section
1.1502-13(f), and will take a fair market value basis in the C stock. D’s basis in its S stock
will increase by the amount of the gain under section 311(b), and decrease by the fair market
value of the stock of C.
3. Under section 355(e), D will recognize gain as if it had sold its C stock on the date of the
distribution. There should be no additional gain, however, because D’s basis in the C stock
equals its fair market value.
What if P acquires C instead of D in Example 12? Sections 355(f) and 355(e) will
operate in the same way as in Example 12. As noted in Part II.B.5., above, the original House
and Senate bills included different measures of gain depending on whether the distributing or
controlled corporation was acquired. However, under section 355(e) as enacted, the gain will be
the same whether the distributing or controlled corporation is acquired.
Example 15: Same facts as Example 14, except that S distributes
its C stock to D, D then distributes its S stock to its shareholders,
and, within two years, P acquires all the stock of D in a section
368(a)(1)(B) reorganization, with the shareholders of D receiving
40 percent of the stock of P in exchange for their D stock.153
Under section 355(f), S will again recognize gain as if it had sold its C stock on the date of the
distribution. In addition, under section 355(e), D will recognize gain as if it sold its S stock on
the date of the distribution. Thus, the gain in both subsidiaries is taxed.154 This makes little
sense since only D and C were acquired.155
regardless of whether the distribution is taxable, and applies to double distributions of the
controlled corporation’s stock. Rev. Rul. 62-138, 1962-2 C.B. 95.
153
See Conference Report, at 534 (Ex. 4).
154
The result would be the same if P acquired S instead of D.
155
See Part III.C.2.c. infra for a discussion of basis shifting in order to reduce gain. See
also Senate Report, at 140; House Report, at 462.
- 63 2.
Section 358(g) Regulations
a.
Overview
Section 1012(b)(2) of the Act added section 358(g), which grants Treasury
regulatory authority to provide stock basis adjustments in the case of a distribution of stock of
one member of an affiliated group to another member under section 355. For this purpose,
affiliated group is defined without regard to whether the corporations are includible corporations
as defined in section 1504(b) (e.g., tax-exempt organizations, life insurance companies, and
foreign corporations). Although the language of section 358(g) grants regulatory authority only
with respect to situations that do not fall within section 355(f), such authority may be exercised
in conjunction with the authority to provide exceptions to section 355(f). Thus, the Conference
Report notes that Treasury could, by regulation, eliminate gain recognition under section 355(f)
in certain circumstances and provide instead for appropriate basis adjustments.156
Treasury’s regulatory authority under this section is prospective only, except in
cases to prevent abuse.157 What constitutes an abuse for this purpose? For example, does the
mere elimination of an ELA or the shifting of basis, which are the apparent targets of new
section 358(g), constitute an abuse? Such consequences are simply the result of applying current
law.158 Presumably, certain “aggressive transactions,” such as engaging in debt transactions
immediately before a spin-off will be required before a transaction is considered abusive.
156
Conference Report, at 534-35.
157
Id. at 537.
158
Code § 358(b), (c); Treas. Reg. §§ 1.358-2(a)(2); 1.1502-19(g), Ex. 3.
- 64 -
As previously mentioned, Congress was concerned that affiliated corporations
could manipulate their stock bases through the use of tax-free intragroup distributions, either
through the elimination of an ELA of a lower tier subsidiary under the consolidated return
regulations159 or through inappropriate shifts of basis as a result of the basis allocation rules of
section 358(c). The Conference Report thus provides that the Treasury may promulgate any
regulations necessary to address these concerns and other collateral issues. The Conference
Report notes that the Treasury may consider rules that require a carryover basis within the group
(including a carryover of an ELA) for the stock of the controlled corporation, or a rule that
requires a modification of outside basis to reflect the inside basis of the controlled corporation.160
Similarly, such regulations may provide for a reduction in the basis of the stock of the
distributing corporation to reflect the change in the value and basis of the distributing
corporation’s assets.161 Importantly, the Conference Report states that “[t]he Treasury
Department may determine that the aggregate basis of distributing and controlled after the
distribution may be adjusted to an amount that is less than the aggregate basis of the stock of the
distributing corporation before the distribution . . . .”162
159
Treas. Reg. § 1.1502-19(g), Ex. 3.
160
Conference Report, at 536.
161
Id.
162
Id.
- 65 b.
Consolidated Return ELA Regulations
On August 12, 1994, the Treasury issued final consolidated return regulations
governing ELAs in a subsidiary’s stock.163 These regulations provide, in general, that an ELA is
treated for all federal income tax purposes as negative basis.164 If the parent corporation is
treated as disposing of the subsidiary’s stock, the parent is required to take into account its ELA
as income or gain from such disposition.165
(i)
Elimination of ELAs
Example 16: A publicly traded corporation (“P”) owns all the
stock of a subsidiary (“D”), which in turn owns all the stock of a
controlled corporation (“C”). P has a $30 ELA in the stock of D,
and D has a $90 ELA in the stock of C. D distributes all of the
stock of C to P. At the time of the distribution, the C stock is
worth $100, and the D stock is worth $300 (including the stock of
C).
D’s distribution of the C stock is treated as a disposition under Treas. Reg. § 1.1502-19(c)(1).
However, under section 355(c) and Treas. Reg. § 1.1502-19(b)(2)(i), D does not recognize gain
as a result of the distribution. Under section 358, D’s ELA in the C stock is eliminated, and P’s
$30 ELA is allocated between the D and the C stock based on their relative values.166 Thus, P
has a $20 ELA in the stock of D and a $10 ELA in the stock of C.167 If P also distributed the
stock of C to its shareholders in a section 355 transaction, P would be required to take its $10
163
Treas. Reg. § 1.1502-19, 59 Fed. Reg. 41666 (Aug. 12, 1994).
164
Treas. Reg. § 1.1502-19(a)(2)(ii).
165
Id. § 1.1502-19(b)(1).
166
Code § 358(b), (c); Treas. Reg. § 1.358-2(a)(2).
167
Treas. Reg. § 1.1502-19(g), Ex. 3(b).
- 66 -
ELA into account, notwithstanding the nonrecognition rules of section 355, because the stock of
C is deconsolidated.168
In promulgating Treas. Reg. § 1.1502-19, Treasury specifically considered the
issue presented by the above example. The preamble to the proposed regulations169 state, in
pertinent part:
The excess loss account (ELA) rules are an extension of the rules
for adjusting stock basis. . . .
An ELA ordinarily arises with respect to a share of [D]’s stock
only if [D]’s losses and distributions are funded with capital not
reflected in the basis of the share. The reductions are funded by
creditors or by other shareholders, including other members.
. . . In general, an ELA is treated as negative basis for
computational purposes, to eliminate the need for special ELA
rules paralleling the basis rules of the Code. Similarly, the rules of
the Code are generally used to determine the timing for inclusion
of an ELA in income. For example, if [D] has an ELA in [C]’s
stock and distributes the stock to P in a transaction to which
section 355 applies, section 358 eliminates [D]’s ELA (instead, P’s
basis in [C]’s stock is an allocable part of P’s basis in [D]’s stock),
and section 355 provides that any gain realized by [D] from the
disposition of [C]’s stock is not recognized.
Treasury apparently believed that the stock basis adjustment rules in Treas. Reg. § 1.1502-32
and the tiering up of adjustments provided therein were adequate to support the ELA rules of
Treas. Reg. § 1.1502-19. Treasury concluded that the elimination of an ELA in the spin-off of a
second-tier subsidiary is not improper or abusive, presumably because the relationship between
P’s basis in D and its value preserve the potential for gain recognition that was reflected in the
ELA.
168
Id. § 1.1502-19(b)(2)(ii), -19(g), Ex. 3(c).
169
57 Fed. Reg. 53,634, 53,643 (Nov. 12, 1992).
- 67 -
To illustrate the preservation of the gain, if in the above example, P sold D
(including C) for its fair market value without the initial spin-off of C, both D and C would cease
to be members of the group. Thus, the ELAs with respect to both D and C would be taken into
account, with the ELA in C’s stock being taken into account first.170 Thus, the group would
recognize a total gain of $330 computed as follows: D would take into account the $90 ELA in
its C stock. Under Treas. Reg. § 1.1502-32(b), this gain would result in an increase in P’s basis
in D’s stock from an ELA of $30 to a positive $60 basis. P’s gain on its D stock would be $240
(i.e., $300 value less $60 adjusted basis).
Alternatively, assume that D spins off C as in the Example 14. If P sold both D
and C (after waiting a sufficient period of time to avoid disqualifying the spin-off), the group’s
total gain would still be $330 – P’s gain on the sale of D stock would be $220 (i.e., $200 realized
plus the $20 ELA in D), and P’s gain on the sale of C stock would be $110 (i.e., $100 realized
plus the $10 ELA in C). Thus, viewing the group as a whole, the “elimination” of the ELA in C
as provided in Treas. Reg. § 1.1502-19(g), Ex. 3, is one in form only. In substance, the amount
of the ELA has been preserved as built-in gain in the stock of D and C.
(ii)
Use of Debt
The incurrence of debt by one of the subsidiaries and the transfer of the proceeds
to another subsidiary does not affect this gain preservation.
Example 17: Same facts as Example 16, but assume further that
P’s $30 ELA in D resulted from debt-financed operating losses of
C that tiered up through D and were reflected on the consolidated
return, and D’s additional $60 ELA resulted from debt-financed
distributions from C to D.
170
Treas. Reg. § 1.1502-19(b).
- 68 -
Presumably, the additional cash in D as a result of the distributions is reflected in the value of D.
The fact that C incurred debt and distributed the proceeds to D should not change this result. P
still indirectly owes the debt and holds the proceeds. Indeed, the Treasury specifically
recognized this possibility in the preamble to proposed Treas. Reg. § 1.1502-19.171
Example 18: Same facts as Example 17, except that after D
distributes the stock of C to P, P distributes the stock of C to its
shareholders.
The result should not change. The value of C has been reduced relative to the value of D
because of the liability, which will be reflected in the basis of the C stock in the hands of P’s
shareholders. Moreover, because no change in control has occurred with respect to either D or
C, the debt and the proceeds of the debt are still held indirectly by the same persons.
Congress apparently felt that the elimination of D’s ELA in C upon the spin-off of
C could lead to abuse.172 Even though the aggregate built-in gain in the stock of D and C had
been preserved, as illustrated above, application of the basis allocation rules of section 358 could
potentially produce a tax benefit to the group if P later sells only one of the subsidiaries.
Example 19: Same facts as Example 16, except that P causes D to
sell the stock of C in the absence of a spin-off.
D would recognize gain of $190 (i.e., $100 plus $90 ELA) on the sale of the stock. However, if
instead of D selling C, D just distributes C to P and P sells the stock of C (after waiting a
171
172
57 Fed. Reg. at 53,643.
Note, however, that the Service has other means available to attack eliminations of
ELAs it believes are abusive. For example, in F.S.A. 200022006 (Dec. 9, 1999), the Service
applied the anti-avoidance rule of Treas. Reg. § 1.1502-19(e) to preserve gain from an ELA in
the context of tax-free intragroup spin-off.
- 69 -
sufficient period of time to avoid disqualifying the spin-off), P would recognize a gain of only
$110 (i.e., $100 plus $10 ELA). P could then liquidate D under section 332 to avoid recognizing
further gain. D’s ELA would disappear, and P would succeed to D’s basis in its assets. Such
results may be exacerbated by further reducing the value of one subsidiary through debt and
increasing the value of another subsidiary from the proceeds of such debt.
(iii)
Section 358(g) Regulations Should be Narrow in Scope
Any regulations promulgated pursuant to section 358(g) should be narrowly
tailored to address this perceived abuse. If new regulations were to impose a strict carryover
basis (or a carryover ELA) requirement, where the relative values of the distributing and
controlled corporations are reflected in the basis allocations, they could have the effect of
duplicating gain recognized on the ultimate distribution of the subsidiaries.
Example 20: Same facts as Example 16, except that regulations
are in effect to provide for a strict carryover of basis (or ELAs) in
the stock of subsidiaries following a spin-off.
P would inherit a $90 ELA in the stock of C and would retain its $30 ELA in D’s stock. As a
result, the group’s aggregate built-in gain would increase from $330 to $420 (i.e., $100 plus $90
ELA in C and $200 plus $30 ELA in D). This result is inappropriate.
c.
Section 358 - Basis Shifts
In addition to the elimination of ELAs, Congress was concerned with
inappropriate shifts of basis and value as a result of the basis allocation rules of section 358(c).
Example 21: A publicly traded corporation (“P”) owns all of the
stock of a subsidiary (“D”). D owns all of the stock of a
corporation (“C”). P’s basis in the stock of D is $50; the inside
asset basis of D’s assets is $50; and the total value of D’s stock
(including the value of C) is $150. D’s basis in the stock of C is
- 70 $0; the inside basis of C’s assets is $0; and the value of C’s stock
and assets is $100. D distributes its C stock to P.
Under section 358, P’s basis in the stock of D after the distribution is approximately $17 (i.e.,
50/150 multiplied by P’s $50 basis in D prior to the distribution), and the inside basis of D is
$50. P’s basis in the stock of C is approximately $33 (i.e., 100/150 multiplied by $50), and the
inside asset basis of C is $0. Had P sold the D stock while holding C, the total gain to P would
have been $100 (i.e., $150 less $50). After the distribution (and an appropriate waiting period),
however, C may be sold at a gain of $67. D’s assets may then be sold for $50 with no gain or
loss. Thus, D and C could be sold at a total gain of $67, rather than the total gain of $100 that
would have been realized without the distribution.173 Congress felt that the avoidance of gain as
a result of shifts of outside stock basis relative to inside net asset basis was inappropriate.
However, this is simply the result that is obtained by applying the rules of section
358. In general, under section 358(a)(1), the basis of property that is permitted to be received
without recognition of gain is the same as the basis of the property exchanged.174 In the case of a
section 355 distribution, section 358(b) provides that, under regulations prescribed by the
Treasury, the basis shall be allocated between the stock of the controlled corporation received
and the stock of the distributing corporation retained. This provision was enacted in 1924 to
reflect the theory that such exchanges were “merely changes in form and not in substance,” and,
therefore, “the property received should be considered as taking the place of the property
173
174
Conference Report, at 535-36 (Ex. 5).
In the case of a section 355 distribution, there is a deemed exchange in which the stock
of the distributing corporation is treated as surrendered, and received back, in the exchange.
Code § 358(c).
- 71 -
exchanged.”175 The Treasury regulations promulgated under section 358 provide that the basis
for the allocation required by section 358(b) is the proportionate fair market values of the stock
of each corporation.176
Accordingly, Congress’ suggestion that Treasury issue regulations providing for a
reduction in the basis of the stock of the distributing corporation to reflect its net asset value, and
its statement that the Treasury may determine that the aggregate basis of distributing and
controlled after the distribution should be less than such aggregate basis before the distribution in
situations like Example 19 is at odds with the statutory language of section 358(b) and its
legislative history.177 If this sort of basis shifting in the context of section 355 distributions,
which does not appear to involve any manipulation, concerns Congress, it should repeal or
amend section 358(b).
On the other hand, transactions intended to manipulate relative inside and outside
bases, such as where one corporation decreases its value by incurring debt and increases the asset
basis and value of another corporation by contributing the proceeds of such debt, would appear
to be outside the language of section 358(b) and, presumably, should be the target of any such
regulations. However, such “manipulative” transactions are typically found in cases where an
acquisition is contemplated, which are already severely limited by sections 355(d), (e), and (f) as
175
H.R. Rep. No. 68-179, at 16-17 (1924).
176
Treas. Reg. § 1.358-2(a)(2).
177
Indeed, the promulgation of such regulations in contradiction to the statute may exceed
Treasury’s authority. See Rite Aid Corp. v. United States, 88 A.F.T.R.2d ¶ 2001-5025 (Fed. Cir.
2001).
- 72 -
well as the device restrictions of section 355(a)(1)(B). Therefore, such regulations are not
necessary.
D.
Control and Step-Transaction Issues
1.
Control
There are two “control” tests that must be satisfied in order to have a tax-free
“divisive” D reorganization under sections 368(a)(1)(D) and 355. Under the section
368(a)(1)(D) control test (prior to the Act), shareholders of a distributing corporation who
receive stock in the controlled corporation must own 80 percent of the voting power and 80
percent of each other class of stock of such controlled corporation immediately after the
distribution.178 Under the section 355(a)(1)(D) control test, the distributing corporation is
required to be in control (again, 80 percent of the voting power and 80 percent of each other
class of stock) of the controlled corporation immediately before the distribution and the
distributing corporation must distribute to its shareholders all of its stock in the controlled
corporation.179 If a section 355 transaction does not involve a D reorganization, taxpayers need
only satisfy the section 355(a)(1)(D) control test.
As stated in Part II.A.3., above, the Act initially reduced the control requirement
under section 368(a)(1)(D) from 80 percent to 50 percent.180 Under section 368(a)(2)(H)(ii) as
178
Code § 368(a)(1)(D), (c).
179
Code § 355(a)(1)(D)(i), (c). If the distributing corporation retains some stock in the
controlled corporation, it must at least distribute control of the controlled corporation, and it must
show why the retention of the stock was not in pursuance of a plan having as one of its principal
purposes the avoidance of federal income tax. Code § 355(a)(1)(D)(ii).
180
The reduced control requirement also applies to section 351 transactions that are part
of section 355 transactions.
- 73 -
enacted by the Act, shareholders who receive stock in a controlled corporation in a section 355
transaction are treated as in control of such corporation if they hold stock representing greater
than 50 percent of the vote and value of such controlled corporation.181 Thus, Congress initially
made the control test of section 368(a)(1)(D) easier to satisfy. However, in 1998, the Reform
Act (as amended by the Extension Act) eliminated the 50-percent control provision, and replaced
it with a provision that states that if the requirements of section 355 are met, the fact that the
shareholders of the distributing corporation dispose of part or all of their controlled corporation
stock, or the fact that the controlled corporation issues additional stock, will not be taken into
account for purposes of determining whether the transaction qualifies under section
368(a)(1)(D).182 Thus, the 80-percent control test in section 368(c) that applied to section
368(a)(1)(D) transactions prior to the Act, again applies to such transactions.183
2.
The Step-Transaction Doctrine
The Service has ruled that even if the control tests of section 368(a)(1)(D) and
section 355(a)(1)(D) are technically satisfied, the Service can view a distribution and acquisition
under step-transaction principles and reorder the steps of such distribution and acquisition so that
the transaction fails one or both of these control tests. The Service has only applied this step-
181
See Conference Report, at 529. See also Code § 351(c)(2).
182
Code § 368(a)(2)(H)(ii).
Section 368(c) provides that the term “control” means “the ownership of stock
possessing at least 80 percent of the total combined voting power of all classes of stock entitled
to vote and at least 80 percent of the total number of shares of all other classes of stock of the
corporation.”
183
- 74 -
transaction concept in situations where the controlled corporation, rather than the distributing
corporation, is acquired.184
a.
The Step-Transaction Doctrine and the Section 368(a)(1)(D)
Control Requirement
The Service has applied the step-transaction doctrine and ruled that certain
transactions fail the section 368(a)(1)(D) control requirement.
Example 22: A publicly held corporation (“D”) conducts two
businesses, Business 1 and Business 2. D contributes Business 2
to a newly formed controlled corporation (“C”) in exchange for all
of C’s stock, and distributes C to its shareholders. As part of a
prearranged plan, C then merges into an unrelated corporation
(“P”), with the shareholders of C receiving less than 80 percent of
the stock of P.
Prior to the issuance of Rev. Rul. 98-27185 and Rev. Rul. 98-44,186 and the enactment of the
Reform Act in 1998, the Service ruled that this transaction did not qualify as a tax-free
transaction.187 The Service reasoned that the prearranged disposition of C stock as part of the
same plan as the distribution prevented the transaction from satisfying the 80-percent shareholder
control requirement under section 368(a)(1)(D). The Service recharacterized the transaction as
(1) a direct taxable transfer of assets by D to P in exchange for P stock, followed by (2) a
distribution of P stock.188
The House and Senate Reports note that “[p]resent law has the effect of imposing more
restrictive requirements on certain types of acquisitions or other transfers following a distribution
if the company involved is the controlled corporation rather than the distributing corporation.”
Senate Report, at 139; House Report, at 461.
184
185
1998-1 C.B. 1159.
186
1998-2 C.B. 315.
187
See Rev. Rul. 70-225, 1970-1 C.B. 80, obsoleted, Rev. Rul. 98-44, 1998-2 C.B. 315.
188
Id.
- 75 -
The Service modified Rev. Rul. 70-225 in Rev. Rul. 98-27, stating that the
Service will no longer apply the step-transaction doctrine in determining whether the distributed
corporation was a controlled corporation under section 355 immediately before the distribution;
i.e., the Service will not reorder the steps of the transaction for purposes of the section
355(a)(1)(D) control requirement. However, Rev. Rul. 98-27 did not rule out the application of
the step-transaction doctrine under the facts of Rev. Rul. 70-225 for purposes of applying the
section 368(a)(1)(D) control requirement. Thus, under Rev. Rul. 98-27, a subsequent acquisition
of Controlled still could have affected the satisfaction of the section 368(a)(1)(D) requirement
that the distributing corporation or its shareholders control Controlled immediately after the D
reorganization.
Section 368(a)(2)(H)(ii) as enacted by the Reform Act (and amended in the
Extension Act) limits the application of the step-transaction doctrine to the control test of section
368(a)(1)(D) in a section 355 transaction. Under section 368(a)(2)(H)(ii), as amended, if the
requirements of section 355 are met, the fact that the shareholders of the distributing corporation
dispose of part or all of their controlled corporation stock, or the fact that the controlled
corporation issues additional stock, will not be taken into account for purposes of determining
whether the transaction qualifies under section 368(a)(1)(D).189 Thus, section 368(a)(2)(H)(ii)
effectively rendered Rev. Rul. 70-225 obsolete. As a result of this statutory change, the Service
issued Rev. Rul. 98-44, formally declaring Rev. Rul. 70-225 obsolete.
189
The 1998 Act provides a similar rule for section 351 transactions.
- 76 -
Although the Reform Act and Rev. Rul. 98-44 prevent the Service from applying
the step-transaction doctrine under the facts of Rev. Rul. 70-225 for purposes of section
368(a)(1)(D), the Reform Act results in the possibility that spin-off transactions will be “tripletaxed.” For example, assume Distributing contributes the assets of one of its two businesses to
newly-formed Controlled in exchange for Controlled stock. Assume further that Distributing has
a built-in gain in the contributed assets. Distributing then distributes its Controlled stock to its
shareholders in a section 355 transaction, and an unrelated party (“Acquiring”) acquires the
Controlled stock within two-years of the distribution, in exchange for five percent of Acquiring
stock in a tax-free B reorganization.
Under the Reform Act, Distributing will not be taxed on the transfer of assets to
Controlled, Controlled will take a carryover basis in the assets received, and Distributing will
take a substituted basis in the stock of Controlled (so that Distributing has a built-in gain in that
stock). Upon Acquiring’s acquisition of Controlled following the distribution of the stock of
Controlled, Distributing will be taxed under section 355(e) on the built-in gain in its Controlled
stock (if it cannot overcome the presumption that the acquisition is pursuant to a plan that existed
at the time of the distribution) (tax # 1). In addition, Acquiring will be taxed if it sells the stock
of Controlled (because under section 362(b), Acquiring’s basis in the stock of Controlled is the
same as the Distributing shareholders’ basis prior to the acquisition, and such basis is not
stepped-up as a result of the section 355(e) tax) (tax # 2). Finally, Controlled will be taxed if it
sells the assets received from Distributing (tax # 3).
- 77 b.
The Step-Transaction Doctrine and the Section 355(a)(1)(D)
Control Requirement
Prior to Rev. Rul. 98-27 and the Reform Act, the Service also applied the steptransaction doctrine in the context of the section 355(a)(1)(D) control requirement.
Example 23: A publicly traded corporation (“D”) owns all the
stock of a preexisting controlled corporation (“C”). For a valid
business purpose, D distributes all of its C stock to its
shareholders. Soon after the distribution, C commences
negotiations with an unrelated corporation (“P”) and merges into
such corporation, with the shareholders of C receiving 25 percent
of the stock of P.
Under these facts, the Service ruled that the control requirement of section 355(a)(1)(D) is
satisfied.190 The Service reasoned that there were no negotiations prior to the distribution, and
that the shareholders of C voted after the distribution to merge with P. However, the Service
implied that it could apply step-transaction principles if there were negotiations prior to the
distribution.191
Shortly after issuing Rev. Rul. 96-30, the Service stated that it would not rule on
requests for section 355 treatment:
if there have been negotiations, agreements or arrangements with
respect to transactions or events which, if treated as consummated
before the distribution, would result in the distribution of stock or
securities of a corporation which is not controlled by the
distributing corporation . . . .192
190
Rev. Rul. 96-30, 1996-1 C.B. 36; see also Rev. Rul. 75-406, 1975-2 C.B. 125.
191
The Service relied on Court Holding in determining whether the form of the
transaction would be respected. If Court Holding principles applied, the transaction presumably
would be recharacterized as a disposition by D of its C stock to P, followed by a distribution of
the P stock received in the exchange. As recharacterized, the distribution would fail the section
355(a)(1)(D) control requirement because D would not be in control of P.
192
Rev. Proc. 96-39, 1996-2 C.B. 300; Rev. Proc. 97-3, § 5.17, 1997-1 C.B. 507. On
(cont. on next page)
- 78 -
Thus, prior to the Act, it appeared that the Service would consider applying the step-transaction
doctrine in analyzing both the section 368(a)(1)(D) control test and the section 355(a)(1)(D)
control test.
Due to the enactment of section 355(e) and the legislative history thereunder, the
Service stated in Rev. Rul. 98-27 that it would no longer apply the step-transaction doctrine for
purposes of determining “whether the distributed corporation was a controlled corporation
immediately before the distribution under section 355(a) solely because of any post-distribution
acquisition or restructuring of the distributed corporation, whether prearranged or not.”193 As a
result, Rev. Rul. 98-27 obsoleted Rev. Rul. 96-30 and Rev. Rul. 75-406. Note, however, that any
such post-distribution acquisition or restructuring could result in a corporate-level tax under
section 355(e).
3.
The Step-Transaction Doctrine and Section 355(e)
a.
Transactions Where Section 355(e) Applies
Example 24: A publicly traded corporation (“D”) owns all the
stock of a controlled corporation (“C”). In order to facilitate a
public offering of the stock of C, D distributes all of its C stock to
its shareholders. Immediately thereafter, C sells 60 percent of its
stock to the public.
Because there is no transfer of property from D to C in Example 24, the control
requirement of section 368(a)(1)(D) does not apply. However, the section 355(a)(1)(D) control
requirement does apply. If the Service applies the step-transaction doctrine and reorders the
November 10, 1997, the Service issued Rev. Proc. 97-53, revoking the “no-rule” position set
forth in Rev. Procs. 97-3 and 96-39. See Part III.D.3. infra for a further discussion of Rev. Proc.
97-53.
193
Rev. Rul. 98-27, 1998-1 C.B. 1159.
- 79 -
steps, the section 355 control requirement will not be satisfied, and the entire transaction will be
taxed.194
However, section 355(e) also applies to this example.195 Accordingly, D will be
taxed on the distribution of the stock of C.
Should the Service continue to apply the step-transaction doctrine where section
355(e) applies? The answer is no. Indeed, the House and Senate Reports stress that one of the
reasons Congress added these new provisions was to minimize the difference in treatment
between transactions involving the distributing corporation and the controlled corporation.196
The Conference Report notes the following:
The House bill does not change the present-law requirement under
section 355 that the distributing corporation must distribute 80
percent of the voting power and 80 percent of each other class of
stock in the corporation. It is expected that this requirement will
be applied by the Internal Revenue Service taking into account the
provisions of the proposal regarding plans that permit certain types
of planned restructuring of the distributing corporation following
the distribution, and to treat similar restructurings of the controlled
corporation in a similar manner. Thus, the 80-percent control
194
If the Service applies the step-transaction doctrine to these facts, it would presumably
reorder the steps as follows. First, C would be treated as selling 60 percent of its stock to the
public. Second, D would be treated as distributing its remaining C stock to its shareholders.
This distribution would fail the section 355 control requirement, as D would be treated as
holding only 40 percent of the C stock. The transaction would not qualify under section 355, and
there would be both a corporate- and shareholder-level tax. See Rev. Rul. 96-30, 1996-1 C.B.
36.
195
Section 355(e) applies because there is a section 355 distribution that is part of a plan
pursuant to which one or more persons (i.e., the public group) acquire stock representing a 50
percent or greater interest in the controlled corporation. See 1997 Blue Book, at 199 (stating that
“a public offering of sufficient size can result in an acquisition that causes gain recognition”
under section 355(e)).
196
See Senate Report, at 140; House Report, at 462.
- 80 requirement is expected to be administered in a manner that would
prevent the tax-free spin-off of a less-than-80-percent controlled
subsidiary, but would not generally impose additional restrictions
on post-distribution restructurings of the controlled corporation if
such restrictions would not apply to the distributing corporation.197
As a result of the legislative history, the Service issued Rev. Rul. 98-27, which states that the
step-transaction doctrine will not be applied to the facts of Example 24.
b.
Transactions Where Section 355(e) Does Not Apply
Example 25: Same facts as Example 24, except that C sells 40
percent of its stock to the public.
In Example 25, section 355(e) does not apply.198 Should the step-transaction
doctrine apply where section 355(e) does not apply? Once again, the answer is no. The
legislative history quoted in Part III.D.3.a., above, makes clear that Congress intended that
transactions not be treated differently merely because the controlled corporation, as opposed to
the distributing corporation, is involved. In fact, the legislative history suggests that Congress
intended to accommodate post-division reorganizations and initial public offerings that are not
affected by section 355(e). Accordingly, step-transaction principles should not apply to Example
23.199
Indeed, as noted above, the Service issued Rev. Rul. 98-27, which states that the
step-transaction doctrine will not be applied to the facts of Example 25.
197
Conference Report, at 529-30 (emphasis added); see Senate Report, at 142.
198
Section 355(e) does not apply because there is no section 355 distribution that is part
of a plan pursuant to which one or more persons acquire stock representing a 50-percent or
greater interest in the controlled corporation. The public only acquires 40 percent of C.
199
Again, this analysis should also apply equally to the application of the step-transaction
doctrine to the section 368(a)(1)(D) control test, as in Rev. Rul. 70-225, discussed supra.
- 81 -
IV.
RECOMMENDATIONS
The anti-Morris Trust and intragroup spin provisions are complicated and raise a
number of unresolved issues. Absent additional guidance, it will be extremely difficult for
taxpayers to determine the scope of sections 355(e) and (f) and 358(g). The Service should
address the following issues:
1. What constitutes an acquisition, including the effect of redemptions, recapitalizations,
conversions, gifts, and bequests?
2. How do the attribution and aggregation rules work?
3. Section 358(g) - What constitutes an abusive transaction necessitating
retroactive regulations? Is it necessary to provide for basis adjustments in cases
where there has been no purposeful manipulation of basis?