On July 14, 2016, the U.S. Department of the Treasury issued proposed regulations under Section 355 of the Internal Revenue Code that would establish new guidelines under the so-called "device" and "active business" tests. The proposed regulations would: (i) limit spin-offs in which either the distributing or controlled corporation has a high proportion of liquid nonbusiness assets; and (ii) establish a bright line value test under the active business requirement. The proposed regulations are generally consistent with the ruling policies articulated in Rev. Proc. 2015-43 and Notice 2015-59 that are believed to have been triggered in part by the proposed (but since abandoned) spin-off by Yahoo! Inc. of its stake in Alibaba Group Holding Ltd.
The IRS also released Revenue Procedure 2016-40 on July 15, 2016, which provides guidance under the "80 percent control" test with respect to the adoption and unwinding of high-vote structures intended to enable the distributing corporation to meet the control test prior to a spin-off. Revenue Procedure 2016-40 affirms the efficacy of transactions creating control prior to a spin-off and provides two safe harbors under which the IRS will not assert that a recapitalization or other acquisition of control prior to a spin-off lacks substance because of a subsequent unwinding of that structure.
Background
The Device Test. In order for a distribution of stock to qualify as a tax-free spin-off under Section 355, the transaction must satisfy the so-called "device" test. Under Section 355(a)(1)(B) and Treas. Reg. Section 1.355-2(d), a transaction will not qualify under Section 355 if the spin-off is considered principally a device for the distribution of earnings and profits of the distributing corporation, the controlled corporation, or both. The device test has continuing vitality, notwithstanding the unified tax rate for long-term capital gains and qualified dividends received by non-corporate stockholders, because differences remain in the U.S. federal income tax treatment of capital gains and dividends (e.g., with respect to basis recovery and the utilization of capital losses against capital gain, but only to a limited extent against ordinary income). The IRS will not provide a ruling with respect to the device test, even if tax issues presented by a spin-off are otherwise the subject of a ruling. See Rev. Proc. 2003-48.
While the presence of substantial investment assets historically has been considered evidence of a device, taxpayers nevertheless have undertaken spin-offs involving entities with substantial or disproportionate amounts of such assets, provided the spin-off had a substantial business purpose. This was considered supportable on the grounds that non-device factors reflected by a substantial business purpose could outweigh evidence of a device.
The Active Business Test. In general, Section 355(b) requires that both the distributing and controlled corporations be engaged in an active trade or business, and that such businesses have been conducted actively throughout the five-year period ending on the date of the spin-off. Neither the statute nor the regulations under Treas. Reg. Section 1.355-3 currently contain a requirement that the value of the active business used to satisfy Section 355(b) must be significant in relation to the value of the distributing or controlled entity. In the preamble to the proposed regulations, the IRS acknowledged that it "has taken the position, in letter rulings and internal memoranda, that an active business can satisfy the active business requirement regardless of its absolute or relative size," although the fact that the qualifying business is small is currently a device factor. The IRS placed this liberal ruling policy in context, however, by indicating that it was motivated in part by the historic technical difficulties in satisfying the active business test, many of which have been addressed by other legislative and regulatory changes, e.g., the adoption of the "separate affiliated group" (SAG) rules of Section 355(b)(3). In recent years, the formal nature of this ruling policy has been highlighted by transactions that have attracted public attention involving very small active businesses with no historical connection to the assets being spun off.
The 80 Percent Control Test. Under the "80 percent control" test of Section 355(a)(1)(A) and (D), the distributing corporation must have and distribute an amount of stock constituting control of the controlled corporation for purposes of Section 368(c), generally requiring 80 percent of the total combined voting power, and 80 percent of the number of shares of each class of the non-voting stock, of controlled. Historically, many transactions have been completed on the basis of IRS public and private rulings as to the efficacy of pre-spin-off recapitalizations, in which two-class voting structures were established, with distributing receiving high-vote stock that meets the requirement of Section 368(c) control. Under the published rulings, the acquisition of control is not permitted to be transitory or illusory, but instead must have substance. See Rev. Rul. 69-407. Because such high-vote structures are often unwieldy, however, and tend to produce uneven trading markets between the two classes of stock, taxpayers usually desire to unwind these structures as soon as possible following a spin-off. The IRS had issued private letter rulings allowing these high-vote structures to be dismantled relatively quickly (see, e.g., PLR 200837027), but in Rev. Proc. 2013-3, the IRS stated that the issue of recapitalizations into control was under study and it would not provide rulings addressing high-vote, low-vote structures or their unwinding until the issue was resolved.
The Device Test Under the Proposed Regulations
The proposed regulations are intended to provide objective standards regarding the application of the device test in the situation where distributing or controlled has substantial nonbusiness assets. The proposed regulations require distributing and controlled to determine the fair market value of both their business assets and nonbusiness assets, which combined are referred to as total assets. Business assets of a corporation comprise all active business assets (including cash and cash equivalents needed for working capital and other business exigencies), regardless of whether the business otherwise meets the five-year active business test of Section 355(b). Nonbusiness assets are all other assets of the corporation. The tests are applied by treating each SAG as a single corporation. Stock of any corporation outside of the SAG is considered a nonbusiness asset, except that the value of the stock of any 50-percent-owned corporation is allocated between business and nonbusiness assets based on the relative value of its underlying business and nonbusiness assets.
The presence of nonbusiness assets is considered evidence of a device, and the larger the ratio of nonbusiness assets to total assets (referred to as the nonbusiness asset percentage), the stronger the evidence of a device. In cases where the nonbusiness asset percentage of each of distributing and controlled is less than 20 percent, however, ownership of nonbusiness assets ordinarily is not considered evidence of a device.
A difference between the nonbusiness asset percentages of the distributing and controlled corporations is also evidence of a device, and the larger the difference, the stronger the evidence of a device. A difference in nonbusiness asset percentages is ordinarily not evidence of a device, however, if the difference is less than 10 percentage points, or if the distribution is not pro rata among the shareholders of the distributing corporation and the difference is needed to equalize the value received by the distributees.
As under prior rules, a corporate business purpose is evidence of nondevice, and can outweigh the evidence of a device, including evidence in the form of ownership of nonbusiness assets. The existence of a corporate business purpose for the ownership of nonbusiness assets may outweigh the evidence of device presented by such ownership, and the existence of a corporate business purpose for a difference between the nonbusiness asset percentages of the distributing and controlled corporations may outweigh the evidence of device presented by such difference. If the business purpose relates to a separation of nonbusiness assets from business assets, however, then the business purpose must involve an exigency that requires an investment or other use of the nonbusiness assets in order to be evidence of nondevice. The proposed regulations provide an example of a nondevice in which the lease of the distributing corporation is expiring and it will use its disproportionate nonbusiness assets to purchase a building following the spin-off.
Under a per se test, a spin-off will be considered a device if either distributing or controlled has a nonbusiness asset percentage of 66 and 2/3 percent or more and the nonbusiness asset percentage differs materially between the two entities, based on the following sliding scale:
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one entity has a nonbusiness asset percentage of 66 and 2/3 percent or more but less than 80 percent, and the nonbusiness asset percentage of the other entity is less than 30 percent;
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one entity has a nonbusiness asset percentage of 80 percent or more but less than 90 percent, and the nonbusiness asset percentage of the other entity is less than 40 percent; or
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one entity has a nonbusiness asset percentage of 90 percent or more and the other entity has a nonbusiness asset percentage of less than 50 percent.
The proposed regulations contain an anti-abuse rule, under which transactions or a series of transactions with a principal purpose of affecting the nonbusiness asset percentage will not be given effect. The rule would not generally apply to non-transitory transactions other than with a related party.
The Active Business Test Under the Proposed Regulations
In contrast to the proposed device regulations, the proposed changes to the active business regulations are relatively straightforward. Under proposed Treas. Reg. Section 1.355-9, for each of distributing and controlled the value of the assets used by it to meet the five-year active business test must be at least 5 percent of the fair market of its total assets.
Various operating rules apply for purposes of measuring fair market value. In general, the value test is applied in accordance with the rules described above for the device test: each SAG is treated as a single corporation (although there is no look-through to the assets of 50-percent-owned corporations as in the device test regulations). There is a look-through to the assets of a partnership, to the extent distributing or controlled is considered to be engaged in a five-year active business by virtue of its holding an interest in the partnership. There is an anti-abuse rule similar to that described above under the proposed device regulations.
Revenue Procedure 2016-40
Revenue Procedure 2016-40 applies to the situation in which the distributing corporation acquires control of the controlled corporation in advance of a spin-off via a recapitalization or other transaction, and then seeks to place the shareholders of controlled in the same position as if the transaction that created the controlling interest not occurred. This is referred to by the IRS as an "unwind."
The IRS makes clear that high-vote, low-vote structures adopted in anticipation of a spin-off can pass muster under Section 355, and also introduced two safe harbors under which a recapitalization into control and an unwind will not result in a challenge to the application of Section 355 to the spin-off on the grounds that distributing lacked control of controlled. The first safe harbor applies if no action is taken, including the adoption of any plan or policy, by controlled's management, board of directors, or controlling shareholders to effectuate an unwind within 24 months of the spin-off.
The second will apply to a situation in which the controlled corporation engages in a transaction (e.g., a merger of controlled) that results in an unwind if: (i) there was no agreement, understanding, arrangement, or substantial negotiations or discussions concerning the transaction... at any time during the 24-month period ending on the date of the distribution; and (ii) no more than 20 percent (by vote or value) of the interest in the other party is owned by the same persons that own more than 20 percent of the stock of the controlled corporation.
Effective Dates
If finalized, the device and active business regulations would generally apply to transactions occurring on or after the date of adoption, with certain transition relief provided for distributions made pursuant to a binding agreement entered into or a distribution described in a public announcement or filing with the SEC on or before the regulations are finalized, or described in a ruling request submitted before July 15, 2016.
Revenue Procedure 2016-40 is effective with respect to distributions that occur on or after August 1, 2016, although it may be applied by taxpayers to spin-offs occurring prior to that date.
