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Proposed Regulations on Tax-Free Spin-Offs

July 15, 2016, the IRS and the U.S. Department of the Treasury issued proposed regulations (REG-134016-15, 81 Fed. Reg. 46004) under section 355 of the Internal Revenue Code.

As a general rule, a corporation’s distribution of property to shareholders is a taxable event for both the corporation and the shareholders. The corporation recognizes gain in the amount that the property’s fair market value exceeds the corporation’s adjusted basis in the distributed property. A shareholder is treated as receiving a dividend to the extent of the corporation’s earnings and profits, then as a recovering basis in the shareholder’s stock, and finally as gain from the sale or exchange of property.

Section 355 provides an exception. If the section 355 requirements are met, both the corporation and its shareholders or security holders avoid tax when the corporation distributes stock or securities of a corporation that it “controls” to the shareholders or security holders. “Control” is defined in Code section 368(c).

Distributions of the stock of a controlled corporation are usually (1) a pro rata distribution to the distributing corporation’s shareholders (a “spin-off”), (2) a distribution of the stock in redemption of the distributing corporation’s stock (a “split-off”), or (3) a liquidating distribution of the stock of more than one controlled corporation, either pro rata or non-pro rata (in either case, a “split-up”). In financial terms, these distributions constitute “divestitures.”

One of the section 355 requirements, designed to prevent shareholders from avoiding tax on dividends, provides that the distribution must not be used principally as a device for distributing the earnings and profits of the distributing corporation and/or the controlled corporation. This is the “device test.” Another restriction requires both the distributing and controlled corporations to be engaged in the “active conduct of a trade or business” immediately after the distribution. This is the “active business test.”

When finalized, these proposed regulations would contain guidance on the device test and would provide a minimum asset threshold for the active business test.

Proposed Guidance on Device Test

Final section 355 regulations issued in 1989 specify three factors that are evidence of “device” and three factors that are evidence of “nondevice.” The proposed regulations would modify two of these factors—the “nature and use of assets device factor” and the “corporate business purpose nondevice factor”—and would add a “per se device test.”

  • Nature and Use of Assets Device Factor: This factor in the 1989 regulations provides that the existence of assets not used in a trade or business, such as cash and other liquid assets not related to the reasonable needs of the business, is evidence of a device.

The proposed 2016 regulations would add clarity to this factor. Ownership by either the distributing or the controlled corporation of “Nonbusiness Assets” (gross assets other than those used in the active conduct of a trade or business) would be evidence of device, but the strength of that evidence would depend on the “Nonbusiness Asset Percentage” (the fair market value of Nonbusiness Assets divided by the fair market value of total assets) for each corporation. The larger the Nonbusiness Asset Percentage, the stronger the evidence that the distribution is a device. If the Nonbusiness Asset Percentage of each corporation were less than 20%, the distribution would probably not be a device. Similarly, a difference between the distributing corporation’s Nonbusiness Asset Percentage and the controlled corporation’s Nonbusiness Asset Percentage would be evidence of device, and the larger the difference, the stronger the evidence. A difference of less than 10% would not suggest device. Also, a difference would not suggest device if the distribution were not made pro rata among the shareholders and the differences were attributable to equalizing the value of the stock and securities of the two corporations.

  • Corporate Business Purpose Non-device Factor: Under the proposed regulations, a corporate business purpose relating to the separation of Nonbusiness Assets from the active conduct of a trade or business or from assets used in such a trade or business would not be evidence of nondevice unless the business purpose required investment or other use of the Nonbusiness Assets in an active trade or business.
  • Per Se Device Test: Subject to limited exceptions, a distribution would be considered a device per se (regardless of any non-device factors) if (1) at least 66 2/3% of either the distribution or the controlled corporation’s total assets consisted of Nonbusiness Assets, and (2) a comparison of the Nonbusiness Asset Percentages of the two corporations fell within one of three “bands” set forth in the proposed regulations.

Proposed Guidance on Minimum Size for Active Business Test

The IRS and the Treasury believe that a distribution that only involves a de minimis active business should not qualify for tax-free treatment under section 355. The proposed regulations, therefore, would only allow tax-free treatment if the “Five-Year-Active-Business Asset Percentage” of each corporation were at least 5%. The proposed regulations define the Five-Year-Active-Business Asset Percentage as the percentage produced by dividing the fair market value of a corporation’s “Five-Year-Active-Business Assets” by the fair market value of its total assets. The Five-Year-Active-Business Assets are the corporation’s gross assets used in the active conduct of a trade or business that meets the requirements of Code section 355(b)(2) and Regulations section 1.355-3(b).

Applicability Date

Subject to transition rules, the regulations are generally proposed to apply to distributions occurring on or after the date on which the regulations are published as final in the Federal Register.

Comments on the proposed regulations must be received by the IRS no later than October 13, 2016.

Learn More

Contact your CT representative or call 1-844-206-9033 to find out how we can help you before, during and after the spin-off process.

Related articles: 

Corporate Spin Offs: Four Essential Compliance Steps

The Four Phases of Corporate Spin Off

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