The IRS issued a revenue procedure (Revenue Procedure 2016-40) that provides for two safe harbors for transactions of a corporation meant to result in a tax free spin-off pursuant to IRC §355.
Specifically the ruling provides that if one of the safe harbors is met, the IRS will not challenge whether a distributing corporation’s acquisition of control of a subsidiary through issuance of additional stock by the subsidiary lacked substance when there is a post distribution transaction by the formerly controlled corporation that restores the shareholders to their effective interests before the issuance of that stock.
IRC §355 generally provides for tax free spin-offs from corporations if certain conditions are met. One of the key issues, found at IRC §355(a)(1)(A), requires the distributing corporation to have control (80%) of the spun-out entity prior to the distribution of that entity.
The safe harbor applies for transactions of the sort described in the procedure:
(1) D (the corporation distributing the stock) owns C (controlled corporation) stock not constituting control of C;
(2) C issues shares of one or more classes of stock to D and/or to other shareholders of C (the issuance), as a result of which D owns C stock possessing at least 80 percent of the total combined voting power of all classes of C stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of C;
(3) D distributes its C stock in a transaction that otherwise qualifies under § 355 (the distribution); and
(4) C subsequently engages in a transaction that, actually or in effect, substantially restores (a) C's shareholders to the relative interests, direct or indirect, they would have held in C (or a successor to C) had the issuance not occurred; and/or (b) the relative voting rights and value of the C classes of stock that were present prior to the issuance (an unwind).
Generally such a transaction raises the risk that the IRS would assert the technical control was illusory and, in fact, D never really possessed the necessary control. Clearly that would be the case if there existed binding agreements entered into before the distribution that the minority shareholders who previously controlled more than 20% of C would be issued “their” extra shares immediately after the transaction.
But interests held in corporations change over time, and it’s very possible a minority shareholder (or shareholders) could later acquire additional shares in a transaction that no one could have foresaw back when the entity had stock held by the distributing corporation. This ruling seeks to give a pair of “bright lines” that, if not crossed, will insure the IRS won’t assert that D never really had the necessary control.
The first safe harbor applies so long as C stays “clean” for 24 months—and that means not just holding off on issuing the stock, but also does not adopt any plan or policy that will lead to an “unwind” even if the shares are not issued until after the 24 month period.
As the ruling provides at Section 4.01:
.01 No Action Taken Within 24 Months. No action is taken (including the adoption of any plan or policy), at any time prior to 24 months after the distribution, by C's board of directors, C's management, or any of C's controlling shareholders (as defined in § 1.355-7(h)(3)) that would (if implemented) actually or effectively result in an unwind.
The second safe harbor applies to a third party transaction (such as a merger) that may result in an effective “unwind”. In this case we have a 24 month “look back” period that applies—that is, there was no groundwork laid for the third party transaction during the 24 months before the distribution. As well, there is a 20% interest test that applies to those who own an interest in C and also in the third party.
As the ruling provides in Section 4.02:
.02 Unanticipated Third Party Transaction. C engages in a transaction with one or more persons (for example, a merger of C with another corporation) that results in an unwind, regardless of whether the transaction takes place more or less than 24 months after the distribution, provided that --
(1) There is no agreement, understanding, arrangement, or substantial negotiations (within the meaning of § 1.355-7(h)(1)) or discussions (within the meaning of § 1.355-7(h)(6)) concerning the transaction or a similar transaction (applying the principles of § 1.355-7(h)(12) and (13), relating to similar acquisitions), at any time during the 24-month period ending on the date of the distribution; and
(2) No more than 20 percent of the interest in the other party, in vote or value, is owned by the same persons that own more than 20 percent of the stock of C. For purposes of this section, ownership is determined by application of the constructive ownership rules of § 318(a) as modified by § 304(c)(3), except that for purposes of applying § 318(a)(3)(A) and (B), the principles of § 304(c)(3)(B)(ii) (without regard to § 304(c)(3)(B)(ii)(I)) apply.
Section 5 of the ruling cautions that these safe harbors only apply for the control requirements, and meeting them will not insure that the transaction is tax free if the fails to qualify for §355 treatment otherwise.
As well, Section 5.02 notes that not meeting the safe harbor is also not fatal to the transaction. Rather, it notes:
.02 Effect of Safe Harbor Not Applying. If a transaction is not described in one of the safe harbors in section 4 of this revenue procedure, this revenue procedure has no effect on the determination of the federal tax treatment of the transaction. Rather, in such cases, the determination of whether an acquisition of control has substance and is therefore respected for purposes of § 355(a)(1)(A), and the proper treatment of all related transactions entered into by or between the parties, will be made under general federal tax principles without regard to the provisions of this revenue procedure.
The procedure also provides that the IRS will no longer automatically decline to issue letter rulings on the acquisition of control issue (modifying Revenue Procedure 2016-3) though the agency still reserves the right to do so in specific cases.
The procedure applies to distributions taking place on or after August 1, 2016, though taxpayers may rely on this procedure for the treatment of distributions taking place prior that date that meet the safe harbor requirements.