United States: REIT Spinoffs: Passive REITs, Active Businesses, Part 2

Last Updated: April 15 2015
Article by Cadwalader, Wickersham & Taft LLP

Most Read Contributor in United States, December 2018

III. SECTION 355 ISSUES

In addition to the many real estate investment trust issues discussed in the previous sections, REIT spinoffs implicate the provisions of section 355. Just as important as SpinCo's REIT qualification is the tax-free qualification of the distribution of SpinCo stock.222 Parent's contribution of assets to SpinCo and the distribution of SpinCo's stock must qualify as a section 368(a)(1)(D) reorganization (D reorganization). A D reorganization includes a corporation's transfer of all or part of its assets to another corporation if, immediately after the transfer, the transferor corporation or one or more of its shareholders, or any combination thereof, has control of the transferee corporation and the stock of the transferee corporation is distributed in a transaction qualifying under section 354, 355, or 356.223

A. Spinoff Policy Analysis

Congress granted tax-free treatment to spinoffs (and split-offs and split-ups) in 1924224 on the belief that they generally represent a mere change in the form of investment.225 However, Congress quickly determined that some taxpayers were using the original spinoff provision to avoid the dividend tax, as shown most prominently by Gregory v. Helvering.226 The taxpayer in Gregory owned a corporation that held appreciated stock. To avoid a taxable dividend of the appreciated stock, the taxpayer caused her corporation to transfer the appreciated stock position to a new subsidiary and distribute that subsidiary's stock to the taxpayer in a putative reorganization (that is, a spinoff). The taxpayer promptly liquidated the new corporation and paid tax on the appreciated stock position at a lower capital gains rate.227 Although the Supreme Court ultimately concluded in 1935 that the transaction was ''a mere device . . . to transfer a parcel of corporate shares to the petitioner'' and denied reorganization treatment,228 Congress had already acted the year before to preclude spinoffs from qualifying as reorganizations.229

In 1951 Congress restored tax-free treatment to spinoffs that satisfied significant new restrictions.230 A spinoff would be tax-free only if (1) the distributing and controlled corporations intended to carry on business after the separation, and (2) the transaction was not a device for distributing the earnings and profits of any party to the reorganization.231 The regulations already imposed a business purpose test.232 These core requirements, modified and supplemented by others, have formed the crux of the test for a spinoff's tax-free qualification ever since.

Initially, several policy arguments might be raised against allowing REIT spinoffs to qualify under section 355. For example, some might contend that a spinoff coupled with SpinCo's REIT conversion allows appreciated assets to leave corporate solution, in conflict with the general policy of imposing a tax in those instances, as in Gregory, and inconsistent with the repeal of the General Utilities doctrine.233 Of course, REITs can be, and indeed most are, corporations for legal purposes,234 and if a REIT transfers property out of corporate solution during the 10-year period after a conversion, the REIT generally will be subject to corporate tax on the portion of the built-in gain attributable to the period when the REIT was a C corporation.235 Although this policy does not completely foreclose the possibility of built-in gain eventually escaping entity-level taxation, it nonetheless is a lengthy restriction that represents a balanced approach by Treasury on where best to draw the line when a C corporation converts to REIT status.236 The separate fact that the REIT generally avoids corporate income tax on its future rental income occurs by design under the REIT rules and should not implicate any section 355 policies, assuming there is at least one valid business purpose for SpinCo's distribution, as is usually the case.

It might also be argued that section 355 should apply only when there is no or a minimal continuing relationship between the parties, and that an OpCo- PropCo lease suggests that no bona fide separation of Distributing and Controlled, as contemplated by section 355, has occurred. Although stapled share structures did not involve section 355 distributions, Congress nonetheless addressed substantially similar policy issues in this area and, in enacting section 269B, drew the line at legally stapled arrangements, which are not present in typical REIT spinoffs.237 Also, while a continuing relationship may support increased scrutiny of the business purpose in a section 355 transaction,238 as described below, REIT spinoff participants typically articulate several valid business purposes for these transactions. No rule provides that transactions featuring relationships such as OpCo-PropCo leases cannot qualify under section 355, and, indeed, the IRS has approved several transactions under section 355 in which the separating companies maintained several long-term continuing relationships.239

Nor can it be said that Parent and SpinCo in a typical REIT spinoff do not enter into a bona fide lease. The parties have, by all accounts, done their best to use arm's-length terms in their leases.240 Parent in each REIT spinoff with an OpCo-PropCo lease loses ownership of the property involved and has only a temporary right of occupation, subject to ejection in several instances.241 After the distribution, SpinCo is an independent corporation, and its directors have a fiduciary duty to act in the best interests of SpinCo's shareholders.242

If the argument is that it is ''bad'' policy to allow REIT spinoffs to take advantage of section 355, the question is why? These transactions generally do not seem to implicate any of the key requirements under section 355 — as discussed below, multiple valid business purposes exist for the distribution of SpinCo stock, and a substantial taxable dividend typically precedes SpinCo's REIT conversion. While the active businesses relied on by SpinCos are generally not large relative to the value of the real property, they should typically suffice as a legal matter, and in any case, the underlying purpose of the active trade or business (ATOB) requirement is to backstop the device test, which REIT spinoffs generally should satisfy.243 Finally, if the focus is on the nontraditional REITs that have provoked the most discussion as of late, it is especially inappropriate to use section 355 to address these concerns, because these new companies are likely to avoid any new restrictions by forming as REITs initially or by converting to REITs wholesale. Accordingly, for all these reasons, it is inappropriate to construe typical REIT spinoffs as contravening any fundamental policy of spinoff taxation.

REIT spinoffs' compliance with the technical requirements of section 355 is discussed below. While section 355 imposes numerous requirements,244 this report focuses on three: business purpose, ATOB, and device.

To read Part 2 of this Report in full, please click here.

Originally published by Tax Notes, March 30, 2015.

Footnotes

222. There are three main methods for dividing an existing company through a tax-free distribution of stock: (1) In a spinoff, a corporation distributes, generally pro rata, stock of one or more subsidiaries to existing shareholders; (2) in a split-off, a corporation exchanges stock of one or more subsidiaries for its own stock held by participating tendering shareholders; and (3) in a split-up, a corporation exchanges stock of two or more subsidiaries for all its outstanding stock in complete liquidation of the corporation. See Boris I. Bittker and James S. Eustice, Federal Income Taxation of Corporations and Shareholders, at section 11.01[1][e] (2000 and supp. 2014-3).

223. The regulations impose additional requirements for qualification as a reorganization. See reg. section 1.368-1.

224. See Revenue Act of 1924, P.L. 68-176, section 203(b)-(c). There is evidence that before 1919, Treasury sometimes indicated in letters that a particular split-off or split-up qualified as tax free. See George E. Holmes, Federal Income Tax, War-Profits and Excess Profits Taxes, 262, n.20 (1920) (listing those letters from 1915 to 1918). The Revenue Act of 1918 granted tax-free status to some exchanges of stock as part of reorganizations, mergers, or consolidations. See Revenue Act of 1918, P.L. 65-254, section 202(b) (1919) (''When in the case of any such reorganization, merger or consolidation the aggregate par or face value of the new stock or securities received is in excess of the aggregate par or face value of the stock or securities exchanged, a like amount in par or face value of the new stock or securities received shall be treated as taking the place of the stock or securities exchanged, and the amount of the excess in par or face value shall be treated as a gain to the extent that the fair market value of the new stock or securities is greater than the cost (or if acquired prior to March 1, 1913, the fair market value as of that date) of the stock or securities exchanged''). It has been disputed whether this language applied both to split-offs and split-ups, or just the latter. See, e.g., Seymour S. Mintz, ''Divisive Corporate Reorganizations: Split-Ups and Split-Offs,'' 6 Tax. L. Rev. 365, 367 (1951) (''It is generally agreed that . . . [these] provisions applied to split-ups, but their applicability to split-offs is denied by those who assert that in the split-off the pro rata transfer to the original corporation of part of its own stock by its shareholders is a formal act not substantially affecting such corporation or its ownership or operation, but merely reducing the number of its outstanding shares and hence, arguably, leaving the split-off essentially indistinguishable from the spin-off'').

225. See letter from David A. Gates, acting commissioner of Internal Revenue, to F. B. MacKinnon (Aug. 3, 1917), in Robert H. Montgomery, Income Tax Procedure 277-278 (1919) (describing an exchange of shares in one company for shares in another as part of a reorganization: ''If the assets are exchanged for other assets of a like character, and no account is taken of compensatory value, it will be held that such a transaction constitutes merely a change in the form of assets, and the investment will be considered a continuing one, no profit or loss to be taken into account until the assets are disposed of for cash or its equivalent on the basis hereinbefore indicated'').

226. 27 B.T.A. 223 (1932), rev'd, 69 F.2d 809 (2d Cir. 1934), aff'd, 293 U.S. 465 (1935).

227. 27 B.T.A. at 224.

228. Gregory v. Helvering, 293 U.S. 465, 469 (1935).

229. See Revenue Act of 1934, P.L. 73-216 (omitting former section 112(g), which provided tax-free treatment to spinoffs, from new income tax code). See also H.R. Rep. No. 73-704, at 14 (1934) (''The committee recommends that section 112(g) be omitted from the bill. This paragraph provides that a corporation by means of a reorganization may distribute to its shareholders stock or securities in another corporation a party to the reorganization without any tax to the shareholder. By this method corporations have found it possible to pay what would otherwise be taxable dividends, without any taxes upon their shareholders.''). Although Congress abolished spinoffs, splitoffs and split-ups generally were still allowed. See New York State Bar Association Tax Section, ''Report on the Role of the Step Transaction Doctrine in Section 355 Stock Distributions: Control Requirement and North-South Transactions'' (Nov. 5, 2013).

230. See Revenue Act of 1951, P.L. 82-183, section 317(a) (enacting former section 112(b)(11)). Abill to permit spinoffs to qualify again for tax-free treatment had passed the House, but not the Senate, in 1948. See Revenue Revision Act of 1948, H.R. 6712, 80th Cong. section 128. Another bill with a similar provision had passed the Senate in 1950, but the spinoff language was removed in conference. See H.R. Rep. No. 81-3124, at 26 (1950). For an overview of the legislative history in this area, see NYSBA, supra note 229, at Section III.

231. See former section 112(b)(11)(A) and (B).

232. Former reg. section 86, 112(g)-1 (1935) (''The provisions of the Act referred to in the preceding paragraph of this article are inapplicable unless there is a plan of reorganization. A plan of reorganization must contemplate the bona fide execution of one of the transactions specifically described as a reorganization in section 112(g) and for the bone fide consummation of each of the requisite acts under which nonrecognition of gain is claimed. That transaction and those acts must be an ordinary and necessary incident of the conduct of the enterprise.''); former reg. section 86, 112(g)-2 (1935) (''Moreover . . . the readjustments involved in the exchanges effected in the consummation [of a reorganization] must be undertaken for reasons germane to the continuance of the business of a corporation a party to the reorganization'').

233. In 1986 Congress repealed the doctrine of General Utilities & Operating Company v. Helvering, 296 U.S. 200 (1935). See Tax Reform Act of 1986, P.L. 99-514, section 631(a). A 1988 bill requested that Treasury promulgate regulations ensuring that regulated investment companies and REITs were not used to circumvent the repeal. See Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647, section 1006(e)(5) (amending section 337(d) to refer to RICs, REITs, and tax-exempt entities). Treasury issued a notice in 1988 providing REITs and RICs the same treatment as subchapter S corporations. See Notice 88-19, 1988-1 C.B. 486, amplified by Notice 88-96, 1988-2 C.B. 420. This notice was followed by temporary and then final regulations. See reg. section 1.337(d)-7.

234. See section 856(a) (defining a REIT as a ''corporation, trust, or association'').

235. See section 1374(a) (imposing a tax on any net recognized built-in gain by an S corporation during a recognition period); section 1374(d) (defining net recognized built-in gain to include gain recognized on the disposition of an asset for which it is not established that the asset was not held by the S corporation at the beginning of its first tax year as an S corporation); section 1374(d)(7) (defining recognition period as the 10-year period beginning with the first day of the S corporation's first tax year); reg. section 1.337(d)-7(b)(1) (providing that a RIC or REIT will be subject to tax under the rules of section 1374 on the net built-in gain on any asset previously owned by a C corporation and received by the RIC or REIT in a conversion transaction).

236. Also, the parties certainly do not intend for SpinCo to dispose of its real estate assets, since they are vital parts of Parent's operations.

237. See Part 1, Section II.C.2.

238. See Rev. Proc. 96-30, 1996-1 C.B. 696, at App. A, section 2.05(5) (providing that a request for a private ruling that a distribution qualified as tax free under section 355 would be subject to special scrutiny in some situations, including the existence of a continuing relationship between Distributing and Controlled), as modified by Rev. Proc. 2003-48, 2003-2 C.B. 86, section 4.01.

239. See Part 1, note 113.

240. See Part 1, note 44.

241. For instance, the lease between Penn National and GLPI provides that GLPI may enter onto the leased property, or relet the property to third parties, in certain circumstances if Penn National fails to comply with applicable laws in using the property or fails to maintain insurance on the property. See Gaming and Leisure Properties Inc., Current Report (Form 8-K) (Nov. 7, 2013), Exhibit 10.1, section 8.2.

242. As discussed above, Parent's and SpinCo's shareholder bases should diverge over time given the different nature of the two companies, and, if there are overlapping directors, SpinCos generally should have strong policies in place to address potential conflicts of interest. The policy on overlapping directors adopted by GLPI is an example. See Part 1, note 114.

243. See infra note 280.

244. Section 355 requires that (1) the distributing company distributes enough of the stock or securities it holds of Controlled to qualify as ''control'' under section 368(c) (section 355(a)(1)(D)); (2) the stock distributed was not acquired in taxable transactions within the five-year period preceding the distribution (section 355(a)(3)(B)); (3) the principal amount of any securities distributed matches that of the securities surrendered, or no securities are distributed (section 355(a)(3)(A)); (4) the transaction has a corporate business purpose that is germane to the business of Distributing, or Controlled, or Distributing's separate affiliated group and is not achievable through a different nontaxable transaction (reg. section 1.355-2(b)); (5) Distributing and Controlled demonstrate that they are, after the transaction, and have been, for five years prior, engaged in qualifying ATOBs (section 355(b)(1)); (6) the businesses engaged in by the enterprise before the transaction continue thereafter (reg. section 1.355-1(b)); (7) one or more persons owning a meaningful interest in the enterprise before separation own a qualifying amount of stock in each of Distributing and Controlled after the transaction (reg. section 1.355-2(c)(1)); (8) the transaction is not a device for the distribution of the E&P of Distributing, Controlled, or both (section 355(a)(1)(B)); (9) no person holds, immediately after the distribution, a 50 percent or greater interest (by vote or value) in either Distributing or Controlled that was acquired (or attributable to purchases) in the five-year period preceding the distribution (section 355(d)); (10) the transaction must not be part of a plan under which one or more persons acquire, directly or indirectly, stock representing a 50 percent or greater interest (by vote or value) in either Distributing or Controlled (section 355(e) and (f)); and (11) neither Distributing nor Controlled holds sufficient investment assets to render either a disqualified investment corporation, or no person holds a new 50 percent or greater interest (by vote or value) in either corporation, immediately after the transaction (section 355(g)).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions