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

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)).

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