United States: New IRS Ruling Guidance May Cast Doubt On Some Tax-Free Spinoffs

On Sept. 14, the IRS released new guidance (Notice and Revenue Procedure) limiting the types of spinoffs eligible for private letter rulings, signaling mounting IRS concerns regarding transactions involving companies with significant passive assets.

The IRS' new no-rule areas will increase apprehension for corporations planning spinoffs and for the investors – hedge funds and private equity funds included – that own stakes in those companies and expect tax-free treatment to strengthen their returns. The guidance will impact a number of potential deals that are already in the works, as well as future restructurings. As a result of the IRS position, some pending spinoffs may be subject to an unexpected degree of tax risk, and future spinoffs may require reliance on opinions of counsel regarding tax-free status.

Internal Revenue Code Section 355 and related Treasury Regulations outline the many requirements for the distribution by a parent corporation ("Distributing") of a corporate subsidiary ("Controlled") to be tax-free. One such requirement is that both Distributing and Controlled must be engaged in the ongoing active conduct of a trade or business ("ATB") for a period of at least five years preceding the spinoff. Many companies satisfy this requirement with a small operating business that is dwarfed in size and value in comparison with the corporation's other assets, which may be a trade or business that does not satisfy the ATB requirements for whatever reason or may consist of passive investment assets. Neither the statute nor existing regulations require that the ATB make up a threshold percentage of a corporation's assets. During the 1990s, the IRS refused to issue private letter rulings confirming the tax-free status of spinoffs when the ATB represented less than 5% of the overall value of the corporation directly conducting the trade or business. Since 2003, there has been no ATB size requirement for the IRS to issue a ruling, and the IRS has issued favorable rulings where the ATB was understood to be much lower – perhaps as low as 1%.

The IRS is now reconsidering whether the active business must be of a certain minimum size in order for the ATB requirement to be satisfied. In the Sept. 14 guidance, the IRS said that, except in unique or compelling circumstances, going forward it will not issue Section 355 rulings when the value of the gross assets of the ATB is less than 5% of the overall value of the gross assets of Distributing or Controlled (and their subsidiaries), as applicable. The IRS' concern about ATB size was highlighted shortly prior to the release of the guidance, when Yahoo Inc. announced that the agency refused to issue a private letter ruling regarding Yahoo's plan to spin off its minority stake in Chinese e-commerce company Alibaba Group Holding. The ATB assets in Yahoo's planned spinoff were estimated to make up less than 0.2% of the value of Yahoo's Alibaba shares.

The IRS also expressed concerns about the increasing number of spinoffs involving the conversion of either Distributing or Controlled into a REIT or a RIC – tax-preferred vehicles that in general do not pay corporate-level income tax. According to the IRS, spinoffs involving conversions to a REIT or a RIC raise significant concerns about the ATB requirement, the statutory prohibition on spinoffs that are mere devices for the distribution of earnings and profits, and the regulatory business purpose requirement. The IRS had previously ruled favorably on Penn National Gaming's 2013 spinoff of its passive real estate assets to shareholders. Following the distribution, the spun-off corporation leased the properties back to Penn National Gaming and elected REIT status. The Sept. 14 guidance provides that the IRS will no longer issue rulings, except in unique or compelling circumstances, regarding spinoffs that are part of a plan or series of transactions in which Distributing or Controlled converts to a REIT or a RIC.

The IRS has also expressed reservations about spinoffs that result in Distributing or Controlled owning a substantial amount of investment assets. Such transactions raise concerns regarding the device prohibition and the business purpose requirement. In addition, Code Section 355(g) taxes certain spinoffs involving a corporation whose investment assets constitute at least two-thirds of the value of the corporation's assets, but only if any person owns at least 50% of the corporation after, but not before, the spinoff. In the Sept. 14 guidance, the IRS said that it will no longer issue spinoff rulings if immediately after the transaction three factors are present: (i) the fair market value of the investment assets of Distributing or Controlled is two-thirds or more of the total fair market value of its assets; (ii) the fair market value of the gross assets of the ATB of such corporation is less than 10% of the fair market value of its investment assets; and (iii) the ratio of the fair market value of investment assets to other assets of such corporation is three times or more of such ratio for the other corporation.

The guidance applies to requests made on or after Sept. 14, 2015. While many transactions will comfortably meet these new standards for rulings, others will face greater ambiguities, which could force them to reconsider their options. In the absence of further guidance or specific rulings from the IRS, many corporations will need to rely more heavily on opinions from counsel while planning, structuring and proceeding with spinoffs. Yahoo, for instance, has indicated its intention to proceed with the spinoff of Alibaba on the basis of an opinion of counsel, despite the IRS' failure to rule.

Ultimately, corporations will have to decide how confident they are in proceeding without an IRS ruling. This will determine whether they proceed with the spinoff as is, restructure the transaction or abandon the plan altogether.

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.

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