United States: IRS Will Resume Ruling On Important Spin-Off Issues

Last Updated: May 31 2017
Article by Richard M. Nugent and Peter Wang
Most Read Contributor in United States, September 2019

In Short

The Situation: The IRS had discontinued issuing private rulings on certain transactions related to spin-offs, leaving companies to wonder if favorable tax treatment was likely.

The Action: Recent IRS guidance announced the resumption of private rulings in transactions under consideration, and provided confirmation that certain "north-south" transactions will not adversely impact second-step spin-offs.

Looking Ahead: Further clarification on these matters is necessary, and additional guidance on spin-offs may be in the offing.

The IRS recently provided taxpayers with favorable guidance involving tax-free spin-offs. First, the IRS will resume issuing private rulings that allow a distributing corporation to satisfy debt it issued in anticipation of a spin-off with stock or debt securities of a controlled subsidiary. This development allows companies considering a spin-off to seek IRS confirmation of tax-free treatment for these exchanges. Second, the IRS issued published guidance confirming that certain exchanges between corporations ("north-south transactions") will not affect a second-step spin-off.

Rev. Proc. 2017-38 – Distribution of Controlled Debt

The IRS will resume ruling on distributions of certain subsidiary ("Controlled") debt securities (or stock) in exchange for parent ("Distributing") debt issued in anticipation of a spin-off. Distributing may generally receive a tax-free cash distribution from Controlled up to Distributing's tax basis in Controlled stock, if Distributing then uses the cash to repay its creditors or distributes the cash to its shareholders ("Boot Purge Rule"). In addition, Distributing may receive certain Controlled debt securities tax-free without regard to Distributing's basis in Controlled stock and then may distribute the securities tax-free in retirement of Distributing's own debt. Deleveraging allows Distributing to increase its equity value tax-free.

Debt-for-debt exchanges typically involve a financial intermediary ("bank") that acquires the Distributing debt some number of days—typically five—before entry into an exchange agreement with Distributing. Following the exchange with Distributing—typically 14 days after the bank's acquisition of Distributing debt—the bank usually sells the Controlled securities to the public. Although the initial private rulings generally involved a bank's acquisition of existing Distributing debt on the market, the IRS eventually permitted Distributing to issue new debt directly to the bank and avoid some of the costs incurred under the original structure.

Rev. Proc. 2017-38 lifts the "no rule" on debt-for-debt exchanges. However, it does not articulate whether, or under what circumstances, Distributing may issue debt to a bank or another creditor in connection with a spin-off, or any other standards that the IRS will apply in evaluating proposed exchanges. A government official recently indicated that the IRS is actively considering guidance which may address these questions.

Rev. Rul. 2017-9 – North-South Transactions and Second-Step Spin-Offs

North-south transactions involve the planned, but formally separate, contribution of assets to, and distribution of other assets from, a corporation. For years, the IRS would issue private rulings on whether the form of the two transactions would be respected in connection with a spin-off. The IRS generally treated the component steps separately, absent any compulsion that the contribution occur as a condition to the distribution. However, in late 2012, the IRS announced that it would no longer rule on whether north-south transactions are respected as separate transactions.

Rev. Rul. 2017-9 provides guidance as to how such transactions should be treated and eliminates the IRS "no rule" policy. The guidance analyzes two situations. In Situation 1, a parent corporation ("Parent") wholly owns a corporation ("Distributing"), which in turn wholly owns another corporation ("Controlled"). Although Parent and Controlled have "active businesses" under section 355(b) of the Internal Revenue Code, Distributing does not, which is a prerequisite to its tax-free spin-off of Controlled stock. Parent transfers its active business to Distributing, which then distributes Controlled stock to Parent. Viewed separately, Parent's asset transfer to Distributing and Distributing's distribution of Controlled stock to Parent are both tax-free. However, if integrated, Distributing would be treated as exchanging a portion of its Controlled stock for Parent assets in a taxable exchange. Moreover, Distributing's entire distribution of Controlled stock would be taxable if the assets Parent transferred to Distributing exceed 20 percent of Controlled's value.

In Situation 2, Controlled distributes cash to Distributing, and, as part of the same plan, Distributing transfers property to Controlled and distributes Controlled stock to Parent in a so-called "divisive D reorganization." If the cash distribution is viewed separately, Distributing may retain the proceeds tax-free up to its basis in Controlled stock. However, if integrated with the second step, the cash is "boot" in the reorganization which Distributing must use to repay its creditors or distribute to its shareholders under the Boot Purge Rule to avoid gain recognition.

In Situation 1, the IRS treated the two steps separately, reasoning that (i) no compelling alternative policy existed to disregard the form, (ii) the two steps did not avoid a particular result intended by the tax law, and (iii) respecting the form was consistent with the intent of the applicable provisions. The IRS concluded that Distributing's receipt of property in a first-step nonrecognition transaction has "independent significance" when undertaken in contemplation of an otherwise qualifying spin-off.

Conversely, in Situation 2, since the first-step cash distribution occurred pursuant to the plan of reorganization, the IRS integrated the two steps and treated the cash as boot in the reorganization, rather than as a dividend from Controlled to Distributing. Accordingly, Distributing must satisfy the Boot Purge Rule to avoid gain recognition on the cash distribution.

While Rev. Rul. 2017-9 provides important guidance, the broader applicability of its principles is unclear. With respect to Situation 1, a government official stated that a Parent that is not transferring an "active business" to Distributing (but may be transferring assets for nontax reasons, such as compliance with debt covenants that Distributing would otherwise breach due to the spin-off) should speak with the IRS, either informally or in seeking a private ruling.

Two Key Takeaways

  1. The IRS will again rule on distributions of certain subsidiary debt securities (or stock) in exchange for parent debt issued in anticipation of a spin-off, allowing companies considering a spin-off to seek IRS confirmation of tax-free treatment.
  2. The IRS will resume ruling on whether north-south transactions are respected as separate transactions and has confirmed that certain north-south transactions will not adversely impact second-step spin-offs.

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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