United States: The IRS Resumes Issuing Private Letter Rulings On ‘Leveraged' And ‘North-South' Spinoffs

The IRS announced in May that it will resume issuing private letter rulings (PLRs) on two types of spinoff transactions — leveraged spinoffs and north-south spinoffs — that had been on its "no-rule" list since 2013. In a spinoff transaction, one corporation (Distributing) distributes the stock or securities of a corporation that it controls (Controlled) to its shareholders and/or creditors. If the requirements for a tax-free spinoff are satisfied, neither Distributing nor its shareholders and/or creditors recognize gain or loss on the distribution of the stock or securities of Controlled.

Leveraged Spinoffs

In a leveraged spinoff, Distributing incurs debt in anticipation of the distribution of Controlled and distributes stock or securities of Controlled to its lender in exchange for, and in retirement of, that debt. If the spinoff satisfies the requirements to be tax-free, Distributing can monetize, on a tax-free basis, its interest in Controlled, or adjust the relative levels of debt between it and Controlled.

The IRS had previously issued favorable PLRs with respect to leveraged spinoffs. As a condition to those PLRs, the IRS at times required that the Distributing debt incurred in anticipation of the spinoff be held by the lender (1) for at least five days before Distributing and the lender enter into an agreement to exchange the stock (or securities) of Controlled for that debt and (2) for at least 14 days before the exchange is effected, and that the aggregate amount of Distributing debt repaid with stock or securities of Controlled not exceed the average amount of Distributing debt outstanding during the prior 12 months.

In 2013, the IRS announced that it would no longer issue PLRs in this area because it was an area under study. In May, the IRS removed leveraged spinoffs from the no-rule list, saying that even though it continues to study this area, it would issue PLRs "in the interest of sound tax administration." The IRS did not indicate whether its views have changed since it stopped issuing PLRs with respect to leveraged spinoffs, or what representations it may require from taxpayers seeking comfort with respect to such transactions.

North-South Spinoffs

In a revenue ruling issued in May, the IRS removed north-south spinoffs from its no-rule list. In contrast to its action with respect to leveraged spinoffs, the IRS did not simply indicate that it would resume issuing PLRs on this issue — it set forth in the revenue ruling its position with respect to two such transactions. The IRS had announced in 2013 that north-south transactions were under study and that it would not issue PLRs with respect to such transactions until it resolved the issue through publication of a revenue ruling, a revenue procedure, regulations or other means.

The specific issue that was previously on the IRS' no-rule list was whether to respect as separate transactions for tax purposes transfers of stock, money or other property by a person to a corporation, and transfers of stock, money or property by that corporation to that person (or a person related to such person), in what are ostensibly two separate transactions (so-called north-south transactions), where at least one of the transfers is a distribution with respect to the corporation's stock, a contribution to the corporation's capital or an acquisition of stock.

Even though the IRS will now rule on north-south transactions, not every taxpayer who requests a PLR with respect to such a transaction will necessarily receive a ruling; some ruling requests will be too fact-specific for the IRS to rule on, or may not present a "significant issue" (the IRS will only rule on "significant issues" in spinoff transactions). The IRS may also decline to issue a PLR addressing the integration of steps when appropriate in the interest of sound tax administration. It remains to be seen what representations the IRS will require in order to issue a favorable PLR; under its prior ruling practice, it required taxpayers to represent that there was no regulatory, legal, contractual or economic compulsion or requirement that one transfer be made as a condition to the other.

The Revenue Ruling

The IRS considered two north-south transactions in its recent revenue ruling. As described below, in Situation 1, the transfers were respected as separate transactions; in Situation 2, the transfers were regarded as steps in an integrated transaction. In both situations, a parent corporation (P) has a wholly owned subsidiary (D), which in turn has a wholly owned subsidiary (C).

In Situation 1, P transfers to D property worth $25X (including property constituting an active trade or business that is transferred so that one of the requirements for a tax-free spinoff can be satisfied) in exchange for additional D stock (the "south" part of the transaction) and, pursuant to the same overall plan, D immediately distributes all of the stock of C, worth $100X, to P (the "north" part of the transaction). The tax consequences of these transfers depend on whether they are treated as separate transactions or whether, because they are undertaken pursuant to the same overall plan, they are viewed as part of a single exchange of property.

If the two transfers are respected as separate transactions, both would be tax-free (the first under Section 351 of the Internal Revenue Code (the Code), and the second under Section 355 of the Code). But if they are integrated into a single exchange, both would be taxable — P would be treated as transferring the property to D in a taxable exchange for 25% of the C stock, and D's distribution of the remaining 75% of the C stock to P would not qualify as a tax-free spinoff because D would fail to meet the requirement of distributing "control" of C in the spinoff transaction.

The IRS respected the back-to-back transfers between P and D as separate, tax-free transactions, stating that the tax treatment of a transaction generally follows the taxpayer's chosen form unless (1) there is a compelling alternative policy, (2) the effect of the steps of the transaction is to avoid a particular result intended by otherwise-applicable provisions of the Code or (3) the effect of the steps of the transaction is inconsistent with the underlying intent of the applicable Code provisions. In this case, the IRS reasoned, each step provides for continued ownership in modified corporate form, the steps do not resemble a sale, and none of the interests are liquidated or otherwise redeemed; therefore, nonrecognition treatment under Sections 351 and 355 of the Code is not inconsistent with congressional intent of those Code provisions, and the effect of the steps is consistent with the policies underlying those Code sections.

The IRS noted that the tax consequences would be the same (qualification under Section 355 of the Code) if, instead of acquiring an active business from P in a Section 351 transfer, D acquires an active business from a subsidiary of P in a cross-chain reorganization. It is not clear how the IRS would view a transfer by P (or one of its subsidiaries) to D of property that did not include property constituting an active business.

In Situation 2, D and C have each been engaged in a business that satisfies the active trade or business requirement for a tax-free spinoff. On Date 1, C transfers money and property to D, pursuant to a dividend declaration, and D retains the money and property (the north transfer). On Date 2, D transfers appreciated property to C (the south transfer), and distributes all the C stock to P in a transaction qualifying as a tax-free reorganization under Sections 368(a)(1)(D) and 355 of the Code. C and D planned and executed the Date 1 transfer in pursuance of the plan of reorganization.

If the Date 1 distribution by C of money and other property to D is treated as separate from the Date 2 transactions, Section 301 of the Code would apply to D's receipt of the money and other property from C (which generally would not be taxable to D, although C could recognize gain on the property distributed as a result of the spinoff), and D would recognize no gain on the transfer of property to C. But if the Date 1 distribution is treated as made in pursuance of the plan of reorganization that includes the Date 2 distribution of C stock, the money and other property distributed by C to D would constitute "boot" to D because D retained the money and property, rather than distributing them to its shareholders. In that case, D would recognize gain on its transfer of property to C to the extent of the amount of money and the fair market value of the property it retained.

The IRS concluded that the Date 1 distribution was made in pursuance of the plan of reorganization — that is, the tax treatment followed the substance of the transaction — with the result that the distribution of money and property by C to D constituted a boot distribution to D. In its analysis, the IRS referenced case law to the effect that the boot rules are the exclusive measure of dividend income where cash is distributed to shareholders as an incident of a reorganization. The IRS stated that Section 361 of the Code broadly looks to whether transfers of money or other property occur in pursuance of the plan of reorganization or in connection with the reorganization.

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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