"Spin-offs" - The Anti-Morris Trust and Intragroup Spin Provisions

By Mark J. Silverman, Andrew J. Weinstein, and Lisa M. Zarlenga

TABLE OF CONTENTS

I. INTRODUCTION

Since the repeal of the General Utilities doctrine in 1986, one of the only ways in which corporations may distribute appreciated property to their shareholders without recognizing corporate-level gain is through the use of spin-off type transactions under section 355 of the Internal Revenue Code. Often, corporations undertake such spin-offs to dispose of unwanted businesses in preparation for a tax-free acquisition by another corporation. For more than 30 years, these so-called "Morris Trust" transactions were blessed as tax free under section 355, provided the requirements of section 355 were met. Not anymore. The Taxpayer Relief Act of 1997 (the "Act") added section 355(e) and (f), which severely limit these transactions.

This article analyzes sections 355(e) and 355(f) and other related changes that were made by the Act. Part II describes the provisions and their history, Part III analyzes the of the statute in the context of several examples and in light of the legislative history, and Part IV provides suggested recommendations to Congress and to Treasury regarding what issues require additional guidance.

Following is a brief description of the statutory language and the history of these provisions. The statutory language raises many issues, which will be discussed in Part III.

A. Description of Statutory Language

On August 5, 1997, President Clinton signed the Act. Section 1012 of the Act amended section 355 to place additional restrictions on the acquisition and disposition of the stock of the distributing or controlled corporations. Section 1012 of the Act contains four basic provisions: (i) an anti-Morris Trust provision, which is contained in section 355(e); (ii) an intragroup distribution provision, which is contained in section 355(f), (iii) a related provision contained in section 358(g) authorizing the Department of the Treasury (the "Treasury") to issue basis adjustment regulations under section 358; and (iv) a modified control provision, which amends sections 351(c) and 368(a)(2)(H).

1. Section 355(e) -- The Anti-Morris Trust Provision

Under section 355(e), the anti-Morris Trust provision, a distributing corporation will recognize gain if one or more persons acquire, directly or indirectly, 50 percent or more of the stock (measured by vote or value) of the distributing or any controlled corporation as part of plan or series of related transactions that was in place at the time of the distribution. The distributing corporation recognizes gain equal to the "built-in" gain in the controlled corporation stock held by the distributing corporation. However, no adjustment to the basis of the stock or assets of either corporation is allowed by reason of the gain recognition. The statute also creates a rebuttable presumption that any acquisition occurring two years before or after a section 355 distribution is part of such a plan. For purposes of determining whether one or more persons has acquired a 50-percent interest, the section 318(a)(2) attribution rules generally apply (without regard to the 50-percent threshold of section 318(a)(2)(C)), and the aggregation rules of section 355(d)(7)(A) apply so that all related persons are treated as one person. Moreover, except as provided in regulations, if a successor corporation in an A, C, or D reorganization acquires the assets of the distributing or any controlled corporation, the shareholders (immediately before the acquisition) of the successor corporation are treated as if they acquired stock in the corporation -whose assets were acquired. In short, section 355(e) essentially eliminated Morris Trust-type transactions and overturned more than 30 years of well-settled tax law.

The statute does, however, include several exceptions. For example, certain acquisitions are not taken into account for purposes of the anti-Morris Trust provision.

1. The acquisition of stock in the controlled corporation by the distributing corporation;

2. The acquisition of stock in a controlled corporation by reason of holding stock in the distributing corporation;

3. The acquisition of stock in any successor corporation of the distributing corporation or controlled corporation by reason of holding stock in such distributing or controlled corporation; and

4. The acquisition of stock in the distributing corporation or any controlled corporation to the extent that the percentage of stock owned directly or indirectly in such corporation by each person owning stock in such corporation immediately before the acquisition does not decrease.

These exceptions apply only if the stock owned prior to the acquisition was not acquired as part of a plan to acquire a 50-percent or greater interest in either the distributing or controlled corporation.

In addition, a plan (or series of related transactions) will not cause gain recognition under section 355(e) if, immediately after the completion of the plan or transaction, the distributing and controlled corporations are members of the same affiliated group. The provision also does not apply to a distribution that would otherwise be subject to section 355(d), or a distribution pursuant to a title 11 or similar case.

The anti-Morris Trust provision further authorizes Treasury to issue regulations necessary to carry out the purposes of the legislation, including regulations (i) providing rules where there is more than one controlled corporation, (ii) treating two or more distributions as one distribution, and (iii) providing rules similar to the substantial diminution of risk rules of section 355(d)(6) where appropriate for purposes of the legislation. In addition, it extends the statute of limitations with respect to gain recognized under section 355(e), so that the statute does not expire until three years from the date the taxpayer notifies the Internal Revenue Service (the "Service") that the distribution occurred.

For purposes of the anti-Morris Trust provision, any reference to a distributing or controlled corporation also refers to any predecessor or successor of the corporation. Section 355(e) generally applies to distributions after April 16, 1997, unless certain transition rules apply.

2. Section 355(f) -- Intragroup Distribution Provision

Under section 355(f), the intragroup distribution provision, section 355, in its entirety, does not apply to any distribution of stock from one member of an affiliated group (whether or not the group files a consolidated return) to another member of such group, if the distribution is part of a plan or series of related transactions to which section 355(e) applies.21 Section 1012(b)(2) of the Act also added section 358(g) to the Code, which authorizes Treasury to issue regulations to provide adjustments to the basis of group members’ stock (whether or not section 355(e) applies) in order to reflect the proper treatment of intragroup distributions. The intragroup distribution provision applies to distributions after April 16, 1997, unless certain transition rules apply.

3. "Control Immediately After" Provision

Prior to its change by the Internal Revenue Service Restructuring and Reform Act of 1998 (the "Reform Act"), Section 1012(c) of the Act also relaxed the rule under sections 351 and 368(a)(1)(D) for determining control immediately after a section 355 transaction. Under the provision, shareholders receiving stock in a controlled corporation were treated as in control of the controlled corporation immediately after the distribution if they hold stock representing greater than a 50-percent interest by vote and value of such controlled corporation.24 The former rule required 80 percent of the vote and 80 percent of each class of nonvoting stock as required by section 368(c). However, the statute did not change the section 355 requirement that the distributing corporation distribute 80 percent of the voting power and 80 percent of each other class of stock of the controlled corporation in the transaction.25 The change in the control test generally applied to transfers after August 5, 1997.

In 1998, the Reform Act replaced the new 50-percent control test with a provision that states that if the requirements of section 355 are met, the fact that the shareholders of the distributing corporation dispose of part or all of their controlled corporation stock will not be taken into account for purposes of determining whether the transaction qualifies under section 368(a)(1)(D). Thus, the 80-percent control test in section 368(c) again applies to divisive section 368(a)(1)(D) transactions. The Tax and Trade Relief Extension Act of 1998 (the "Extension Act") contained a further technical correction of section 368(a)(2)(H)(ii), providing that the fact that the controlled corporation issues additional stock will not be taken into account for purposes of determining whether the transaction qualifies under section 368(a)(1)(D).

B. History of the Statute

1. Administration’s Budget Proposal

On February 6, 1997, the Clinton Administration, as part of its 1998 budget proposal, proposed anti-Morris Trust legislation to be included in section 355(d). The proposal would have required the distributing corporation (but not its shareholders) to recognize gain on the distribution of the stock of the controlled corporation, unless the direct and indirect shareholders of the distributing corporation, as a group, continued to own at least 50 percent of the total vote and value of both the distributing and controlled corporations at all times during the four-year period beginning two years before and ending two years after the distribution.

In determining whether shareholders retain the requisite ownership of both corporations throughout the four-year period, acquisitions or dispositions of stock that are "unrelated" to the distribution would be disregarded. A transaction would be treated as unrelated if it were not "pursuant to a common plan or arrangement that includes the distribution." Thus, for example, public trading of the stock in either the distributing or controlled corporation would disregarded, even if the trading occurred in contemplation of the distribution. Similarly, a hostile acquisition of the distributing or controlled corporation after the distribution would be disregarded – but a friendly acquisition would generally be considered related to the distribution if it were pursuant to an arrangement negotiated (in whole or in part) prior to the distribution, even if it were subject to certain conditions (e.g., shareholder approval) at the time of the distribution.

2. Archer/Roth/Moynihan Bill

On April 17, 1997, Bill Archer, Chairman of the House Ways and Means Committee, introduced legislation in the House of Representatives to restrict the use of section 355. William Roth, Chairman of the Senate Finance Committee, and Daniel Moynihan, Ranking Minority Member of the Senate Finance Committee, introduced identical legislation in the Senate on the same date (collectively the "Archer/Roth/Moynihan bill"). Although the bill was similar to the President’s budget proposal in that it required recognition of corporate-level gain if either the distributing or controlled corporation was acquired, it differed in several important respects.

First, the proposal would have been added as a new subsection (e) to section 355, rather than as an addition to section 355(d). Under section 355(e), as proposed by the bill, if a distribution were "part of a plan (or series of related transactions) pursuant to which a person acquires stock representing a 50-percent or greater interest in the distributing corporation or any controlled corporation (or any successor of either)," corporate-level gain would be recognized. The import of the move from subsection (d) to subsection (e) was to make clear that an acquisition of the distributing or controlled corporation was not limited to "purchase" transactions as defined in section 355(d). To coordinate the two subsections, the bill contained a provision that section 355(e) would not apply to any distribution to which section 355(d) applied.

Second, the bill did not limit corporate-level gain recognition to the distributing corporation. Rather, the bill provided that if the distributing corporation were acquired, gain would be recognized by the controlled corporation equal to the amount of gain that the distributing corporation would have recognized had it sold its assets for their fair market value immediately after the distribution. Conversely, if the controlled corporation were acquired, gain would be recognized by the distributing corporation equal to the amount of gain that the distributing corporation would have recognized had it sold the stock of the controlled corporation for its fair market value on the date of the distribution.

Third, prohibited acquisitions were not limited to those occurring during the four-year period beginning two years before the distribution. Instead, if the distribution of the controlled corporation were part of a plan or series of related transactions pursuant to which a person acquired a 50-percent or greater interest in either the distributing or controlled corporation, gain would be recognized. There was a rebuttable presumption that such an acquisition was pursuant to a plan or series of related transactions, however, if the acquisition occurred during the four-year period beginning two years before the distribution. Thus, although a plan was presumed to exist during the four-year period, a plan was not limited to the four-year period.

Fourth, a prohibited acquisition could occur with respect to the distributing or controlled corporation, or any successor thereof.

Fifth, the bill authorized Treasury to prescribe regulations necessary to carry out the purposes of the subsection, including regulations (i) providing for the application of section 355(e) where there is more than one controlled corporation, (ii) treating two or more distributions as one distribution, and (iii) providing for rules suspending the four-year period where stock is subject to a substantial diminution of risk.

Sixth, the bill extended the statute of limitations for the assessment of any deficiency attributable to gain recognized as a result of a prohibited acquisition to three years from the date the taxpayer notifies the Service that the distribution occurred. Such a deficiency -could be assessed within the three-year period, notwithstanding other provisions of law that would otherwise prevent assessment.

Finally, the bill added a new subsection (f) to section 355, an extremely broad intragroup distribution provision, which did not appear in any form in the President’s proposal. Subsection (f) provided that section 355, in its entirety, would not apply to the distribution of stock from one member of an affiliated group filing a consolidated return to another member of such group. The provision also required Treasury to issue regulations providing for proper adjustments for the treatment of such distributions, including adjustments to stock basis and earnings and profits.

The bill would apply to distributions made after April 16, 1997, unless certain transition rules applied.

3. House Bill

On June 26, 1997, the House of Representatives passed a modified version of the Archer/Roth/Moynihan bill (the "House bill"). The House bill provided for a broader class of potential acquirers. The House bill’s version of section 355(e) still provided for corporate-level gain recognition if a 50-percent or greater interest of either the distributing or controlled corporation is acquired pursuant to a plan or series of related transactions. However, instead of -the acquisition being by "a person," as provided in the Archer/Roth/Moynihan bill, a prohibited acquisition could be made under the House bill by "1 or more persons . . . directly or indirectly." The House bill also broadened the class of potential acquirees. The Archer/Roth/Moynihan bill provided that a prohibited acquisition could occur with respect to "the distributing corporation or any controlled corporation (or any successor)." The House bill, on the other hand, deleted the parenthetical reference to successor and added a new provision stating that "for purposes of this subsection, any reference to a controlled corporation or a distributing corporation shall include a reference to any predecessor or successor of such corporation."

In addition, the House bill added some new provisions. First, the House bill added a provision treating the acquisition of assets by a successor corporation in an A, C, or D reorganization (or any other transaction specified in Treasury regulations) as an acquisition of stock by the shareholders of such successor corporation. Although Chairman Archer’s introductory statement to the Archer/Roth/Moynihan bill noted that "[i]t is anticipated that certain asset acquisitions would be treated as stock acquisitions," no such provision was included in that bill.

Second, while the House bill retained the exception for acquisitions of stock in any controlled corporation by reason of holding stock in the distributing corporation, it added three new exceptions for certain acquisitions, all of which appear in the final Act.

Third, the House bill modified the attribution rule for purposes of determining whether an acquisition has occurred. Rather than apply the entity attribution rules of sectiona)(2) without regard to the 50-percent threshold in section 318(a)(2)(C), as in the Archer/Roth/Moynihan bill, the House bill applied section 355(d)(8)(A), which incorporates section 318(a)(2), but attributes stock owned by a corporation to its shareholder only if the shareholder owns 10 percent of the corporation.

Finally, the House bill added a provision amending the "control" requirement of sections 351 and 368(a)(1)(D) where the distributing corporation contributes appreciated assets to the controlled corporation in connection with the section 355 distribution. Under the proposal, the distributing corporation’s shareholders need only hold more than 50 percent of the vote and value of the controlled corporation’s stock following the distribution, as opposed to 80 percent of the vote and 80 percent of each class of nonvoting stock as currently required by section 368(c).

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