The IRS has signaled its willingness to consider relaxing one of the chief requirements for a U.S. tax-deferred corporate spin-off—the requirement that the business being spun off ordinarily be revenue-generating. This new outlook, announced by the IRS on September 25, could prove a boon to businesses that make significant investments in research and development, but which have yet to generate revenue.
What You Need To Know
- The IRS's new approach to spin-offs could benefit a wide variety of U.S. companies—from pharmaceutical and technology companies to natural resources and infrastructure companies—by deferring taxes at both the corporate and shareholder levels.
- In addition, non-U.S. companies with a large U.S. shareholder base could also benefit from tax-deferral at the shareholder level.
- Companies seeking a tax ruling from the IRS under the new approach should consider acting soon.
One of the chief requirements for a U.S. tax-deferred spin-off is that the company spun off must be engaged in an active trade or business for the five years preceding the spin-off. An active trade or business, according to tax regulations, "ordinarily must include the collection of income and the payment of expenses."1
If a business fails to generate income over the five-year period preceding the spin-off, it therefore typically cannot be spun off as a stand-alone corporation on a tax-deferred basis, even if the business is actively engaged in, and has invested significant amounts in, research and development for many years.
New IRS Approach
In a September 25 statement, the IRS signaled its willingness to address the income requirement. In addressing the requirement, the IRS noted the example of pharmaceutical and technology companies:
"The IRS has observed a significant rise in entrepreneurial ventures whose activities consist of research and development in lengthy phases. During these phases, the ventures often collect no income or negligible income but nonetheless incur significant financial expenditures and perform day-to-day operational and managerial functions that historically have evidenced an "active" business. For instance, a venture in the pharmaceutical or technology field might engage in research to develop new products with the purpose of earning income in the future from sales or licenses. The venture might even forgo current income opportunities to obtain increased future income by developing products on its own. The nature and duration of the research phases is often dictated by regulatory agencies, which require complex review processes that can span multiple years and cost millions of dollars."2
Reflecting its new approach, the IRS intends to issue guidance addressing the application of the spin-off rules to entrepreneurial ventures (including businesses within larger entities) that have yet to collect income. Pending the completion of a study of the issues involved, the IRS noted that it "will entertain requests for private letter rulings regarding the [active trade or business] qualification of corporations that have not collected income."
What kind of company is likely to benefit from the new approach?
Certainly a U.S. biotech or pharmaceutical company with a significant investment in developing a new drug can now consider spinning off the relevant business unit. The same is true of a technology company developing a new product. Aside from these obvious beneficiaries, we see potential benefits for natural resources and infrastructure companies, where significant upfront investments may take years to generate income.
What relevance does a new approach have for a non-U.S. company?
Not only U.S. companies, but Canadian and other non-U.S. companies with a significant U.S. shareholder base can benefit from a new approach. This is because a new approach could permit the spin-off of an entrepreneurial division on a tax-deferred basis for U.S. shareholders.
Is there any benefit for a small company?
A small startup that lacks the five-year business history required for a U.S. tax-deferred spin-off is unlikely to see any benefit under the new rules. But for startups with a track record of investment in R&D for five years or more, the new rules might permit the separation of multiple business segments, which could be attractive to certain investors.
When should a company act?
The IRS has vacillated in its willingness to rule on tax-deferred spin-offs. In 2017, however, it renewed its practice of issuing transactional spin-off rulings under a "pilot program" that expires on March 21, 2019.3 After that date, the IRS may be less open to ruling on spin-offs. While the anticipated spin-off guidance may provide comfort with respect to tax-deferred treatment, many companies prefer the certainty of a formal tax ruling.
1 U.S. Treasury Regulations Section 1.355-3(b)(2)(ii).
2 U.S. Internal Revenue Service, "IRS Statement Regarding the Active Trade or Business Requirement for Section 355 Distributions" (September 25, 2018).
3 U.S. Internal Revenue Service, Revenue Procedure 2017-52.
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