On July 14, 2016, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released proposed regulations addressing spinoffs involving significant nonbusiness assets or de minimis qualifying business assets (the so-called “hot dog stand” issue).1 The proposed regulations also provide additional guidance on the application of the “device” test. The guidance follows last year’s IRS announcements in Notice 2015-59 and Revenue Procedure 2015-43 that it is studying these issues and would cease issuing private letter rulings on these issues pending further review.2 In general, the proposed regulations would restrict companies (including REITs) from effecting tax-free pro rata spinoffs involving significant nonbusiness assets. The proposed regulations would also require each of the spinning corporation (Parent) and spun off corporation (Spinco) to hold assets of a qualifying trade or business with a fair market value of at least five percent of its total assets. The proposed regulations are not yet effective and contain a generous transition rule for transactions that are in advanced stages prior to the publication of final regulations in the Federal Register.
In addition, on July 15, 2016, the IRS issued additional spinoff guidance in the form of Revenue Procedure 2016-40.3 This Revenue Procedure provides a two-year safe harbor for unwinding high-vote/low-vote structures commonly used in connection with spinoffs.
Background
Section 3554 provides that, if certain requirements are met, a Parent’s distribution of the stock of a Spinco will be tax-free to both the Parent and the Parent’s shareholders. These requirements include:
- The spinoff must be motivated by a non-tax business purpose;
- The spinoff must not be principally used as a “device” for the distribution of earnings and profits in a tax-favored manner (the device requirement);
- Both before and after the spinoff, each of the Parent and Spinco must be engaged in an activity that constitutes an “active trade or business” (the ATB requirement); and
- The Parent must own stock in Spinco representing at least 80 percent of the outstanding voting stock of Spinco (the 80 percent requirement).
The Proposed Device Regulations
Under current regulations, whether a spinoff is a prohibited device is a facts and circumstances test based on a weighing of various device and nondevice factors set forth in the regulations. The main purpose of the device requirement is to prevent shareholders from converting what would otherwise be dividend income into capital gain. For example, a corporation contemplating a cash dividend might instead deposit the cash in a Spinco and distribute the stock of Spinco to its shareholders. If this transaction were permitted to occur on a tax-free basis, the shareholders could then sell the stock of Spinco and recognize a capital gain instead of the dividend income they would have received had the Parent paid the cash to them directly. The device prohibition originated in an era where dividends were taxed at much higher rates than capital gains. Today, dividends are taxed at the same rate as capital gains, which led some tax advisors to view the device requirement as having diminished importance. The preamble to the proposed regulations makes clear that the IRS disagrees and views the device requirement as having continued vitality (the rationale being that even though rates are the same, a capital gain transaction permits a shareholder to offset their gain with their tax basis in the stock, whereas a dividend would not). To that end, the proposed regulations would make three key changes to the current device rules.
First, the proposed regulations would modify the “nature and use” device factor in the current regulations. This factor currently treats any asset that does not meet the ATB requirement as evidence of a device, but does not lay out any specific guideposts. The proposed regulations would add definitions of “business assets” and “nonbusiness assets” and provide that the presence of nonbusiness assets having a fair market value of less than 20 percent of total assets is ordinarily not evidence of device. Further, where the percentages of nonbusiness assets of the Parent and Spinco are different, such difference is generally not considered evidence of a device if both the Parent and Spinco’s percentage of nonbusiness assets varies by less than 10 percentage points.5 Anything above these thresholds, however, is evidence of a device and the larger the percentage of nonbusiness assets, the stronger is the evidence of a device.
Second, the proposed regulations would modify the business purpose nondevice factor in the current regulations. This factor provides that the business purpose for the spinoff can offset other indicia of a device. The proposed regulations would modify this factor and provide that a corporate business purpose that relates to the separation of nonbusiness assets cannot be used as a nondevice factor unless the business purpose involves an exigency that requires an investment or other use of the nonbusiness assets. Additionally, the proposed regulations would provide that evidence of a device presented by the ownership of nonbusiness assets or differing percentages of nonbusiness assets between the Parent and Spinco can be outweighed by the existence of a business purpose for the ownership or the difference.
Third, the proposed regulations add a “per se” rule that treats a distribution as a device notwithstanding the presence of nondevice factors if the Parent or Spinco’s percentage of nonbusiness assets is 66-2/3rd percent or more and the other company’s percentage of nonbusiness assets is below a specified threshold (30 percent if the first company’s percentage is less than 80 percent; 40 percent if the first company’s percentage is 80 percent or more but less than 90 percent, and 50 percent if the first company’s percentage is 90 percent or more). The IRS and Treasury believe that all of these situations represent cases in which the nonbusiness percentage is significantly different between the Parent and Spinco. The three bands described above were intended to avoid having to determine the exact percentage of business to nonbusiness assets for purposes of the per se test. The test is subject to a number of limited exceptions for transactions not ordinarily considered a device, including certain non-pro rata split-off transactions. While such transactions may avoid the per se rule, they may nonetheless be subject to similar restrictions found in Section 355(g), which addresses non-pro rata distributions involving companies with a disproportionately large amount of investment assets.
The proposed regulations would also add an anti-abuse rule to the effect that transactions undertaken with a principal purpose of affecting the percentage of nonbusiness assets may not be taken into account.
The Proposed ATB Regulations
The proposed regulations would modify the ATB requirement by requiring that the assets that meet the technical definition of an ATB (generally, a business that has been actively conducted by the Parent or Spinco for at least five years) have a fair market value of at least five percent of the fair market value of total assets. The proposed regulations contain special rules on how to calculate this percentage, but the five percent threshold is absolute. This contrasts with the IRS’s no-rule policy on this issue, which contains an exception for purely internal spinoffs within corporate groups. Therefore, unless the proposed regulations are modified, internal spinoffs will be subject to the same ATB requirement. While the five percent requirement is generally taxpayer friendly and should not create many practical issues for most companies, the new requirement could, for instance, make spinoffs of REITs that hold triple net leased assets significantly more challenging because there are no special exemptions for REITs.
Prior to the proposed regulations, tax practitioners cited language in Revenue Ruling 73-44 that “[t]here is no requirement in section 355(b) that a specific percentage of the corporation’s assets be devoted to the active conduct of a trade or business” as support for a de minimis business satisfying the ATB requirement. The preamble to the proposed regulations argues that the ruling does not validate this view because the relevant business in the ruling was in fact substantial. The preamble announces that this language in the ruling will be modified to clarify this point.
Effective Date
Both the proposed device regulations and ATB regulations are proposed to be effective for transactions occurring on or after the date that final regulations are issued. However, transactions occurring after this date would not be subject to these regulations if they are (i) made pursuant to an agreement, resolution or other corporate action that is binding on or before such date and at all times thereafter; or (ii) described in a public announcement or filing with the Securities and Exchange Commission on or before such date.6 This transition rule should be contrasted with recent IRS guidance in the international arena, which has generally imposed retroactive effective dates.7
Despite the generous transition rule, the proposed regulations have no immediate impact on the IRS’s no ruling policy on these issues. Accordingly, taxpayers seeking to pursue a transaction raising these issues will need to do so on the basis of a tax opinion from their advisor. Although the proposed regulations arguably establish new law (which is consistent with the prospective effective date), tax advisors may nonetheless be reluctant to issue tax opinions contrary to the proposed regulations, especially when the preamble seems to go out of its way to argue that current guidance does not support a de minimis ATB of less than five percent and because the device test is based on all facts and circumstances, rather than on purely technical rules.
Revenue Procedure 2016-40
As noted above, one of the requirements for tax-free treatment of a spinoff is that the Parent own at least 80 percent of the voting stock of Spinco. Because this requirement focuses on voting stock, a common planning technique is to have Spinco adopt a “high-vote/low-vote” structure for its stock which enables the Parent to satisfy this requirement even though it owns less than 80 percent of the economic value of Spinco. A frequent question that arises in these transactions is whether the high-vote/low-vote structure can be unwound following the spinoff without jeopardizing its tax-free status. In 2013, the IRS announced that it would cease issuing private letter rulings on this issue pending further study.8
Revenue Procedure 2016-40 now provides two safe harbors for unwinding a high-vote/low-vote structure. First, the IRS will not challenge a structure if no action is taken (including, most importantly, the adoption of any plan or policy), at any time prior to 24 months after the spinoff, by Spinco’s board of directors, management or controlling shareholders that would (if implemented) actually or effectively result in an unwind. Second, an unwind that results from a transaction with an unrelated (measured by using a 20 percent threshold) third party (e.g., an acquisition of Spinco) will not be challenged as long as there was no agreement, understanding, arrangement or substantial negotiations or discussions concerning the transaction or a similar transaction during the 24-month period ending on the date of the spinoff.
The Revenue Procedure also revokes the IRS’s no-ruling policy on high-vote/low-vote structures. This opens the door to taxpayers who want to seek guidance on transactions outside the safe harbors, but the Revenue Procedure cautions that the IRS may decline to issue a ruling on whatever grounds it deems appropriate.
These safe harbors should re-open the use of high-vote/low-vote structures. Although they impose more stringent requirements than suggested by prior IRS ruling practice, they provide much needed certainty in an area that had been called into question with the no-rule policy.
1 “Guidance Under Section 355 Concerning Device and Active Trade or Business,” available at: https://www.federalregister.gov/articles/2016/07/15/2016-16512/guidance-under-section-355-concerning-device-and-active-trade-or-business.
2 See Sidley Update “Notice 2015-59: Treasury and IRS Target Certain Tax-Free Spinoffs, Including REIT Spinoffs,” available at: http://www.sidley.com/en/news/2015-09-17_tax_update.
3 “Revenue Procedure 2016-40,” available at: https://www.irs.gov/pub/irs-drop/rp-16-40.pdf.
4 All section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
5 The proposed regulations further provide that the differential can vary by more than 10 percentage points without being treated as evidence of a device in a non-pro rata “split-off” transaction where the difference is required to equalize the value of the Spinco stock and securities exchanged in the split.
6 A third exception applies if the transaction is described in a ruling request submitted to the IRS on or before July 15, 2016.
7 See, e.g., Sidley Update “Treasury and IRS Propose New Debt/Equity Regulations: Significant for Tax Structures Involving Related Party Debt,” available at: http://www.sidley.com/en/news/04-11-2016-tax-update and Sidley Update “New Inversion Regulations Implement and Expand the Scope of the Anti-Inversion Tax Rules,” available at: http://www.sidley.com/en/news/2016-04-07-tax-update.
8 See Rev. Proc. 2013-3.
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