IRS to resume rulings on leveraged spin-offs
Removes debt issued in anticipation of spin-off from ‘no-rule’ list
TAX ALERT |
The IRS announced in Rev. Proc. 2017-38 that it will resume ruling on spin-offs that involve issuance of debt in anticipation of the spin-off. Spin-offs receive tax-free treatment under section 355 if certain requirements are met.
The tax-free treatment extends to situations that involve repayment of debt with securities (stock or certain debt instruments) of the spun-off company. This rule permits ‘monetization’ of the value of the spun-off subsidiary in certain types of transactions.
The IRS formerly issued private letter rulings on these transactions, then ceased in 2013. Now the IRS is once again willing to provide rulings, although whether its ruling requirements will remain unchanged from those it applied in 2013 remains to be seen.
Spin-offs in general
In a spin-off, one corporation (Distributing) distributes all the stock of a subsidiary (Controlled) to its shareholders. The shareholders may be a diverse group, or may be just one or two shareholders who control Distributing. To attain tax-free treatment, spin-offs must meet various requirements, including an active trade or business requirement, a business purpose requirement and the spin-off must not be a device for the distribution of earnings and profits.
Monetization effect of debt repayment via spin-off
If the spin-off is structured properly, the tax-free treatment applies to both the distribution of securities (such as stock) of Controlled to Distributing’s creditors as well as its shareholders. The economic effect of the debt repayment on Distributing is similar to that of a sale Controlled where he proceeds are used for repayment of Distributing’s debt. This monetization effect may raise issues relating to the qualification of the spin-off for tax-free treatment, particularly where Distributing issues the debt that will be repaid in this manner prior to and in anticipation of the spin-off.
Here is an example of how debt repayment has been employed in a spin-offs.
- Distributing owns 100 percent of Controlled
- Distributing and Controlled each conduct an active trade or business, and there is a corporate business purpose for separating the businesses via a distribution of Controlled stock by Distributing to Distributing’s shareholders
- Distributing issues new short-term debt (the New Debt) to an investment bank
- At least five days after the New Debt issuance, the investment bank and Distributing enter into an agreement to exchange the Controlled stock for the New Debt (the Exchange Agreement)
- At least 14 days after the New Debt issuance, Distributing repays the New Debt by transferring stock of Controlled to the investment bank
- Distributing distributes Controlled stock to its shareholders
Absent spin-off qualification, Distributing generally would be taxed on gain (if any) represented by the excess of (1) the fair market value of the Controlled stock transferred to the creditor (the investment bank), over (2) Distributing’s tax basis in that stock. In this spin-off transaction, however, Distributing does not incur federal income tax even though it has repaid its creditor by transferring part of the value of Controlled to the creditor.
The five- and 14-day waiting periods in the example above are consistent with standards the IRS previously applied in its private letter ruling practice. These waiting periods are essentially intended to ensure that the investment bank is a bona fide creditor of Distributing.
The IRS stopped issuing private letter rulings on leveraged spin-offs in 2013. Now the IRS is ready to start issuing private rulings again. The IRS has issued little guidance in this area that all taxpayers can rely on (there is a 1979 revenue ruling that permits replacement of one creditor with a new one in advance of a spin-off). With this general lack of guidance, the ability to pursue private letter rulings is particularly valuable for companies pursuing leveraged spin-offs.
Leveraged spin-offs can result in tax-free monetization of the part of a controlled subsidiary’s value, as in the above example. They can also be used to alter the balance between Distributing’s debt levels and Controlled’s immediately after the spin-off. If your company is considering engaging in any tax-free spin-off transaction, it should consult with a tax advisor with expertise in this area.