Retention of controlled stock in a section 355 spin-off
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When a parent corporation (Distributing) wishes to distribute the stock of a subsidiary (Controlled) without recognizing gain, section 355 is the only viable alternative. One of the many requirements of section 355 is that Distributing must distribute all of the stock or securities in Controlled, or at least an amount of stock that constitutes control under section 368(c). Further, where Distributing retains part of the stock or securities in Controlled, Distributing must establish to the satisfaction of the IRS commissioner that the retention was not "in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax."1
In general, Distributing’s retention of stock is viewed as counter to the business purpose of a split-up. As such, a presumption exists that the purpose for the retention of stock is to avoid tax. In such cases, the taxpayer has the burden to rebut this presumption and establish that a sufficient business purpose exists for the temporary retention of stock in Controlled. In PLR 201503006 (the ruling), based upon the facts and representations made by the taxpayer with respect to a proposed spin-off, the IRS ruled that Distributing could retain certain Controlled shares following the spin-off.
In the ruling, Distributing is the common parent of an affiliated group of corporations that filed a consolidated tax return. Controlled is a wholly owned subsidiary of Distributing. Distributing has the following two stock-based, non-cash compensation plans, which were payable in shares of Distributing stock:
- A plan under which deferred shares can be received by non-management members of the board of directors (BOD). Under this plan, the BOD members are permitted to annually elect to defer a portion of their fees earned for services, with such deferred fees payable in Distributing stock. Upon such election, fully vested shares are transferred to a trust (the Director Trust)
- A plan under which incentive awards are payable in the form of restricted stock units (RSUs) for certain employees, officers and members of the BOD.
The proposed transaction includes a spin-off of Controlled by Distributing to its public shareholders. Distributing would distribute control (more than 80 percent of the shares of Controlled), pro rata, to its public shareholders and retain a certain number of shares (less than 20 percent). The actual number of shares and percentages were redacted from the ruling. Post-transaction, Distributing would dispose of the retained stock in Controlled through a number of pre-defined arrangements.
First, part of the retained stock would be transferred to the Director Trust. This transfer would occur at the same time as the spin-out distribution to the public shareholders. It appears the business purpose for retaining this stock would be to make the members of the BOD whole for the diminution in value of the Distributing stock held in the Director Trust. All public shareholders of Distributing would receive a pro rata amount of Controlled stock through the spin-off. Here, the retained stock distributed to the Director Trust would serve the same purpose by providing the directors with their pro rata portion of Controlled.
Next, part of the retained stock would be retained and paid to the incentive award recipients (i.e., the RSU holders) depending on the type of RSU and when the award becomes payable. Similar to the above transfer, the business purpose for this retention appears to relate to the reduction in value of pre-spin shares in Distributing.
Finally, Distributing would sell on the open market the amount of retained Controlled stock neither transferred to the Director Trust nor retained for the RSUs and use the net proceeds to reduce Distributing’s outstanding debt obligations and maintain its credit rating and liquidity. Distributing noted that it had $Z debt outstanding, excluding obligations solely related to Controlled, and would continue to have that amount of debt outstanding post-spin. Further, Distributing noted that the value of the retained controlled stock would be less than its outstanding debt but that the proceeds from the sale of this stock would be used to pay down a portion of the obligation. Any additional Controlled stock that was reserved for the Director Trust or the RSUs would be disposed of in the same way. Finally, to the extent the net proceeds from the sale exceeded the outstanding debt obligations of Distributing, the excess value would be used to fund future acquisitions and for liquidity purposes.
In its ruling request, Distributing provided the following business purposes for the retention of stock: (1) to reflect the diminution of value of the shares of Distributing held by the Director Trust, (2) to support the existing incentive rewards, (3) to facilitate the reduction of debt, (4) to enhance Distributing's liquidity, and (5) to maintain Distributing’s current credit rating through the dispositions of the retained stock of Controlled. These business purposes reflect the interests of two separate parties. First, the participants in the stock incentive plans would be provided value since the stock of Distributing would be inherently less valuable post-distribution. Second, the stock that is to be disposed of on the open market would benefit Distributing, as the proceeds would reduce debt and any additional proceeds could be used to fund future acquisitions, increase liquidity, etc.
As mentioned above, under section 355(a)(1)(D)(ii), Distributing must satisfy, to the satisfaction of the commissioner, that its retention of stock was "not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax.”2 Appendix B of Rev. Proc. 96-30 provides that the IRS will generally issue favorable rulings regarding the retention of Controlled stock in transactions where Controlled stock is widely held if:
- A sufficient business purpose exists for the retention of the stock
- None of Distributing's directors or officers will serve as directors or officers of Controlled while Distributing retains the stock
- The retained stock will be disposed of as soon as a disposition is warranted consistent with the business purpose specified and, in any event, not later than five years after the distribution
- Distributing will vote the retained stock in proportion to the votes cast by Controlled's other shareholders. For example, if after the distribution the other shareholders of Controlled vote 70 percent in favor of a matter and 30 percent against, Distributing would be required to vote the stock 70 percent in favor of and 30 percent against the matter.
This ruling illustrates that the use of shares of Controlled is not limited to distribution to Distributing’s shareholders in a section 355 spin-off and that some of Controlled’s shares can be used as currency in limited circumstances. As a result, where a company is exploring a section 355 transaction, it is important to consider various tax-efficient ways in which the parties can utilize the stock of Controlled.
1 Reg. sections 1.355-2(e)(1) and (2).
2 See, e.g., Reg. section 1.355-2(e)(2) and Rev. Procs. 89-28, 91-62 and 96-30.