Favorable development for life science and technology sectors
A spin-off of a subsidiary whose business lacked current revenue from sources other than its former parent company received a favorable private letter ruling from the IRS in PLR 201920008. The subsidiary was capitalized with business assets corresponding to a relatively new segment of its former parent company’s business. It was then spun-off to the parent company’s shareholders. Immediately after the spin-off, the spun-off subsidiary would receive new equity financing and would use the financing proceeds in its business.
In September 2018, the IRS announced a study of its spin-off ruling policy that could permit rulings like this one. The release of PLR 201920008 indicates that the IRS’ change in ruling policy is now official. This ruling policy change is particularly favorable to taxpayers in the life science (biotech and pharmaceutical) and technology sectors, as we discussed in our prior article, Tax-free spin offs prior to product sales stage could become a reality.
Active trade or business requirement satisfied
Spin-offs (and split-offs, which generally are subject to the same requirements for tax-free treatment) involve a parent corporation (Distributing) that distributes stock of a subsidiary corporation (Controlled). A spin-off must meet numerous requirements to qualify for tax-free treatment. One of them is the active trade or business (ATB) requirement. Distributing and Controlled must each conduct an ATB after the spin-off, and each ATB must previously have been conducted by Distributing, Controlled or certain of their affiliates for a five year period.1
Continuing business relationships between Distributing and Controlled after the spin-off, such as one providing services to the other, are not prohibited. To achieve tax-free treatment, however, it is necessary to establish that any continuing relationships between the two are not so significant as to render the separation ineffective.2 In this regard, planning for the continuing relationships to diminish or vanish over time can help.3
Diminishing continuing relationships after the spin-off were anticipated in PLR 201920008. The ruling noted that “once Controlled ceases providing Services to Distributing, Controlled may not generate revenue, but it will continue to seek to generate future revenue through future Events.” Although the published ruling’s description of the “Events” referred to is redacted, the ruling also refers to potential product sales by Controlled.
Controlled’s lack of independent revenue at the time of the spin-off would have presented an obstacle to tax-free qualification of the spin-off under prior ruling policy. Regulations addressing the ATB requirement states that an ATB “ordinarily must include the collection of income and the payment of expenses.”4 However, as the IRS’ September 2018 announcement recognized, many ventures (e.g., development of a new drug or device) include a lengthy research and development period entailing day-to-day operations, like any active business, do not generate current revenue but are geared toward generating significant amounts of revenue upon completion of development or receipt of regulatory approval. PLR 201920008 demonstrates that the IRS believes that development-stage businesses can meet the ATB requirement for a tax-free spin-off.
The IRS’ change in spin-off ruling policy is a positive development for companies in the life science and technology sectors. Corporations in the sectors have increased opportunities to dispose of, combine, or raise capital for one or more businesses tax-efficiently because the IRS has recognized that a research and development stage business can be an ATB.
Companies should note that this ruling policy change only liberalizes one element of the ATB requirement. To qualify for tax-free treatment, spin-offs still need to satisfy the other elements of the ATB requirement, as well as numerous other requirements. Any company considering a spin-off transaction should consult with a tax adviser who can analyze and interpret these various requirements.
1. Sections 355(a)(1)(C), (b)(1), and (b)(2)(A), Regulation section 1.355-3i).2. See Rev. Rul. 2003-75, 2003-2 C.B. 79; Rev. Rul. 2003-74, 2003-2 C.B. 77.3. See Rev. Rul. 2003-75, 2003-2 C.B. 79.4. Regulation section 1.355-3(b)(2)(ii).