If your transaction’s facts fit a safe harbor for favorable tax treatment set out in IRS guidance, you can feel good about your tax results. If not, remember that meeting a safe harbor is not strictly necessary for a favorable tax result. As an illustration, we consider a recent private letter ruling (PLR), PLR 202139006. The taxpayer in that PLR received a favorable ruling, even though it was not able to provide the IRS with all of the typical factual representations.
The PLR we are focusing on involved a leveraged spin-off. In a spin-off, a corporation (Distributing) distributes the stock of a subsidiary (Controlled) to its shareholders. A spin-off must meet various requirements to qualify for tax-free treatment under section 355, and the transaction must meet several rigorous requirements. A leveraged spin-off involves distributions of Controlled stock (or debt securities) to holders of Distributing’s debt securities. A successful leveraged spin-off permits Distributing to pay off some of its debt using Controlled stock, without incurring the federal income tax liability that would result from a sale of the stock for cash.1
Standard representations for leveraged spin-off rulings
The IRS set out specific guidance for obtaining favorable private letter rulings (PLRs) on leveraged spin-offs in Rev. Proc. 2018-53, including a set of standard factual representations. Our Alert discussing Rev. Proc. 2018-53 is available: Detailed guidance for leveraged spin-off rulings.
The standard representations set out in Rev. Proc. 2018-53 are similar to a ‘safe harbor’ for achieving favorable tax treatment. If the taxpayer can make the standard representations, the IRS sees no reason to disbelieve the taxpayer, and other requirements are met, the IRS generally should grant the favorable PLR requested by the taxpayer.
Recent PLR representations differed
The taxpayer in PLR 202139006 made a number of representations to the IRS that differed from the standard representations laid out in Rev. Proc. 2018-53. The favorable ruling obtained by the taxpayer illustrates that favorable tax treatment may be available in situations where taxpayer’s facts and circumstances, particularly those driven by a non-tax business purpose, differ from what is typical for transaction attaining that tax treatment.
Differences between the facts in this PLR and typical facts set out in the standard Rev. Proc. 2018-53 representations included, for example:
Revolver debt to finance acquisitions: One standard leveraged spin-off representation is that Distributing debt assumed or satisfied in the spin-off will not be replaced with previously committed borrowing, other than borrowing in the ordinary course of business. The taxpayer in this PLR, however, planned to borrow under a revolving credit agreement to finance acquisitions. Although the acquisitions would not be ordinary course transactions, the IRS concluded that these borrowings would not affect the favorable tax result.
Delayed distributions of Controlled stock: Typically, all of Controlled stock is distributed by Distributing at the closing of a spin-off transaction. The facts in this PLR, however, involved Distributing retaining stock of Controlled for some months, and possibly up to five years. Distributing’s retention of controlled stock was motivated (at least in part) by its desire to optimize its capital structure and to retire some outstanding debt in an orderly manner, including its convertible notes. The IRS required representations regarding this non-tax business purpose for retaining stock, and required some additional representations regarding the stock retention period. In the end, the IRS concluded that Distributing’s retention of controlled stock would not prevent a favorable tax result.
Contingent convertible notes: A typical leveraged spin-off involves Distributing’s repurchase of some of its debt securities that are neither (a) convertible into Distributing’s stock nor (b) contingent payment debt instruments (within the meaning of Reg. section 1.1275-4). Distributing in this PLR, however, would repurchase outstanding contingent convertible notes (convertible notes that were contingent payment debt instruments within the meaning of Reg. section 1.1275-4). The IRS concluded that Distributing’s repurchase of the contingent convertible notes would not affect the favorable tax result.
Safe harbors available for attaining favorable tax treatment are great, in that they provide relative certainty of tax results. PLR 202139006 illustrates the principle that good tax results can be obtained in some situations where safe harbor-type standards are not met. This principle applies to all types of taxpayers, even though leveraged spin-offs like the one addressed in the PLR typically are implemented only by very large companies. Any company considering a leveraged spin-off, or any other significant distribution or reorganization transaction, should consult its Tax Advisors.
1The tax proposal released in September 2021 by the House Ways and Means Committee includes a provision that would significantly limit certain tax benefits available to companies engaging in leveraged spin-off transactions. This provision would primarily impact very large companies; middle-market and smaller companies more rarely implement leveraged spin-offs.