Tax-free spin-offs prior to product sales stage could become a reality
INSIGHT ARTICLE |
On Sept. 25, 2018, the IRS announced a new development in the area of corporate spin-offs that is particularly favorable to taxpayers in the life science (biotech and pharmaceutical) and technology sectors. To qualify for tax-free treatment of a spin-off under existing regulations, where a company spins-off a business, both the distributing (D) and controlled (C) corporations must ordinarily generate revenue.
This announcement is welcome news to taxpayers in the life science and technology sectors. Companies in these sectors traditionally incur significant research and development and operating expenses prior to having a product available for sale (e.g., For example, a smaller pharmaceutical company may incur significant expenses and insignificant revenue in its business for years before making sales of a newly developed drug to a large pharmaceutical company).
In the announcement, the IRS said it was studying the revenue generation element of the active trade or business (ATB) requirement for tax-free spin-offs. Taxpayers should note that a favorable answer to this study would only liberalize one aspect of the ATB requirement and taxpayers would still need to satisfy the remaining requirements of section 355.
In the event a section 355 distribution becomes available prior to the revenue generating stage, taxpayers, particularly in life sciences and technology, would have significantly more opportunities to dispose of, combine, or raise capital for one or more businesses tax efficiently.
Section 355 in general
Section 355 distributions, referred to as a “spin-off” in this discussion could also occur as a split-up or split-off as well, are the exclusive method for distributing appreciated property from a corporation in a tax-free manner. As a result, congress established a strong set of requirements to meet in order to qualify for tax-free treatment.
In addition to the active trade or business requirement, to be tax-free to both the corporations and shareholders, additional section 355 requirements include:
- Business purpose: The distribution must have a significant non-tax business purpose, which generally would not include the immediate sale of the distributed or retained business.
- Device test: The distribution must not be a device for the distribution of earnings and profits, which is a facts and circumstances test impacted by the strength of business purpose, whether distributions are ratable and subsequent sales of D or C.
- Disqualified distribution: In general, 50 percent or greater of D or C cannot be held by a person that acquired their interest via purchase during the prior five years.
- Anti-Morris Trust rule: Neither D nor C can undergo a change in control (50 percent or more) pursuant to a plan at the time of the distribution. The Treasury and IRS have established a number of safe harbors for taxpayers to look to in determining satisfaction of this test under Regulation section 1.355-7.
The active trade or business test (ATB)
In order to satisfy the ATB requirement both D and C must operate an ATB immediately after the distribution. As discussed briefly above, generally both D and C must generate revenue to satisfy this requirement. However, with the significant changes in the economy over the past two decades, particularly in the life science and technology sectors, many taxpayers and tax practitioners have questioned whether collection of revenue is an appropriate test for establishing that an ATB exists. The announcement included the observation that many ventures (e.g. development of a new drug or device) includes a lengthy research and development (R&D) period and day-to-day operations like any active business, but that lacks current revenue. The observation also noted that in many cases the company may forgo income currently to generate significantly more income upon further development, and observed that often times it is regulatory agency approval that delays the ability to generate revenue.
The announcement went on to state that due to this shift in the marketplace the IRS and Treasury are considering guidance that would allow such activities as described above to satisfy ATB when they are incurred to generate future income even though no current income is being generated.
Example assuming revenue is not necessary to satisfy ATB:
D is a pharmaceutical company that has an existing suite of drugs that D has manufactured and sold over the last decade. In addition, D has spent significant R&D developing a new drug that D believes could generate significant revenue in the future. However, to further develop and bring the drug to market, significantly more investment is required, which D is not prepared to fund. Investment bankers believe they can bring in the needed investment, but that new investors would want the product in a separate entity that is not controlled by D. To accomplish the separation D transfers the business related to the new drug to C and then distributes the C stock to D shareholders in a spin-off. Following the spin-off, C issues additional shares to the investor group in an amount that is less than 50 percent of C’s vote and value.
Assuming that D transferred the related employees and assets allowing C to perform the day-to-day operational and managerial functions of the business, the fact that C does not generate revenue would not keep C from satisfying ATB.
The example above includes new investment into C, but that is not necessary. Business purposes such as fit and focus, competition for capital, shareholder disputes, and going your own way amongst others could be plausible reasons for a spin-off.
Note that the announcement does not appear to impact at all the remaining ATB requirement. As a result, careful consideration must be given as to whether, after the spin-off, both D and C independently perform active and substantial managerial and operational functions of each separate business. Merely creating a second corporation to hold the new drug is not sufficient, rather, C will need to operate a separate business from D, and while some overlap in employees is often acceptable during a transition, C generally must have separate management, an independent board (without majority overlap) and key operational employees. This requirement can in some situations be too expensive or cumbersome for taxpayers to undertake. If overlap in employees continues for an extended period of time, the IRS may take notice, as it is necessary for D and C to establish that the continuing relationship between the two is not so significant as to render the separation ineffective.
The IRS’ announcement of its ATB requirement study is welcome news to taxpayers in the life science and technology sectors amongst others. It may well be good news to investors as well, and may help accelerate development of new products by lowering tax barriers to new investment. The announcement is a clear acknowledgement that flexibility in tax rules surrounding M&A transactions in a fast moving business environment is a necessity.
Until the study is completed, the IRS will entertain private letter rulings requests on the issue. Based upon a lack of existing authority addressing treatment of pre-revenue stage businesses as ATBs, a private letter ruling request would appear highly advisable. Taxpayers should consult a tax advisor if they are considering such a spin-off.
 Rev. Rul. 73-237, 1973 C.B. 184. Rev. Proc. 96-30, 1996-1 C.B. 696. Rev. Rul. 73-234, 1973-1 C.B. 180.