Spin-off revenue ruling resolves 'North-South' issues
Addresses pre-spin-off transactions between parent and subsidiary
TAX ALERT |
Corporate spin-offs—where a corporation (Distributing) distributes all the stock of a subsidiary (Controlled) to its shareholders—frequently involve preparatory steps where a shareholder transfers some assets to a corporation and a corporation transfers some assets to the shareholder. A tax question often raised by these transfers is whether they should be treated as part of the spin-off transaction or as separate transactions.
These questions are called ‘North-South’ issues because the transactions involve some assets moving upward (North) and others downward (South) on a corporate organizational chart. North-South issues are particularly common in spin-offs, but may also arise in non-spin-off transactions.
Providing some certainty in a gray area
In Rev. Rul. 2017-09, the IRS has released guidance in this gray area of the tax law. The ruling addresses two specific North-South spin-off fact patterns and provides some analysis that can be applied in other situations. However, this ruling does not turn the entire North-South gray area into black and white. Because there are so many situations in which North-South issues can arise, many North-South transactions remain in the gray area.
Situation 1 – parent transfers a business to subsidiary, subsidiary spins-off another business to parent
Situation 1 involves three corporations: Parent, Distributing and Controlled. Distributing plans to distribute all of the stock of Controlled to Parent, Distributing’s sole shareholder.
For the spin-off to qualify for tax-free treatment, Distributing and Controlled must each conduct an active trade or business (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. In Situation 1, Parent and Controlled each operate an ATB – ATB A and ATB B respectively. Distributing does not operate an ATB.
First, Parent transfers assets comprising ATB A (the Business Contribution). Distributing then distributes all of the stock of Controlled to Parent, its sole shareholder (the Spin-off Distribution). The purpose of the Business Contribution from Parent to Distributing is to permit Distributing’s subsequent distribution of Controlled to Parent to meet the ATB requirement for tax-free treatment.
The IRS held that the Business Contribution in Scenario 1 is treated as a separate transaction from the Spin-off Distribution. This provides a favorable tax result. Both transactions qualify for tax-free treatment under the tax code – the Business Contribution qualifies under section 351 and the Spin-off Distribution qualifies under section 355.
If the Business Contribution and the Spin-off instead were treated as one transaction, neither would qualify for tax-free treatment (this unfavorable result for the Spin-off is based in part on the values of the property transferred between Parent and Distributing). Tax practitioners have expressed some concern about the potential for this double-taxable result. The revenue ruling generally obviates the concern and provides some certainty in this previously gray area.
The IRS reasoned that treating the Scenario 1 Business Combination as a separate tax-free transaction is consistent with the underlying purpose of section 351. Its purpose is to allow taxpayers to incorporate a business without imposition of income tax, and that is what happens in Scenario 1 – Parent contributes a business to Distributing, and Distributing operates it afterwards.
Situation 2 – subsidiary pays dividend, parent transfers assets to subsidiary then spins off subsidiary
Situation 2 also involves Parent, Distributing and Controlled. Distributing plans to distribute all of the stock of Controlled to Parent, Distributing’s sole shareholder.
First, however, Distributing transfers assets to Parent (the Pre-Spin Distribution). Then Parent transfers assets to Distributing (the Pre-spin Contribution). Distributing then distributes all of the stock of Controlled to Parent, its sole shareholder (the Spin-off Distribution).
The IRS held that the Pre-Spin Distribution in Scenario 2 is treated as part of the same transaction as the Pre-Spin Contribution and the Spin-off Distribution. This provides a generally unfavorable tax result – Distributing would recognize gain on the Pre-Spin Contribution based on the excess of the fair market value of the contributed property over its tax basis, up to the amount of the Pre-Spin Distribution.
The Spin-off may otherwise qualify as a tax-free spin-off under section 355 and a reorganization under section 368(a)(1)(D). In tax parlance, the Pre-Spin Distribution is treated as ‘boot’ in the reorganization, which triggers the recognition of gain described above.
If the contrary result applied—separate transaction treatment—the Pre-Spin Distribution could be treated as a dividend or a return of capital. Although dividends generally are taxable, in little or no tax might result from dividend characterization in Situation 2 based on considerations such as the elimination of dividends between members of an affiliated group of companies filing a consolidated federal income tax return in a domestic context, or because of tax treaties in a cross-border context. Accordingly, the IRS’ conclusion that single transaction treatment applies may provide a taxpayer-unfavorable result.
The IRS’ reasoning in Scenario 2 was based on a line of Tax Court cases. Based on the statutory language and legislative history, the decisions in these cases concluded that the corporate reorganization boot rules apply to any distribution in pursuance of a reorganization, in lieu of the general corporate distribution provisions that apply to dividend and return of capital distributions in non-reorganization contexts.
Rev. Rul. 2017-09 adds some certainty to a gray area of the tax law – North-South transactions. Although some North-South issues remain in the gray area, the IRS has provided clear guidance for two specific situations. The tax-free result in this ruling’s Situation 1 will help many companies successfully structure tax-free spin-offs. The gain recognition result in Situation 2 can also help companies decide on how to structure their corporate transactions, even though the IRS’ conclusion in Situation 2 is an often undesirable tax result. If your company is structuring a spin-off or reorganization, it should consult with a tax advisor with expertise in this area.