United States: New Temporary Section 355(e) Regulations – A Vast Improvement

By Mark J. Silverman and Lisa M. Zarlenga

In 1997, Congress enacted the Taxpayer Relief Act of 1997, which added section 355(e) to the Internal Revenue Code. Under section 355(e), the so-called anti-Morris Trust provision, a distributing corporation will recognize gain if one or more persons acquire, directly or indirectly, 50 percent or more of the stock (measured by vote or value) of the distributing or any controlled corporation as "part of a plan (or series of related transactions)" (referred to herein as a "plan") that was in place at the time of the distribution. Section 355(e) also creates a rebuttable presumption that any acquisition occurring two years before or after a section 355 distribution is part of such a plan (the "two-year presumption") "unless it is established that the distribution and the acquisition are not pursuant to a plan or series of related transactions." Section 355(e) further authorizes Treasury and the Internal Revenue Service (the "Service") to issue regulations "necessary to carry out the purposes" of the legislation.

On August 24, 1999, Treasury and the Service issued proposed regulations under section 355(e)6 that provided guidance as to what constitutes a plan (the "1999 proposed regulations"). The 1999 proposed regulations created a complicated series of elements that the distributing corporation had to establish to rebut the two-year presumption. The particular rebuttal that applied depended upon when the acquisition occurred relative to the distribution. Not only were the rebuttals the exclusive means of overcoming the two-year presumption but the taxpayer also had to establish that it satisfied the rebuttals by a high burden of proof – clear and convincing evidence. As a result, the 1999 proposed regulations expanded the scope of an already overly broad statute.

On January 2, 2001, Treasury and the Service withdrew the 1999 proposed regulations, and issued new proposed regulations in their place (the "2001 proposed regulations"). The 2001 proposed regulations adopted a facts-and-circumstances approach, which is consistent with the statute. The 2001 proposed regulations contained six safe harbors that, when applicable, obviate the need to perform the facts-and-circumstances analysis. If the safe harbors were not satisfied, the 2001 proposed regulations contained a list of nonexclusive factors to consider in determining whether or not there is a plan. Finally, the 2001 proposed regulations deleted references to a clear and convincing standard of proof.

On August 3, 2001, Treasury and the Service issued temporary regulations under section 355(e). The temporary regulations are identical to the 2001 proposed regulations, except that the temporary regulations reserve section 1.355-7(e)(6) (suspending the running of any time period prescribed in the regulations during which there is a substantial diminution of risk of loss under the principles of section 355(d)(6)(B)) and Example 7 (concluding that multiple acquisitions of target companies using Distributing stock were part of a plan, regardless of whether targets were identified at the time of the spin-off, where purpose for the spin-off was to make such acquisitions). The temporary regulations were issued in response to numerous comments that immediate guidance was needed. Nevertheless, the preamble to the temporary regulations states, "The IRS and Treasury will continue to devote significant resources to analyzing the comments and, in the near future, expect to issue additional guidance regarding the interpretation of the phrase ‘plan (or series of related transactions).’"

The 2001 proposed regulations represented a vast improvement over the 1999 proposed regulations, and the temporary regulations, by deleting an overly broad example and a rule that was unclear in its application, represent further improvement. There are, however, still areas that need clarification. This article will summarize the temporary regulations and point out a few areas that need clarification. An in-depth analysis of the temporary regulations is beyond the scope of this article.

A. Safe Harbors

The temporary regulations contain six safe harbors. If an acquisition and distribution fall within one of the safe harbors, then they are not treated as part of a plan, and the distributing corporation need not apply the facts-and-circumstances test, which is described below.

1. Business purpose safe harbors

a. Safe Harbor I - Non-acquisition business purpose

(i) In general

Safe Harbor I provides that a distribution and an acquisition occurring after the distribution are not part of a plan if: (i) the acquisition occurred more than six months after the distribution (and there was no agreement, understanding, arrangement, or substantial negotiations before a date that is six months after the distribution), and (ii) the distribution was motivated in whole or substantial part by a business purpose other than a business purpose to facilitate an acquisition.

Safe Harbor I refers to a business purpose other than to facilitate "an" acquisition. Thus, the safe harbor appears to be inapplicable in the following situation: D distributes C to facilitate an acquisition of D by X. Negotiations between D and X subsequently break down. One year after the spin-off, Y acquires C. There was a business purpose to facilitate "an" acquisition (i.e., the acquisition of D by X). Thus, Safe Harbor I does not apply. Similarly, an intent to facilitate any acquisition, however small, precludes the use of Safe Harbor I. Thus, for example, a spin-off to enable key employees to purchase five percent of the stock of the controlled corporation would not fall within Safe Harbor I.

Safe Harbor I precludes an agreement, understanding, arrangement, or substantial negotiations concerning the acquisition "before a date that is six months after the distribution." Thus, if substantial negotiations occurred several years before the distribution, Safe Harbor I would be unavailable. As a practical matter, however, this rule is limited by the reference to "the" acquisition – the negotiations must occur with respect to the acquisition that actually occurred.

(ii) Multiple business purposes

Where there are two business purposes for a distribution – one acquisition and one non-acquisition – the distributing corporation must show that the non-acquisition business purpose was "substantial." The preamble to the 2001 proposed regulations states that analyzing whether a non-acquisition business purpose is substantial is similar to analyzing whether there is a corporate business purpose for a distribution in light of the potential avoidance of federal taxes; the non-acquisition business purpose thus must be "real and substantial even in light of the acquisition business purpose." In discussing the 1999 proposed regulations, representatives from the Treasury and the Service had informally indicated that this test was intended to be a "but-for" analysis: Would the distributing corporation undertake the spin-off without the acquisition business purpose? Presumably, since the language of the rule has not changed, the but-for analysis continues to apply with respect to the temporary regulations.

The temporary regulations contain certain operating rules that deem or create an acquisition business purpose; i.e., reasonable certainty, internal discussions, and hostile takeovers, which are discussed below. The preamble to the 2001 proposed regulations states that these operating rules apply in determining whether the non-acquisition business purpose is substantial. Thus, for example, if the stated business purpose for a spin-off is cost savings, but an acquisition business purpose is deemed under the operating rules, the distributing corporation must do the but-for analysis. This appears to be true even if the distributing corporation obtained a private letter ruling relying solely on the cost savings business purpose.

(a) Operating rule 1 - reasonable certainty

The first business purpose operating rule is that reasonable certainty that an acquisition will occur is evidence of an acquisition business purpose. Thus, in the case of a post-spin acquisition, if it is reasonably certain that within six months after the distribution an acquisition would occur, an agreement, understanding, or arrangement would exist, or substantial negotiations would occur regarding an acquisition, then there is evidence of an acquisition business purpose. In the case of a pre-spin acquisition, if it is reasonably certain that within six months after the acquisition a distribution would occur (or an agreement, understanding, arrangement, or substantial negotiations would occur), then there is evidence of an acquisition business purpose. In addition, if the acquisition occurs after the public announcement of the distribution, the public announcement is, itself, evidence of an acquisition business purpose.

Regarding the reasonable certainty rule, the preamble to the 2001 proposed regulations states:

Thankfully, the reasonable certainty test appears much narrower and much less complicated than the reasonable anticipation test of the 1999 proposed regulations. In addition, the reasonable certainty test plays a diminished role in the temporary regulations – it provides evidence of a factor, rather than being an exclusive test. However, it is not clear who bears the burden of proving reasonable certainty. Must the Service first assert that an acquisition that occurred was reasonably certain, or must the taxpayer in all cases produce evidence that the acquisition was not reasonably certain?

The change between the reasonable anticipation test and the reasonable certainty test is illustrated most clearly by comparing the hot market examples of the 1999 proposed regulations and the temporary regulations. Under the 1999 proposed regulations, if a distributing corporation spun off a controlled corporation in a hot market, so that it was reasonable to anticipate that the controlled corporation would be acquired, section 355(e) applied. Under the temporary regulations, however, reasonable certainty that the controlled corporation would be acquired is evidence of an acquisition business purpose. If an actual acquisition does not occur for six months, the distributing corporation may avoid section 355(e) under Safe Harbor I or II. If the acquisition does occur within six months, the distributing corporation may still avoid section 355(e) if it can satisfy the facts-and-circumstances analysis.

Regarding the public announcement rule, presumption of a tainted business purpose apparently follows from the definition of controlling shareholder, which is tested immediately before or immediately after the acquisition. Thus, one who acquires a controlling interest imparts a tainted business purpose on the transaction. The temporary regulations do not, however, limit the rule to persons who become controlling shareholders by reason of the acquisition. Final regulations should clarify this point.

(b) Operating rule 2 - internal discussions

The second business purpose operating rule is that internal discussions regarding an acquisition may be indicative of an acquisition business purpose. The temporary regulations do not, however, provide any guidance as to what is meant by "internal discussions." Are discussions among non-management level employees sufficient? What if management is considering the possibility of a spin-off, but has not yet approached the board of directors? What if the board has heard a spin-off proposal and has ordered a feasibility study? What if the discussions cease? Representatives of the Treasury and Service had informally indicated that under the 1999 proposed regulations, mere due diligence did not rise to the level of intent for purposes of the general pre-spin rebuttal. However, "internal discussions" appears to encompass a broader spectrum of activities than "intent."

(c) Operating rule 3 - hostile takeovers

The third business purpose operating rule relates to hostile takeovers. The temporary regulations provide that if the distribution is intended, in whole or substantial part, to decrease the likelihood of the acquisition of either the distributing or controlled corporation by separating it from another corporation that is likely to be acquired, then the distributing corporation will be treated as having an acquisition business purpose. Apparently, the concern is that a distribution to separate the wanted company from the unwanted company actually facilitates the acquisition of the wanted company. However, this is not the case where the acquirer wants both the distributing and controlled companies, and the distribution makes the acquirer’s goal more difficult to achieve. Although the language of the temporary regulations technically does not apply to the latter situation, it will be difficult, as a practical matter, to distinguish the two situations.

(iii) Similar acquisitions

Unlike the plan and non-plan factors discussed below, Safe Harbor I does not refer to "similar acquisitions." Thus, it appears that Safe Harbor I would apply in the following situation: D has a substantial non-acquisition business purpose for the distribution of C. Within six months, C begins negotiations with potential acquirer X, which negotiations ultimately break down. Eight months after the spin-off, C begins negotiations with potential acquirer Y for a similar acquisition, and ten months after the spin-off, Y acquires C. The acquisition occurs more than six months after the distribution, and no agreement, understanding, arrangement, or substantial negotiations concerning "the" acquisition occurred within six months after the distribution.

b. Safe Harbor II - Acquisition business purpose

Safe Harbor II provides that a distribution and acquisition will not be considered part of a plan if (i) the acquisition occurred more than six months after the distribution (and there was no agreement, understanding, arrangement, or substantial negotiations before a date that is six months after the distribution); (ii) the distribution was motivated in whole or substantial part by a business purpose to facilitate an acquisition or acquisitions of no more than 33 percent of the stock of the distributing or controlled corporation; and (iii) no more than 20 percent of the stock of the corporation whose stock was acquired in the acquisition or acquisitions that motivated the distribution was either acquired or subject to an agreement, understanding, arrangement, or substantial negotiations within six months after the distribution. According to informal statements made by representatives of the Treasury and the Service, this safe harbor was intended to address criticisms under the 1999 proposed regulations that if the distributing corporation had an intent to facilitate any acquisition (even a small one), the general post-spin rebuttal was not available for any subsequent, unintended acquisitions. For example, if D distributes C to facilitate a 15-percent public offering by C, and D is subsequently acquired in an unexpected acquisition, section 355(e) would apply under the 1999 proposed regulations. Under the temporary regulations, Safe Harbor II would apply to D’s acquisition (note that the safe harbor does not apply with respect to C’s public offering).

2. Safe Harbors III and IV - Acquisitions more than two years out

Safe Harbor III provides that if an acquisition occurs more than two years after a distribution, and there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition at the time of the distribution or within six months thereafter, the acquisition and distribution are not part of a plan. Thus, for example, if D began negotiating with a potential acquirer eight months after the distribution and was acquired 25 months after the distribution, Safe Harbor III should apply.

Safe Harbor IV provides that if an acquisition occurs more than two years before a distribution, and there was no agreement, understanding, arrangement, or substantial negotiations concerning the distribution at the time of the acquisition or within six months thereafter, the acquisition and distribution are not part of a plan. Thus, for example, if A acquires 50 percent of the stock of D, and eight months later, D begins considering a spin-off, and the spin-off occurs one year after A’s acquisition, Safe Harbor IV should apply.

3. Safe Harbor V - Public trading

Safe Harbor V provides a safe harbor for public trading. Safe Harbor V provides that an acquisition of stock of the distributing or controlled corporation that is listed on an established market is not part of a plan if the acquisition is pursuant to a transfer between shareholders, neither of whom is a five-percent shareholder. This safe harbor expressly does not apply to public offerings or redemptions. Nor does it apply if the transferor or transferee was acting pursuant to an understanding with other persons who, in the aggregate, own five percent or more of the stock of the corporation whose stock is transferred, or if the corporation knows or has reason to know that the transferor or transferee intends to become a five-percent shareholder at any time during the two-year period before and after the distribution.

Safe Harbor V refers to transfers "between shareholders," which implies that the public trading must occur between existing shareholders. Final regulations should clarify that market sales to new shareholders that own less than five percent of the stock fall within Safe Harbor V.

4. Safe Harbor VI - Compensatory stock arrangements

Safe Harbor VI provides a safe harbor for compensatory stock arrangements. Safe Harbor VI provides that if the stock of the distributing or controlled corporation is acquired by an employee or director of the distributing, controlled, or related corporation in connection with the performance of services in a transaction to which section 83 applies, the acquisition is not part of a plan. Note that this safe harbor does not apply to independent contractors.

Safe Harbor VI literally applies to acquisitions of stock in section 83 transactions. The scope of this requirement is unclear. It does not appear to apply to stock acquired pursuant to the exercise of an option to which section 83 does not apply, such as a qualified incentive stock option. The preamble to the 2001 proposed regulations states that Safe Harbor VI excludes from a plan "an acquisition of stock by an employee or director in connection with the performance of services, including an acquisition resulting from the exercise of certain compensatory stock options." Although it appears from this statement that the safe harbor is intended to reach any transaction in which stock is acquired by an employee or director as compensation, it refers only to "certain" compensatory stock options. Final regulations should clarify the scope of this safe harbor.

While Safe Harbor VI seems to protect the exercise of compensatory stock options, the grant of a compensatory stock option is protected by Temp. Treas. Reg. § 1.355- 7T(g)(3)(ii), which is further discussed below.

B. Facts-and-Circumstances Test

The temporary regulations provide that whether a distribution and acquisition are part of a plan is determined based on all the facts and circumstances. The ultimate factual determination is the intent of the distributing corporation, the controlled corporation, and their respective controlling shareholders (collectively the "relevant parties"). With respect to a pre-spin acquisition, the focus is on the intent of the relevant parties that a distribution occur in connection with the acquisition; with respect to a post-spin acquisition, the focus is on the intent of the relevant parties that the acquisition or a similar acquisition occur in connection with the distribution. The temporary regulations make it clear that the reference to "similar" does not mean identical – "the actual acquisition and the intended acquisition may be similar even though the identity of the person acquiring stock of Distributing or Controlled (acquirer), the timing of the acquisition or the terms of the actual acquisition are different from the intended acquisition." Nonetheless, the scope of "similar acquisition" is not entirely clear. For example, is an acquisition at a different price similar? What if the price difference is substantial? What about a change in the type of consideration? What about a change in the target corporation (i.e., an acquisition of the controlled corporation rather than the distributing corporation)?

The 2001 proposed regulations seemingly adopted a broad interpretation of the scope of "similar acquisition." Example 7 of the 2001 proposed regulations involved a distribution by D for the purpose of using stock of D to expand its business through the acquisition of target corporations. At the time of the distribution, D had no specific goals regarding how much of its stock would ultimately be used. D had identified X and Y as potential targets before the public announcement of the distribution and had begun negotiations with X after the announcement but before the distribution. D acquires X one month after the distribution, and acquires Y one year after the distribution (negotiations with Y began seven months after the distribution). D identifies Z as a potential target after the distribution and acquires Z 18 months after the distribution. The 2001 proposed regulations concluded that the acquisition of X was part of a plan within the meaning of section 355(e) and that, because the acquisitions of Y and Z were "similar" to that of X, they too were part of a plan.

In light of the purpose of section 355(e) to prevent disguised sales, the Y and Z acquisitions should not be considered part of the same plan as the distribution. Y had only been identified at the time of the disposition. There was no contact with Y at the time of the distribution; indeed, negotiations did not even begin until seven months after the distribution. Moreover, Z had not even been identified as a potential target at the time of the distribution. By including the Y and Z acquisitions as part of the same plan, Example 7 illustrated that corporations, as a practical matter, can no longer consummate tax-free spin-offs for the corporate business purpose of acquiring target corporations. Fortunately, Treasury and the Service have recognized that Example 7 needs further consideration and have removed the example from the temporary regulations.

The temporary regulations provide a list of nonexclusive factors to consider in demonstrating the existence of a plan, which are discussed below. The weight given to each factor depends on the particular case, and the existence of a plan is not determined merely by comparing the number of plan and non-plan factors. Thus, Treasury and the Service appear to have adopted the approach of the regulations relating to the device test of section 355.

1. Plan factors

The temporary regulations list nine factors that tend to show the existence of a plan:

1. In the case of a post-distribution acquisition, a relevant party and the acquirer discussed the acquisition or a similar acquisition before the distribution.

2. In the case of a post-distribution acquisition, a relevant party and a potential acquirer discussed the acquisition before the distribution, and a similar acquisition by a different person occurred after the distribution.

3. In the case of a post-distribution acquisition involving a public offering or auction, a relevant party discussed the acquisition with an investment banker or other outside adviser before the distribution.

4. In the case of a pre-distribution acquisition, a relevant party and the acquirer discussed a distribution before the acquisition.

5. In the case of a pre-distribution acquisition, a relevant party and a potential acquirer discussed a distribution before the acquisition, and a similar acquisition by a different person occurred before the distribution.

6. In the case of a pre-distribution acquisition involving a public offering or auction, a relevant party discussed a distribution with an investment banker or other outside adviser before the acquisition.

7. In the case of either a pre- or post-distribution acquisition, the distribution was motivated by a business purpose to facilitate the acquisition or a similar acquisition of the distributing or controlled corporation.

8. In the case of either a pre- or post-distribution acquisition, the acquisition and the distribution occurred within six months of each other, or there was an agreement, understanding, arrangement, or substantial negotiations regarding the second transaction within six months after the first transaction.

9. In the case of either a pre- or post-distribution acquisition, the debt allocation between the distributing and controlled corporations made an acquisition likely in order to service the debt.

To view this article in its full entirety (and any footnotes/diagrams), please enter the following link into a fresh browser:
http://www.steptoe.com/publications/968101.PDF

Copyright © Steptoe & Johnson LLP. All Rights Reserved.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.