United States: Revenue Ruling 98-27 and New Spin-off Control Provision in IRS Restructuring Bill

I. Revenue Ruling 98-27 Renders Rev. Rul. 96-30 and 75-406 Obsolete

On May 14, 1998, the Internal Revenue Service ("Service") issued Revenue Ruling 98-27, which renders obsolete Rev. Rul. 96-30, 1996-1 C.B. 36, and Rev. Rul. 75-406, 1975-2 C.B. 125, and modifies Rev. Rul. 70-225, 1970-1 C.B. 80.

In Rev. Rul. 96-30,¹ a subsidiary was spun off tax-free pursuant to section 355 of the Internal Revenue Code and then was acquired by an unrelated corporation in a tax-free reorganization in which the subsidiary's former shareholders received 25% of the acquirer's stock. The Service ruled that the spin-off qualified as a tax-free section 355 transaction followed by a tax-free acquisition, provided that (i) there was a separate and independent shareholder vote after the spin-off approving the acquisition and (ii) the distributing corporation had not entered into negotiations with the acquirer before the spin-off. If either of those conditions were not satisfied, however, the Service indicated that it could reorder the two transactions (so that the acquisition would precede the spin-off distribution) pursuant to the step-transaction doctrine of Commissioner v. Court Holding Co., 324 U.S. 331 (1944). Pursuant to such a reordering, the distributing corporation would be treated as exchanging the stock of its subsidiary for 25% of the acquiring corporation's stock, and then distributing that 25% stock interest to the shareholders of the distributing corporation. Thus, the distributing corporation would not "control" the distributed corporation immediately before the distribution, and would be deemed not to have distributed "control" of the distributed corporation as required by section 355(a)(1)(D). Therefore, the distribution would be fully taxable.

In 1997, Congress added section 355(e), which imposed a corporate-level tax on section 355 distributions that are part of a plan (or series of related transactions) pursuant to which one or more persons acquire stock representing at least a 50 percent or greater interest in the distributing or controlled corporation.² The legislative history under section 355(e) indicated that the Service should not apply the section 355 control test to impose additional restrictions on post-distribution restructurings of the controlled corporation, if such restrictions would not apply to the distributing corporation.

Due to the addition of section 355(e) and the legislative history thereunder, the Service in Rev. Rul. 98-27 stated that it would no longer apply the step-transaction doctrine for purposes of determining "whether the distributed corporation was a controlled corporation immediately before the distribution under section 355(a) solely because of any postdistribution acquisition or restructuring of the distributed corporation, whether prearranged or not." As a result, Rev. Rul. 98-27 obsoletes Rev. Rul. 96-30 and Rev. Rul. 75-406. Note, however, that any such postdistribution acquisition or restructuring could result in a corporate-level tax under section 355(e).

Rev. Ruls. 96-30 and 75-406 applied to section 355 spin-offs that did not follow a section 368(a)(1)(D) reorganization. In Rev. Rul. 70-225, the Service ruled that a contribution to a controlled corporation ("Controlled") in a section 368(a)(1)(D) reorganization, followed by a section 355 spin-off of Controlled and subsequent acquisition of Controlled by an unrelated corporation does not qualify as a tax-free transaction. The Service reasoned that a pre-arranged disposition of Controlled stock as part of the same plan as the distribution prevented the transaction from satisfying the requirement under section 368(a)(1)(D) that the distributing corporation's shareholders be in "control" of the controlled corporation "immediately after" the distribution.

Rev. Rul. 98-27 modified Rev. Rul. 70-225, stating that the Service will no longer apply the step-transaction doctrine in determining whether the distributed corporation was a controlled corporation under section 355 immediately before the distribution, i.e., the Service will not reorder the steps of the transaction. However, Rev. Rul. 98-27 did not rule out the application of the step-transaction doctrine under the facts of Rev. Rul. 70-225 for purposes of applying the section 368(a)(1)(D) control requirement. Thus, even though a subsequent acquisition of Controlled will not affect the satisfaction of the section 355(a)(1)(D) requirement that the distributing corporation distribute all of its stock in Controlled, a subsequent acquisition of Controlled still could affect the satisfaction of the section 368(a)(1)(D) requirement that the distributing corporation or its shareholders controls Controlled immediately after the D reorganization.

A provision in the Senate version of the Internal Revenue Service Restructuring and Reform Act of 1998 (the "Act") would eliminate the application of the step-transaction doctrine to the control test of section 368(a)(1)(D) in a section 355 transaction.³ Under Section 6010 of the Act, section 368(a)(2)(H) would be amended to state that, if the requirements of section 355 are met, the fact that the shareholders of the distributing corporation dispose of part or all of their controlled corporation stock will not be taken into account for purposes of determining whether the transaction qualifies under section 368(a)(1)(D).⁴ Thus, if the Act is passed in present form, Rev. Rul. 70-225 would effectively be rendered obsolete.

Although the Act will apparently prevent the Service from applying the step-transaction doctrine under the facts of Rev. Rul. 70-225 for purposes of section 368(a)(1)(D), the Act results in the possibility that spin-off transactions will be "triple-taxed." For example, assume Distributing contributes the assets of one of its two businesses to newly-formed Controlled in exchange for Controlled stock. Assume further that Distributing has a built-in gain in the contributed assets. Distributing then distributes its Controlled stock to its shareholders in a section 355 transaction, and an unrelated party ("Acquiring") acquires the Controlled stock within two-years of the distribution, in exchange for 5% of Acquiring stock in a tax-free B reorganization.

Under the Act, Distributing will not be taxed on the transfer of assets to Controlled, Controlled will take a carryover basis in the assets received, and Distributing will take a substituted basis in the stock of Controlled (so that Distributing has a built-in gain in that stock). Upon Acquiring's acquisition of Controlled following the distribution of the stock of Controlled, Distributing will be taxed under section 355(e) on the built-in gain in its Controlled stock (if it cannot overcome the presumption that the acquisition is pursuant to a plan that existed at the time of the distribution) (tax # 1). In addition, Acquiring will be taxed if it sells the stock of Controlled (because under section 362(b), Acquiring's basis in the stock of Controlled is the same as the Distributing shareholders' basis prior to the acquisition, and such basis is not stepped-up as a result of the section 355(e) tax) (tax # 2). Finally, Controlled will be taxed if it sells the assets received from Distributing (tax # 3).