PricewaterhouseCoopers Suggests Changes to Anti-Morris Trust Regs

[1] These comments are made in response to the Notice of Proposed Rulemaking (REG-116733-98) published in the Federal Register on August 19, 1999, containing proposed Treasury Regulation Section 1.355-7 (the "Proposed Regulations"). The Proposed Regulations sets forth a series of rules interpreting the phrase "plan or series of related transactions" in Section 355(e).

Background

[2] Section 355(e) was enacted by the Taxpayer Relief Act of 1997, ¹ to curtail perceived abuses in spin-off transactions in which a distributing corporation ("Distributing"), as part of a plan, would distribute the stock of a controlled corporation ("Controlled") to its shareholders in a tax-free spin-off followed by a transaction in which new shareholders acquire ownership of a substantial interest in either Distributing or Controlled. ² Congress viewed such a spin - off as a "corporate level disposition of the portion of the business that is acquired." ³

[3] Section 355(e) generally provides that Distributing must recognize gain ⁴ on the distribution of Controlled's stock if the distribution is part of a plan (or series of related transactions) pursuant to which one or more persons acquire, directly or indirectly, stock representing a 50%-or-greater interest in either Distributing or Controlled. ⁵ The legislative history to Section 355(e) provides that the prohibited 50%-or-greater acquisition must be made pursuant to "a plan or arrangement in existence ON THE DATE OF DISTRIBUTION." ⁶ Section 355(e)(2)(B) provides that such a plan or arrangement is presumed to exist on the date of distribution where the 50%-or-greater acquisition occurs within two years after the date of the spin-off, "unless it is established that the distribution and the acquisition are not pursuant to a plan or series of related transactions." ⁷

Proposed Regulations

[4] The Proposed Regulations set forth a series of rules designed to provide guidance concerning the interpretation of the phrase "plan (or series of related transactions)." In determining what constitutes a plan or series of related transactions, the Proposed Regulations rely on a variety of factors, including (i) the business purpose for the distribution; (ii) the intentions of the parties to the spin-off and of certain shareholders; (iii) the existence of agreements, understandings, arrangements or substantial negotiations; (iv) the timing of the transaction; (v) the likelihood of an acquisition; and (vi) the causal connection between the distribution and the acquisition. These factors are incorporated into two methods to rebut the statutory presumption of section 355(e)(2)(B) for acquisitions occurring within two years after a distribution.

[5] First, under the "general rebuttal," Distributing may rebut the statutory presumption by establishing by clear and convincing evidence that:

(i) The spin-off was motivated substantially by a business

(i) Either (a) at the time of the distribution, Distributing,

[7] Realizing that the existence or nonexistence of a "plan (or series of related transactions)" might not be readily apparent, Congress adopted the four-year period with respect to the statutory presumption, mainly for two reasons. First, we believe that Congress wanted to make clear to taxpayers that, if a 50%-or-greater acquisition occurred within a 4-year time period, they would be expected to establish under their normal burden of proof that a plan to effect that acquisition did not exist at the time of the spin-off. Second, we also believe that Congress wanted to provide assurance to taxpayers that their spin-off generally would not be taxable if the 50%-or-greater acquisition occurred outside the 4-year time period.

[8] We believe that Congress was concerned that section 355(e)(2)(A), if it existed by itself without the presumption in section 355(e)(2)(B), would make the question of whether a plan existed an entirely open-ended one. Congress did not want a taxpayer who, for example, effected a 50%-or-greater acquisition three years after the spin-off to be subject to an Internal Revenue Service (the "Service") claim that a plan to effect that acquisition existed on the spin-off date and have the burden to prove otherwise. It wanted to discourage the Service from challenging those taxpayers. Conversely, Congress did not want taxpayers adopting different standards for determining when a sufficient time period had expired to safely effect an acquisition without fear of being challenged; some taxpayers, for example, might believe that six months is sufficient, while others would want to wait several years. The presumption was enacted to provide uniformity among taxpayers.

"Reasonable Anticipation" Requirement of Alternative Rebuttal

[9] Underlying Section 355(e) was a congressional intent to tax those corporate taxpayers that had an actual plan to engage in spin-off transactions resembling sale transactions. We believe that Congress wanted to cover only those transactions where the taxpayer already had planned (or, alternatively, actually had completed) the acquisition transaction before the spin-off was consummated. Congress was focused on those taxpayers that contemplated selling a business in a taxable transaction but restructured the transaction to create a tax-free "Morris Trust" transaction. ⁸ Nothing in the legislative history suggests that Congress intended that plans would be deemed to exist where they did not based on whether a future acquisition could be reasonably anticipated.

[10] We disagree with the Service's position that the reasonable anticipation standard "is necessary to implement section 355(e)." The Service fears that a spin-off may take place under circumstances virtually assuring an acquisition of Distributing or Controlled, where the taxpayer is asserting that no plan for the acquisition existed on the spin-off date. That fear is already addressed by the taxpayer's burden to prove that no such plan existed. ⁹ Obviously, if those circumstances exist, the taxpayer will have a more difficult time proving its case. However, nothing in Section 355(e) or the legislative history suggests that taxpayers would be unable to launch a full scale "facts and circumstances" defense, using whatever evidence available to prove that such a prohibited plan did not exist at the time of the spin-off. Consistent with the congressional intent described above, taxpayers should be afforded that opportunity.

Clear and Convincing Evidence Standard

[11] Nothing in Section 355(e) or the legislative history suggests that Congress intended to change the evidentiary standard by which taxpayers rebut a statutory presumption. In fact, at the time the Taxpayer Relief Act of 1997 was enacted, Congress was in the midst of shifting the burden of proof from certain individual taxpayers to the Service pursuant to the Internal Revenue Service Restructuring and Reform Act of 1998. ¹⁰ It seems unlikely that Congress was, at the same time, implementing a burden of proof for taxpayers with a standard that is nearly impossible to satisfy.

[12] We acknowledge, as other commentators have, that the Service has incorporated the "clear and convincing evidence" standard in regulations providing for the rebuttal of a statutory presumption. ¹¹ However, in each of those instances, Congress expressly incorporated the heightened standard in the statute. See, e.g. Sections 280G ¹² and 613A. ¹³ The absence of a similar provision in Section 355(e) and the absence of any reference to such a heightened standard in the legislative history suggests that the Service was not authorized and Congress never intended to incorporate a heightened standard in the Section 355(e) arena. Therefore, the "clear and convincing evidence" standard introduced by the Proposed Regulations should be removed.

Taxpayers Obtaining Rulings Based on Acquisition Business Purposes

[13] One common business purpose for a spin-off is to facilitate equity offerings of companies, in order to fund capital expenditures, make acquisitions or reduce external debt, or to facilitate the issuance of stock in connection with acquisitions (an "acquisition business purpose"). The Service recently confirmed that it will issue private letter rulings for spin-offs based on such a business purpose. ¹⁴

[14] Nothing in Section 355(e) or the legislative history provides that spin-offs made for the express purpose of permitting distributing or controlled to issue its stock in acquisitions or public offerings are subject to more scrutiny if a 50%-or-greater acquisition or issuance actually does occur, than spin-offs based on other business purposes. Indeed, the legislative history even acknowledges that the 1997 legislation "permits" taxpayers to spin off controlled subsidiaries followed by a "planned restructuring" of Distributing or Controlled. ¹⁵ As a result, taxpayers have obtained rulings after the enactment of Section 355(e) on the basis of a business purpose to facilitate an acquisition or issuance of the stock of Distributing or Controlled, without sufficient notice that a subsequent acquisition or issuance of 50% or more of the stock of Distributing or Controlled not planned at the time of the spin-off would subject the spin-off to a heightened level of scrutiny by the Service.

[15] We are submitting comments on behalf of a taxpayer who obtained a private ruling from the Service that such a transaction would qualify under Section 355, and as part of the ruling process represented that the spin-off was not part of a plan or series of related transactions pursuant to which one or more persons will acquire 50% or more of the stock of Distributing or Controlled. The taxpayer also represented that Controlled would issue a significant amount of its stock in either a public offering or an acquisition within one year of the spin-off to effectuate the business purpose of the transaction. In a manner consistent with these representations, negotiations have been held by Controlled in pursuance of the completion of a public offering.

[16] If a 50%-or-greater acquisition were to occur, the taxpayer could be required to rebut the statutory presumption under the Proposed Regulations' alternative rebuttal. In that case, the taxpayer would have to show by clear and convincing evidence that it should not have reasonably anticipated that it is more likely than not that the 50%-or-greater acquisition would occur within two years after the spin-off. Thus, the taxpayer would be subject to a higher level of scrutiny solely because of the acquisition business purpose underlying the spin-off transaction.

[17] We acknowledge that the Proposed Regulations are not scheduled to become effective until after the issuance of final regulations. However, we are concerned that a revenue agent or a court will regard the Proposed Regulations, if finalized, as a reasonable interpretation of the statute during the interim period.

Request for Interim Relief

[18] During the pending Treasury Department deliberations on these regulations, interim relief is necessary and appropriate to provide guidance to taxpayers consummating legitimate transactions in reliance upon private letter rulings issued by the Service.

[19] We request that interim relief provide that taxpayers receiving a private letter ruling from the Service during the period beginning on the effective date of the 1997 Act legislation and ending on the date of finalization of the regulations may, in certain circumstances, be entitled to rely on the general rebuttal rules of the Proposed Regulations or similar rules.

[20] For example, if the stated business purpose in a private letter ruling received by a taxpayer is to facilitate an acquisition of stock of Distributing or Controlled, but the actual acquisition that implicated Section 355(e) involves the other corporation, the taxpayer may rebut the statutory presumption by establishing by clear and convincing evidence (or some lesser standard) that such acquisition occurred more than six months after the spin-off distribution and that there was no agreement, understanding, arrangement or substantial negotiations concerning such acquisition at the time of the distribution or within 6 months thereafter.

[21] Apparently, the Service's rationale for treating spin-offs based on an acquisition business purpose with more scrutiny is that the spin-off and subsequent acquisition must necessarily be related if the acquisition actually provides the business purpose for the spin-off. However, this rationale should not require that an acquisition of Distributing, for example, be subject to heightened scrutiny just because the business purpose for the spin-off was to facilitate an acquisition of Controlled's stock.

[22] We further request that the interim relief provide that in the case of a taxpayer proceeding with a specific acquisition of Distributing or Controlled stock pursuant to the stated business purpose and commitments made by the taxpayer in the application for a ruling issued by the Service, any subsequent additional acquisitions of stock would be subject to the general rebuttal rules. In these circumstances, the Service has accepted a specific acquisition transaction as the business purpose; any transactions outside the specific grounds for the ruling should be eligible to be tested under the general rebuttal.

[23] Finally, we request clarification that under the general rebuttal, the "agreement, understanding, arrangement or substantial negotiations" that are prohibited during the six-month period are those concerning the acquisition that actually occurs. Some commentators have suggested that Prop. Treas. Reg. section 1.355- 7(a)(2)(ii)(A)(2) is slightly ambiguous as to which "agreement, understanding, arrangement or negotiations" are prohibited. This might be solved simply by changing the second use of the term "the acquisition" to "such acquisition."

[24] We appreciate the opportunity to provide comments on the Proposed Regulations and look forward to appearing at your public hearing on January 26. An outline of the topics that we propose to discuss at the hearing is attached. If you desire to discuss any of our comments with us, please contact us at the phone numbers listed below.

Sincerely

² The Section 355(e) legislation is often referred to as the "anti-Morris Trust" legislation based on a case that permitted a spin-off of Controlled followed by a tax-free merger of Distributing into an acquiring corporation. See Mary Archer Morris Trust v. Comm'r, 367 F.2d 794 (4th Cir. 1966), aff'g 42 T.C. 79 (1964).

³ H.R. Rep. No. 105-148, at 462 (1997).

⁴ The gain recognized by Distributing will be the difference between the fair market value of the Controlled stock at the time of the distribution and Distributing's basis in such stock. section 311(b).

⁵ "50%-or-greater" means 50% or more of the voting power or value of the stock. Sections 355(e)(4)(A).

⁶ H.R. Rep. No. 105-148, at 462 (1997) (emphasis added).

⁷ The legislative history states that the presumption of section 355(e)(2)(B) may be rebutted upon a showing by the taxpayer that the 50%-or-greater acquisition occurring during the four-year period is "unrelated to the distribution." S. Rep. No. 105-33, at 139-40 (1997).

⁸ Introductory Statement by Mr. Archer of Bills (H.R. 1365, S. 612), to Close Tax Loophole Involving "Morris Trust Transactions, 4/17/97: "The recent transactions that raise concerns . . . are pre- arranged structures designed to avoid corporate-level gain recognition. In essence, these transactions resemble sales. If such transactions were treated as sales for tax purposes, the remaining corporation would recognize gain with respect to the stock of the acquired corporation."

⁹ As additional protection, the Service has an extended statute of limitations period for the assessment of any deficiency attributable to gain recognized because of the application of Section 355(e)(1). Section 355(e)(4)(E).

¹⁰ Pub. L. No. 105-206 (1998).

¹¹ See, e.g., Treas. Reg. section 1.613A-7(c) and (d); Prop. Treas. Reg. section 1.280G-1, Q&A 25-6.

¹² "[A]ny payment pursuant to -- (i) an agreement entered into within 1 year before the [change in ownership], or (ii) an amendment made within such 1-year period of a previous agreement, shall be presumed to be contingent on such change unless the contrary is established by clear and convincing evidence." Section 280G(b)(C).

¹³ "Price increases after February 1, 1975, shall be presumed to take increases in tax liabilities into account unless the taxpayer demonstrates to the contrary by clear and convincing evidence." Sections 613A(b)(3)(A) and (B).

¹⁴ Rev. Proc. 96-30, 1996-1 C.B. 696, App. A, sections 2.02, 2.07, 2.08.

¹⁵ S. Rep. No. 105-33, at 139-40 (1997).