NYC Bar Committee Criticizes Proposed Anti-Morris Trust Regs

The regs' "reasonably anticipated" standard in the alternative rebuttal is unworkable in practice, the committee says, because it requires a taxpayer to prove a negative -- specifically, the absence of an intent to effect the distribution at the time of the acquisition. Also, it says, the regs' restrictions on the use of the alternative rebuttal when persons become controlling shareholders after an acquisition are overly broad.

[2] As discussed in more detail in the comments, we generally applaud the proposed regulations' attempt to provide clear rules for determining whether a distribution and an acquisition are part of a plan or series of related transactions. However, we believe that the proposed regulations in their current form pose a number of serious problems. The following is a summary of our principal concerns.

[3] In the case of an acquisition within two years following a distribution, the treatment of any purpose of facilitating an equity offering as an insufficient corporate business purpose for satisfying the general rebuttal is unduly restrictive. An intent to facilitate the issuance of no more than a 20% stock interest in the distributing or controlled corporation for purposes such as raising funds through an IPO or from a strategic investor or providing compensation for employees should be treated as a qualifying business purpose. In addition, we believe that the "reasonably anticipated" standard in the alternative rebuttal is unworkable in practice. It should be sufficient for purposes of the second prong of the alternative rebuttal that the distributing corporation not be aware of an intent on the part of any third party to effect an acquisition of control.

[4] Although situations in which an acquisition precedes a distribution have been the subject of substantially less commentary than post-distribution acquisitions, the proposed regulations in this area raise a number of serious issues. The general rebuttal, although appropriate in principle, is likely to be very difficult to establish in practice, since the taxpayer would be required to establish a negative -- i.e., the absence at the time of the acquisition of an intent to effect the distribution -- by clear and convincing evidence. The alternative rebuttal is unduly restrictive insofar as it requires establishing that the distribution would have taken place at substantially the same time and on substantially the same terms had the acquisition not occurred. In addition, the restrictions on use of the alternative rebuttal where persons become controlling shareholders following an acquisition are overly broad.

[5] Finally, while we recognize that many difficult issues need to be resolved prior to finalizing the regulations, we urge the Treasury Department and Internal Revenue Service to make clear as promptly as possible that, consistent with the effective date in the proposed regulations, taxpayers may rely both as a substantive law matter and for ruling purposes on a facts and circumstances analysis and will not be bound by the proposed regulations prior to issuance of final regulations. In addition, it may be appropriate to provide guidance regarding specific issues in the form of notices or revenue rulings prior to finalizing the regulations.

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[6] If you have any questions about our comments, please call the undersigned at (212) 837-6315 or Dean Shulman at (212) 735-2008.

Very truly yours,

[8] We commend the Internal Revenue Service (the "Service") and Treasury for developing a framework that we believe should, with certain important modifications, enable taxpayers and the Service to determine whether a distribution of stock of a controlled corporation ("Controlled") that otherwise qualifies as tax-free under section 355 should nevertheless be taxable to the distributing corporation ("Distributing") because such 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-percent or greater interest in [Distributing or Controlled]" (a "50-Percent Acquisition"). ²

[9] The meaning of the words "plan" and "related" is, of course, inherently ambiguous in almost any setting. The statutory language of section 355(e) provides only one factor to consider in determining whether a distribution and acquisition are "related" or part of a "plan": distributions and acquisitions that occur within two years of each other are "presumed" to be part of a plan or series of related transactions (the "Statutory Presumption").

[10] The Service and Treasury have clearly identified in the preamble (the "Preamble") to the Proposed Regulations the most important factors to be considered in determining whether a distribution and an acquisition should be treated as "related" or part of a "plan": "[1] the business purpose or purposes for the distribution; [2] the intentions of the parties; [3] the existence of agreements, understandings, arrangements, or substantial negotiations; [4] the timing of the transactions; [5] the likelihood of an acquisition; and [6] the causal connection between the distribution and the acquisition."

[11] In commenting on the Proposed Regulations and in making our recommendations, we have been guided by the degree to which the presence or absence of each factor identified by the Service and Treasury could readily and reliably be demonstrated by a taxpayer to the Service, as well as the degree to which these factors are germane to the purposes of section 355(e). In addition, we have been guided by the following principles:

[12] First, determining the existence of a plan (or series of related transactions) generally requires a complex factual inquiry. Given the difficulties in making such a factual determination, the amount of tax that may be at stake if such determination is incorrect, and the potential audit and litigation burden that may be placed on both taxpayers and the Service in order to resolve such factual determinations, the development of one or more safe harbors under section 355(e) is essential. We strongly endorse the effort made by the Service and Treasury to develop a safe harbor.

[13] Second, a safe harbor can be useful to taxpayers and the Service only if it is based upon factors that are objective and readily and reliably demonstrable, not subjective and speculative.

[14] Third, any safe harbor developed for section 355(e) should not undermine the private letter ruling process. Instead, any safe harbor should support and be supported by the private letter ruling process. Taxpayers should be able to obtain private letter rulings that provide an appropriate degree of comfort regarding the potential applicability of section 355(e).

[15] Fourth, absent clear direction to the contrary from the statutory language and legislative history, any definition of the terms "plan" and "related" (including for purposes of a safe harbor) should be reasonably consistent with the existing body of U.S. federal income tax law.

[16] Fifth, many taxpayers engaging in either distributions or an acquisitive transactions will strive to qualify for any safe harbor even if they do not intend to pursue any second step that would potentially trigger application of section 355(e). Unless they do so, they may be subject to a two-year moratorium on certain corporate business actions. A safe harbor consequently has the potential of indirectly influencing a variety of business decisions of corporations that ultimately may not engage in a combination of transactions potentially subject to section 355(e). Our comments recommend changes to provide certainty to taxpayers and, at the same time, avoid or minimize such unintended side effects on the corporate decision making process.

[17] The body of this Report is divided into four parts. Part I analyzes the rebuttals in the Proposed Regulations regarding distributions that are followed by acquisitions and provides recommendations for changes. In particular, Part I addresses whether the "general rebuttal" ³ can in fact operate as a safe harbor and suggests modifications to the general rebuttal that we believe will make it a fairer and more effective safe harbor. Part I also suggests modifications to the "alternative rebuttal" ⁴ to make such rebuttal more realistic in practice. Part II provides a suggested definition of "agreement, understanding, arrangement, or substantial negotiations" (hereinafter, collectively, "Substantial Negotiations"). Part III analyzes the rebuttals in the Proposed Regulations for distributions that are preceded by acquisitions and provides recommendations for changes. Part IV addresses certain issues related to options.

I. DISTRIBUTIONS FOLLOWED BY ACQUISITIONS

A. SUMMARY OF "GENERAL REBUTTAL" UNDER THE PROPOSED REGULATIONS

[18] The Proposed Regulations provide two exclusive ⁵ means for rebutting the Statutory Presumption for distributions that are followed by acquisitions, the so-called general and alternative rebuttals. The general rebuttal requires the taxpayer to prove, by clear and convincing evidence, with respect to "an acquisition" of Controlled or Distributing stock that occurs after a distribution, that:

(i) the distribution was motivated in whole or in

B. ISSUES UNDER THE "GENERAL REBUTTAL" UNDER THE PROPOSED REGULATIONS

1. IMPLICATIONS OF STOCK ISSUANCE BUSINESS PURPOSE

[19] Although the Preamble, the actual language of the general rebuttal, and Example (7) ⁸ under the Proposed Regulations are somewhat ambiguous on this point, at least one Service employee has indicated (and a number of commentators have acknowledged) that the general rebuttal is not available if the only substantial corporate business purpose for a distribution is to facilitate "an acquisition" of any amount of the stock of Distributing or Controlled, no matter how small, even if such Acquisition is designed to provide incentives to employees through the formation of an employee stock ownership plan ("ESOP") or otherwise.

[20] Thus, under the current formulation of the general rebuttal, there will generally be a two-year moratorium on any 50- Percent Acquisition of Distributing or Controlled if the only substantial corporate business purpose supporting such distribution was to facilitate an equity issuance of any size by Distributing or Controlled (whether through an IPO, the issuance of stock in corporate acquisitions, or the formation of an ESOP). This is because the general rebuttal will be unavailable and because of the serious practical difficulties for any taxpayer in relying upon the current formulation of the alternative rebuttal, as discussed below.

[21] The desire to avoid being subject to such a moratorium will inevitably lead taxpayers, other than those desiring to create a "poison pill" to prevent a 50-Percent Acquisition, to manage their businesses so that they may properly document a primary corporate business purpose for a distribution under the "fit and focus" rationale, reduced cost of debt financing, or some other business purpose unrelated to an issuance of stock. Thus, similarly situated taxpayers could be subject to vastly different treatment under the Proposed Regulations based exclusively on how they analyze and document the business purpose for the distribution.

[22] Although a taxpayer may assert multiple business purposes, including purpose of facilitating a stock offering, the "intent" of issuing any equity will be considered as a negative factor in determining whether a non-Acquisition-related business purpose was "substantial" enough for the general rebuttal to apply. ⁹

[23] Thus, adoption of the proposed general rebuttal would create a potentially non-economic incentive for taxpayers to avoid or de-emphasize equity financing so that they may pursue distributions supported by a non-Acquisition-related business purpose on the basis of a private letter ruling or otherwise. ¹⁰ This would be particularly unfortunate because the "stock issuance" business purpose is perhaps the most readily and reliably demonstrable corporate business purpose for a distribution. A significant amount of objective data can often be obtained to demonstrate the real business exigency for the capital expenditures or intended corporate acquisitions of the issuing corporation, the need for such capital to be raised in the form of equity (or acquisitions to be paid for in equity), and the dramatic improvement in equity pricing that is possible as a result of a distribution. Investment bankers can definitively demonstrate the improvement in equity pricing expected to result from a distribution.

[24] Most importantly, we do not see any reason why a taxpayer that can demonstrate its need to issue equity capital to grow a business (whether to fund capital expenditures or potential acquisitions) should effectively be presumed to be more likely to dispose of such business than a taxpayer whose distribution is supported by a "fit and focus" or debt financing business purpose. In each case, the distribution is being pursued to enhance the ultimate success of the business. Thus, the approach of limiting the availability of the general rebuttal in the context of an Acquisition-related business is based on an inaccurate and unsupportable premise.

[25] In order to address these concerns, we strongly recommend that taxpayers demonstrating a corporate business purpose of facilitating a stock issuance of no more than 20 percent of the total combined voting power or value of the outstanding equity of either Distributing or Controlled also be eligible to rely upon the general rebuttal.

[26] Finally, we note that the Proposed Regulations appear to preclude reliance on the general rebuttal when the distribution is motivated by the desire to facilitate an equity issuance of Distributing that is not a 50-Percent Acquisition, even if the ultimate 50-Percent Acquisition relates to Controlled, and vice versa. We believe this result may have been unintended and should, in any event, be rectified in the final regulations promulgated under Section 355(e). ¹¹

2. THE RELEVANCE OF "INTENT" TO FACILITATE AN ACQUISITION

[27] The Proposed Regulations provide that the "intent of [Distributing, Controlled, or the Controlling Shareholders] to facilitate an acquisition or decrease the likelihood of the acquisition of one or more businesses by separating those businesses from others that are likely to be acquired is relevant in determining the extent to which the distribution was motivated by a corporate business purpose within the meaning of Treasury Regulations section 1.355-2(b) (other than an intent to facilitate an acquisition or decrease the likelihood of the acquisition of one or more businesses by separating those businesses from others that are likely to be acquired)" (the "intent test"). ¹² We are unsure as to what is intended by this statement in the Proposed Regulations. If all that is meant is that the demonstrable existence of a purpose to facilitate a 50-Percent Acquisition requires careful scrutiny of the bona fides of the substantiality of any asserted non-acquisitive business purpose, we think that this is merely a re-statement of existing law and is therefore superfluous. If, on the other hand, the Proposed Regulations are intended to require a substantively higher standard for the substantiality of a non-Acquisition-related business purpose where there is also an Acquisition-related business purpose or a balancing of the relevant weights of the different corporate business purposes, we believe that this rule could have the effect of preventing the general rebuttal from functioning as a safe harbor.

[28] The potential application of the intent test is illustrated by Examples 3 and 5 in the Proposed Regulations. In Example 3, "[Acquiror] announces an intention to acquire Distributing, principally to acquire Controlled's business . . . to lower its financing costs and, in substantial part, to deter the acquisition of Distributing by separating it from the more attractive Controlled." ¹³ Distributing distributes Controlled. The parties do not engage in any Substantial Negotiations within six months of the distribution. One year after the distribution, Acquiror acquires Distributing.

[29] In Example 5 Distributing (i) believes it would be a "more attractive" acquisition candidate if it did not own Controlled and (ii) intends to "maximize" the "possibility" of its acquisition by distributing Controlled. Distributing distributes Controlled "[t]o achieve significant nontax cost savings and, in substantial part, to maximize the possibility of Distributing's acquisition." Distributing in fact commences an auction process seven months after the distribution that results in the acquisition of Distributing one year after the spin-off.

[30] Both examples conclude that the Acquisition-related intent (to deter a 50-Percent Acquisition of Distributing in Example 3; to facilitate a 50-Percent Acquisition of Distributing in Example 5) is "a factor tending to disprove" that the distribution was "motivated in substantial part" by the non-Acquisition-related business purpose (to lower Distributing's financing costs in Example 3; to achieve significant non-tax cost savings in Example 5). Only if Distributing can establish by clear and convincing evidence that the distribution was nonetheless motivated in substantial part by the non-Acquisition- related business purpose can Distributing avail itself of the general rebuttal.

[31] The Preamble states that "analyzing whether there is another substantial corporate business purpose for the distribution in light of an acquisition-related purpose is similar to analyzing whether there is a corporate business purpose for a distribution in light of the potential avoidance of federal taxes." See Treasury Regulations section 1.355-2(b)(1) and (5), Example 8. That example involves a distribution of a Controlled for purposes of (i) making an S corporation election with respect to either Distributing or Controlled and (ii) providing equity compensation to a key employee. Thus, the comparison is between (i) an objective post-distribution tax benefit conferred as a matter of law (future and ongoing "flow- through" taxation as an S corporation) and (ii) a presumably demonstrable future and ongoing business benefit (retention of a key employee). ¹⁴ In contrast, the analysis under the proposed general rebuttal requires a comparison between (i) a subjective state of mind ("the intent") regarding an estimated probability (the "likelihood" of a future Acquisition), both of which must be inferred, presumably from all the facts and circumstances, and (ii) a clearly established corporate business purpose that has already satisfied the federal tax-avoidance standard described above.

[32] Thus, it appears that the Proposed Regulations may require a more subjective and stringent test than the test illustrated by Example 8 under Treasury Regulations section 1.355- 2(b)(5). More importantly, it is possible that the general rebuttal in its current form could in many instances require an assessment of all the facts and circumstances in order to determine, under the "clear and convincing" evidentiary standard, the absence or relative weakness of the proscribed intent. A safe harbor that ultimately requires a comprehensive factual inquiry in order to determine by clear and convincing evidence the absence or relative insignificance of a prior state of mind and/or probability is not a safe harbor. We are concerned that both taxpayers and the Service may therefore bear heavy audit and litigation burdens under the existing version of the general rebuttal.

[33] In order to permit the general rebuttal to function as the safe harbor, we believe it should be clarified that the general rebuttal will be available if Distributing can satisfy the business purpose standard under existing law ¹⁵ with respect to any business purpose which renders the general rebuttal available. ¹⁶ This is a reasonable and administrable standard which would allow taxpayers to rely on the existing body of law addressing the business purpose requirement of section 355. As further explained in Part I.C.6 below, such standard would address the factors germane to the purpose of section 355(e).

C. PROPOSED GENERAL REBUTTAL

[34] Consistent with the foregoing discussion, our proposal is that the general rebuttal be modified as follows:

(ii) REBUTTAL FOR ACQUISITIONS AFTER A DISTRIBUTION. -- (A) In

[36] The proposed general rebuttal would address the six factors cited in the Preamble as indicative of a plan (or series of related transactions), as well as the principles set forth in the introduction, in the following way.

1. BUSINESS PURPOSE FOR THE DISTRIBUTION. A valid corporate business purpose or purposes for the distribution unrelated to a 50- Percent Acquisition would be demonstrated by clear and convincing evidence-a very high standard. Taxpayers are already accustomed to preparing and obtaining, before undertaking a distribution, extensive information (including from third-party experts and advisors) that demonstrate the existence of one or more valid corporate business purposes. Therefore, the safe harbor would be based principally upon objective information regarding positive intentions that taxpayers can readily and reliably demonstrate to the Service. In addition, taxpayers would have the flexibility to undertake distributions in order to obtain more efficiently priced equity capital, provided such issuances did not exceed 20 percent (by vote or value) of the equity of the issuer.

2. INTENTION OF THE PARTIES. One of the most difficult facts to demonstrate reliably-the absence or relative insignificance of a state of mind or a prior assessment of a probability-would be indirectly addressed through compliance with the strict requirements of the general rebuttal safe harbor and reserved for direct consideration in cases in which the general rebuttal does not apply.

3. EXISTENCE OF AGREEMENTS, UNDERSTANDINGS, ARRANGEMENTS, OR SUBSTANTIAL NEGOTIATIONS. The absence of Substantial Negotiations would have to be demonstrated by clear and convincing evidence. Part II describes our proposed definition of Substantial Negotiations, which would be broadly defined to include certain types of communications with any person, whether or not such person is the actual acquiror in the Acquisition that results in a 50-Percent Acquisition. This is designed to avoid the complicated factual inquiries that have been well documented by other commentators ¹⁸ and to provide strong indirect evidence of the lack of the intention to facilitate a 50-Percent Acquisition. It would therefore be extremely difficult for taxpayers to "game" the safe harbor.

4. TIMING OF THE TRANSACTIONS. The distribution and acquisition would have to be separated by at least six months. Moreover, because of the strictures of the proposed definition of Substantial Negotiations and the ban on such Substantial Negotiations during the relevant six-month period, few if any 50-Percent Acquisitions could qualify for the safe harbor unless they were actually consummated at least nine months to a year after the distribution.

5. LIKELIHOOD OF A 50-PERCENT ACQUISITION. The most difficult factor to prove (under any evidentiary standard and particularly a "clear and convincing" standard), the "likelihood" of a 50-Percent Acquisition, would be set aside in order to prevent inevitable "battles of the experts" and reserved for indirect consideration if the general rebuttal does not apply. In such case the "likelihood" factor would be indirectly taken into account to some degree in addressing the "intent" test under the alternative rebuttal.

6. CAUSAL CONNECTION BETWEEN THE TRANSACTIONS. By virtue of addressing the first factor, the taxpayer would have demonstrated, again, by clear and convincing evidence, that any subsequent Acquisition was not the cause of the distribution, because the distribution would have occurred, indeed, was "required" by the "exigencies" ¹⁹ of the businesses of Distributing or Controlled, regardless of whether an Acquisition was anticipated. Therefore, the taxpayer would have demonstrated, at the very least, that a subsequent Acquisition was not the "but for" cause of the distribution, in other words, that it is not the case that the distribution would not have occurred but for an anticipated Acquisition. Moreover, the other factors described above also tend to break any perceived causal connection between the transactions.

[37] Applying such a causation analysis would also be consistent with the principle set forth in the introduction that, absent clear direction to the contrary from the statutory language and legislative history, any definition of the terms "plan" and "related" (including for purposes of a safe harbor) should be reasonably consistent with the existing body of U.S. federal income tax law. The provisions under U.S. federal income tax law that are probably the most analogous provision to section 355(e) are the partnership disguised sale rules under section 707(a)(2)(B) and applicable Treasury regulations thereunder. Under the partnership disguised sale rules, two otherwise tax-free transactions that occur within two years of each other are presumed to be "related" and constitute a single taxable exchange, but only if, among other requirements, "the transfer of money or other consideration [by the partnership] would not have been made but for the transfer of property [by the partner]." ²⁰ Under the proposed general rebuttal, a taxpayer would effectively be required to demonstrate, by clear and convincing evidence, that the distribution would have been made whether or not an Acquisition was anticipated because of the existence of a valid corporate business purpose under existing law.

[38] We believe that the general rebuttal as proposed would be consistent with Congressional intent and far more restrictive than any prior application of the step-transaction doctrine or any current or prior test for a "plan" or "related" transactions under U.S. federal income tax law. ²¹

D. THE ALTERNATIVE REBUTTAL

[39] The second rebuttal provided in the Proposed Regulations is the so-called "alternative rebuttal." The alternative rebuttal requires the taxpayer to prove by clear and convincing evidence that:

(A) (1) at the time of the distribution, Distributing,

[41] The primary difficulty is that, in order to satisfy the second prong alternative rebuttal, the taxpayer must prove by clear and convincing evidence that, at the time of the distribution, neither Distributing, Controlled nor their controlling shareholders reasonably would have anticipated that it was more likely than not that one or more persons would acquire a 50-Percent interest in Distributing or Controlled within two years after the distribution.

[42] This test apparently is driven by Treasury's and the IRS' concern that an objective test is necessary to enforce the principles and purposes of Section 355(e) because the focus is on whether there is a "relationship" between the distribution and acquisition and not necessarily pre-distribution negotiations or intentions. The preamble to the Proposed Regulations provides that "it is appropriate . . . to require [Distributing] to take into account the reasonably anticipated, likely actions of others to demonstrate that a distribution and acquisition are not part of a plan."

[43] It will, however, as a practical matter, be virtually impossible for taxpayers to obtain any level of comfort that the "reasonably anticipated" standard has been satisfied. Moreover, the standard goes far beyond the plain meaning of the phrase "plan or series of related transactions" in the sense that it could apply if no party to the transaction at issue intended for such subsequent transaction to occur at the time of the distribution or such subsequent transaction arose, at least in part, as a result of unanticipated or intervening events.

[44] It is difficult to see how Congress could have intended Section 355(e) to apply to a distribution and subsequent transaction if no party to the distribution intended the subsequent transaction to occur. Even the broadest formulation of the "step transaction" doctrine would not approach the breadth of the "reasonably anticipated" test. ²²

[45] The perception of the Treasury and IRS appears to be that, simply because Distributing or Controlled may be in a consolidating industry, an acquisition is more likely than not to occur or if a company appears to be trading below its inherent valuation, it is a likely takeover candidate. In fact, this is overly simplistic and unrealistic. While investment bankers (including industry analysts) can evaluate the potential for an acquisition based on industry consolidation or other relevant financial data, whether a subsequent transaction actually occurs is very often a function of many other factors with respect to which an investment banker would not be willing to opine or express an opinion. "Social issues," such as whether the CEO of a newly independent Controlled would be willing to "walk away" before he has had a chance to run an independent public company, economic conditions and issues relating to purchase price will often have a greater impact on whether a subsequent transaction occurs than the aforementioned "objective" factors.

[46] In order to attempt to obtain some degree of comfort that the "reasonably anticipated" standard has been met, taxpayers would likely request an opinion at the time of the distribution from an investment banker that an acquisition was not "more likely than not" in order to support its "reasonable belief." An investment banker, however, would likely not be willing to give an opinion. Most investment bankers would not be comfortable providing such an opinion because of the concern that the only time the opinion will ever be relevant is if an acquisition has actually occurred within two years, in which case professional liability issues could arise if their opinion is determined to be "wrong" by a court of law as a result of "20/20 hindsight."

[47] In many cases, at least one of the parties to the transaction expressly intended that a subsequent acquisitive transaction not occur. Many practices that are customarily employed in preparing a corporation for its post-distribution existence could give rise to a presumption that an acquisition may reasonably be anticipated. For example, Distributing may assist Controlled in implementing a shareholder rights plan, a staggered board and other defensive provisions in an effort to ensure that Controlled and its board are able to protect Controlled from unsolicited takeover offers. Information statements or other disclosure documents prepared in connection with spin-off transactions frequently recite that Controlled may be vulnerable to unsolicited offers in light of the absence of Distributing's former control position. Particularly when Controlled is in an industry undergoing consolidation, the IRS may assert that any spin-off in which such defensive measures were implemented would fail to satisfy the reasonably anticipated test, as the very inclusion of such terms arguably suggests that such an acquisition was reasonably anticipated.

[48] In summary, taxpayers will not be able to rely on the alternative rebuttal because (i) a useful opinion of an investment banker will be difficult, if not impossible, to obtain, and (ii) if a transaction does occur within two years, hindsight will be "20/20" and it will come down to a "battle of experts" as to what should have been "reasonably anticipated." In light of the enormous potential stakes that often exist (i.e., corporate level gain) and the fact that the taxpayer will be forced to prove a negative, a prudent taxpayer will be forced to rely on the general rebuttal if it is available or otherwise face serious risk if "discussions" commence within two years.

[49] We do believe, however, that it is appropriate to deny application of the alternative rebuttal in the case of an unintended acquisition where Distributing is aware that a specific acquisition is likely to occur, based upon the stated intention of an identifiable potential acquirer. For example, if, prior to a distribution, a third party states to management or publicly announces that it intends to commence a hostile takeover of Distributing or Controlled, it is appropriate to view the distribution and ensuring acquisition as related, even if the management of Distributing and Controlled did not want or intend for it to happen. This is, of course, a much higher standard than the "reasonably anticipated" standard of the Proposed Regulations.

E. PROPOSED AMENDMENTS TO THE ALTERNATIVE REBUTTAL

[50] We believe that it is imperative that the alternative rebuttal be modified to eliminate the "reasonably anticipated" test. At the same time, we believe that, in order to address IRS and Treasury concerns if discussions commence within six months of the distribution, a heightened degree of scrutiny could be applied under the "intent" prong of the alternative rebuttal if there is, with respect to the acquisition at issue, an agreement, understanding, arrangement or substantial negotiations within six months following the distribution.

[51] Accordingly, under the modified alternative rebuttal, taxpayers would be required to prove by clear and convincing evidence that, at the time of the distribution, Distributing, Controlled and their controlling shareholders did not intend that one or more persons would acquire a 50-Percent Interest in Distributing or Controlled during the two-year period following the distribution. Taxpayers would not be able to satisfy the modified alternative rebuttal by demonstrating that the intent to facilitate the Acquisition was only insubstantial in relation to a valid corporate business purpose. ²³ As discussed below, we believe such an approach is consistent with the intent and language of the statute.

[52] Moreover, the Committee's recommendations would make the alternative rebuttal more realistic by imposing the "intent test" of the alternative rebuttal on the relevant parties (i.e., Distributing, Controlled, and the controlling shareholders), which is consistent with the statutory language of Section 355(e). If the parties to the spin-off can prove by clear and convincing evidence that they did not intend to engage in a subsequent acquisitive transaction, the Committee believes that this should definitively disprove the existence of a plan to engage in such a transaction or the relationship between the spin-off and such a transaction, absent the existence of an acquisition unintended by the distributing corporation that is nonetheless anticipated based upon the stated intention of an identifiable potential acquirer.

[53] Nowhere in the Code or legislative history to Section 355(e) is there an inference that taxpayers would be required to satisfy the onerous "reasonably anticipated" standard if an acquisitive transaction can be proven not to be part of a "plan or series of related transactions" that includes the distribution. The requirement to prove by clear and convincing evidence that the parties to the spin-off did not intend an acquisition of 50% or more of the stock of Distributing or Controlled (subject to a heightened degree of scrutiny in the case of an acquisition in which "discussions" commenced within six months of the spin-off), combined with our suggested requirement that the parties not be aware of a specific impending "unintended" acquisition, will, as a practical matter, enforce the edict of the statute because taxpayers will still have to bring forward objective evidence, such as proof of a change in circumstances. In addition, the requirement will be very difficult to satisfy factually in cases in which "discussions" commence within 6 months of the distribution because of the heightened degree of scrutiny. For example, if the business purpose for a distribution is an IPO of Controlled, and Controlled is sold pursuant to an auction process that commenced within six months of the distribution, the taxpayer will have the difficult task of establishing by clear and convincing evidence that such sale was not intended at the time of the distribution (subject to the heightened degree of scrutiny).

[54] Consistent with the foregoing discussion, our proposal is that the alternative rebuttal be modified as follows:

(A) (1) at the time of the distribution, the distributing

[55] The term "negotiations" implies a dialogue back and forth between two or more parties. Any approach where the subject company does not have any discussions with potential acquirors, or says only as much as is necessary to inform potential acquirors that it is not interested in pursuing a transaction currently, should not be treated as Substantial Negotiations for purposes of the modified general rebuttal.

[56] On the other end of the spectrum, a signed letter of intent generally includes one or more terms of a potential transaction. Although a signed letter of intent is usually not binding as to a particular transaction until a more definitive agreement is entered into, it suggests that a more significant intention has been formed with regard to a potential acquisition and should constitute Substantial Negotiations unless, of course, it has been terminated.

[57] In general, we would consider Substantial Negotiations to include communications between (i) any person considering making an Acquisition or any agent acting on its behalf (including investment bankers and attorneys) and (ii) any of Distributing, Controlled, any controlling shareholder of Distributing or Controlled, or any of their respective agents acting on their behalf (including investment bankers and attorneys), but only if such communications at the time of the distribution or at any time during the succeeding six months result in an exchange of proposals regarding the terms that would be material for such Acquisition.

[58] Substantial Negotiations would also include any actions taken by an investment bank, with the consent of Distributing, Controlled or any of their respective controlling shareholders, to prepare a prospectus, offering memorandum, auction materials or any similar document in connection with an Acquisition including a primary public offering of stock of Distributing or Controlled, a secondary offering of the stock held by any controlling shareholder of Distributing or Controlled, or a sale of substantially all of the assets or a merger of Distributing or Controlled.

III. ACQUISITION FOLLOWED BY DISTRIBUTION

A. GENERAL

[59] Although section 355(e) by its terms potentially applies regardless of whether the disposition precedes the acquisition or vice versa, the statute was primarily motivated by concerns about transactions where the distribution precedes the acquisition. The basic policy concern behind enactment of section 355(e) appears to have been to prevent the distributing corporation and its shareholders from effectively disposing of one or more of its businesses on a tax-free basis while retaining full ownership of the remaining businesses. In many cases in which an acquisition precedes a disposition, this concern is simply not present.

[60] For example, if a corporation merges into the distributing corporation in a transaction which results in an acquisition of a 50% or greater interest in the distributing corporation, following which the distributing corporation spins off a subsidiary in a pro rata distribution to its shareholders, the distributing corporation's original shareholders end up with equal percentage interests in both businesses. Even though section 355(e) may literally apply in such a situation, it does not appear that the potential abuse which is targeted by the statute is present. Although the regulations must, of course, follow the dictates of the statutory language, they should be evaluated in light of the underlying policy concerns.

B. DISTRIBUTION WITHIN TWO YEARS FOLLOWING AN ACQUISITION

[61] Despite the fact that an acquisition prior to a distribution frequently poses fewer policy concerns than an acquisition following a distribution, the rebuttals provided in the proposed regulations for distributions within two years before or after acquisitions are often harder to meet where the acquisition precedes the distribution. As discussed in more detail below, the general rebuttal provides for what is, in principle, an appropriate test, but in many cases it will be very difficult if not impossible to meet the evidentiary standard required under the Proposed Regulations to establish that this test is satisfied. The alternative rebuttal is somewhat more susceptible of proof, but includes a number of requirements that are irrelevant to both the statutory language and purpose of section 355(e) and that, as drafted, will make it impossible to determine whether section 355(e) will apply until long after the distribution.

1. GENERAL REBUTTAL

[62] Under Proposed Regulations section 1.355-7(a)(2)(v)(A), the general rebuttal applies if Distributing can establish by clear and convincing evidence that, at the time of the acquisition, Distributing and its controlling shareholders did not intend to effect the distribution. This test is, in the abstract, a reasonable one. As a practical matter, however, it will at best be extremely difficult to establish the general rebuttal because it requires the taxpayer to prove a negative by clear and convincing evidence.

[63] The taxpayer is required to prove that, at the time of the acquisition, there was no intention to effect the subsequent distribution. Unlike an acquisition, a distribution can be unilaterally effected by the distributing corporation, without the consent or participation of any third party. Although pre- distribution board minutes reflecting discussions of a possible distribution clearly constitute evidence that a distribution was intended, the absence of such minutes does not necessarily prove that management had no such intention. ²⁴

[64] By contrast, in order to come within the general rebuttal for an acquisition following a distribution, the taxpayer can produce evidence to establish the existence of a non-acquisition business purpose as well as the absence of any Substantial Negotiations with the acquiring party during a six month period. It may be possible to come within the general rebuttal by establishing that a distribution following an acquisition was motivated by business purposes that can objectively be shown to have arisen as a result of circumstances arising after the acquisition. However, such cases will probably be rare, since the decision to effect a distribution probably results in many if not most cases from issues that have existed for some time and have proven over time not to be susceptible to other solutions.

2. ALTERNATIVE REBUTTAL

[65] Under Proposed Regulations section 1.355-7(a)(2)(v)(B), the alternative rebuttal requires establishing by clear and convincing evidence satisfaction of what is essentially a two-prong test. First, it must be established that "the distribution would have occurred at approximately the same time and under substantially the same terms regardless of the acquisition (and, in the case of an issuance of stock, all acquisitions that are part of such issuance)." Second, no person acquiring an interest in the acquisition may become a controlling shareholder by reason of the acquisition or at any point thereafter within the two year period beginning on the date of the distribution (or later, pursuant to an agreement, understanding, or arrangement existing at the time of the distribution or within six months thereafter). Although not entirely clear, it appears that where there is a controlling shareholder the alternative rebuttal is unavailable with respect to all stock acquired in the acquisition, not just the stock acquired by the controlling shareholder.

[66] The alternative rebuttal is somewhat more likely to be available as a practical matter than the general rebuttal because it requires proof of positive rather than negative facts and therefore poses less of an evidentiary problem. However, we believe that the alternative rebuttal is unduly restrictive for two reasons.

[67] First, with respect to the first prong of the rebuttal, it should be sufficient to establish that the distribution would have occurred absent the acquisition, without the requirement of demonstrating that it would have occurred at substantially the same time or on substantially the same terms. What is important here is that the distribution be motivated by purposes unrelated to the acquisition. The fact that an acquisition may result in changes in management or capital structure that affect the timing or particular terms of the distribution should be irrelevant. Similarly, where the distributing corporation acquires a new division or subsidiary in a transaction that results in an acquisition of control of the distributing corporation, the addition of a portion of the newly acquired business to the previously owned business that was intended to be the subject of the distribution, which arguably is a change in the terms of the distribution, should not preclude the alternative rebuttal from being met; Section 355(e) may, however, be implicated if there has been, in substance, a change in control of the newly acquired business. ²⁵

[68] Second, we believe that whether anyone becomes a controlling stockholder should be relevant only if the distribution is non-pro rata and the person becomes a controlling shareholder by reason of the acquisition or a plan existing at the time of the acquisition. If the distribution is pro-rata, there is no alteration of the relative percentage interests of the distributing corporation's original shareholders in the distributing and controlled corporations, and the new controlling shareholder acquires an equal interest in both corporations. Moreover, a person becoming a controlling shareholder in an unrelated transaction after the acquisition should only taint the stock acquired by the controlling person, and should not result in the alternative rebuttal being unavailable for the entire original acquisition.

[69] Under the Proposed Regulations as drafted, if a person receives a de minimis interest as a result of the acquisition and then, in a wholly unrelated transaction, becomes a controlling shareholder within two years after the distribution, the alternative rebuttal will be unavailable. In addition to being totally irrelevant to the purpose of Section 355(e), this requirement prevents the distributing corporation from having any certainty at the time of the distribution as to whether the alternative rebuttal will apply, because it is impossible to tell whether any person who acquired stock in the acquisition will later become a controlling shareholder. Of course, any subsequent acquisition of stock by such a person must be tested independently to determine whether it is part of a plan or series of related transactions that includes the distribution, even though the subsequent acquisition should not taint the original acquisition.

[70] The no controlling shareholder requirement also appears to create an artificial distinction between economically equivalent acquisition transactions that take different forms. For example, if there is a direct merger between two corporations, neither of which has a controlling shareholder, a subsequent distribution will not run afoul of the no controlling shareholder requirement. If, on the other hand, a corporation acquires control of a distributing corporation in a reverse subsidiary merger, a subsequent distribution by the distributing corporation of a subsidiary to the acquiring corporation, followed by a distribution by the acquiring corporation to its shareholders, may result in unavailability of the alternative rebuttal because the acquiring corporation will have acquired a controlling interest in the distributing corporation, even if the acquiring corporation itself has no controlling shareholders. This anomaly would be eliminated if the no controlling shareholder requirement were revised to apply only to non-pro rata distributions.

[71] Accordingly, we recommend that the alternative rebuttal be revised so that it applies in any situation where the taxpayer can establish that the distribution would have occurred even absent the acquisition, except in the case of a non-pro rata distribution with respect to stock acquired by a person who acquires a controlling interest as a result of the acquisition or as part of a plan that includes the acquisition.

C. DISTRIBUTION MORE THAN TWO YEARS AFTER AN ACQUISITION

[72] Under Proposed Regulations section 1.355-7(a)(3)(ii), an acquisition more than two years prior to a distribution is not part of a common plan unless the IRS can establish by clear and convincing evidence that, at the time of the acquisition, the distributing corporation or its controlling shareholders intended to effect the distribution and that either the distribution would not have occurred at approximately the same time and under substantially the same terms regardless of the acquisition or the no controlling shareholder test provided in the alternative rebuttal is violated. Consistent with our comments on the alternative rebuttal, we recommend that the Internal Revenue Service be required to prove both that there was an intent to effect the distribution at the time of the acquisition and that either the distribution would not have occurred absent the acquisition or the no controlling shareholder test (as modified in accordance with the above recommendations) is met.

D. OTHER FORM-BASED ANOMALIES

[73] There are other form-based anomalies that may affect acquisitions preceding distributions which appear to follow from a literal reading of the statute but can probably be corrected by regulations. For example, if one corporation merges into another corporation, as a result of which the merged corporation's shareholders acquire a controlling interest in the acquiring corporation, a subsequent distribution by the acquiring corporation of a former subsidiary of the merged corporation may run afoul of Section 355(e) if the rebuttals are not met, whereas there would be no issue if the direction of the merger were reversed. The Proposed Regulations should clarify that the substance of the transactions should control -- i.e., that Section 355(e) should not apply in the case of a distribution of a former division or subsidiary of the "dominant" party to an acquisition.

IV. CERTAIN ISSUES RELATED TO OPTIONS -- AVAILABILITY OF THE GENERAL REBUTTAL

[74] Proposed Regulations section 1.355-7(a)(7) provides that if the stock of Distributing or Controlled is acquired pursuant to an option, the option will be treated as an agreement on the date of issuance unless Distributing establishes by clear and convincing evidence that on the later of the date of distribution or the date of issuance, the option was not more likely than not to be exercised. ²⁶ The determination as to whether an option is more likely than not to be exercised is based on all the facts and circumstances.

[75] An anomaly arising under Proposed Regulations section 1.355-7(a)(7) is that an option granted (or for that matter an agreement entered into) by Distributing or Controlled prior to the formulation of any intent to engage in a distribution, which continues to remain outstanding at the time of the distribution, literally appears to be an AGREEMENT concerning an acquisition "at the time of the distribution or within 6 months thereafter" unless it can be established by clear and convincing evidence that, on the later of the date of distribution or the date of issuance, the option was not more likely than not to be exercised. Because the more likely than not standard will be difficult, if not impossible, to disprove in most instances, the "old and cold" option appears to be an agreement in existence "at the time of the distribution" that renders the general rebuttal unavailable with respect to any subsequent acquisition of stock pursuant to the exercise of the option (whether or not such acquisition occurs within two years of the distribution). ²⁷ This result is clearly inconsistent with the principles of section 355(e). It could not be intended that an acquisition pursuant to the exercise of an option that was granted prior to the formulation of any intent to engage in a distribution could be integrated with the distribution and count towards the 50% threshold of section 355(e). This is borne out by Proposed Regulations section 1.355-7(a)(2)(v) which provides that an actual acquisition of Distributing or Controlled stock will not be integrated with a distribution if, at the time of the acquisition, Distributing (and its controlling shareholders) did not intend to effect the distribution. Thus, if stock was actually issued at the time of the option grant (before the formulation of any intent to pursue a distribution), such an acquisition would clearly not be considered part of a "plan (or series of related transactions)" that includes the distribution. An option grant should certainly not be treated differently than an actual stock issuance in this context. Accordingly, the Proposed Regulations should be clarified to provide that the general rebuttal (available for acquisitions before a distribution) should apply to any acquisition (at any time) pursuant to an option (or an agreement) if the taxpayer can establish by clear and convincing evidence that the option was granted (or the agreement was entered into) prior to the formulation of an intent to pursue a distribution.

             COMMITTEE ON TAXATION OF BUSINESS ENTITIES ²⁸

² Section 355(e)(2)(A)(ii). For the sake of simplicity, this Report does not address the distribution of more than one controlled corporation by Distributing.

³ "General rebuttal" is the term used in the Preamble to refer to the rebuttal set forth in Proposed Regulations section 1.355- 7(a)(2)(ii).

⁴ "Alternative rebuttal" is the term used in the Preamble to refer to the rebuttal set forth in Proposed Regulations section 1.355-7(a)(2)(iii).

⁵ Almost all commentators have objected to the exclusivity of the rebuttals, i.e., to the fact that taxpayers unable to qualify under the "safe harbor" rebuttals provided in the Proposed Regulations cannot rebut the Statutory Presumption based upon a facts and circumstances analysis. Although we would prefer that the rebuttals not be exclusive, we believe that the rebuttals provided under the Proposed Regulations could provide a workable approach, provided that the suggestions contained herein are accepted and that reasonable rules are added to preclude public trading in the stock of Distributing or Controlled from being deemed to be part of a plan (or series of related transactions) that includes the distribution.

⁶ Proposed Regulations section 1.355-7(a)(2)(ii).

⁷ Proposed Regulations section 1.355-7(a)(2)(iii).

⁸ Proposed Regulations section 1.355-7(a)(8) Example (7).

⁹ Proposed Regulations section 1.355-7(a)(2)(ii)(B). See the discussion of the "intent test" below.

¹⁰ Thus, taxpayers could be compelled to issue debt, rather than equity, even if the issuance of equity may be more consistent with the taxpayer's business objectives and capital structure.

¹¹ In addition, we believe that this result should be rectified immediately through the issuance of a Notice, Revenue Ruling or other formal guidance.

¹² Proposed Regulations section 1.355-7(a)(2)(ii)(B).

¹³ Proposed Regulations section 1.355-7(a)(8) Example 2 (incorporated by reference into Example 3).

¹⁴ The test was presumable satisfied if the benefits of retaining the employee were "substantial" in relation to the present value of the reasonably projected decrease in future "Federal" taxes, which would presumably include corporate-level taxation.

¹⁵ See Treasury Regulations section 1.355-2(b).

¹⁶ This clarification to the general rebuttal is necessary without regard to the proposed modifications discussed above to include as a permissible business purpose for the general rebuttal the issuance of 20 percent or less of the stock of Distributing or Controlled.

¹⁷ Commentators have almost uniformly criticized the reliance upon the "clear and convincing" evidence standard to demonstrate each element of the rebuttals. Although we are in general agreement with other commentators on this point, we believe that the use of such standard in the Proposed Regulations would be acceptable, provided that the suggestions contained herein with respect to the general rebuttal and alternative rebuttal are accepted.

¹⁸ See Michael L. Schler, The Meaning of "Plan" Under Section 355(e), 85 Tax Notes 913 (1999) (Part VI.B.6).

¹⁹ Treasury Regulations section 1.355-2(b).

²⁰ Section 707(a)(2)(B)(ii); Treasury Regulations section 1.707-3(b)(1)(i).

²¹ Note, for example, that although the partnership disguised sale rule applies the same causation test as the one proposed herein for purposes of section 355(e), the partnership disguised sale rule only applies to transactions between partners and a partnership, that is, transactions between parties that are already bound by a contractual relationship; whereas the section 355(e) could, under the definition of Substantial Negotiations provided herein, apply to parties that have not had any contact whatsoever, still less a formal or informal legal relationship.

²² The step transaction doctrine collapses or combines multiple steps or transactions into fewer steps or transactions for federal income tax purposes. The three formulations of the step transaction doctrine under current law are the "binding commitment" test, the "mutual interdependence" test and the "end result" test. See Comm'r v. Gordon, 391 U.S. 83 (1968) (binding commitment test); J.E. Seagram v. Comm'r, 104 T.C. 75 (1995) (binding commitment test); Intermountain Lumber Co. v. Comm'r, 65 T.C. 1025 (1976) (binding commitment test); Manhattan Bldg. Co. v. Comm'r, 27 T.C. 1032 (1957), acq. 1957-2 C.B. 5 (mutual interdependence test); American Bantam Car co. v. Comm'r, 11 T.C. 397 (1948), aff'd per curiam, 177 F.2d 513 (3d Dir. 1949), Cert. Denied, 339 U.S. 920 (1950) (mutual interdependence test); Kuper v. Comm'r, 553 F.2d 152 (5th Cir. 1976) (end result test); King Enterprises, Inc. v U.S., 418 F.2d 511 (Ct. Cl. 1969) (end result test).

²³ See Proposed Regulations sections 1.355-7(a)(2)(iii)(A)(2) and (iii)(C).

²⁴ Ironically, the strongest case for establishing the general rebuttal may be a situation where there is evidence of a concerted effort following an acquisition to sell the controlled corporation for cash in a taxable transaction, and the distribution is decided upon only after the post-acquisition sale efforts prove unsuccessful. It is unclear whether this situation is really intended to come within the general rebuttal.

²⁵ If the acquisition takes the form of a merger of an acquired corporation into the distributing corporation where the acquired corporation's shareholders end up owning a majority of the distributing corporation's stock, we do not believe that there has been, in substance, a change of control of the former subsidiaries of the acquired corporation that should result in the potential applicability of section 355(e). See discussion on pages 24 and 25 below.

²⁶ Proposed Regulations section 1.355-7(a)(7)(ii) defines the term "option" to include call options, warrants, convertible obligations, the conversion feature of convertible stock, put options, redemption agreements, restricted stock, any other instruments that provide for the right or possibility to issue, redeem or transfer stock, cash settlement options, or any other similar interests. Proposed Regulations section 1.355-7(a)(7)(iii), however, generally excludes from the definition of "option" certain options that are part of a security arrangement in a typical lending transaction, certain compensatory options (as discussed below), and certain options exercisable only upon death, disability, mental incompetency or retirement.

²⁷ Any acquisition pursuant to the exercise of the option will be presumed to be part of a "plan (or series of related transactions)" with the distribution, regardless of whether the acquisition occurs within two years of the distribution. See Proposed Regulations section 1.355-7(a)(2) (distribution within two years of acquisition presumed to be part of a "plan (or series of related transactions)"); Proposed Regulations section 1.355-7(a)(3) (acquisition that occurs more than 2 years after a distribution is presumed to be part of a "plan (or series of related transactions)" only if there was an agreement, understanding, or arrangement concerning the acquisition at the time of the distribution or within 2 years thereafter).

²⁸ The principal authors of this letter were Dean Shulman, Michael Humphreys, and Andrew Braiterman. Additional contributions were made by John Berna and by Caroline Gottschalk of the Association's Committee on Mergers, Acquisitions & Corporate Control Contests. Helpful comments were received from Alan Appel, Dale Collinson, David Kahen, and Seymour Marks.