NYSBA Tax Section Suggests Changes to Spinoff Regulation

I am pleased to submit the attached report of the Tax Section of the New York State Bar Association. The report makes proposals regarding the allocation of earnings and profits ("E&P") in connection with divisive transactions described in section 355 of the Internal Revenue Code. Because a section 355 distribution of a controlled corporation ("Controlled") by a distributing corporation ("Distributing") results in the division of a single corporation into two corporations, it is necessary to have rules to determine the post-transaction E&P of Distributing and Controlled after the division in order to preserve the relationship of the shareholders to the E&P.

The allocation of E&P in connection with a spin-off is currently governed by Treas. Reg. § 1.312-10. This Regulation was issued in 1955, when individuals were taxed at significantly higher rates on dividend income than capital gains, multinational corporations with complex structures and attribute profiles were uncommon, and the tax law generally was less complex. The Regulation is ambiguous in certain respects, resulting in uncertainty, and in certain contexts does not reach appropriate results.

Today, the location and category of E&P following cross-border section 355 transactions is critical for determining the tax consequences of future distributions by foreign corporations. In this context, clear rules are essential in order to minimize inappropriate repatriation opportunities and provide taxpayers with certainty. In the domestic context, the amount of E&P allocated is critical when the dividing company does not have E&P in excess of contemplated shareholder distributions by Distributing and Controlled, or where Controlled must manage its E&P for qualification as a real estate investment trust.

The report recommends relatively modest changes to the Regulation to: (i) provide certainty to taxpayers and the government, (ii) minimize inappropriate tax planning, (iii) minimize differences between a spin-off of a newly-formed Controlled and a pre-existing Controlled, and (iv) provide guidance for a divisive section 368(a)(1)(D) reorganization ("divisive D reorganization") where Controlled is pre-existing. Our recommendations provide consistent results regardless of whether there is a divisive D reorganization and regardless of whether Controlled is pre-existing or newly-formed.

Specifically, in the context of a spin-off of a newly-formed Controlled corporation:

This report ("Report")¹ of the New York State Bar Association Tax Section makes proposals regarding the allocation of earnings and profits ("E&P") in connection with divisive transactions described in section 355 of the Internal Revenue Code of 1986, as amended (the "Code").² In a section 355 transaction, the controlled corporation ("Controlled") is separated from the distributing corporation ("Distributing").³ Because a section 355 distribution results in the division of a single corporation into two corporations, it is necessary to have rules to determine the post-transaction E&P of Distributing and Controlled after the division in order to preserve the relationship of the shareholders to the E&P.

Section 312(h), enacted in 1954 as section 312(i), provides that a proper allocation of E&P must occur in the connection with a section 355 distribution. Pursuant to the authority granted by Congress, in 1955, the Treasury Department ("Treasury") and Internal Revenue Service (the "Service") issued Treas. Reg. § 1.312-10 (the "Regulations"), governing the allocation of E&P in connection with a spin-off. The Regulations are ambiguous in certain respects, resulting in uncertainty as to the precise allocation of E&P after many section 355 transactions. Additionally, the Regulations were developed at a time when individuals were taxed at significantly higher rates on dividend income than capital gains, multinational corporations with complex structures and attribute profiles were uncommon, and the tax law generally was less complex. Consequently, the Regulations do not reach appropriate results in certain contexts.

Today, the location and category of E&P following cross-border section 355 transactions is critical for determining the tax consequences of future distributions by foreign corporations. In this context, clear rules are essential in order to minimize inappropriate repatriation opportunities and provide taxpayers with certainty.⁴ In the domestic context, the amount of E&P allocated is critical when the dividing company does not have E&P in excess of contemplated shareholder distributions by Distributing and Controlled, or where Controlled must manage its E&P for qualification as a real estate investment trust ("REIT").⁵

Our examination has concluded that there is no practical allocation system that will reach appropriate results in all contexts. Therefore, the Report focuses on balancing the various policy objectives, including minimizing opportunities for inappropriate tax planning, and removing the uncertainties that exist under the Regulations. The proposals in the Report are applicable to all spin-offs, including cross-border spin-offs.⁶

Part II of this Report summarizes our recommendations. Part III of the Report reviews the relevant provisions of the Code and regulations governing E&P adjustments in section 355 transactions and the case law, legislative history, and commentary that provide insight into the purpose of these provisions. Part IV summarizes the relevant policy objectives for revising the Regulations. Part V explores methods for allocating Distributing's E&P to Newco Controlled in a divisive D reorganization. Part VI focuses on allocations of Distributing's E&P to Oldco Controlled. Part VII addresses the allocation of Distributing's E&P in a divisive D reorganization where assets are transferred to Oldco Controlled. Part VIII addresses related issues commonly raised when allocating E&P in a spin-off: (i) the determination of Distributing's E&P available to be allocated; (ii) the impact of section 301 distributions on the amount of Distributing's E&P available to be allocated; and (iii) the allocation of E&P where Controlled is less than 100 percent owned.

II. SUMMARY OF RECOMMENDATIONS⁷

This Report proposes modest changes to the Regulations in order to: (i) provide certainty to taxpayers and the government, (ii) minimize inappropriate tax planning, (iii) minimize differences between a spin-off of a Newco Controlled and an Oldco Controlled, and (iv) provide guidance for Oldco divisive D reorganizations. Our recommendations provide consistent results regardless of whether there is a divisive D reorganization and regardless of whether Controlled is a Newco Controlled or an Oldco Controlled. Specifically, the Report recommends:

Although a corporation's accumulated E&P is not necessarily equal to its accumulated taxable income or to its retained earnings, there is generally a relationship among the three amounts. As stated by Bittker and Eustice:

In Helvering v. Jarvis,¹⁷ the Board of Tax Appeals considered this issue in the context of a non-pro-rata redemption distribution. There, a corporation with capital of $1,910,000 and accumulated E&P of $1,448,000 redeemed 10% of its stock for $1,160,000. The Board of Tax Appeals held that the amount of the redemption distribution chargeable to the capital account was equal to the redeemed shares' pro-rata portion of the capital account, or $191,000 (10% of $1,910,000). The balance of the distribution ($969,000) reduced E&P. Accordingly, after the distribution, the corporation had just $479,000 of E&P -- 67% less than it had before the redemption.

The following year, in Woodward Investment Company v. Commissioner,¹⁸ the Board of Tax Appeals used a different formula to determine the effect on E&P of a pro-rata distribution in partial liquidation. The Board of Tax Appeals held that the distribution should be deemed made partly out of capital and partly out of E&P, based on the relative balances of those accounts. Thus, the court determined the amount of the reduction to the E&P was computed by multiplying the amount of the distribution by a ratio, the numerator of which was the amount of E&P and the denominator of which was the sum of E&P and capital. The underlying rationale was that a proportionate amount of E&P and capital should be treated as standing behind each of the corporation's assets.¹⁹ Consequently, as other commentators have noted, the Woodward formula produces the same reduction to E&P as would a formula that reduces E&P in proportion to the basis of the assets distributed over the basis over the assets retained.²⁰

Section 312(n)(7) reduces the amount of the reduction to E&P beyond that of the Woodward approach, limiting the amount of the reduction to the "ratable share of earnings and profits" of the redeemed stock, where such ratable share is determined by taking the ratio of the value of the redeemed shares over the total value of all the corporation's shares outstanding immediately before the redemption transaction.²¹ Thus, under the facts of Jarvis, the ratio would be 10%, and the reduction to E&P would not exceed $144,800 ($1,448,000 x 10%).

In Sansome, a corporation transferred all of its assets to a newly formed corporation and in return, the new corporation issued all of the shares of its stock to the old corporation's shareholders, in proportion to their shareholdings in the old corporation. Subsequently, the old corporation dissolved. The overall transaction qualified as "a mere change in identity, form, or place of organization" of the old corporation, and hence a reorganization under the Revenue Act of 1921. The question presented was whether the E&P of the old corporation carried over to the new corporation for the purpose of determining whether subsequent distributions by the new corporation were taxable dividends to its shareholders.²³ The Board of Tax Appeals determined that the E&P did not carry over, on the ground that the new corporation did not acquire any E&P as such from the old corporation; rather, it acquired assets, which, under basic tax-accounting principles, should be treated as capital.²⁴ The Second Circuit, however, reversed. Judge Learned Hand, writing for the court, inferred, from the theory underlying the tax-free reorganization provisions, that Congress did not intend for the transaction at issue to convert the old corporation's E&P into capital. He expressed the court's holding as follows: "a corporate reorganization which results in no gain or loss . . . does not toll the company's life as [a] continued venture . . . and that what were 'earnings or profits' of the original, or subsidiary, company remain, for purposes of distribution, 'earnings or profits' of the successor."²⁵

The Sansome rule was applied to other types of tax-free transactions, including tax-free corporate divisions.²⁶ Although the cases involving corporate divisions made plain that an allocation of E&P was required, they did not squarely address how that allocation was to be made.²⁷ For example, in Mandel v. Commissioner,²⁸ Distributing transferred 60 percent of the book value of its assets to newly formed Controlled and then split off Controlled to its shareholders in a divisive D reorganization. The taxpayer argued that because the assets transferred to Controlled were originally received by Distributing as capital contributions, none represented the E&P of Distributing, and therefore the amount of E&P allocable to Controlled was zero. The Tax Court, however, rejected the premise that a corporation's E&P and capital accounts represent or stand for specific assets on its balance sheet, and held that Distributing's E&P should be allocated based on relative book values.²⁹ The decision does not disclose the relationship of those figures to fair market value or tax basis.

Early applications of the Sansome rule emphasized the importance of a continued venture. For example, in Campbell v. United States,³⁰ the Third Circuit held that the Sansome rule extended only to those cases involving a continuation of the corporate venture by the same shareholders, and declined to apply the rule where the shareholders of the old corporation received less than half the stock of the new corporation. Over time, however, the scope of the Sansome rule expanded and the theory underlying it evolved. The first major development came in Commissioner v. Munter,³¹ where the Supreme Court declined to follow the narrow interpretation of the Third Circuit and applied the Sansome rule on facts similar to Campbell. In the process, the Court clarified and restated the rationale underlying the Sansome rule. As the Court stated in Munter:

Two years later, the Court made this plain in Commissioner v. Phipps.³³ In that case, a parent corporation liquidated, on a tax-free basis, five wholly owned subsidiaries. Four of the subsidiaries had deficits in E&P, which, in total, exceeded the parent's E&P. The following year, the parent made a distribution to its shareholders, including the taxpayer. The taxpayer claimed that the Sansome rule required the subtraction of the subsidiaries' net deficit from parent's E&P for purposes of determining whether that distribution was taxable as a dividend or a tax-free return of capital to its shareholders. The Court, however, disagreed. As the Court stated, "[i]f the assets of the parent and subsidiary are combined via a tax-free reorganization or liquidation, the effect of the Sansome rule is this: a distribution of the assets that would have been taxable absent the reorganization does not lose that character by virtue of the tax-free transaction."

As mentioned, this is essentially the same approach adopted by the Board of Tax Appeals in Woodward. However, section 310(c) did not expressly provide that a corresponding amount of E&P be allocated to Controlled. Instead, the House Committee on Ways and Means noted it did not intend "a result, under existing law, which [would] produce more earnings and profits in existence immediately after the transaction, than were in existence immediately prior to the transaction." ³⁶ Thus, the Committee seemed primarily concerned with calculating a proper reduction to E&P, and preventing the creation of additional E&P in the system.

The Committee on Taxation of the Association of the Bar of the City of New York recognized this omission, and recommended that "express provision should be inserted in the bill with regard to the amount of earnings and profits to be transferred to the transferee corporation in corporate separations which would be consistent with the reduction of the transferor's earnings and profits provided by section 310(c)."³⁷

First, the Finance Committee recommended a net worth limitation on the allocation, indicating that "as a result of such allocation, in no case may the earnings and profits of a corporation exceed its total net worth," with net worth defined to mean the sum of the bases of the properties plus cash minus all liabilities.³⁹ Second, in a divisive D reorganization, the Finance Committee gave the general admonition that "the principle of the Sansome case . . . will be applied to allocate a portion of the earnings and profits of the distributing corporation to the controlled corporation." Finally, the Finance Committee provided that "no deficit of a distributing corporation will ever be allocated to a controlled corporation."⁴⁰

The Regulations further provide that, "[i]n a proper case, allocation shall be made between the distributing corporation and the controlled corporation in proportion to the net basis of the assets transferred and of the assets retained or by such other method as may be appropriate under the facts and circumstances of the case." The term "net basis" is defined as the basis of the assets less liabilities assumed or liabilities to which such assets are subject. No explanation or examples are provided that elucidate what is a "proper case." Significant uncertainty under current law stems from this element of the Regulations. Some have suggested that, in light of the change in scope of the Regulations from the proposed version to the final version, as described above, a transfer of assets to Oldco Controlled in a divisive D reorganization may be "a proper case."⁴²

It is interesting to note that Congress's directive to apply the Sansome principle in the legislative history was only in reference to divisive D reorganizations.⁴⁵ At the same time the 1954 Act enacted section 312, it also eliminated the prior law requirement that the distribution be part of a reorganization, allowing for the first time a section 355 distribution of Oldco Controlled.⁴⁶ As a result, it is unclear what to make of the lack of a direct reference to the Sansome principle in the context of Oldco Controlled. Presumably, the goal of neutralizing the effect of a spin-off on the taxability of future distributions should be relevant regardless of whether the spin-off follows a divisive D reorganization.

The court relied heavily on the legislative history of section 312(h)(1) to interpret the meaning of "proper case," noting that section 312(i) as enacted was intended to be flexible, as evidenced by the abandonment of the proposed House version of the provision.⁵⁰ While the Commissioner was given broad authority to determine an allocation method, Congress provided that the allocation of E&P must comply with the Sansome principle. The court observed that the Regulations create a general preference for the fair market value method, but that the ultimate selection of an appropriate method was dependent on the facts and circumstances of each case.⁵¹ Under the facts and circumstances of Bennett, the court held that the fair market value method was the appropriate method because (i) it would protect the Sansome principle, expressed as "the prevention of tax avoidance at the shareholder level"⁵² ; (ii) the net worth limitation, if relevant, would not be violated; and (iii) the value of both Distributing and Controlled, as publicly traded companies, was easily ascertained.

The Bennett case perpetuates the uncertainty regarding the potential scope of the "proper case" language in light of its fact-specific analysis that seemingly focused on finding the distributions were taxable. However, the court noted that the issue of taxability is not "dispositive" and that where there are "compelling countervailing circumstances," a proper case may not maximize taxability.⁵³ Interestingly, the Bennett case rejected the taxpayer's criticism that E&P allocations under the fair market value method improperly reflect the appreciation in value of the properties transferred to Controlled because additional E&P will be generated when Controlled later disposes of the properties. As discussed further below, the Service has put forth a similar line of reasoning in support of the net basis method in the context of proposed regulations dealing with cross-border spin-offs.⁵⁴

The Bennett case could be interpreted as a results-oriented decision. The court, with the benefit of hindsight, concluded that the taxpayer's chosen allocation method was not proper because it eventually led to a reduction in shareholder tax liability of a post spin-off corporate distribution. Nevertheless, the Bennett case supports the proposition that upholding the Sansome principle -- that continuity of shareholder taxability is not to be obliterated by the intervention of a tax-free reorganization -- guides the overriding determination of whether an allocation method is appropriate under the facts and circumstances.⁵⁵

The Section 367 Proposed Regulations generally adopt the principles of section 312(h), but modify their mechanics to meet the objectives of certain international provisions, such as the sourcing and foreign tax credit rules, and provide clarity as to what rules should apply in ambiguous cases, such as a divisive D reorganization involving a transfer of assets to Oldco Controlled. The modifications apply to three categories of transactions: (1) a transfer of assets to Newco Controlled in a divisive D reorganization; (2) a spin-off of Oldco Controlled where there is no transfer of assets; and (3) a transfer of assets to Oldco Controlled in a divisive D reorganization.

In the context of a transfer of assets to Newco Controlled in a divisive D reorganization, the Section 367 Proposed Regulations propose to modify Treas. Reg. § 1.312-10(a) by expressly requiring that the allocation of Distributing's E&P be made based on the relative net basis⁵⁷ of assets transferred to Controlled in order "to [reflect] the view that net basis is the most accurate measure of the appropriate amount of earnings and profits that should be allocated to the assets transferred by a distributing corporation in the D reorganization."⁵⁸ To illustrate the concern regarding accuracy, the Section 367 Proposed Regulations give an example in which Controlled later recognizes gain on appreciated property transferred in the spin-off (and, thus, creates additional E&P). However, the Section 367 Proposed Regulations do not address scenarios where allocating E&P based on net basis can lead to other distortions, as described below.

In the context of a spin-off of Oldco Controlled, the Section 367 Proposed Regulations provide the E&P of Distributing is reduced by the amount that E&P would have been reduced if it had transferred the stock of Controlled to a new corporation and allocated based on net basis with no net worth limitation on such reduction.⁵⁹ The Section 367 Proposed Regulations would not increase or substitute Controlled's E&P as a result of Distributing's reduction.⁶⁰

In the context of a transfer of assets to Oldco Controlled in a divisive D reorganization, the Section 367 Proposed Regulations provide a hybrid method incorporating the concepts of the two previously described rules.⁶¹ Distributing's E&P would be decreased both for the net basis of assets transferred in the divisive D reorganization and for the distribution of Oldco Controlled stock. Oldco Controlled's E&P would be increased only to the extent of the E&P attributable to the assets received in the divisive D reorganization. In the preamble to the Section 367 Proposed Regulations, the Service states that Treas. Reg. § 1.312-10(a) "does not specifically address the allocation and reduction of earnings and profits in connection with a D/355 distribution that involves a pre-existing controlled corporation."⁶²

In all cases, the Section 367 Proposed Regulations provide that an allocation or reduction of Distributing's E&P generally shall be pro rata out of a cross-section of Distributing's E&P. The preamble states that this is preferable to "some other measure, such as by determining the earnings and profits attributable to the income generated by assets transferred or distributed (a tracing model) or by decreasing most recently accumulated earnings and profits to the extent of assets transferred or distributed (a dividend model)."⁶³

IV. POLICY CONSIDERATIONS

As explored below, there is no possibility of devising a perfect system for allocating Distributing's E&P when it engages in a spin-off. There are too many factual permutations that can alter the efficacy of a particular model. Because precision is not attainable, there must be a balancing of competing policy goals. In the analysis of possible E&P allocation methods that follows, these policy considerations are taken into account in assessing merits and demerits of each method. As demonstrated, each method will reach appropriate result for some cases, and each will reach inappropriate results for other cases. Because there is no "one size fits all" solution to this problem, the tax system will be required to make choices among the relevant policies as some of them cannot co-exist.

This principle reflects two distinct aims. The first, and arguably most important, is that the allocation should maintain the relationship of the shareholders to the E&P accumulated prior to the division. This goal is rooted in the Sansome principle, which holds that a tax-free transaction should not have the effect of converting a distribution that would have otherwise been a dividend into a tax-free return of capital or capital gain. Support for this goal is abundant: it is manifest in the early case law, the legislative history to section 312(i), Treas. Reg. § 1.312-10, and the Bennett case, which elevated it to a criterion of the adequacy of any allocation method.

The second aim is that the allocation should maintain the relationship of the shareholders to the "potential E&P" -- that is, Distributing's pre-division E&P adjusted for any net unrealized built-in gain or loss at the time of the division.⁶⁴ This objective is satisfied when E&P is allocated such that, if all built-in gain or losses were realized, the E&P of the Distributing and Controlled corporations would be in proportion to their respective fair market values at the time of division. This goal finds implicit support in the legislative history to section 312(i) (the forerunner to section 312(h)), which contemplates a "net worth" limitation on any adjustment to Controlled's E&P in connection with a straight section 355 distribution, and explicit support in the preamble to the Section 367(b) Proposed Regulations. It also comports with the balance sheet conceptualization of E&P -- the notion, discussed below, that E&P is essentially a balancing figure on the tax basis balance sheet that represents the difference between the corporation's net basis in its assets and its capital account.

Because the tax basis balance sheet has played a significant role in the development of general E&P rules, it should be taken into account in balancing the various objectives at play in the E&P allocation rules for spin-offs. Nevertheless, a balanced tax basis balance sheet is not currently a fundamental principle underlying the tax law as it relates to movements of assets and E&P. Leaving aside the debt and shareholder capital elements of the tax basis balance sheet consider the fact pattern in which Y corporation, which has $200 of asset basis (cash) and $200 of E&P, acquires the stock of X corporation for $200 in a qualified stock purchase. Further assume that X's assets have a net fair market value of $200 and a $0 basis, and X has no E&P. If following the acquisition X liquidates into Y under section 332, Y would succeed to X's basis in its assets ($0), and X's E&P ($0).⁶⁵ In this case, Y would have an unbalanced tax basis balance sheet -- asset basis of $0 and E&P of $200 (i.e., its historic E&P). Similar results may occur, for example, in (i) section 368(a)(1) reorganizations where the acquiring corporation issues boot as part of the consideration (e.g., an acquisitive D reorganization using solely cash⁶⁶), (ii) section 304 transactions, (iii) non-dividend equivalent redemptions, (iv) triangular reorganizations, and (v) divisive section 368(a)(1)(D) reorganizations.⁶⁷ For instance, assume that Y, which has $200 of asset basis (cash) and $200 of E&P, instead acquired the stock of X corporation for $200 from Parent, the sole shareholder of Y and X, in a section 304(a)(1) transaction. Further assume that Parent's basis in its X stock is $200. This transaction similarly unbalances Y's tax basis balance sheet -- asset basis of $200 (carryover basis in the X stock) and E&P of $0 ($200 of historic E&P less $200 of deemed dividend to Parent). In fact, except for the few transactions that are governed by rules that require a connection between E&P and tax basis, most transactions in which assets move today result in unbalanced balance sheets. Consequently, it is likely that a large number of corporations with any significant history will not have a balanced tax basis balance sheet.

As discussed above, in Bennett, the Claims Court specifically rejected the taxpayer's argument that E&P was a function of a tax basis balance sheet. There does not seem to be any indication from Congress or the case law that maintaining a balanced tax basis balance sheet was a policy driver for section 312(h). In a tax system that generally does not pursue the balance between E&P and tax basis, it does not seem that maintaining equilibrium between E&P and tax basis in connection with a spin-off is a worthwhile pursuit. Nevertheless, we also recognize that harmonizing shareholder capital/E&P and tax basis may be a principle to be considered in the income tax system more generally, with a view to addressing the myriad of transactions that implicate the relationship in a consistent manner. Absent such significant changes to the tax system as a whole, however, we do not believe this policy should drive the outcome of the E&P allocation rules if there are more important policies to balance.

In some ways, the net worth limitation is a close relative to a balanced tax basis balance sheet; it doesn't always ensure a balanced tax basis balance sheet, but it prevents Controlled's E&P from exceeding its tax basis in its assets.

The origins of the net worth limitation can be traced to the legislative history to section 312(h). In providing that an allocation of E&P would be made under regulations, the Senate Finance Committee stated that "[a]s a result of such allocation, in no case may the earnings and profits of a corporation exceed its total net worth."⁶⁸ For this purpose, the net worth limitation is a tax basis, rather than fair market value, concept.⁶⁹

Interestingly, the Senate's direction that the E&P of a corporation may never exceed its net worth was not specifically directed to a straight section 355 distribution or a divisive D reorganization followed by a spin-off. Indeed, the court in Bennett acknowledged that the net worth limitation should similarly apply to allocations under Treas. Reg. § 1.312-10(a), despite the lack of a direct reference to such a limitation in the Regulation.⁷⁰ Further, the court reconciled the presence of a net worth limitation with the direction to follow the Sansome principle as follows:

This leads to a broader question of whether a net worth limitation and the Sansome principle can coexist, and if not, which principle should trump. As explained above, the overriding policy objective for allocating E&P in a spin-off is to preserve continuity in future shareholder taxability -- i.e., the Sansome principle. On the other hand, the net worth limitation is grounded on the premise that a corporation's tax basis balance sheet should balance. As explained in the previous section, there are numerous instances in which a corporation's tax basis balance sheet may become unbalanced. As such, it is questionable what role, if any, the policy of preserving a balanced tax basis balance sheet should play in the rules governing E&P allocations in spin-offs. When weighing the importance of protecting the Sansome principle against the secondary concerns of a balanced tax basis balance sheet, we believe it is clear that the Sansome principle should take priority.

A net worth limitation could easily frustrate the Sansome principle in many spin-offs. For instance, it is common for a Controlled corporation to be leveraged equal to the basis in its assets. As a result, many Controlled corporations would have a $0 net worth, and thus would be allocated no E&P in a spin-off. For example, in cases where a Controlled corporation is leveraged in an amount equal to the basis in its assets, such leverage is only economically sustainable because the fair market value of Controlled's assets exceeds the basis in its assets. As explained further below in the section discussing the Net Basis Method, while there is some logic to this approach, the results may be inconsistent with the Sansome principle.

In sum, although the legislative history to section 312(h) provided for a net worth limitation, we believe that the directive to follow the Sansome principle is more important and thus should control. Accordingly, we recommend that future guidance addressing E&P allocations in spin-offs does not contain a net worth limitation.

Instead of allocating, in theory, Distributing's pre-spin-off E&P could remain in a pool which would be jointly available to both Distributing and Controlled following the spin-off (the "Pooling Model").⁷³ Even if there were authority to adopt the Pooling Model, its detriments outweigh any conceptual appeal it may have. However, it provides perspective for assessing the allocation methods below and, therefore, is worthy of elaboration.

Under the Pooling Model, if either corporation were to make a post-spin-off distribution, it would have E&P available first from its own post-spin-off operations and then from the common pool, in an amount up to its fair market value immediately after the spin-off. The main attraction of the Pooling Method is that, by making the entire amount of Distributing's pre-spin-off E&P available to Distributing and Controlled following the spin-off, it neutralizes the effect of a spin-off in some circumstances in which an allocation-based method does not.

Although the Pooling Model generally would result in a more thoroughgoing application of the Sansome doctrine to spin-offs than an allocation-based approach, it would fall short of fully neutralizing the effect of the spin-off. In particular, where Distributing and Controlled come to be held by different shareholders, the Pooling Model could result in a post-spin-off distribution being treated more favorably than it would have been treated absent the spin-off.⁷⁴

Moreover, any benefits associated with the Pooling Method would come at the cost of considerable complexity. Each of Distributing and Controlled would need to know the amount of post-distribution E&P and distributions of the other in order to know how much E&P remains in the pool. As one example, suppose that Distributing (but not Controlled) generates an E&P deficit from its own post-spin-off operations.⁷⁵ In order to neutralize the effect of the spin-off on subsequent property distributions, the deficit would reduce the pool. The upshot -- that the amount of E&P in the pool is subject to change, based on the post-spin-off operations and distributions of Distributing and Controlled -- would pose serious practical issues. For one, in order to compute the amount of E&P available in the pool, Distributing and Controlled would be required not only to share information about their respective operations but also to coordinate their tax reporting positions on matters affecting E&P. And if they were unable to agree about a particular tax reporting position -- a likely prospect, given the pervasive uncertainty surrounding the computation of E&P -- intractable disputes among Distributing, Controlled, and the Service could ensue.⁷⁶

The Pooling Model could entangle Distributing and Controlled in other respects as well. Inevitably, there will be cases in which Distributing and Controlled each make property distributions in the same year, and the total amount of the distributions during the year exceeds the amount of E&P in the pool. Thus, there would be a need for ordering rules governing post-spin-off distributions. Each of the obvious options, however, would create problems. If the distributions are charged against the pool according to the order in which they are made, there could be disputes between Distributing and Controlled as to which corporation declares dividends first. alternative -- allocating a pro rata portion of the E&P in the pool to each distribution -- is hardly better, as it would allow a distribution by one corporation to be affected by a subsequent distribution by the other In the public company context, this could frustrate the ability of Distributing and Controlled to comply with tax reporting obligations applicable to property distributions.⁷⁷

V. ALLOCATION OF E&P TO NEWCO CONTROLLED

Much has been written on the issue of allocating E&P to Newco Controlled, around the time of the promulgation of the Regulations⁷⁸ and more recently with the proliferation of section 355 distributions involving multinational corporations with significant foreign entities.⁷⁹

Below we analyze five basic potentially meritorious models for allocating E&P to Newco Controlled.

• Under the "Fair Market Value Method," E&P would be allocated based on the relative fair market values of Distributing and Controlled. As discussed above, allocating E&P on the basis of relative fair market values is the "general" rule in the Regulations for allocating Distributing's E&P to Newco Controlled. Presumably the fair market value allocation rule was adopted to maintain the relationship of the shareholders to the E&P accumulated prior to the division, which was the subject of case law at the time the Regulations were adopted.⁸⁰

• Under the "Net Basis Method," as it has been used in the modern tax law, E&P would be allocated based on the net basis of assets transferred to Controlled relative to those retained by Distributing. The Net Basis Method has its underpinnings in the balanced tax basis balance sheet, which would suggest that if basis is transferred to Controlled, some amount of E&P should move with it. However, it does not address what happens to the shareholder capital in the spin-off. As discussed above, the Section 367 Proposed Regulations proposed to adopt the Net Basis Method for all cross-border section 355 distribution because it takes into account potential E&P.

• Under the "Tracing Method," to attempt to allocate E&P as if Distributing's and Controlled's businesses were always separate, E&P would be traced to the assets that generated the E&P and allocated to the corporation that receives those particular assets. As discussed below, while the Tracing Method has been endorsed by commentators, it is complex and will often lead to inappropriate results.

• Under the "Balance Sheet Method," to address all the elements of a truly balanced tax balance sheet, both shareholder capital and E&P would be allocated between Distributing and Controlled. First, capital would be allocated according to the relative fair market values, and then E&P would be allocated according to the difference between tax basis and capital.⁸¹ The Balance Sheet Method will achieve similar results as the Net Basis Method in a fact pattern in which shareholder capital is small relative to E&P. However, where shareholder capital is significant relative to E&P, the amount of E&P allocated to Controlled will be less than the amount allocated in the case of the Net Basis Method.

• Under the "Modified Fair Market Value Method," to address the fact that the Fair Market Value Method does not maintain the shareholders' relationship to potential E&P, adjustments to the bases of the assets of the resulting corporations would be made solely for purposes of computing their E&P on subsequent dispositions of those assets. The E&P basis adjustments will address the longer-term issue of Distributing and Controlled having too much or too little E&P where there is unrealized appreciation in the assets.

• A. The Fair Market Value Method

The Fair Market Value Method does not necessarily achieve the second shareholder continuity goal of making an allocation, which is to preserve the relationship of the shareholders to Distributing's potential E&P. This defect stems from the fact that Fair Market Value Method does not take into account differences in the net basis of the assets of the corporations.⁸⁴ In Example 1, immediately after the division, Distributing's assets had a net unrealized built-in gain of $50, whereas Controlled's assets had a net unrealized built-in gain of $150. If each corporation were to sell its assets, Distributing's E&P would be increased to $100 ($50 (allocated E&P) + $50 (gain) = $100), whereas Controlled's E&P would be increased to $200 ($50 (allocated E&P) + $150 (gain) = $200). Note that X's potential dividend liability with respect to future distributions is $50 less than it would have been in the absence of the division, and Y's potential dividend liability with respect to future distributions by Controlled is $50 greater than it would have been in the absence of the division. Because the E&P of Distributing and Controlled ultimately would not be in proportion to their respective fair market values at the time of the division, the Fair Market Value Method fails to preserve the relationship of the shareholders to Distributing's potential E&P.

This can result in distortions in the timing and character of X's and Y's income with regard to their respective investments. Suppose that after the built-in gains in their respective assets have been recognized, Distributing and Controlled each makes a distribution of $175. Of the $175 distributed by Distributing to X, the first $100 would be considered a dividend, even though $150 is in substance a distribution of corporate income. Thus, $50 of ordinary income has been permanently converted into capital gain. Further, because the next $50 would be considered a tax-free return of capital, the shareholder-level tax would be delayed. Y, on the other hand, is not so fortunate.⁸⁵

Despite the fact that her original investment appreciated by only $150, she would have a dividend of $175 -- an instance of "the miracle of income without gain."⁸⁶

While Example 1 depicts a non-pro rata split-off, the principles are relevant in pro rata spin-offs as well. In some cases, where shareholders retain their proportionate interest in both businesses following the division (e.g., in a pro rata spin-off), the distortions may be harmonized from the overall investment perspective. However, this is impossible when a corporation is allocated E&P in excess of its net basis in its assets. Suppose the facts are the same as in Example 1, except that at the time of the division, the assets transferred to Controlled have a tax basis of $0. Upon recognizing the $200 built-in gain in the assets, Controlled's E&P would be increased from $50 to $250. Because Controlled cannot make a distribution in excess of its fair market value of $200, $50 of potential future E&P effectively disappears from the system.⁸⁷

It is important to keep in mind, though, that the distortions wrought by the Fair Market Value Method are merely potential in nature. First of all, it is possible that the built-in gains may never be realized, and hence may never be reflected in E&P. example, to the extent the built-in gain is reflected in stock of a controlled subsidiary, it may be eliminated upon a future distribution qualifying under section 355 or a complete liquidation qualifying under section 332.⁸⁸ Moreover, it is possible that neither Distributing nor Controlled will make a distribution in excess of its share of pre-division E&P, in which case, in the domestic context at least, the distortion would be confined to the corporate level.⁸⁹

Failure to maintain the relationship of the shareholders to the pre-division E&P can also distort the timing and character of income at the shareholder level. Suppose that Controlled makes a distribution of $50 to Y before the built-in gains in its assets are realized. Of that distribution, the first $25 would be considered a dividend and the second $25 would be considered a return of capital. If it is assumed that Controlled would have made a $50 distribution to Y in any case, the division has the effect of permanently transforming $25 of ordinary income into capital gain. This result is inconsistent with the Sansome rule insofar as the division and resultant allocation has the effect of converting a distribution that would have otherwise been a dividend into a tax-free return of capital.

If it were the general rule, the Net Basis Method would frequently place shareholders in position to realize such a benefit. When Distributing has debt outstanding, it is often necessary to shift a portion of Distributing's debt to Controlled to rationalize their capital structures -- especially in the case of a division of a public company. Further, it is common for the amount of the debt shift to equal or exceed the net basis of the assets transferred to Controlled. Accordingly, there would be a significant class of cases in which Controlled would be allocated no E&P. This could raise significant policy concerns in a variety of contexts, including cross-border spin-offs and REIT spin-offs.

To be sure, there are other constraints on the ability of shareholders to exploit the distortions created by the Net Basis Method. For one, it is a requirement of section 355 that the division not principally be a device for the distribution of E&P of Distributing or Controlled. However, relying on the device requirement to fix the problems created by the Net Basis Method has several disadvantages. First, while the device requirement would thwart obvious bailout schemes, it would not accomplish the broader objective of section 312(h), which, again, is to assure future distributions are taxed as dividends to the extent of pre-division E&P. For example, the device requirement generally does not apply in the case of a non-pro rata split-off, such as Example 2.⁹⁰ Moreover, the device requirement generally would not apply if, following the division, Distributing or Controlled were to make a return-of-capital distribution that was not planned at the time of the division. In such situations, discontinuities could arise innocently. Second, the device requirement is a balancing test, and, as such, its application can be indeterminate. Where the Net Basis Method yields, serendipitously, a significant potential benefit to shareholders, the prospect of that potential benefit could interject uncertainty regarding the qualification of the distribution under section 355.

The main justification for the Net Basis Method is that it is more effective than the Fair Market Value Method at preserving the relationship of the shareholders to Distributing's potential E&P. Therefore, it promotes continuity in the taxability of future distributions over the long run. This is certainly true in Example 2. There, if each corporation were to sells its assets, Distributing's E&P would be increased to $125 ($75 (allocated E&P) + $50 (gain)), and Controlled's would be increased to $175 ($25 (allocated E&P) + $150 (gain)). Notice that this is still distortive: X's potential dividend liability with respect to future distributions by Distributing is $25 less than it would have been in the absence of the division, and Y's potential dividend liability with respect to future distributions by Controlled is $25 greater than it would have been in the absence of the division. However, on these facts, the distortion is half as great as it was under the Fair Market Value Method.⁹¹

Second, even if it were feasible, the Tracing Method would not necessarily result in neutralizing the effect of the division on shareholder tax liability. Allocating E&P so as to mimic the state of affairs that would have existed if the shareholders originally had set up the different businesses as separate corporations does not necessarily serve this purpose. In some cases, the Tracing Method will disrupt the relationship of the shareholder to the pre-division E&P, leading to the same short-run distortions as the Net Basis Method.

On this view, where Distributing has a balanced tax basis balance sheet immediately before the division, Distributing's E&P would be allocated according to the following procedure: first, Distributing's capital account⁹⁵ would be allocated between Distributing and Controlled in proportion to their respective fair market values; then, Distributing and Controlled would each be allocated a portion of the pre-division E&P equal to the difference between its net basis in its assets and its capital account (the "Balance Sheet Method").⁹⁶

However, the Balance Sheet Method would fully preserve the relationship of the shareholders to Distributing's potential E&P. Suppose Distributing and Controlled sell their respective assets following the division. Distributing's E&P would be increased to $150 ($100 (allocated E&P) + $50 (gain)), and Controlled's would be increased to $150 ($0 (allocated E&P) + $150 (gain)). Accordingly, the E&P of the corporations will be in proportion to their respective fair market values at the time of the division. Thus, provided that no return-of-capital distributions are made before the net unrealized built-in gains in the assets are realized, the Balance Sheet Method neutralizes the effect of the division on the taxability of future distributions.⁹⁷

                             Comparison of Results

One potential option would be to allocate E&P according to the Fair Market Value Method, but to adjust the tax basis of the assets of Distributing and Controlled solely for purposes of computing their E&P on the disposition or consumption of those assets, to prevent future distortions.

The downside of the Modified Fair Market Value Method is that it would engender significant complexity. Rules would be needed for allocating the basis adjustments among the corporation's assets. Where Distributing or Controlled owns stock in subsidiaries, corresponding adjustments would need to be made to the E&P tax basis of the assets of those subsidiaries, in order to prevent taxpayers from nullifying the E&P tax basis adjustments through a section 332 liquidation.¹⁰¹ In large corporate groups, this exercise is apt to be particularly burdensome. Further, the taxpayers would be compelled to compute tax basis separately for both E&P and regular tax purposes. However, it bears mention that taxpayers are required to compute separate tax basis for E&P purposes in various other contexts. As one example, a corporation may have one basis in an asset for purposes of determining gain or loss upon disposition for regular federal income tax purposes (reflecting MACRS depreciation deductions) and another for E&P purposes (reflecting straight-line depreciation deductions). As another, the consolidated return regulations require separate stock basis calculations for regular federal income tax and E&P purposes.¹⁰²

VI. ALLOCATION OF E&P TO OLDCO CONTROLLED

Thus far, this Report has focused on methodologies for allocating Distributing's E&P in a section 355 transaction where Distributing transfers assets to Newco Controlled in a divisive D reorganization and distributes the stock of Newco Controlled to its shareholders in a section 355 distribution. As explained above, on balance we believe that an allocation of Distributing's E&P should be based on the relative fair market value of Distributing and Newco Controlled. However, another category of corporate division transactions that must be considered is one in which Distributing distributes Oldco Controlled in a section 355 distribution that is not preceded by a divisive D reorganization (a "straight section 355 distribution").

Although a straight section 355 distribution differs from a divisive D reorganization in some respects, the underlying policy goals relating to E&P allocation remain unchanged. That is, regardless of whether Controlled is newly formed or pre-existing, there must be an allocation of Distributing's E&P in order to promote continuity in shareholder taxation on future distributions.

A straight section 355 distribution does, however, invoke additional considerations related to E&P allocation, most notably, how to account for Oldco Controlled's existing E&P prior to the distribution.

In addition, as described above, under the Regulations, the Controlled Net Basis Amount imposes a ceiling on the reduction to Distributing's E&P As explained above, the imposition of a net worth limitation may frustrate the Sansome principle and we recommend future guidance not contain such a limitation (which would effectively remove the Controlled Net Basis Amount from Step 1). As such, the examples below do not take into account the Controlled Net Basis Amount.

On the other hand, the mechanics of Treas. Reg. § 1.312-10(b) have allowed E&P to be eliminated from the broader corporate tax system. Prior to the spin-off, Distributing had $70 of E&P and Oldco Controlled had $30 of E&P (aggregate E&P of $100). After the spin-off, each of Distributing and Oldco Controlled has $35 of E&P (aggregate E&P of $70). The loss of $30 of E&P from the system is the result of the non-reciprocal relationship between the Step 1 reduction to Distributing's E&P and the Step 2 adjustment to Controlled's E&P.

Is "disappearing E&P" appropriate in light of the policies of Treas. Reg. § 1.312-10 and the broader framework governing corporate E&P? In Example 6, $35 of E&P for each of Distributing and Controlled after the spin-off arguably represents an appropriate division of Distributing's pre-spin-off E&P between Distributing and Oldco Controlled. Moreover, there may be compelling reasons why Distributing's E&P should be reduced, without regard to whether Controlled's E&P is increased, in a spin-off. First, the spin-off will reduce Distributing's ability to make distributions in the future -- i.e., after the spin-off, Distributing is worth less than it was before the spin-off. Thus, to the extent that E&P is intended to measure the capacity of a corporation to pay dividends, a reduction of Distributing's E&P should seemingly be proper where Distributing distributes a valuable asset. Second, in addition to a loss of value, Distributing has also lost its basis in an asset -- the stock of Controlled. As discussed above, in many instances in the tax law, there is a parallel relationship between E&P and tax basis. The Service has previously stated that when a corporation makes a disposition of property with respect to stock, E&P must be reduced by the adjusted basis of the distributed property because it is the adjusted basis that is reflected in the E&P of the corporation.¹⁰³ Neither of these principles turns on whether, or by how much, Controlled's E&P is increased.

Viewed more broadly, however, E&P represents corporate earnings that have not yet been taxed at the shareholder level. Under this view, is it appropriate for E&P to disappear before it is taxed at the shareholder level? To be sure, there are many instances in which corporate E&P is reduced without a corresponding dividend to shareholders.¹⁰⁴ However, these instances and their related policy goals are different those present in a spin-off. For example under section 312(n)(7), discussed further above, a corporation's E&P is reduced in a section 302(a) (i.e., non-dividend equivalent) redemption by the ratable share of earnings and profits of the redeemed stock. A corporate redemption is fundamentally a corporate contraction transaction, and the reduction to a corporation's E&P in this case is primarily about preserving the correct amount of corporate E&P vis-à-vis the non-redeemed shareholders. A spin-off, on the other hand, is a corporate division. The prevailing policy goal of Treas. Reg. § 1.312-10 is to prevent a spin-off from allowing a corporation to make a tax-free distribution of assets that would have been a taxable dividend but for the spin-off.¹⁰⁵

In this light, the disappearance of E&P caused by Treas. Reg. § 1.312-10(b) could have the effect of reducing the extent to which a future distribution would have otherwise been taxable absent the spin-off, because there is less E&P available within the corporate tax system for future distributions to shareholders. As such, this result would run contrary to the prevailing policy objectives of the E&P allocation rules.

On balance, we believe the underlying policy objectives of Treas. Reg. § 1.312-10 should generally preclude (or at least not promote) the elimination of E&P in the context of a section 355 distribution. In addition, disappearing E&P may lead to unnecessary adverse consequences in cross border spin-offs,¹⁰⁶ as well as planning opportunities.

In sum, Distributing's post-spin off E&P would be $35, regardless of whether the spin-off was undertaken as a divisive D reorganization; similarly, the combined E&P of Newco Controlled and Oldco Controlled would be $65 in the case of a divisive D reorganization (although this E&P would be divided between corporate tiers), which is the same as Oldco Controlled's E&P under the Unlimited Top-up Adjustment Alternative. Accordingly, an advantage of the Unlimited Top-up Adjustment Alternative, as compared to the Reduction Limitation Alternative, is that it reduces, to a degree, the ability to control the allocation of E&P through transaction electivity (i.e., the decision to undertake a divisive D reorganization vs. a straight section 355 distribution).

However, the Combined E&P Alternative presents at least several issues. First, the approach seems to be too far reaching in disregarding corporate tiers. Making Oldco Controlled's E&P available to Distributing for allocation purposes is fundamentally inconsistent with the general corporate tax framework and the rules governing E&P generally.

Second, unless the Combined E&P Alternative combines the E&P of all of Distributing's and Controlled's subsidiaries, it may not achieve its intended results if Distributing and/or Controlled is a holding company, which is often the case in a spin-off. In order to fully implement a Combined E&P Alternative, the E&P of subsidiaries should be included, resulting in administrative complexity and exacerbating the other detriments noted herein.

Third, where the amount of Distributing's Hypothetical E&P is greater than Distributing's actual E&P, would E&P be allocated from Oldco Controlled to Distributing? This result generally would be inconsistent with the fundamental focus of Treas. Reg. § 1.312-10 on how much, if any, of Distributing's E&P should be allocated to Controlled, not vice versa. To address this concern, the Combined E&P Approach could include specific rules prohibiting, for example, an allocation of Oldco Controlled's E&P to Distributing. However, numerous and complex rules would be needed to fully assuage the myriad of issues raised by the Combined E&P Approach across a wide range of fact patterns (e.g., cross border spin-offs, spin-offs involving a partially owned Oldco Controlled, pre-spin-off dividends from Oldco Controlled to Distributing). This added complexity would both create uncertainty and be difficult to administer.

Lastly, similar to the Reduction Limitation Alternative, the ultimate allocation consequences of the Combined E&P Alternative could be avoided by structuring the spin-off as a divisive D reorganization. Further, the results of the Combined E&P Alternative could be easily manipulated by altering Oldco Controlled's E&P prior to the spin-off (e.g., a lower-tier subsidiary of Oldco Controlled could pay a dividend to Oldco Controlled).

VII. ALLOCATION OF E&P IN AN OLDCO DIVISIVE D REORGANIZATION

When assets are transferred to Oldco Controlled in a divisive D reorganization in connection with a distribution under section 355 (an "Oldco divisive D reorganization"), there are additional considerations to those discussed in Parts IV and V. The Regulations do not provide specific guidance for Oldco divisive D reorganizations.¹⁰⁸ The fundamental challenge posed by an Oldco divisive D reorganization is that it involves both a transfer of assets from Distributing to Controlled, and a distribution of Oldco Controlled, which has its own pre-contribution value and E&P. In sum, the Oldco divisive D reorganization contains aspects of both a divisive D reorganization involving Newco Controlled and a straight section 355 distribution.¹⁰⁹

Because this Report recommends the Fair Market Value Method for a spin-off of Newco Controlled, for purposes of the following examples, the Fair Market Value Method is used to apply the Assets Transferred Alternative.

This potential for inappropriate results from the Assets Transferred Alternative can be further highlighted through a more extreme example.

Our recommendations for allocating E&P in a spin-off of Newco Controlled, Oldco Controlled and an Oldco divisive D reorganization result in the same allocation of Distributing's E&P regardless of the transactional form selected.

VIII. RELATED ISSUES

The Proration Method finds support in the regulations under section 316.

Specifically, Treas. Reg. § 1.316-2(b) provides in relevant part that:

The efficacy of the Closing of the Books Method is supported by numerous other areas of the tax law in which allocations between two periods are determined by closing a corporation's books as of a particular date. For example, Treas. Reg. § 1.382-6(b) allows an election to be made to close the books for purposes of allocating net operating loss or taxable income and net capital loss or gain of a loss corporation in the event of an ownership change, the general rule of Treas. Reg. § 1.1502-76(b)(2)(i) requires a closing of the books for purposes of allocating items of income, gain, deduction, loss, and credit when a subsidiary becomes or ceases to be a member of a consolidated group, and a partnership termination under section 708 (b)(1)(B) requires a closing of the books to allocate U.S. taxable income between the old partnership and new partnership.

The Section 367 Proposed Regulations allocate Distributing's "pre-transaction earnings", indicating a Closing of the Books Method. While the Proposed Regulations do not define "pre-transaction earnings", Prop. Reg. § 1.376(b)-8(b)(v) provides that the pre-transaction earnings that are subject to allocation or reduction under paragraph (b)(1)(i) shall include any increase in E&P from gain recognized or income included by the distributing corporation as a result of the foreign divisive transaction, which seems inconsistent with the pro-ration method. The Section 367 Proposed Regulations contain examples illustrating how the allocation rules are intended to work. In each example, the distributing corporation and the controlled corporation (whether foreign or domestic) use a calendar taxable year, and the contribution/distribution transaction occurs on January 1, 2002. Furthermore, each example provides that the distributing corporation's pre-transaction earnings (for purposes of allocation) consist of its accumulated E&P plus the amount of gain/income generated by the contribution/distribution transaction. Notwithstanding that the contribution/distribution occurs on the first day of the distributing corporation's taxable year, the examples neither pro-rate the gain/income generated by the contribution/distribution transaction nor take into account any earnings and profits generated by the distributing corporation during the portion of the taxable year after the date of the contribution/distribution.

We note, however, the Service has previously questioned "whether corporations ordinarily close their books prior to year-end so that an accurate computation of interim earnings can actually be made. Furthermore, even if an accurate interim account can be computed, the administrative burden to the Service in confirming that computation could be overwhelming."¹¹⁴

For example, Rev. Rul. 74-339¹¹⁹ addresses a situation in which a corporation, with a $60x accumulated E&P deficit and $60x of current E&P, first redeemed a portion of its shareholders in a section 302(a) redemption, and then made a section 301 distribution to its remaining shareholders that exceeded its current E&P. The Service observed that whether the section 301 distribution is a dividend depends upon the rule used to determine the order in which ordinary distributions, redemption distributions, and other type distributions are charged to E&P. The ruling also interprets Treas. Reg. § 1.316-2(b) to provide that, if current E&P (computed as of the close of the year without diminution by reason of any distributions made during the year and without regard to the amount of E&P at the time of the distribution) is sufficient to cover all the section 301 distributions during that year, each distribution is a taxable dividend. Based upon these factors, the ruling concludes that, because distributions subject to section 301 have priority over distributions subject to section 302(a) in drawing current E&P, the current E&P is available to the section 301 distributions undiminished by the section 302(a) distributions.¹²⁰

We believe this ruling reaches the appropriate results. By extension of these principles, Distributing should compute its current E&P as of the close of the taxable year without diminution by reason of an allocation or reduction to Distributing's E&P under Treas. Reg. § 1.312-10 due to a spin-off made during the taxable year. As such, a section 301 distribution paid by Distributing during the same tax year as a spin-off -- whether paid before or after the spin-off -- would be applied against, and reduce, Distributing's current year E&P. This approach is also consistent with the policy goals of section 312(h) and the Regulations by preserving the taxability of a section 301 distribution that would have otherwise been taxable as a dividend absent a spin-off. Stated differently, if Distributing allocated a portion of its current E&P to Controlled the taxability of a section 301 distribution paid after, but during the same tax year as, a spin-off could be reduced.¹²¹

The Service's private letter ruling policy is also in line with the view that section 301 distributions reduce the E&P available for allocation under Treas. Reg. § 1.312-10 on subsequent section 355 distributions in the same taxable year.¹²⁴ Similar to the current E&P considerations above, prioritizing E&P for use in section 301 distributions, as opposed to allocations, preserves the taxability of a section 301 distribution.

• Current E&P: A section 301 distributions is sourced from, and thus reduces the amount of, current year E&P, if any, of Distributing, regardless of whether the section 301 distribution is made before or after the spin-off; and

• Accumulated E&P: If a section 301 distribution is made prior to the spin-off, the distribution reduces Distributing's E&P available for allocation. If a section 301 distribution is made after the spin-off, it should be sourced from Distributing's post-allocation E&P

• C. Less-Than Wholly-Owned Controlled

  (i) Background

We note that if Distributing distributes less than all the stock of Controlled (but all the stock it owns) in a spin-off of Oldco Controlled with no divisive D reorganization, a similar result would be obtained under current law (and the Report's proposal).

² Unless indicated otherwise, all "section" references are to the Code and all "Treas. Reg. § " references are to the Treasury regulations promulgated under the Code, both as in effect on the date of this Report.

³ A section 355 transaction may take the form of a pro rata distribution to shareholders ("spin-off"), a distribution in redemption of shares ("split-off"), or a distribution in liquidation of Distributing ("split-up"). This Report generally refers to all forms of section 355 distributions as "spin-offs" for ease of reading. In some spin-offs, Controlled is newly formed in connection with the spin-off (a "Newco Controlled") pursuant to section 368(a)(1)(D) (a "divisive D reorganization") while, in others, Controlled is pre-existing and may have its own E&P (an "Oldco Controlled"). For a more thorough examination of section 355 in general, see New York State Bar Association Tax Section, Report on the Role of the Step Transaction Doctrine in Section 355 Stock Distributions: Control Requirement and North-South Transactions (Report No. 1292, November, 4, 2013) (the "Section 355 No-Rule Report").

⁴ For example, if a foreign Distributing or Controlled corporation is allocated minimal or no E&P in a spin-off of Controlled to the U.S., it may be possible to repatriate earnings more tax efficiently than could have been achieved absent the spin-off.

⁵ The Report does not address the interactions of E&P allocations with the E&P tiering rules in Treas. Reg. § 1.1502-33. For a thoughtful discussion of these consolidated return issues, see Bryan P. Collins, Andrew W. Cordonnier & Darin A. Zywan, Allocation of E&P in a Spin-Off by a Consolidated Group: New Developments Answer Some Questions but Leave Many Unanswered, Corporate Tax Practice Series, Vol. 17, Ch. 212 (PLI 2014). The examples in the Report assume that Distributing and Controlled are not members of a consolidated group.

⁶ There are issues specific to cross-border spin-offs that are not addressed in this Report and that require an examination of additional policies. For example, the Report does not address the treatment of E&P deficits, whether and how foreign taxes and section 959 previously taxed income should be allocated, or whether a cross-section of all of Distributing's E&P should be allocated.

⁷ All defined terms in this Part II not previously defined are defined later in the Report.

⁸Henry C. Beck Co., 52 T.C. 1, 6 (1969), aff'd per curiam, 433 F.2d 309 (5th Cir. 1970).

⁹ William N. Colby, Boyd A. Blackburn & Dana L. Trier, Elimination of Earnings and Profits from the Internal Revenue Code, 39 Tax Law. 285, 287 (1985-1986).

¹⁰See Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders, ¶ 8.04 Earnings and Profits, (7th ed. 2000 & Supp. 2015-02).

¹¹ Debra J. Bennett, Corporate Tax Watch -- Earnings and Profits: A Balance Sheet Account, Taxes, February 2008, at 10; Charles R. Nesson, Earnings and Profits Discontinuities Under the 1954 Code, 77 Harv. L. Rev. 450, 457 (1964); Daniel Halperin, Carryovers of Earnings and Profits, 18 Tax L. Rev. 289, 292 (1963).

¹² Section 312(a)(1).

¹³ Section 312(a)(2).

¹⁴ Section 312(a)(3).

¹⁵See Bittker and Eustice, supra note 9 at ¶ 8.04.

¹⁶See generally Haskell Edelstein & Herbert J. Korbel, The Impact of Redemption and Liquidating Distributions on Earnings and Profits: Tax Accounting Aberrations Under Section 312(e), 20 Tax L.Rev. 479 (1964-1965); Arthur R. Albrecht, "Dividends" and "Earnings and Profits", 7 Tax L. Rev. 157 (1951-1952); Rev. Rul. 79-376, 1979-2 C.B. 133 (obsoleted by Rev. Rul. 95-71, 1995-2 C.B. 323).

¹⁷ Helvering v. Jarvis, 123 F.2d 742 (4th Cir. 1941), aff'g 43 B.T.A. 439 (1941), acq., 1979-2 C.B. 1.

¹⁸Woodward Investment Co. v. Commissioner, 46 B.T.A. 648 (1942), acq., 1970-2 C.B. XVIII.

¹⁹See Edelstein and Korbel, supra note 15, at 506.

²⁰Id.

²¹See I.R.S. Priv. Ltr. Rul. 200352015 (Dec. 26, 2003).

²² 60 F.2d 931 (2d Cir. 1932).

²³Sansome was decided before the introduction of section 381 in the Internal Revenue Code of 1954. Prior to this, the rules governing the carryover of attributes in reorganizations was judicially developed through a series of cases, including Sansome.

²⁴Sansome v. Commissioner, 22 B.T.A. 1171, 1175 (1931) ("Although the new corporation took over all the assets of the old company in exchange for its stock, any undivided profits or earnings of the old company were not acquired as profits or earnings of the new corporation. Any amount appearing on the books of the old company as surplus or undivided profits, which was carried forward on the books of the new corporation as surplus, was a part of its capital, and in any event was nothing more than paid-in surplus.").

²⁵Sansome, 60 F.2d at 933.

²⁶See, e.g., United States v. Kauffman, 62 F.2d 1045 (9th Cir. 1933) (applying Sansome to a tax-free combination of three corporations); Robinette v. Commissioner, 148 F.2d 513 (9th Cir. 1945) (applying Sansome to a tax-free liquidation); Harter v. Helvering, 79 F.2d 12 (2nd Cir. 1935) (applying Sansome to a tax-free liquidation of a corporation with an E&P surplus into a corporation with an E&P deficit).

²⁷See, e.g., Murchison's Estate v. Commissioner, 76 F.2d 641, 642 (5th Cir. 1935); Estate of McClintic v. Commissioner, 47 BTA 188 (1942); Barnes v. United States, 22 F. Supp. 282 (E.D. Pa. 1938).

²⁸ 5 T.C. 684 (1945). See also Barnes, 22 F. Supp. 282.

²⁹Mandel, 5 T.C. at 689.

³⁰ 144 F.2d 177 (3d Cir. 1944).

³¹ 331 U.S. 210 (1947).

³²Id. at 214, 215.

³³ 336 U.S. 410 (1949).

³⁴ For an analysis of the law enacted regarding acquisitive reorganization, see New York State Bar Association Tax Section, Report on Proposed Regulations § 1.312-11: Allocation of Earnings and Profits in Connection with Asset Reorganizations (Report No. 1275, October 16, 2012).

³⁵ H.R. 8300, 83d Cong. (1954).

³⁶ H.R. Rep. No. 1337, 83d Cong., A95-A96 (1954).

³⁷ The Committee on Taxation of the Association of the Bar of the City of New York, First Report on H.R. 8300 (1954), reprinted in 7 Internal Revenue Acts of the United States: The Revenue Act of 1954 with Legislative Histories and Congressional Documents, 557 (Bernard D. Reams, Jr., ed. 1982).

³⁸ Treas. Reg. § 1.312-10 (1955).

³⁹ S. Rep. 83-1622, 250-251 (1954).

⁴⁰Id. at 250.

⁴¹ Prop. Treas. Reg. § 1.312-10(a), 19 Fed. Reg. 8236, 8251 (Dec. 11, 1954).

⁴²See John H. Alexander, Some Earnings and Profits Aspects of the Internal Revenue Code of 1954, 7 Hastings L.J. 285 (1955-1956); Thomas F. Wessel, Joseph M. Pari, Richard D'Avino, Stephen G. Charbonnet & M. Todd Prewett, Corporate Distributions Under Section 355, Corporate Tax Practice Series, Vol. 15, Ch. 201 (PLI 2014). See also Devon M. Bodoh, J. Brian Davis, Greg W. Featherman & Blake D. Bitter, Reconciling the Irreconcilable: Earnings and Profits in Cross-Border Separations, 55 Tax Management Memorandum 155 (May 5, 2014).

⁴³ Treas. Reg. § 1.312-10(b)(1).

⁴⁴ Treas. Reg. § 1.312-10(b)(2). The Controlled Net Basis Amount implements the Congressional recommendation for a net worth limitation on the allocation of E&P to Controlled.

⁴⁵See S. Rep. 83-1622, at 250-251 ("In a distribution or exchange to which section 355 applies and which is pursuant to a reorganization as defined under section 368(a)(1)(D) (and takes place immediately after the corporate transfer of assets) the principle of the Sansome case will be applied to allocate a portion of the earnings and profits of the distributing corporation to the controlled corporation." (internal citations omitted, emphasis added).

⁴⁶See H. Rep. No. 1337, 83d Cong., at 267 (1954). The purpose for this change was to eliminate the need to form a holding company solely to effect a tax-free division of a pre-existing subsidiary. For a more complete history of the spin-off provisions, see the Section 355 No-Rule Report.

⁴⁷ This Report does not consider the policy implications of E&P deficits or whether a deficit should be allocated in a spin-off.

⁴⁸ Other cases that have mentioned the Regulations have not considered the allocation issues addressed in this Report. See IU Int'l Corp. v. United States, 116 F.3d 1461 (Fed. Cir. 1997) (amount and method of E&P allocation not at issue where Distributing sought to increase basis in Controlled in an amount equal to E&P allocated to Controlled); HIE Holdings, Inc. v. Commissioner, 97 T.C.M. (CCH) 1672 (2009) (the Regulations were relevant to determining E&P in tax deficiency case involving, in part, a nontaxable spin-off, but otherwise directing parties to independently provide E&P calculations).

⁴⁹ 427 F.2d 1202 (Ct. Cl. 1970).

⁵⁰Id. at 1209.

⁵¹Id. at 1210.

⁵²Id. at 1210-1211.

⁵³Id. at 1212.

⁵⁴See section III.F, below, discussing Prop. Reg. § 1.367(b)-8.

⁵⁵Bennett, 427 F.2d at 1212.

⁵⁶ Prop. Treas. Reg. § 1.367(b)-8, 65 Fed. Reg. 69138-01 (Nov. 15, 2000).

⁵⁷ The Section 367 Proposed Regulations clarify that "net basis" means "net tax basis." See Examples 1 and 2, Prop. Treas. Reg. § 1.367-8(c)(3), 65 Fed. Reg. 69138-01 (Nov. 15, 2000) (in a transaction where Distributing recognizes gain immediately prior to the distribution, net basis is increased by the amount of tax gain recognized).

⁵⁸ Prop. Treas. Reg. § 1.367(b)-8, 65 Fed. Reg. at 69145.

⁵⁹See Prop. Treas. Reg. § 1.367(b)-8(b)(1)(ii)(A), 65 Fed. Reg. 69138-01 (Nov. 15, 2000).

⁶⁰ The E&P that is reduced disappears unless otherwise included in income, such as under Treas. Reg. § 1.367(b)-5.

⁶¹See Prop. Treas. Reg. § 1.367(b)-8(b)(4), 65 Fed. Reg. 69138-01 (Nov. 15, 2000).

⁶²See Preamble to Prop. Treas. Reg. § 1.367(b)-8, 65 Fed. Reg. 69138-01, 69145 (Nov. 15, 2000).

⁶³See Id. at 69146.

⁶⁴ Colby et al., supra note 8.

⁶⁵See sections 334(b) and 381(a). See also Rev. Rul. 90-95, 1990-2 C.B. 67 (a qualified stock purchase of a target corporation followed by a liquidation of the newly acquired target corporation is respected as a stock acquisition followed by a liquidation rather than a direct asset acquisition).

⁶⁶See Treas. Reg. § 1.368-2(l).

⁶⁷ For further discussion, see Charles R. Nesson, supra note 10.

⁶⁸See S. Rep. 83-1622, 250; 3 U.S.C.C.A.N. 4621, 4887-4888 (1954).

⁶⁹ See S. Rep. 83-1622, 250-251; Treas. Reg. § 1.312-10(b). See also Bennett v. United States, 427 F.2d 1202, 1211 (Ct. Cl. 1970) ("it is evident that for purposes of the limitation Congress envisioned net worth in its conventional and generally understood balance sheet sense; not the hybrid net worth, based on market value rather than book value of assets, that has been infrequently employed and, when employed, specifically defined.").

⁷⁰ The question of whether a net worth limitation applied to the facts of the Bennett case was not relevant to the final holding.

⁷¹Bennett, 427 F.2d at 1213-1215.

⁷²See, e.g., Treas. Reg. § 1.1502-9T(c)(2), providing that when a member of a consolidated group leaves the group, it is allocated a pro rata portion of each of the group's consolidated overall foreign loss accounts, consolidated separate limitation loss accounts and consolidated overall domestic loss accounts are determined accounts based on the member's share of the group's assets that generate income subject to recharacterization under the corresponding loss account at the time the member ceases to be a member.

⁷³See Corporate Reorganization and Continuity of Earnings History: Some Tax Aspects, 65 Harv. L.Rev. 648 (Feb. 1952); Nesson, supra note 10, at 475.

⁷⁴ Consider the following example: USP owns all the stock of FD1 and FD1 owns all the stock of FD2. In a divisive D reorganization, FD2 contributes part of its assets to newly formed FC in exchange for all FC's stock, and then spins off the FC stock to FD1. Immediately thereafter, FD1 spins off the FC stock to USP in a distribution described in section 355. Assume that at the time of the transaction, FD1 has no E&P and FD2 has $50 of E&P. Further, the fair market value of the assets transferred to FC, as well as the fair market value of the assets retained by FD2, is greater than $50. Following the spin-off, in an unrelated transaction, FD2 distributes $50 to FD1. The following year, FC distributes $25 to USP. FD2's $50 distribution to FD1 would be out of the pool of FD2's pre-spin-off E&P, and hence would be taxable as a dividend. The common pool having thus been exhausted, no portion of FC's subsequent $25 distribution to USP would be taxable as a dividend. This is a result that could not have been obtained but for the spin-off, and, moreover, one that would not have been available had a portion of FD2's E&P been allocated to FC in connection with the divisive D reorganization.

⁷⁵ A similar issue would arise if Distributing or Controlled were to redeem certain of its shares in a transaction to which section 302(a) applies. Specifically, should the amount of E&P subject to reduction under section 312(n)(7) include the pool of pre-spin-off E&P available to both Distributing or Controlled or, instead, should it be limited to E&P arising out of the redeeming corporation's own post-spin-off operations?

⁷⁶ If Distributing or Controlled were to undergo a subsequent divisive D reorganization before exhausting the amount of E&P in the pool from the original division, the burden of complying with, and administering, the Pooling Method would become greater still, as there would now be three entities whose separate activities could affect the amount of E&P available in the pool.

⁷⁷See, e.g., section 6043(c).

⁷⁸See, e.g., John S. Pennell, Divisive Reorganizations and Corporate Contractions, 33 Taxes 924 (1955);Alexander, supra note 41; Halperin, supra note 10, at 292; Haskell Edelstein, Searching for Some Logic in the Earnings and Profits Rules: Some Recent Developments, 23 Proc. Ann. Tul. Tax. Inst. 73(1974).

⁷⁹See, e.g., Collins et al., supra note 4; Bodoh et al., supra note 41; Jasper L. Cummings, Jr., E&P in Spinoffs -- Part 2, 2014 TNT 33-5 (Feb. 19, 2014).

⁸⁰ Some have observed that because fair market value most closely indicates the corporation's future earning power, it is a close proxy for the Tracing Method. See Alexander, supra note 41.

⁸¹ This is consistent with basis allocations under section 358.

⁸² For purposes of the examples used in this Report, we have assumed the deferred tax liability associated with the underlying assets of Distributing and Controlled does not alter the fair market value of the stock of each corporation.

⁸³ We note that a corporation's ability to pay a dividend may depend not just on the fair market value of its assets, but also on a variety of legal and economic factors such as liquidity position, debt repayment needs, cash flow, access to financing.

⁸⁴ With the repeal of the General Utilities doctrine, this problem has become more acute. See Robert Willens, Allocating Earnings and Profits in a Spinoff -- Time for a Change?, 119 Tax Notes 1369 (June 30, 2008) ("To prevent a "double dose of E&P" from a single taxable event involving the same properties -- a result that can no longer be avoided by bringing one's case under the umbrella of the General Utilities doctrine -- the net basis method of allocating a parent's E&P to a spun-off subsidiary, in the case of a divisive D reorganization, should be anointed as the default method.").

⁸⁵ We acknowledge that the conversion of ordinary income into capital gain, or vice versa, is not easily distinguished as either taxpayer favorable or unfavorable. Rather, such a determination is highly dependent on the facts. For example, if Y were a corporation, additional dividend income may be more tax-favorable if Y is eligible for a dividends received deduction, which itself could lead to additional complexities and considerations, such a section 1059.

⁸⁶ Thomas Reed Powell, Income from Corporate Dividends, 35 Harv. L. Rev. 363 (1921-1922).

⁸⁷ The "net worth" limitation contained in Treas. Reg. § 1.312-10(b) protects against this result in a straight section 355 distribution. However, it is unclear whether such limitation applies in the case of divisive D reorganization subject to Treas. Reg. § 1.312-10(a). See supra Part IV.C.

⁸⁸ When there is parity between the basis of the liquidating subsidiary's stock and the net basis of the subsidiary's assets, the built-in gain will be preserved. See section 334(b).

⁸⁹But cf. section 1248 (under specified conditions, gain from the sale or exchange of stock of a foreign corporation included in gross income as a dividend to the extent of the foreign corporation's E&P).

⁹⁰ Treas. Reg. § 1.355-2(d)(5)(iv).

⁹¹ Note that the amount of the distortion changes as the proportion of built-in gain changes.

⁹² Preamble to Prop. Treas. Reg. § 1.367(b)-8, 65 Fed. Reg. 69138-01, 69146 (Nov. 15, 2000) ("The proposed § 1.367(b)-8(b) cross-section rule decreases the earnings and profits of a distributing corporation without regard to the type of income generated by the assets of the controlled corporation. This is consistent with the general assumption in § 1.312-10 and the proposed regulations that the earnings and profits of the distributing corporation should be decreased proportionately to reflect the transfer or distribution of assets, rather than by some other measure, such as by determining the earnings and profits attributable to the income generated by assets transferred or distributed (a tracing model) . . . ").

⁹³See , e.g. , T.D. 9424, 2008-2 C.B. 1012 (preamble to Treas. Reg. § 1.1502-36 , which expressly rejected a tracing approach); Libson Shops, Inc. v. Koehler, 353 U.S. 382 (1957).

⁹⁴See Bennett v. U.S., 192 Ct. Cl. 448, 470 (Ct. Cl. 1970) ("The short answer to this, as explained at the outset, is that the earnings and profits figure is not an ingredient of a corporation's balance sheet structure. Earnings and profits are neither a corporate resource nor liability. Since, aside from corporate accumulation penalties, the earnings and profits account functions solely as a check valve on the taxable character of shareholder distributions, a balance sheet entry pertaining to it would properly be in the nature of an annotation for stockholder information purposes, not a part of the accounting portrayal of the corporation's own financial condition."); Brief of Margaret R. Phipps, Respondent, 336 U.S. 410 (1949) (No. 83). Altering the U.S. tax basis of controlled foreign corporations may give rise to additional complications; cf. section 901(m).

⁹⁵ In general, the capital account is an historical figure, reflecting the portion of the corporation's total assets attributable to amounts contributed by shareholders as capital. On the facts of this example, Distributing's capital account is $100, that is, the amount of cash received on formation.

⁹⁶ Nesson, supra note 10; Halperin, supra note 10.

⁹⁷ This example presumes that Distributing has a balanced tax basis balance sheet before the spin-off transaction. In many circumstances, this may not be the case. For example, where Distributing has E&P in excess of the difference between Distributing's net basis in its assets and its capital account, application of the Balance Sheet Method would necessarily result in a net reduction to E&P. In other circumstances, the capital account of Distributing may not be known. For an application of tax basis balance sheet principles in either scenario, see infra note 98.

⁹⁸ This example above presumes that Distributing has a balanced tax basis balance sheet before the spin-off transaction. As discussed above, there are many circumstances in which this may not be the case; in other instances, it may not be possible to determine Distributing's capital account. In either scenario, the tax basis balance sheet principles may still be applied through the following process: (1) allocate Distributing's E&P according to the Fair Market Value Method, (2) determine Distributing's potential E&P (i.e., Distributing's E&P if the net unrealized built-in gain in Distributing's assets was recognized) immediately before the spin-off, (3) hypothetically allocate Distributing's potential E&P according to the Fair Market Value Method, and (4) adjust the aggregate E&P tax basis of the assets of Distributing and Controlled by the difference between the hypothetical amount in (3) and the amount each would have under the actual allocation in (1) if all gains were recognized.

⁹⁹ For regular federal income tax purposes, Distributing would recognize a gain of $50, the difference between its amount realized ($200) and its regular tax basis in its assets ($150).

¹⁰⁰ For regular federal income tax purposes, Controlled would recognize a gain of $150, the difference between its amount realized ($200) and its regular tax basis in its assets ($50).

¹⁰¹ For a similar approach, see section 732(f).

¹⁰²See Treas. Reg. § 1.1502-33(c)(1). 52

¹⁰³See, e.g., Rev. Rul. 78-123, 1978-1 C.B. 87. Cf. section 312(d)(1) (The distribution to a distributee by a corporation of stock or securities in another corporation is not a distribution of E&P if no gain to such distributee from the receipt of such stock or securities was recognized under this title).

¹⁰⁴See, e.g., section 312(n)(7), Treas. Reg. § 1.312-11(c), Rev. Rul. 72-327, 1972-2 C.B. 197.

¹⁰⁵ This policy goal does not turn on whether the shareholders of Distributing before the spin-off remain shareholders of both Distributing and Controlled after the spin-off and, thus, is equally applicable in the case of a split-off.

¹⁰⁶ For example, spin-offs involving controlled foreign corporations are subject to the rules of Treas. Reg. § 1.367(b)-5. The historic policy objective of these rules is generally preserving the potential application of section 1248. To this end, Treas. Reg. § 1.367(b)-5 requires a comparison of the section 1248 amounts associated with the stock of a foreign distributing and foreign controlled before and after a spin-off. To the extent there is a reduction in either section 1248 amount after the spin-off, Treas. Reg. § 1.367(b)-5 results in stock basis reduction and/or income inclusion. Because E&P is a component of the section 1248 amount, disappearing E&P in the context of a spin-off by a controlled foreign corporation may cause a reduction to the section 1248 amount, thereby causing basis adjustment and income inclusion. Because the mechanics of Treas. Reg. § 1.312-10(b) can cause E&P to disappear, when applied to a foreign divisive transaction, it creates a strong bias towards basis reduction and/or acceleration of income, rather than the preservation of the section 1248 amount.

¹⁰⁷ We note that special rules would need to be developed to address situations where Oldco Controlled has an E&P deficit.

¹⁰⁸See Preamble to Prop. Treas. Reg. § 1.367(b)-8, 65 Fed. Reg. 69138-01, 69145 (Nov. 15, 2000)("Section 1.312-10 does not specifically address the allocation and reduction of earnings and profits in connection with a D/355 distribution that involves a pre-existing controlled corporation."); Collins et al., supra note 4 ("The regulation is unclear whether Treas. Reg. § 1.312-10(a) is the exclusive guidance for an Oldco divisive D reorganization").

¹⁰⁹ As discussed above, the government has recognized the hybrid nature of Oldco divisive D reorganizations and, in the cross border context, has proposed E&P allocation rules that essentially bifurcate the transaction into a Newco divisive D reorganization to the extent of the assets transferred, and a straight section 355 distribution of Oldco Controlled to the extent of Oldco Controlled's pre-existing assets. See Prop. Treas. Reg. § 1.367(b)-8.

¹¹⁰ For instance, the opening sentence of Treas. Reg. § 1.312-10(a) refers to a transaction where one corporation transfers part of its assets constituting an active trade or business to another corporation in a D reorganization. The use of the term "another corporation," without any qualifications, clearly allows for such corporation (i.e., the controlled corporation) to be newly formed or pre-existing. Similarly, the opening sentences of Treas. Reg. § 1.312-10(b) states that this subsection applies "[i]f a distribution or exchange to which section 355 applies . . . is not in pursuance of a plan meeting the requirements of a reorganization as defined in section 368(a)(1)(D)." This view is consistent with Bennett v. United States, 427 F.2d 1202, 1213 (Ct. Cl. 1970) (The court summarized Treas. Reg.§ 1.312-10 as follows: "In format, the regulation is drafted in three subparagraphs. Subparagraph (a), previously quoted herein, deals solely and expressly with spin-offs incident to "D" reorganizations, the case at hand. Subparagraph (b) deals exclusively with spin-offs in pursuance of non-"D" reorganizations, not this case. Subparagraph (c) concerns allocation of deficits, an issue not present here.").

¹¹¹ E&P is not allocated in a section 351 contribution. See Reg. 1.312-11(a).

¹¹²See, e.g., I.R.S. F.S.A. 200225014 (June 21, 2002), where the Service was confronted with the question of whether a taxpayer is required to show, where it is possible, the actual interim E&P to the date of the distribution or if the taxpayer can instead use the Proration Method. The Service concludes that Treas. Reg. § 1.316-2(b) contemplates using the Proration Method unless the taxpayer chooses to and can demonstrate the amount of interim E&P to the date of the distribution. Essentially, the Service concluded that the regulation allows the taxpayer to use the Proration Method as the default method.

¹¹³See, e.g., Rev. Rul. 74-164, 1974-1 CB 74 where the Service analyzed how current E&P is prorated in four different situations involving X corporation, a calendar year taxpayer that makes a distribution of $15,000 to its shareholders on July 1, and makes no other distributions to its shareholders during the taxable year. In situations 3 and 4, X has accumulated E&P of $40,000 and a current E&P deficit of $5,000 and $55,000, respectively. The Service ruled that in the case of a deficit in E&P for the taxable year in which distributions are made, the taxable status of distributions is dependent upon the amount of accumulated E&P available on the dates of distribution. In determining the amount of such E&P, the Service stated that Treas. Reg. § 1.316-2(b) provides, in effect, that the deficit in E&P of the taxable year will be prorated to the dates of distribution. Accordingly, the Service ruled that in situation 3, the current E&P deficit for the entire year must be prorated to the date of the distribution (1/2 of $5,000 = $2,500) such that the E&P available on July 1 is $37,500 ($40,000 less $2,500). The same proration method is applied in situation 4 such that the E&P available on July 1, after reducing accumulated E&P by half of the current E&P deficit (1/2 of $55,000 = $27,500), is $12,500 ($40,000 less $27,500). See also Rev. Rul. 74-339, 1974-2 CB 103 and Rev. Rul. 74-338, 1974-2 CB 101, infra Parts VIII.A 1 and 2, for examples of the Service applying the daily proration method to determine the amount of E&P available at the time of a redemption transaction.

¹¹⁴See e.g., I.R.S. G.C.M. 35307 (Apr. 16, 1973).

¹¹⁵ Future guidance should address the allocation of other E&P-related accounts, including foreign taxes.

¹¹⁶See, e.g., I.R.S. Priv. Ltr. Rul. 201330002 (July 26, 2013); I.R.S. Priv. Ltr. Rul. 201111003 (Mar. 18,2011); I.R.S. Priv. Ltr. Rul. 200803012 (Jan. 18, 2008).

¹¹⁷See section 316; Treas. Reg. §§ 1.316-1 and 1.316-2.

¹¹⁸See, e.g., Baker v. U.S., 308 F. Supp. 1129 (D. Neb. 1970), aff'd, 460 F.2d 827 (8th Cir. 1972)(Taxpayers were shareholders in a corporation that had no accumulated E&P at the beginning of the current year, and generated approximately $1.5 million of current E&P during the year. Within a single taxable year, the corporation first redeemed certain stockholders (not including the taxpayers) under section 302(a) for approximately $1.6 million, and it then distributed approximately $1.9 million in cash to its remaining shareholders under section 301. It was stipulated that approximately $0.1 million of the redemption was properly chargeable to the capital account, and the taxpayers contended that the remaining $1.5 million of the redemption should reduce E&P, leaving virtually zero E&P available for the section 301 distribution. The taxpayer argued that the phrase "any distribution" in the parenthetical of section 316(a)(2) disregards only section 301 distributions, and therefore current E&P was reduced on the date of the section 302(a) distribution under section 312(a), with only the remaining E&P being available on the subsequent date of the section 301 distribution. The IRS, on the other hand, argued that the $1.9 million section 301 distributions should be given priority in drawing on current E&P, with only the remainder (if any) of E&P after the section 301 distribution being available for reduction by the section 302(a) distribution. The court held that the Congress intended the phrase "any distribution" in section 316(a)(2) to apply to all types of distributions, and that section 301 distributions should be given priority as it relates to actually drawing on current E&P.); Anderson v. Commissioner, 67 TC 522 (1976), aff'd per curiam, 583 F2d 953 (7th Cir. 1978) (similar). See also John Andrew Jones, , 27 Sw. L. J. 277 (1973) (noting that the court in Baker "reached the conclusion which Congress probably would have intended had it considered the problem.") and Haskell Edelstein, Eighth Circuit's Baker Decision: Filling a Statutory Gap by Judicial Pragmatism, 38 J. Tax'n 66(1973) ("Section 312(a) deals with the effect of distributions on the earnings and profits account, without reference to the definition of 'dividend' contained in section 316(a) . . . section 316(a)(2) supplies a definition of 'dividend' needed principally to enable section 301(c)(1) to function to tax the shareholders. Accordingly, section 316(a)(2) contains its own special rules, which and must, operate independently of section 312(a). Accordingly, the priority and time of the effect of distributions on current earnings and profits, solely for purposes of determining whether a distribution comes within the 'dividend' definition of section 316(a)(2), must be determined by section 316(a)(2) alone, and not by section 312(a). If that Method is not taken, there will be an insoluble conflict between the requirements of the two rules. Since we have been told that redemption distributions are not encompassed with section 316(a), except in the parenthetical phrase of section 316(a)(2), they should not be taken into account in determining whether a distribution constitutes a distribution of current earnings and profits, and hence falls within the definition of 'dividend' provided by section 316(a)(2).").

¹¹⁹ 1974-2 C.B. 103.

¹²⁰See also Rev. Rul. 74-338, 1974-2 C.B. 101, infra.

¹²¹But see Cummings, supra note 79.

¹²² 1974-2 C.B.

¹²³See also Rev. Rul. 77-335, 1977-2 C.B. 95 the Service considered the section 306 implications of the distribution of common and preferred stock of a controlled corporation in a section 355 transaction. The controlled corporation's preferred stock was not section 306 stock to the distributing corporation, but the section 355 distribution of the preferred stock could have resulted in the preferred stock being section 306 stock to the recipient shareholders if their hypothetical receipt of cash in lieu of the preferred stock would have been treated by section 356(b) as a section 301 distribution taxable to the shareholders as a dividend. Notably, the ruling did not mention the Treas. Reg. § 1.312-10 allocation/reduction in this hypothetical section 356(b) analysis, suggesting that, to the extent the distributing corporation is treated as making a section 301 distribution, the distribution's status as a dividend depends on the E&P of the distributing corporation without diminution by virtue of any allocation/reduction of the distributing corporation's E&P. This implicitly supports the conclusion that, where a distribution that is potentially taxable as a dividend is paid as part of a section 355 distribution, the dividend distribution is treated as being paid before the section 355 distribution, and the distributing corporation reduces E&P under section 312(a) prior to the allocation/reduction under Treas. Reg. § 1.312-10.

¹²⁴See, e.g., I.R.S. Priv. Ltr. Rul. 201330002 (July 26, 2013) (Prior to eight separate divisive D reorganizations, the respective distributing corporations each made a cash distribution to their shareholders. For each transaction, the Service ruled that "[E&P] of distributing, if any, will be allocated between [distributing] and [controlled] in accordance with section 312(h) and Reg. § 1.312-10(a), after taking into account the decrease in [E&P] resulting from the [cash distribution]." I.R.S. Priv. Ltr. Rul. 201111003 (Mar. 18, 2011) (ruling 12: "After taking into account the Pre-Spin Cash Distribution, earnings and profits will be allocated between Distributing and Controlled in accordance with section 312(h) and Reg. §§ 1.312-10(a) and 1.1502-33"); I.R.S. Priv. Ltr. Rul. 200803012 (Jan. 18, 2008) (ruling 37: "Earnings and profits of Distributing, if any, will be allocated between Distributing and Controlled in accordance with Reg. §§ 312(h), 1.312-10(a) and 1.1502-33(e)(3), after taking into account the decrease in earnings and profits attributable to the portion of the Net Cash Amount distributed to the Distributing shareholders."); I.R.S. Priv. Ltr. Rul. 200732002 (Aug. 10, 2007) (ruling 17: "Earnings and profits of Distributing (if any) will be allocated between Distributing and Controlled in accordance with section 312(h) and Reg. §§ 1.312-10(a) and 1.1502-33(e)(3) after taking into account the decrease resulting from the Cash Distribution."); I.R.S. Priv. Ltr. Rul. 200708016 (Feb. 23, 2007) (ruling 17: "Earnings and profits of Distributing (if any) will be allocated between Distributing and Controlled in accordance with section 312(h) and Reg. §§ 1.312-10(a) and 1.1502-33(e)(3) after taking into account the decrease resulting from the Cash Distribution.").

¹²⁵ This distortion can arise in other contexts as well -- such as, for example, when the distributing corporation distributes less than all of the stock that it owns in the controlled corporation.