Attorney Comments on Corporate Distributions Guidance

The recently-issued Notice 2015-59 expresses significant concerns with the application of section 355 to certain corporate separations, including transactions that result in distributing corporation (Distributing) or distributed corporation (Controlled) having large amounts of investment assets, and suggests that these transactions may run afoul of section 355 and circumvent the purposes of General Utilities repeal.

This submission responds to request for comments in Notice 2015-59, section 3. A version of these comments was published as an article titled "Investment Assets in Corporate Separations," 149 Tax Notes 707 (Nov. 2, 2015).

The author, Stanley Barsky, is a partner with Fox Rothschild LLP in New York. The author respectfully submits the comments in his individual capacity, and the views expressed herein should not be attributed to Fox Rothschild LLP.

COMMENTS

Corporate separations are usually incredibly complicated and labor-intensive.¹ The IRS and the courts already have all the necessary tools at their disposal to distinguish transactions that should qualify for nonrecognition treatment from ones that should not qualify. Business purpose and device requirements, which are intended to consider all facts and circumstances-should be rigorously applied to determine whether investment assets prevent a corporate separation from qualifying under section 355.² A resource-conscious attempt by the IRS to replace the business purpose and device requirements with arbitrary investment asset formulas would be inappropriate, because that would almost certainly result in denial of nonrecognition treatment to some transactions that would otherwise qualify under section 355. Nor are the purposes of the legislation that repealed General Utilities appropriate for judging whether a particular investment asset ratio should disqualify a corporate separation from nonrecognition treatment.

There are two ways in which the IRS can utilize the business purpose requirement in evaluating the nature of the assets. First, the IRS should confirm the existence of a corporate business purpose for the distribution. As stated in a preamble to Treasury regulations section 1.355-2, "a transaction that is not carried out for a corporate business purpose should not qualify under section 355, even if it was not used principally as a device for the distribution of earnings and profits."⁴ The court decisions also encourage a critical examination of the business purpose for the separation.⁵ The IRS could utilize the business purpose guidance in Revenue Procedure 96-30 Appendix A to confirm the existence of a corporate business purpose for the distribution.

Second, the IRS should inquire whether the business purpose for the separation explains the allocation of investment assets between Distributing and Controlled. For example, some separations are undertaken to achieve business purposes that require a significant amount of liquid assets. In the private ruling context, the IRS used to accept at least two business purposes that were consistent with a high proportion of investment assets. These business purposes were (i) borrowing, and (ii) facilitating an acquisition by Distributing or Controlled.⁶ In both cases it would be expected that immediately or shortly after the distribution, Distributing or Controlled would have a significant amount of investment assets. The factors used by Revenue Procedure 96-30 to establish these business purposes could be used to help identify whether there is a business need for the high proportion of investment assets.

The IRS's device analysis should focus on whether the investment asset allocation is consistent with the needs of Distributing's and Controlled's businesses. Some businesses (in addition to the financial trades or businesses contemplated by section 355(g)(2)(B)(ii)) require high amounts of liquidity. In the context of such businesses investment assets should not be treated with the suspicion evident in Notice 2015-59. For example, high liquidity is required for businesses that do not have a steady revenue stream over the course of a year, especially if they have high operating costs. These businesses require a significant amount of investment assets to survive the lean periods, especially during uncertain economic times. Also, businesses with high research and development costs require high liquidity, especially if they don't have a product that generates substantial revenues.

In addition, where applicable, the IRS could ask whether the proposed allocation of investment assets between Distributing and Controlled is consistent with the historic allocation of investment assets between the businesses that would be operated by Distributing and Controlled. There is precedent for this type of inquiry, specifically, the IRS used to review historic debt levels for purposes of determining whether a distribution of debt securities qualifies for nonrecognition treatment under section 361(c) in the context of an otherwise tax-free corporate separation.⁸

Finally, in evaluating the investment asset allocation between Distributing and Controlled it is important to consider that there is no general section 355 rule that would prevent corporations with high investment assets from effecting a tax-free corporate separation. In other words, Distributing's aggregate investment assets must be allocated between Distributing and Controlled and thus the IRS should take into account the total amount of Distributing's pre-distribution investment assets in evaluating whether an allocation of investment assets is consistent with the business purpose for the distribution and with the needs of Distributing's and Controlled's businesses.

² The investment assets that concern the IRS are the ones described in section 355(g)(2)(B), as modified by Revenue Procedure 2015-3 section 5.01(26). See Notice 2015-59; Rev. Proc. 2015-43. These investment assets do not include any assets that are held for use in the active and regular conduct of (i) a lending or finance business, (ii) a banking business, or (iii) an insurance business. See section 355(g)(2)(B)(ii).

³ As Notice 2015-59 observes, section 355(g) provides bright-line rules for denying nonrecognition treatment to certain distributions involving investment assets, but is too narrow in scope to address the IRS's concerns with allocations of investment assets in a wide variety of transactions.

⁴See T.D. 8238 (1989).

⁵See Rafferty v. Comm'r, 452 F.2d 767 (1st Cir. 1971) (expressing concern over the "somewhat uncritical nature'" of the Tax Court's finding of business purpose); Comm'r v. Wilson, 353 F.2d 184 (9th Cir. 1965) (noting the Tax Court's finding that the asserted business purposes were not bona fide; concluding that absence of a tax avoidance motive is not sufficient to satisfy the business purpose requirement).

⁶ With respect to borrowing, taxpayers had to demonstrate that (i) Distributing or Controlled needed to raise a substantial amount of capital in the near future for business needs, (ii) the separation would enable Distributing or Controlled to borrow significantly more money or borrow on significantly better nonfinancial terms, (iii) the funds raised in the borrowing would, under all circumstances, be used for the business needs of Distributing or Controlled, and (iv) the borrowing would be completed within one year after the distribution. See Rev. Proc. 96-30 Appendix A § 2.03.

With respect to facilitating an acquisition by Distributing or Controlled, taxpayers had to demonstrate that (i) the combination of the target corporation with Distributing or Controlled would not be undertaken unless Distributing and Controlled are separated, (ii) the acquisition could be accomplished by an alternative nontaxable transaction that would not involve the distribution of Controlled stock and was neither impractical nor unduly expensive, (iii) the target corporation was not related to Distributing or Controlled, and (iv) the acquisition would be completed, generally within one year of the distribution. See Rev. Proc. 96-30 Appendix A § 2.08.

⁷ Although split-offs are "ordinarily" considered not to constitute device, the rule has two limitations. First, it is arguably a stretch to read "ordinarily" as "always." Second, in the context of a publicly-traded Distributing, it is often impossible to predict with certainty whether the split-off will be fully subscribed, which raises the possibility of a clean-up spin-off.

⁸See Amy S. Elliott, "IRS Rethinking Policy on Repayment of Distributing Debt in Spinoff," 133 Tax Notes 144 (Oct. 10, 2011).

⁹ See H.R. Rep. 100-391 (II) (Oct. 26, 1987), 1987 WL 61524, at 2313-699. This report described the purpose of section 337(d) in the context of proposing technical amendments to section 337(d) that were ultimately enacted in 1988. For an in-depth discussion of the legislative history of section 337(d) and an early proposal for Treasury regulations to be issued under section 337(d), see N.Y.S.B.A. Tax Sec. Comm. on Reorgs., "Report on Proposals for Treasury Regulations under Section 337(d) Relating to Section 355 Distributions," reprinted in 90 TNT 9-18 (Dec. 7, 1989).

¹⁰Cf. Thomas F. Wessel et al., "Corporate Distributions Under Section 355" § V.E.5., PLI/Tax (2012) (observing that after the enactment of sections 355(d) and 355(e) "it would seem . . ., unlikely that any regulations under section 337(d) limiting the availability of section 355 will be promulgated. . . .").