Of Acquisitions and Spin-offs

Lehman Brothers tax expert Robert Willens explains the ramifications of the IRS's proposed regulations.
Robert WillensJuly 17, 2001

At the end of 2000, the IRS issued proposed regulations that define the circumstances under which an acquisition will be treated [within the meaning of Sec. 355(e)] as part of a plan or series of related transactions that includes a spin-off.

If the acquisition and spin-off are, in fact, part of such a plan, the spin-off will be taxable at the corporate level because the distributed stock will lose its status as “qualified” property.

The proposed regulations, however, only apply to distributions completed after the date such regulations are finalized.

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The proposed regulations have been exceedingly well-received. To inject a welcome degree of certainty into the decidedly uncertain issue—that exists under the “common law”—regarding whether an acquisition and spin-off are sufficiently connected to be considered component parts of a single plan, many taxpayers have requested permission to employ the principles of the proposed regulations in advance of their finalization.

While the IRS has not, in any official way, sanctioned such early adoption of these principles, the evidence continues to mount—as reflected in the private ruling process—that the Service has acceded to these blandishments and is, itself, entirely comfortable employing the tenets of the proposed regulations. Therefore, in evaluating the entitlement of a spin-off that occurs in conjunction with an acquisition to tax-free treatment, it seems entirely prudent for taxpayers to “test” the transaction against the backdrop of the proposed regulations.

The latest evidence of this phenomenon can be found in LTR 200128038. In that case, a spin-off took place and within a short period of time following such spin-off the distributed company’s stock price had appreciated by in excess of 100 percent. The spun-off corporation decided to use this valuable currency to effect an acquisition and, due to the relative sizes of the spun-off corporation and its target, such spun-off corporation issued, in the merger, in excess of 50 percent of its outstanding stock.

If the spin-off and acquisition were deemed to be part of a plan, the spin-off would fail in light of the fact that in excess of 50 percent of the corporation’s stock would then reside in the hands of shareholders not classified as “historical” shareholders. However, the ruling concludes that the issuance of stock in the acquisition was separate from the spin-off and, thus, the acquisition and the spin-off were not part of a prohibited plan.

In reaching this conclusion, the Service relied–seemingly exclusively– on the fact that the overall transaction exhibited “factors,” set forth in the proposed regulations, “tending to show” that the acquisition and distribution are not connected.

Thus, the taxpayer prevailed for the following reasons:

  • The agreement and plan of merger were entered into more than six months after completion of the distribution;
  • Neither the distributing corporation nor the controlled corporation and the acquirer, or any potential acquirer, discussed the acquisition, or a similar acquisition, prior to the distribution;
  • There was an identifiable, unexpected change in market or business conditions (here, the marked increase in the value of the distributed corporation’s stock), after the distribution, that resulted in the “unexpected”; the acquisition;
  • The distribution was motivated by a corporate business purpose (here, both “fit and focus” and the desire to provide, through the creation of an ESOP, equity interests to the corporation’s employees) other than a purpose to “facilitate” the acquisition or a similar acquisition, and,
  • The distribution would have occurred, at approximately the same time, and in similar form, regardless of the acquisition or a similar acquisition.

LTR 200128038 sets forth a particularly pro-taxpayer set of facts. However, if the principles of the proposed regulations were not liberally employed to reach what seems like an a fortiori result, the question of whether the acquisition and distribution were impermissibly connected would have to be analyzed under the uncertain standards set forth in the statute and its legislative history: Those guidelines, sparse at best, do not provide the certainty and objectivity that taxpayers can prudently rely on to plan transactions.

Accordingly, it is to the IRS’s credit that it has recognized the untenable situation that a lack of standards fosters and–somewhat out of character–has chosen to redress this problem by accelerating the application of the detailed analytical standards embodied in the proposed regulations.

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