IRS Puts its Spin on Taxable Spin-offs and Acquisitions

Lehman Brothers tax expert Robert Willens provides the latest details.
Robert WillensAugust 10, 2001

The next round of tax relief is going to corporations. Specifically, the Internal Revenue Service provided much needed guidance for its proposed regulations, defining the circumstances under which an acquisition or spin-off will be viewed as part of a “plan” and therefore taxable at the corporate level.

That’s a relief for many corporate managers; since the regulations’ proposal in January, taxpayers have been resigned to vague guidelines and precluded from using the regulations for spin-offs until they were finalized. But in the process of reducing the uncertainty, the I.R.S. labeled the proposed regulations “temporary,” dramatically elevating their status.

The temporary regulations apply to distributions occurring after August 3, 2001. So with the temporary status, companies can rely on them.

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The regulations came in response to a rule, contained in Sec. 355(e) of the tax code, that says a spin-off that otherwise qualifies for tax- free status becomes taxable if it is found to be part of a “plan” or “series of related transactions” pursuant to which one or more persons acquire stock representing a 50 percent or greater interest in either the distributing or spun-off corporation.

Also known as the “anti-Morris Trust” rule, it embodies a presumption that has discouraged prospective suitors from attempting a takeover of the parties to a spin-off; any such acquisition that occurs during the four year period that begins two years prior to the spin-off is presumed to be part of a prohibited plan.

The regulations, were exceedingly well-received by the tax community because they embody various safe harbors which, if satisfied, will conclusively establish that the events — the spin-off and acquisition — are not part of a proscribed plan.

Unfortunately, these regulations had no practical significance (although, unofficially at least, the I.R.S. did apply their tenets in connection with the issuance of rulings regarding the application of Sec. 355(e)) because they would only be applicable with respect to spin- offs that took place after the date the regulations were finalized. In the interim, therefore, taxpayers were relegated, as regards the application of Sec. 355(e), to the vague guidelines contained in the statute itself and its accompanying legislative history.

Certainly, running afoul of Sec. 355(e) is not recommended. The distributing corporation is, in these cases, treated as if it sold the spun-off stock for an amount of money equal to the fair market value of such stock on the date it was distributed to the shareholders of such distributing corporation. The gain from the “deemed” sale is fully taxable even though the deemed sale is just that; it’s a sale with respect to which no cash is generated with which to defray the resulting tax liability.

Now with the temporary status, however, taxpayers will be able to rely on the objective rules contained in the proposed regulations in assessing whether a spin-off and acquisition are part of a plan.

Perhaps the most useful feature of the regulations is the safe harbors, which provide absolute protection against the I.R.S.’s mounting of a Sec. 355(e) challenge. The most well-known of the safe harbors effectively shortens the waiting period, before an acquisition attempt can be mounted, from two years to six months.

Thus, an acquisition and spin-off will not be regarded as part of a plan if:

  1. The acquisition does not occur until after six months following the spin-off
  2. There was no agreement, arrangement, understanding or “substantial negotiations,” concerning the acquisition, before six months had elapsed following the spin-off and
  3. The spin-off was motivated by a business purpose (for a spin-off to be tax-free it must be undertaken for one or more non-federal tax purposes that are “germane” to the business of the distributing corporation, the spun-off corporation or the affiliated group of corporations to which the distributing corporation belongs) other than to facilitate the acquisition

Thus, the conversion of the proposed regulations into temporary regulations injects a much needed degree of certainty into the process. Presumably, prospective acquirers of corporations that were parties to a spin-off delayed, or even abandoned, their plans, for fear that the acquisition would trigger the application of Sec. 355(e) and, in light of the indemnity agreements that accompany virtually all spin-offs, require such acquirer to reimburse the distributing corporation for the taxes that the acquisition triggered.

On the other hand, to the extent the specter of Sec. 355(e) served as something of a “poison pill”, spun-off corporations that are not particularly interested in fending off a takeover attempt have been robbed of an effective defense mechanism.