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July 14 — Companies seeking to spin off units will face tougher IRS requirements to prove the transaction isn't a “device” used to distribute earnings and profits to shareholders without paying tax.
The Internal Revenue Service outlined the government's evolving views in July 14 proposed rules (REG-134016-15, RIN:1545-BN47) on what transactions qualify as tax-free spinoffs after uncertainty in the area stymied deals. The rules would require both the parent corporation and the spun-off company to have at least 5 percent of their value be active-business assets.
The Section 355 proposal became a notable issue last year when the IRS declined to rule on taxation of Yahoo! Inc.'s proposed spin off of holdings in Alibaba Group Holding Ltd. and smaller legacy businesses. Yahoo is now pursuing a sale of its core business (174 DTR G-4, 9/9/15).
The proposed rules also say that the presence of a business purpose for the spinoff doesn't mean the transaction isn't a device, which would make the deal taxable. Business rationale has been viewed as a “non-device super factor” in the past, Robert Willens, a tax consultant in New York, told Bloomberg BNA July 14.
“The IRS and Treasury have attempted to inject some objective ‘ground rules' into an area that has always been fraught with contention resulting from the presence of numerous ‘factors' that required balancing but that did not come with a set of instructions for how such balancing was to be carried out,” Jonathan Talansky, a partner at King & Spalding LLP, told Bloomberg BNA in an e-mail.
The IRS has been working on these rules related to the business purposes of spinoffs, active business size and whether the transaction is being used as a device since September (178 DTR G-3, 9/15/15).
IRS Associate Chief Counsel (Corporate) Robert Wellen has said he hopes this guidance and other regulatory projects related to spinoff issues where the IRS currently won't issue private letter rulings will reduce the need for taxpayers to request IRS input on deals.
The agency proposes what it calls a per se device test, under which “a strong device potential exists” if the distributing or controlled company has a nonbusiness asset percentage of two-thirds or more. The test also looks at the discrepancy between the investment asset percentages of the two companies. If one company has a much lower percentage, the deal is considered to be a device.
The rules said that “if a high enough proportion of assets of Distributing or Controlled consists of nonbusiness assets, and if the assets of the other corporation include a much lower proportion of nonbusiness assets, the evidence of device is so strong that nondevice factors generally should not be allowed to overcome the evidence of device.”
The government is saying “if you don't have a significant business and you don't have a legitimate purpose for separating those businesses, then they're going to tell you, ‘First, you don't have an active business and second, you have the risk of simply violating the device test,” Mark Silverman, a partner at Steptoe & Johnson LLP, said. “If you have this per se violation where you have so many nonbusiness assets, they're basically going to tell you, 'sorry, it doesn't work.' ”
The proposed rules are a response to what government officials have said was an increase in corporations seeking aggressive spinoff deals. The transaction has become a popular demand of activist investors looking to increase value for shareholders in recent years.
“It would appear that many transactions that would be captured by these rules had already been ‘chilled' by the IRS pronouncements in 2015, which continued an IRS trend of scaling back significantly its spin-off ruling program,” Talansky said. “These rules will prospectively provide more certainty and line-drawing for taxpayers attempting to plan spin-off transactions.”
Tax-free split-offs, such as the one by Liberty Interactive Corp. to separate Liberty Expedia Holdings Inc., could become an increasingly popular option for corporate reorganizations after this proposal is made final, Willens said.
Split-off transactions, unlike spinoffs, don't have to demonstrate that the deal isn't a device, he said. In a split-off, the parent company allows shareholders to exchange the parent company shares for new shares of a subsidiary, rather than spinning off or distributing shares of a new company equally among investors.
Both the parent corporation and the newly formed company in split-offs and spinoffs must have at least 5 percent of their value be active-business assets to qualify for tax-free treatment.
“You don’t have to run the gauntlet of the device test,” Willens said. “The fact that the separation has device factors is irrelevant. It's the path of least resistance.”
The rules—which aren't effective until made final—are scheduled to be published in the Federal Register on July 15. Comments are due by Oct. 13.
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Text of REG-134016-15 is in TaxCore.
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