The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 6, January 1999, Panel Publishers, New York, NY.
RETIRING DEBT AFTER A SPINOFF
By Robert W. Wood, San Francisco
Suppose that a parent corporation is contemplating a spinoff in connection with which it will drop assets into a newly created subsidiary. The spinoff will be part of a ‘D' reorganization and the parent will receive the latter's stock in exchange for the assets, and will distribute that stock to its shareholders. In connection with this spinoff, let's also assume that the parent would like to retire a portion of its indebtedness.
If the parent corporation causes the subsidiary to assume its debt as part of the arrangement, and that assumed debt exceeds its basis in the assets contributed, the excess will create a gain (under Sec. 357(c)). This will produce a tax liability for the parent. Even if there is a gain because of the debt, that will not invalidate the spinoff on the grounds that the subsidiary is not engaged in an active business, because the latter will have acquired its business, within the five year pre-distribution period, in a transaction in which gain or loss was recognized in whole or in part. (See Rev. Rul. 78-442.)
Another alternative might be for the parent to retain subsidiary stock, but the parent can retain no more than 20% of it, and can only do so if the retention is demonstrated to be for purposes other than tax avoidance. The parent might then sell the retained stock and use the proceeds to retire an appropriate amount of its own debt. Of course, any gain from the sale of that stock would be taxable to the selling parent.
Parents Do Retire!
If these alternatives do not sound too wonderful, there is another choice. The tax law permits the parent to retire debt, on a wholly tax-free basis, if the subsidiary's stock is distributed directly to creditors (in retirement of their debt claims) in connection with the spinoff. This is apparent from a reading of Code Section 361(c)(1), which provides that no gain or loss shall be recognized to a corporation that is a party to a reorganization on the distribution to its shareholders of property. A distribution of "qualified property", a term which encompasses subsidiary stock received in the reorganization exchange, can be accomplished tax-free pursuant to the plan of reorganization even if the stock is appreciated. (See I.R.C. §361(c)(2).) Section 361(c)(3) provides that a transfer of such property by the corporation to its creditors shall be treated as a distribution to its shareholders.
If this strategy is pursued, not more than 49.9% of the subsidiary's stock should be conveyed to creditors in the transaction. This limit is necessary to insure that the parent's shareholders receive at least 50.1% of the stock so that the transaction meets the requirements of both Sec. 368(a)(1)(D) and Sec. 355(e). Together, these provisions require that the shareholders of the distributing corporation have control of both the distributing and distributed entities after the distribution. Plus, for the distributee creditors to receive subsidiary stock on a tax-free basis, it is necessary for the debt instruments to qualify as "securities", a term generally understood to refer to long-term instruments with an average maturity (at the time of their issuance) of more than five years. (See Rev. Rul. 59-98.)
Be careful though. Although the transfer of subsidiary stock to the parent's creditors does not give rise to gain or loss, it can create cancellation of indebtedness income (COD) in those rare cases where the value of the transferred stock is smaller than the adjusted issue price of the debt being canceled. In cases where there is an excess of debt canceled over the value of the stock transferred, the parent would have COD income to the extent of that shortfall.
Retiring Debt After a Spinoff, Vol. 7, No. 6, M&A Tax Report (January 1999), p. 5.