The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 7, February 2001, Panel Publishers, New York, NY.
NEW SECTION 355(e) RULES SAVE US!
By Robert W. Wood
Okay, so maybe this title is a big dramatic. But surely one of the most important developments this month is the issuance of new proposed regulations defining the scope of a "plan" under Section 355(e). Although it is overdramatic to say that the IRS banned Section 355(e) regulations (quite the contrary), and the IRS must be quite happy with the statute, at least this new set of proposed regulations returns this area of spinoff law to the realm of reason. The new proposed regulations (REG-107566-00) replace earlier proposed regulations (REG-116733-98) that the IRS had eventually withdrawn under a storm of controversy. (For recent coverage of Section 355(e) and its regulations, see Malik, "Living with 355(e)," Vol. 8, No. 11, The M&A Tax Report (June 2000), p. 1.)
Section 355(e) was added to the Code by the deceptively named Taxpayer Relief Act of 1997. It was designed to do away with what had been an established technique for more than 30 years. The so-called Morris Trust transaction, based on Commissioner v. Morris Trust, 367 F.2d 794 (4th Cir. 1966), allowed companies to combine a tax-free spinoff with a tax-free reorganization to insure that a target corporation was lean and mean. The target could be stripped of an unwanted trade or business that was unsuitable to the acquiring company. All that history — and all that common sense — was trumped by Section 355(e).
Importance of a Plan
Section 355(e) is the provision under which stock of a controlled corporation will not qualify if it is distributed as part of a plan or series of related transactions under which one or more persons acquire, directly or indirectly, stock representing a 50% or greater interest in the distributing corporation or any controlled corporation. The big question that has been on practitioners' minds since this insidious subsection was added to Section 355 in 1997 is just what a "plan (or series of related transactions)" might be.
The new proposed regulations (like the earlier ones) take on the task of defining this phrase. The new proposed regulations also deal with the determination of the distributing corporation's gain when multiple controlled corporations are distributed and the distributions are part of a plan under which a 50% or greater interest in one or more (but not all) of the distributed controlled corporations is acquired.
Different Time Frames
Like the earlier set of proposed regulations, the new proposed anti-Morris Trust regulations split the definition of a plan into several distinct timeframes. On this (and just about every other point), though, the new proposed regulations are far more favorable than the old ones. For discussion of the previously proposed regulations, see Wood, "Morris Trust Regulations at Last," Vol. 8, No. 3, The M&A Tax Report (October 1999), p. 7; and Vol. 8, No. 4, The M&A Tax Report (November 1999), p. 7.
Under the new proposed rules, in the case of an acquisition after a distribution, the distribution and acquisition will be considered part of a plan if the distributing or controlled corporations (or any of their controlling shareholders) intended on the date of distribution that the acquisition or similar acquisition occur in connection with the distribution. As to acquisitions before a distribution, the distribution and acquisition will be considered part of a plan if the distributing or controlled corporations (or any of their controlling shareholders) intended on the date of acquisition that the distribution or a similar distribution occur in connection with the acquisition.
Both of these rules will require a facts and circumstances analysis, but they reflect a more reasoned view of just what a "plan" is all about than the previous proposed regulations had done. In fact, the new proposed regulations include a non-exclusive list of facts and circumstances that should be considered in making the determination whether a distribution and acquisition are part of a plan. One of these lists of factors tends to demonstrate that a distribution and an acquisition are part of a "plan." The other list tends to demonstrate that the distribution and acquisition are not. How one weighs the factors depends on the particular case. The mere number of factors that lean a particular way is not determinative.
Apart from these lists, there are six safe harbor provisions under which an acquisition and distribution will not be considered part of a plan. Many of the factors that suggest that a plan exists focus on whether the distributing or the controlled corporations (or their controlling shareholders) participated in discussions with outside parties regarding the second transaction.
Other factors that suggest that a plan exists depending on other indications of the intent of the corporations and their controlling shareholders. For example, that intent may be inferred where the distribution was motivated by a business purpose, whether the transactions occurred within six months of each other, or whether there was an agreement, understanding, arrangement, or negotiations regarding the second transactions within six months of the first transaction. In this respect, the new set of proposed regulations use the same six month benchmark that had existed under the old set, but again with a different emphasis.
Inferring a Plan
Perhaps one of the more troubling plan factors is whether the distribution was motivated by a business purpose to facilitate the acquisition or a similar acquisition of the distributing or controlled corporation. Evidence of a business purpose to facilitate an acquisition of the distributing or controlled corporation exists if there was a reasonable certainty that within six months after the distribution an acquisition would occur, an agreement, understanding, or arrangement would exist, or substantial negotiations would occur regarding an acquisition. See Prop. Reg. §1.355-7(e)(1)(i). Mere internal discussions may be indicative of the business purpose that motivated the distribution.
Another factor that may indicate that a plan exists examines whether the debt allocation between the distributing and controlled corporations made an acquisition of the distributing or the controlled corporation likely to service the debt. The reference to debt service may be easy to manipulate, but it also may be easy for the Service to use where taxpayers are not careful to monitor their debt structure.
Some of the factors which can show that a distribution and an acquisition do not constitute part of a plan are merely the flip side of these so-called "plan factors." For example, it will be helpful if one can show the absence of discussions with outside parties regarding the second transaction. Some of the other "nonplan" factors examine whether there was an identifiable, unexpected change in market or business conditions after the first transaction that resulted in the second transaction occurring. In effect, this amounts to showing that the second transaction was unexpected. Another nonplan factor examines whether the distribution would have occurred at approximately the same time (and in a similar form) regardless of the acquisition, or a previously proposed similar acquisition.
The six safe harbors may not generate a great deal of interest among practitioners. On the other hand, all tax lawyers like to crawl inside a safe harbor whenever possible. The Service has offered six in this set of proposed regulations. The first two safe harbors cover acquisitions that are more than six months after a distribution. For both of the first two safe harbors, there must be no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition at least six months after the distribution. Still, there are differences between these first two safe harbors, and subtleties that need to be observed.
Two other safe harbors deal with acquisitions and distributions that are more than two years apart. The fifth safe harbor provides that an acquisition of the distributing or controlled corporation's stock that is listed on an established market is not part of a plan, as long as the stock is transferred between less than 5% shareholders. The sixth safe harbor provides that an acquisition of stock by an employee or director for services (including compensatory stock options) will not be considered part of a plan.
Watch Out for Arrangements and Substantial Negotiations
One of the underlying themes of Section 355(e) — and it certainly is expanded upon in the proposed regulations — is the existence of an agreement, understanding, arrangement, or that more ephemeral concept, "substantial negotiations." This loaded phrase comes up again and again in the new set of proposed regulations. The Service recognizes that they have not defined these concepts. However, there are a few references to this topic in the preamble to the proposed regulations that are worth noting.
The Service notes, for example, that a binding contract is certainly an agreement. However, depending on all of the relevant facts and circumstances, the parties can have an "agreement, understanding or arrangement" even though they have not reached agreement on all terms. Indeed, under some circumstances, such as in public offerings or auctions of the distributing or controlled corporation stock, an agreement, understanding, arrangement or substantial negotiations can exist regarding an acquisition even if the acquirer has not been specifically identified. This last concept (substantial negotiations being present even when a specific acquirer has not been identified) may seem a bit odd. It does represent perhaps a vestige of the Service's strict views expressed in the earlier set of proposed regulations.
Moreover, the fact that there is not more discussion in the proposed regulations about defining an "understanding, arrangement or substantial negotiations" seems disturbing. It is simply not clear what body of law applies here. Most of us remember the old and hoary step transaction doctrine. Fortunately, most of the case law that developed under the step transaction doctrine was relatively favorable to taxpayers. (For a summary, see Wood, "Is the Step Transaction Doctrine Still a Threat for Taxpayers?" 72 J. Tax'n 296 (1990).) But it is clear the Service is contemplating a lot more than merely binding contracts here. Mere "substantial negotiations" can be enough.
It is hard to read the new proposed regulations without at least a partial sigh of relief. Although all problems are not eliminated (and the whole notion of Section 355(e) remains nettlesome), the current set of proposed regulations is a far cry from the Treasury's Draconian first stab.
Still, the kind of certainty that is often demanded by clients (and shareholders!) in big stakes deals makes some of the loosey-goosey plan definition irksome. My bet is that all of this will cause taxpayers to try whenever possible to rely on the six safe harbors.
New Section 355(e) Rules Save Us!, Vol. 9, No. 7, M&A Tax Report (February 2001), p. 1.