The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 12, July 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

It is well-known that one of the primary hurdles that must be navigated to qualify for tax-free spinoff treatment under Section 355 of the Code is the requirement that there be a valid business purpose for the transaction. In previous issues, we've covered not only spinoff mechanics but, M&A Tax Report readers should recall, a plethora of publicized transactions in which spinoffs were either used or contemplated.

As promised last month as part of our continuing review of spinoffs, we'll look at a few transactions this month, stopping first to note that what is apparently blooming as the most often quoted business purpose has really come into its own. That business purpose, of course, is "savings." See Wood, "Spinoffs and the All-Important Business Purpose," Vol. 7, No. 5, The M&A Tax Report (December 1998), p. 1. Economists sometimes refer to this with the more exotic "economies of scale" moniker, but it doesn't really matter exactly how the savings arise as long they are attributable to the separation, one way or the other.

Revenue Procedure 96-30

Most readers of this newsletter will recall Revenue Procedure 96-30. Certainly, readers who are as myopic about Section 355 as we are here at The M&A Tax Report will well recall that revenue procedure. In it, the IRS generously provided practitioners with what turned out to be a nonexclusive list of business purposes. The existence of any one of these business purposes should be sufficient (according to the revenue procedure) to elicit a favorable ruling as long as the other requirements of Section 355 were met. One of these purposes enumerated in the procedure is the purpose to achieve significant cost savings.

Fundamentally, three words are critical here. What is significant? What are costs? And what are savings? These three important elements must all be met to achieve the "significant cost savings" business purpose.

"Significant" = Size is Important?

The "significant" wing of this tripartite nirvana might seem on first blush to be the most unnerving. However, cost savings are deemed to be significant if, for the three-year period following the distribution, they are equal to at least 1% of the net consolidated financial income of the group for the three-year interval preceding the distribution. In other words, there is both a three-year pre-transaction window that is reviewed, as well as a three-year post-transaction window that is compared. If the latter window involves cost savings that at least equal 1% of the net consolidated financial income of the group, then the "significant" threshold has been circumnavigated.

Under Revenue Procedure 96-30, 1996-1 C.B. 696, to establish that a corporate business purpose for a distribution is significant cost savings, the taxpayer ordinarily must demonstrate that the distribution will produce "significant" cost savings. That's actually what Rev. Proc. 96-30 says. Fortunately, it goes into a little more detail. For an advance ruling, the taxpayer is to submit an analysis based on the professional judgment of persons qualified to speak on such matters (such as the taxpayer's insurer for insurance savings, an investment banker for lowering borrowing costs, and in appropriate cases, the taxpayer's employees).

Savings and Alternatives

The analysis is to explain these savings, as well as why these savings cannot be achieved through a nontaxable transaction that does not involve the distribution of stock of the controlled company, and which is neither impractical nor unduly expensive. A great deal of headscratching has been done over the "neither impractical nor unduly expensive" language.

Revenue Procedure 96-30 goes on to state that significant cost savings generally are projection period cost savings, equal to at least 1% of the base period net income of the distributing company's affiliated group. Projection period cost savings are the total anticipated future cost savings to the distributing company, the controlled company and their affiliated group for the three-year period following the distribution reduced, however, by the transaction costs of the distribution, and any anticipated additional direct or indirect costs to the distributing company, controlled company and their affiliated group. All of these costs are computed on an after-tax basis.

All savings (whether or not from the same source), and all additional costs to the distributing company, controlled company and their affiliated group, are to be aggregated. Base period net income for this purpose is the total net consolidated financial income of the distributing company's affiliated group for the three-year period preceding the distribution, all of which, again, is computed on an after-tax basis.

Interestingly, the taxpayer may choose to use the five-year periods preceding and following the distribution for its base period and projection period instead of the three-year periods preceding and following the transaction. Thus, there is at least some flexibility in calculating the degree of cost savings over these respective periods.

Some foreign tax savings may be pertinent, of course. If foreign tax savings are claimed, Revenue Procedure 96-30 directs the taxpayer to explain the extent to which the foreign tax that is expected to be saved would have resulted in foreign tax credits or foreign tax credit carryovers for U.S. federal income tax purposes.

The revenue procedure indicates that the IRS may apply different guidelines in various situations, including:

The above bulleted guidelines should indicate that there is both some flexibility and some danger in the "significant cost savings" business purpose. However, given the evidentiary items that the Service apparently wants, it will often be an imminently achievable business purpose.

New Letter Ruling

Letter rulings, of course, cannot technically be cited as precedential authority by other taxpayers. But all of us do so, and all of us take some comfort in rulings that are issued on matters that we find to be pertinent. These days, there is not much of a battle about the precedential effect of letter rulings, although there once was. Indeed, it was not too many years ago that the Supreme Court even went so far as to cite letter rulings as precedent, setting off a row (excuse the pun) over this issue after Rowan Companies v. U.S., 452 U.S. 247 (1981). Anyway, if the Supreme Court even cites letter rulings, it seems that we at The M&A Tax Report should certainly be able to do so, too.

In Letter Ruling 9917038, the corporation in question had concluded that it needed to expand in order to remain competitive in its chosen field of endeavor. To expand it needed to acquire interests in licenses in the telecommunications field. To make the acquisitions, it needed to preserve joint ventures that it had structured with an investor. The preservation of this relationship with the investor was critical to the entire enterprise. The licenses in question were only granted to members of certain minority groups to which this investor belonged.

Thus, the investor demanded the right to convert his joint venture interest into stock of a particular subsidiary of the parent. This demand was a condition to continuing with the joint venture relationship. (It sounds a little like the key employee business purpose, often used as a requisite for Section 355, doesn't it?)

This investor also stated that the subsidiary's stock would only be acceptable to him if the subsidiary was, at the time the conversion rights were exercisable, an independent concern that was not controlled by a single corporate shareholder. Once again, this sounds awfully like the "key employee" reason for a spinoff, where a key employee of one division insists on stock in a company, but only wants stock in his division and doesn't want that division to be controlled by the parent or subject to the risks and vicissitudes of the other divisions.

Standalone Operation

Similarly, in Letter Ruling 9917038, the investor insisted that the equity into which his joint venture interest was convertible would have to be in the independent company that was to be the result of—you guessed it—a tax-free separation. There were other conditions, too. If the investor was instead forced (because the subsidiary had not been granted its "independence" in time), the investor would accept parent stock. However, the investor was demanding almost a punitive amount of that stock, since it really was his desire that he get the stock of the independent unit.

In short, the business purpose was to achieve the business benefits associated with preserving this joint venture, a goal that itself did not require the distribution, but that was needed to avoid the remittance of what was viewed (in the ruling) as a penalty amount of parent stock upon conversion of the joint venture interest.

Can you guess the result? Was the avoidance of what was a punitive stock conversion ratio considered a significant cost savings so as to achieve a favorable ruling under Section 355? The answer the Service gave in Letter Ruling 9917038 was a decided yes. The distribution was clearly undertaken for reasons germane to the business. The purpose was the preservation of a key commercial relationship and, at the same time, avoiding a drain on corporate resources through the issuance of what the IRS apparently agreed were excessive amounts of stock. The only way to avoid this punitive amount was the corporate separation.

Good News for Harcourt, Too

Apart from the good news discussed above, we assume there also should be good news for Harcourt in general and its plans to spinoff the Neiman Marcus group. One of the prerequisites to Section 355 treatment, of course, is that the distributing corporation must be in control of the corporation whose shares it is distributing immediately before the distribution. Plus, both the distributing and distributed corporations must be engaged in the active conduct of a trade or business immediately after the distribution. Control for this purpose means 80% of the stock ownership of the company's combined voting power of all classes of stock entitled to vote. There is currently no requirement that this control also encompass any particular percentage of the value of the corporation.

Thus, under current law, only 80% of the total combined voting power of all classes is required. One generally measures voting power by looking solely to the ability of the stock to elect a board of directors. (On this point see Revenue Ruling 69-126, 1969-1 C.B. 218.)

There is a restriction on the active conduct of a trade or business rule that ties in with the voting stock control. A corporation will not be treated as engaged in the active conduct of a trade or business if control of that corporation was acquired by the distributing corporation within the five-year period preceding the distribution, unless control is so acquired only by reason of transactions in which no gain or loss is recognized (in whole or in part), combined with acquisitions of stock prior to the commencement of the five-year period.

In the case of Harcourt and Neiman Marcus, Harcourt is to obtain control of Neiman Marcus in a recapitalization that qualifies under Section 368(a)(1)(E). It therefore seems apparent that this acquisition by Harcourt will satisfy the control rule described above (80% of the voting stock of all classes entitled to vote will have been obtained), plus the active business requirement. The latter requires an active business. Here, there is no barrier by virtue of the five-year rule, since even though Neiman Marcus was acquired within the prior five-year period, it was acquired in a tax-free manner. Thus, it would seem that there should be no hitches to the Harcourt/Neiman Marcus deal from a tax viewpoint, assuming (as we do) that the transaction is being undertaken for purposes germane to the business of either Harcourt, Neiman Marcus (or both), or the affiliated group to which Harcourt belongs.

Stock Change, Maybe

Before we leave the relatively mechanical nature of the 80% stock requirement, we should note about this 80% control requirement that there may be change in the offing. One of the budget items included in President Clinton's budget package is a provision that would alter the control definition for various corporate transactions, including spinoffs. If this change is passed, the definition of "control" for this purpose would be met only if the prospective distributing corporation owned at least 80% of the voting power of the company, as well as 80% of the value of the stock of the corporation to be distributed. If this change is enacted, it would only affect distributions occurring after the enactment of this proposal. Presumably Harcourt would be safe, but others less far along in their planning should probably pay attention to this potential change in the law.

RJR Nabisco, Conventional and Reverse Spinoffs

The most direct result for achieving a spinoff is for the parent to distribute the stock it owns in a subsidiary to its shareholders (either a newly-created subsidiary or an old one). In some cases, the parent will drop its assets and liabilities (other than the stock of the subsidiary) into a new company (Newco) and spinoff Newco. In this way, the parent, post-spinoff, merely becomes a holding company for the stock of the partially owned subsidiary.

This latter type of transaction appears to fall well in line with RJR Nabisco's spinoff of its domestic tobacco operations, done presumably to address liability protection (or at least isolation) issues surrounding the large potential tobacco liabilities. But there can be another reason for using this spinoff structure, including the parent's wishes to achieve some degree of monetization with respect to a spinoff—hopefully in a way that does not create immediate tax.

After all, suppose that a conventional spinoff is preceded by a special dividend from the subsidiary to its shareholders in amounts that exceed the parent's basis in the subsidiary's stock. That excess amount would create an excess loss account that would be included in the parent's taxable income on the date of the distribution. An excess loss account under the consolidated return rules is triggered and taken into income when, among other things, the subsidiary (with respect to which the excess loss account exists) is disaffiliated. See Reg. §1.1502-19(b).

However, in a reverse spinoff structure, the monetization described above could be accomplished on a tax-free basis. The subsidiary would still remit a special dividend, and the amount would still be in excess of the parent's basis in its stock. Thus, an excess loss account would still be created.

However, here the subsidiary would not leave the consolidated group, so the excess loss account would not be triggered. Instead, the reverse spinoff structure would achieve an identical economic result, but in a manner that does not trigger the excess loss account and require it to be included in income. Of course, the excess loss account remains a potential income item. But, on a long-term basis, it may be possible to bleed it off through the accrual of post-spinoff earnings.

The excess loss account might even be eliminated entirely by a Section 332 liquidation of the subsidiary into the parent. After all, if the minority shareholder of the subsidiary receives parent stock in exchange for the holding company, it would constitute a tax-free reorganization for the shareholders. On this transaction, see Reg. §1.1502-19(e); see also Revenue Ruling 89-98, 1989-2 C.B. 219.

The foregoing demonstrates that a legitimate reason (does that mean a good business purpose?) for engaging in a reverse spinoff is to achieve some level of cash (or "monetization") but doing so on a tax-free (or perhaps more accurately described as tax-deferred) basis.

Spinoffs and Cost Savings: Is It The Business Purpose?, Vol. 7, No. 12, The M&A Tax Report (July 1999), p. 1.