The following article is adapted from reprinted from the M&A Tax Report, Vol. 8, No. 2, September 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

Few phrases are both so cryptic and so classic to our corporate tax literature as the proverbial "device to distribute earnings and profits." Long ago shortened by those in the know merely to a "device," this surprising amorphous bad thing is primarily relevant in the context of our old friend Section 355. An otherwise valid Section 355 transaction will fail if it constitutes a device.

The current transaction in which CWZ is participating serves as a useful reminder of what the enigmatic know-it-when-we-see-it device moniker is all about. CWZ is owned 53 percent by the English company Cable & Wireless, 18 percent by Bell Atlantic and the balance by the public. CWZ is participating in a deal that essentially amounts to a spinoff followed by acquisitions of both of the corporate parties to the spinoff. One of the acquisitions, to be effected by NTLI, involves the payment of a substantial amount of cash (in addition to stock) to the CWZ shareholders.

The deal is conditioned on Bell Atlantic's ability to receive both the spinoff stock as well as the NTLI stock on a tax-free basis. With respect to the former, the distribution must qualify as a valid spinoff under U.S. tax principles. In addition—and this is somewhat unusual—the transaction is conditioned on a finding that the distribution is not considered to be as used principally as a device for the distribution of earnings and profits. If the prohibited E&P distribution purpose is found, the spinoff would not qualify for tax-free treatment and one of the conditions to consummating the deal would therefore not be met.

What's a Device?

The device test is designed to be a flexible mechanism to prevent the use of Section 355 to avoid the dividend provisions of the Code. See Rev. Rul. 77-377, 1977-2 C.B. 111. The possibilities for raising the spectre of a device are legion. Still, the device problem is perhaps more often raised in a situation where, as in the Cable & Wireless fact pattern, a parent distributes the stock of a subsidiary on a pro-rata basis, and the distribution is followed by a pre-arranged sale of the stock of either party to the spinoff.

Clearly, a tax-free reorganization-conducted solely for acquirer stock does not constitute such a pre-arranged sale. At the same time, a pre-arranged sale is deemed to occur where the merger consideration consists of property other than stock in the acquirer. Accordingly, it seems at least arguable that the Cable & Wireless transaction involves a prohibited pre-arranged sale. See Rev. Rul. 78-251, 1978-1 C.B. 89.

Indeed, it is probably a good deal more than arguable that this intended spinoff exhibits this one device factor, the pre-arranged sale. However, the mere presence of one or more device factors does not necessarily mean a prohibited device will ultimately be found to exist. The analysis (thankfully!) is not that simple or automatic. A device will not be found in cases where the spinoff exhibits "non-device" factors (now there's a clever label!) that, collectively, outweigh the presence of the device factors.

Device vs. Nondevice

Weighing In one recent case, Pulliam v. Commissioner, T.C. Memo 1997-274, the Tax Court found that the business purpose supporting the corporate separation (a non-device factor) outweighed the negative implications of the device factor. The device factor present in the Pulliam case, like the Cable & Wireless deal, was a pre-arranged sale of a substantial portion of the stock of one of the parties to the spinoff. Unfortunately, the IRS has issued a nonacquiescence with respect to the Pulliam decision. See AOD 1998-007 (November 20, 1998), Tax Analysts Doc. No. 98-33972.

Consequently, the Service might be expected to challenge similar transactions with respect to their device aspects. Yet in the past, even the Service has had to acknowledge that the strength of a business purpose can actually help negate the presence of a device. See Wood, "Spinoffs and Cost Savings: Is It The Business Purpose?" Vol. 7, No. 12, M&A Tax Report (July 1999), p. 1.


Despite the Service's nonacquiescence in Pulliam, the advisers to CWZ may take some degree of comfort from the Tax Court's findings in Pulliam. Indeed, counsel may well conclude that the compelling business purpose that is undoubtedly motivating the CWZ separation effectively insulates the transaction from a device finding, notwithstanding the pre-arranged sale of stock. Anyone want to write that legal opinion?

Bad "Device" Present in Cable & Wireless Deal, Vol. 8, No. 2, The M&A Tax Report (September 1999), p. 7.