The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 3, October 1999, Panel Publishers, New York, NY.
DEVICES UNDER SECTION 355: WHO, ME?
By Robert W. Wood
Recently, we looked at one aspect of the "device" rule, which arises frequently under Section 355. See Wood, "Spinoffs and Cost Savings: Is It The Business Purpose?" Vol. 7, No. 12 M&A Tax Report (July 1999, p. 1). The regulations under Section 355 are pretty clear as to the factors it considers "device factors" and those that it considers "nondevice factors." These should roll off the tongue, perhaps more than the "nondevice" designation does. It is important to try to list as many factors as you have in the good side of the column as opposed to the bad.
Perhaps the best evidence of a device, even though it is a bit of a tautology, is if the distribution is pro rata. A dividend distribution would be pro rata. As such, a pro rata distribution under Section 355 would present the greatest potential for the avoidance of the dividend provisions of the Code. See Reg. §1.355-2(d)(2)(ii).
Second, a subsequent sale or exchange of the stock is also considered an indication of a device. The regulations don't give a great deal of guidance, except to say that the greater the percentage of the stock sold or exchanged after the distribution, the stronger the evidence of the device generally is. The shorter the time between the distribution and the sale, the stronger the evidence of the device. See Reg. §1.355-2(d)(2)(iii).
What is perhaps more relevant is exactly how the sale or exchange is negotiated. A sale that is agreed to before the distribution is "substantial evidence" of a device. On the other hand, a sale that is not made pursuant to a pre-arranged deal is still evidence of a device. See Reg. §1.355-2(d)(2)(iii)(D) and (C).
Type of Assets
Another factor that is considered relevant in assessing the device status of a spin is the nature and use of the assets. The existence of assets that are not used in a trade or business that satisfies the Section 355(b) requirements will constitute evidence of a device. Typical examples of such assets include cash and other liquid assets that are not related to the reasonable needs of the business.
The strength of this evidence of a device depends on all facts and circumstances, including the ratio of the value of assets not used in a trade or business to the value of assets that satisfies the Section 355(b) requirements. A difference in this ratio between the distributing and controlled corporations is ordinarily not evidence of a device if the distribution is not pro rata among shareholders of the distributing corporation, and if the difference is attributable to a need to equalize the value of the stock distributed and the value of the stock or securities exchanged. Thus, cash and other liquid assets can be used as equalizing devices in a non-pro rata spin with much more certainty. See Reg. §1.355-2(d)(2)(iv)(B).
In other words, the standards for non-pro rata spinoffs are substantially easier, both on the surface and once one begins to look at particular consideration distributed.
The last "device" factor mentioned in the regulations (although there are some mentioned in other literature) is the "related function." There will be evidence of a device if a business of either the distributing or controlled corporations (or a downstream subsidiary) is a secondary business that continues as a secondary business for a significant period after the separation, and if the secondary business could be sold without adversely affecting the business of the other corporation.
What's all this about? A secondary business is one that either the distributing or controlled corporation operates if its principal function is to serve the business of the other corporation (or a corporation controlled by it). A secondary business can include a business transferred to a newly-created subsidiary or a business which serves a business transferred to a newly-created subsidiary.
The activities of the secondary business may consist of providing property or performing services. The regulations refer to an example where there is evidence of a device if the principal function of a coal mine continued after the separation and the coal mine could be sold without adversely affecting the steel business. See Reg. §1.355-3(c), Example 11. Likewise, there would be evidence of a device if the principal function of a sales operation after a 355 separation, is to sell the output from the manufacturing operation, and the sales operation could be sold without adversely affecting the manufacturing operation. See Reg. §1.355-3(c), Example 10. Regarding the related function device factor, see Reg. §1.355-2(d)(iv)(C).
Whether one agrees with the English grammar associated with the "non-device" factor, the list is always a helpful one. As we noted recently (see Wood, "Spinoffs and Cost Savings: Is It The Business Purpose?" Vol. 7, No. 12 M&A Tax Report (July 1999), p. 1.), perhaps the most important non-device factor is the corporate business purpose. The strength of a corporate business purpose is evidence of a non-device. The stronger the evidence of the device (pro rata, let's say), then the stronger the corporate business purpose will be required in order to refute it.
All this sounds a bit silly, but when one is requesting a ruling (or, God forbid, litigating over these issues), the importance of the device and non-device factors cannot be overstated.
The regulations even give a hierarchy for thinking about a corporate business purpose. Assessing the strength of a business purpose is based on all facts and circumstances, but at least the following:
the importance of achieving the purpose to the success of the business;
the extent to which the transaction is prompted by a person not having
a proprietary interest in either corporation, or by other outside factors
beyond the control of the distributing corporation; and
the immediacy of the conditions prompting the transaction. Reg. §1.355- 2(d)(3)(ii).
Another non-device factor is present where the distributing corporation is publicly traded and widely held. Reg. §1.355-2(d)(3)(iii).
Dividends Received Deduction?
Finally, believe it or not, it is a non-device factor if the stock of the controlled corporation is distributed to one or more domestic corporations that, if Section 355 did not apply, would be entitled to a dividends received deduction under Section 243. Once one gets over the headscratching, this makes eminent sense. It is one facet of the "available alternatives" notion. If the tax consequence would not be too terrible of not applying Section 355, then presumably there cannot have been intended a device to distribute earnings and profits.
A dividend, in this case, would have been a dividend qualifying for the dividends received deduction anyway. For details, see Reg. §1.355-2(d)(3)(iv). This is kind of a "no-harm-no-foul" concept.
More on Devices
In a future issue, we'll look at more of the lore of the device and the non-device. The regulations give illustrations of transactions that are not ordinarily considered devices. As a practical matter, although these are not classed as "non-device" factors, they seem to have the same effect. Perhaps the best-known example is the absence of earnings and profits! (See Reg. §1.355-2(d)(5)(ii).)
Next time, we'll look at some illustrations, as well as some of the Service's further announcements on the device and non-device debate. Stay tuned for that coverage.
Devices Under Section 355: Who, Me?, Vol. 8, No. 3, M&A Tax Report (October 1999), p. 6.