The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 10, May 2002, Panel Publishers, New York, NY.
SPINOFFS: THE GOOD, THE BAD AND THE UGLY
By Robert W. Wood, San Francisco M&A Tax Report readers know our collective fascination with Section
355. Revered, exploited, criticized or neglected (and sometimes all of
these things at once), Section 355 is still one of the few holes in the
dyke of General Utilities repeal. For those of you who don't remember,
the 1986 Tax Reform Act reshaped Subchapter C by doing away with the venerated
General Utilities doctrine, thus making corporate dispositions considerably
more expensive. Section 355 (even with its relatively recently imposed
demon subpersonality of Section 355(e)), offers, quite simply, a chance
to separate on a tax-free basis. The simplicity of Section 355 ends there.
Much of the meat of Section 355 lore, and much of the necessary planning,
involves either what happens before or after such a division. And that,
of course, is the main topic addressed by Section 355(e).
To Rule or Not to Rule?
Section 355 has traditionally been one of the few areas where most
advisors admonished that getting a ruling from the IRS was necessary. Our
collective knee-jerk reaction was (and continues to be) that the stakes
in a spinoff are high enough (obviously, depending on the numbers) and
a couple of uncertainties significant enough that if (and usually we stressed
the IF) the deal went bad, the corporate gain on the distribution and the
corollary dividend treatment to shareholders would be disastrous. The relative
ease or difficulty of obtaining a Section 355 ruling has waxed and waned
over the years, but certain features of a ruling request (such as the fundamental
prerequisite of showing a good business purpose) have sometimes been difficult
to overcome.
Showing that a transaction was not a device could also be dicey (more
about the "device" problem appears below). To be sure, a significant number
of spinoffs (and even some large ones) have been done without the benefit
of the IRS' advance blessing. Closing transactions based on opinions of
counsel became popular, although many of those opinions (as legal opinions
are often wont to be) had significant enough qualifiers that I question
in many cases whether the company really got what it thought it was buying.
But however the transaction is closed, whether with a ruling or without,
I believe many have assumed that Section 355 transactions were relatively
unlikely to be attacked by the IRS. That makes the recent Tax Court case
of South Tulsa Pathology Laboratory, Inc. v. Commissioner, 118 T.C. No.
5 (Jan. 28, 2002), especially important. The Tax Court there held that
the spinoff of a corporation was a device to distribute earnings and profits,
that the corporation lacked sufficient business purpose to overcome the
device argument, and that section 311(b) required the corporation to recognize
gain.
Trouble in Oklahoma
South Tulsa Pathology Laboratory Inc. (South Tulsa) was a C corporation
owned by physicians which provided pathology-related medical services.
Apart from rendering medical services, it also ran a clinical laboratory
operation. South Tulsa received offers to purchase its clinical business
but refused until 1993, when the shareholders decided to sell the clinical
business, fearing they would be forced out by competition from national
laboratories.
In 1993 South Tulsa was approached about purchasing the clinical
business and decided to sell it to National Health Laboratories Inc. (NHL).
The parties negotiated a sales price and structured the sale as a sale
of stock of a yet-to-be-incorporated laboratory company that would be capitalized
with the clinical business and spun off from South Tulsa. South Tulsa formed
Clinpath Inc. on October 5, 1993, and purchased all of its common stock.
On October 29, 1993, South Tulsa entered into a reorganization agreement
with the shareholders and contributed the clinical assets for the stock
and then distributed the stock to the shareholders. On October 30, 1993,
the shareholders transferred the stock to NHL for $5,530,000. As a condition
of the sale, each shareholder agreed not to compete with NHL in the clinical
laboratory business within the 918 area code of Oklahoma for five years.
NHL paid each physician $10,000 for the covenant not to compete.
The IRS audited and asserted that the spinoff was bad. In Tax Court,
Judge Marvel concluded that the spinoff wasn't a D reorganization under
section 368(a)(1)(D) because there was no qualified stock distribution
under section 355. The court concluded that the spinoff and sale were prearranged,
and that South Tulsa must recognize gain on the stock distribution. The
court concluded that there was substantial evidence that the transaction
was used principally as a device for the distribution of E&P of South
Tulsa. The court pointed toward several factors that favored the finding
that it was a device, such as the proportional distribution of the stock
to the shareholders, the sale of the stock after the distribution, and
the negotiated agreement before the distribution.
Judge Marvel rejected South Tulsa's reliance on Pope & Talbot
Inc. v. Commissioner, 104 T.C. 574, (1995) affd. 162 F.3d 1236 (9th Cir.
1999), and noted that the issue was whether South Tulsa must recognize
gain under section 311(b) and not the value under section 311(d). M&A
Tax Report readers will surely remember Pope & Talbot. In the first
iteration of the Pope & Talbot case, 104 T.C. 574 (1995), Pope &
Talbot transferred partnership units, and the big question was valuation.
The distribution was clearly taxable, with the common shareholders of Pope
& Talbot receiving partnership interests in a partnership that held
some of the assets that were previously held by Pope & Talbot.
The question was how much these partnership units were worth. The
taxpayer argued the fair market value of the property should be determined
by the value of the partnership units received by each shareholder. The
IRS, on the other hand, argued that Section 311(d) required the fair market
value of the property distributed to be determined as if the property had
been sold in its entirety. The Tax Court concluded that the IRS was right.
The next iteration of Pope & Talbot was two years later, T.C.
Memo 1997-116 (1997). This Pope & Talbot case considers primarily INDOPCO
v. Commissioner, 503 U.S. 79 (1992). In addition to INDOPCO issues, reverting
to the issue in the first case, the Tax Court calculated the fair market
value of the distributed property by determining what a willing buyer would
pay in a hypothetical sale of the property on the date of the distribution.
Pope & Talbot was not finished, though. On appeal in the Ninth
Circuit, the taxpayer challenged the methodology by which the Tax Court
valued the distributed properties, and challenged the value placed on those
properties. See Pope & Talbot, Inc. v. Commissioner, 162 F.3d 1256
(9th Cir. 1999). The Ninth Circuit disagreed with all of the taxpayer's
arguments, concluding that the property distributed by the corporation
had to be valued as if the taxpayer had sold the property at the time of
the distribution. For full discussion, see Wood, "Pope & Talbot's Last
Gasp," Vol. 8, No. 1, The M&A Tax Report (August 1999), p. 1.
In any case, the court in South Tulsa rejected the valuation "expert"
report as not credible. Noting that in an arm's-length sale between NHL
and the shareholders, NHL paid $5,530,000 for the stock, the court said
South Tulsa failed to reconcile the sale with the valuation. Thus, Judge
Marvel held that the fair market value of the stock on the distribution
date was $5,530,000 and that South Tulsa has gain.
No Ruling
How important was it that no ruling was obtained on this transaction?
I suppose no one knows the answer to that question. Some believe that disclosing
a Section 355 transaction on a return (where there has been no ruling and
one by definition cannot attach the ruling to the return), will pique the
IRS' interest. Here, whether that was the reason, or whether it was mere
coincidence, the South Tulsa return did get examined.
When the IRS concluded that the distribution of stock to the South
Tulsa shareholders failed the tests of Section 355, the asserted consequences
were severe: the excess of the fair market value of the assets distributed
over their tax basis was to be taxable income to South Tulsa. Plus, the
fair market value of the spun off company (Clinpath) stock was a taxable
dividend to the South Tulsa shareholders who received it. The corporate
treatment to South Tulsa was before the Tax Court, and the Tax Court noted
that there were four requirements that needed to be methodically reviewed
in order to determine whether Section 355 had been satisfied:
the distribution must be solely of stock of the controlled corporation; the distribution must not be used principally as a device for the distribution
of earnings and profits of the distributing corporation, the controlled
corporation, or both; the active business requirements of Section 355(b) must be satisfied;
and stock in the controlled corporation constituting control must be distributed. The court also noted that the business purpose requirement had to be
met, and even that there had to be continuity of proprietary interest after
the distribution. (These nonstatutory requirements are contained in Reg.
§1.355-2(b) and (c).)
Device
Perhaps it is ironic that the test the Tax Court determined was
flopped here was the second requirement: the transaction cannot be a device
to distribute earnings and profits. I say that seems ironic, because that
is the most amorphous test, and therefore the one that (in the absence
of a ruling blessing the transaction) is always the hardest one to say
convincingly has been avoided. Truth is, a majority of Section 355 transactions
are accomplished — whatever terrific business purposes there may be — at
least in part because of tax savings opportunities.
There is nothing wrong with that. But the "no device" prohibition
is a little frightening. Admittedly, the "no device" moniker is modified
by the word "principally," so that presumably one could have a transaction
where at least part of your motivation (and part of your use of the stock
distribution) is to distribute E&P. You simply can't use the distribution
"principally" for that bad and nefarious aim.
Why did the IRS argue here that this was a device to distribute E&P?
The IRS referred to both of the requirements added by the regulations.
The IRS argued that the distribution was principally a device to distribute
earnings and profits to the physician/shareholders, that it had no independent
corporate business purpose, that it failed the continuity of interest test
because the Clinpath stock was sold immediately under a prearranged plan.
It looked pretty bad.
The device argument hinged on the two factors noted in the regulations
for evoking evidence of a device to distribute earnings and profits to
the shareholders. The first factor is that the distribution is pro rata.
A dividend, of course, would be pro rata. Note that certainly does not
mean that any pro rata spinoff is a device. That is obviously not true.
Still, it has always been true that there is significantly less scrutiny
on a non-pro rata spinoff.
The second factor is that the distributed stock was subsequently
sold or exchanged. This is important. In this case, the Clinpath stock
was immediately sold to NHL for cash, and this produced the same economic
effect for the shareholders as if South Tulsa had sold the Clinpath assets
for cash, and then just distributed the proceeds. Of course, it was especially
nefarious here, said the Service, that the sale to NHL occurred under an
agreement that was entered into before Clinpath was even created.
How convincing was it that South Tulsa argued that it was the buyer,
NHL, that insisted on this deal structure? The judge in the Tax Court dismissed
this. The Tax Court pointed out that NHL usually structured its acquisitions
as asset purchases, thus undercutting the notion that NHL would have insisted
on buying Clinpath stock. Moreover, the court simply divined that the spin
followed by the immediate sale of the Clinpath stock (on the same day)
was simply designed to eliminate the corporate level tax that would have
been due had South Tulsa sold its clinical business to NHL directly or
distributed the clinical business to its shareholders prior to their sale.
E&P Levels
How significant is the level of E&P? This is an interesting
one. South Tulsa argued that however the transaction took shape, it could
not be a device simply because South Tulsa's accumulated earnings and profits
figure (then $226,347 as of July 1, 1993) was not significant enough to
warrant the conclusion that the spinoff was a device. I actually kind of
liked this argument. Menacingly, though, the Tax Court observed that the
regulation provided no safe harbor for corporations with insignificant
or minimal earnings and profits. At the same time, it seems to me that
the "principally" modifier that is supposed to qualify the device prohibition
ought to take into account implicitly the level of E&P. The court,
though, didn't buy it.
More difficult still was the effect on E&P that the distribution
of the stock had. The IRS argued that the distribution of the Clinpath
stock itself would have generated an additional $5,424,985 of pretax earnings
and profits as of October 30, 1993. This amount, according to the IRS and
the court, could in no way be viewed as insignificant or minimal. Using
the well-worn "bail out" metaphor, the IRS argued that the corporate profits
the South Tulsa shareholders intended to bail out were the anticipated
profits of the prearranged sale. It was not merely the E&P accumulated
through operations — whether one views that $226,347 number as insignificant
or not.
Did it matter that South Tulsa was a professional corporation that,
as do most, paid out substantially all of its earnings in deductible compensation
annually? South Tulsa argued that this method of distribution virtually
assured that there would be little or no corporate income tax liability,
irrespective of the ultimate outcome of the spinoff. The Tax Court characterized
this argument as disingenuous.
Good Business Purpose?
As we noted in the advance ruling context, a business purpose is
one of the lynchpins of Section 355. And, given the "device" discussion
above, a really solid business purpose can counteract — or in the words
of Judge Marvel in the South Tulsa case, can "trump" — a conclusion that
the transaction was used principally as a device to distribute earnings
and profits. The much paraphrased definition of a good business purpose
is a real and substantial non-federal tax purpose germane to the business
of the distributing corporation, the controlled corporation, or the affiliated
group. I find the business purpose discussion in this case quite interesting,
particularly since it ties into issues that come up on ruling requests
(even though the South Tulsa transaction was presumably a long way away
from ruling discussion!).
One age-old question about business purpose is whether you want to
advance more than one. Does listing more than one business purpose serve
to water down your best business purpose, or does it help to have more
than one. Are business purposes like partygoers, the more the merrier?
In Tax Court, South Tulsa argued there were three business purposes:
The increasingly competitive market for clinical laboratory services
favored national laboratories, making this deal important. Oklahoma law prevented nonphysicians from owning stock in a professional
corporation like South Tulsa, thus mandating the separation. NHL required that the physician/shareholders sign binding and enforceable
noncompete agreements as to the clinical laboratory services. How did all of these business purpose assertions fare? The competitive
problem (business purpose assertion 1) explained why South Tulsa might
want to sell the clinical laboratory part of its business. The stock ownership
problem (business purpose assertion 2) might explain why NHL could not
purchase the South Tulsa stock, but it didn't explain why the Clinpath
stock was not sold to NHL by South Tulsa (with no distribution of Clinpath
stock). The covenant not to compete argument (the third asserted business
purpose) was, according to Judge Marvel of the Tax Court, based on an overly
narrow view of the Oklahoma law governing noncompete agreements.
In short, all of these asserted business purposes made some sense.
The problem was that all of them suggested a separation of the professional
corporation from the clinical laboratory services, but none of them suggested
any reason why the distribution of the Clinpath stock needed to occur!
That is the kind of issue that presumably would have come up in a heartbeat
in a ruling request setting.
For example, if market conditions, investment bankers, insurance
brokerage issues, risks and vicissitudes of several different lines of
business, distribution schemes, competition issues with other companies
— or whatever it may be — favor separating business B from the corporate
umbrella of business A, you must query whether these business goals would
be satisfied by having a common parent. Is a separate corporate shell sufficient?
Sometimes it may be, and sometimes not. And it may be on this point that
South Tulsa shareholders simply did not go far enough in thinking this
through.
Their second asserted business purpose, that Oklahoma law prevented
nonphysicians from owning stock in a professional corporation like South
Tulsa, just doesn't go far enough. If the facts showed that the professional
corporation owned purely by doctors and the clinical laboratory services
business could not be run under the same corporate roof (or even under
the same corporate parent) because to survive the laboratory business needed
to admit shareholder/employees, perhaps this would have worked. The "key
employee" purpose for a spinoff has been much touted over the years, and
like many features of Section 355 lore, this business purpose has waxed
and waned. Whatever would have happened with South Tulsa, though, probably
nothing could have cured the bad sale immediately after the distribution.
Anyway, after reviewing all of the asserted corporate business purposes,
the Tax Court concluded that there was substantial evidence of a device
and that this evidence was not overcome by substantial evidence of nondevice
(or by proof that there was a lack of current or accumulated earnings and
profits).
How Much Is It Worth?
In what seems to have been a Hail Mary pass, South Tulsa argued
that even if the distribution was taxable, the fair market value of the
Clinpath stock was only $1,040,000, not the $5,530,000 asserted by the
IRS. This number was important, since that was the number used for purposes
of measuring gain on the stock distributed to the South Tulsa shareholders.
Remember, in this case, we're talking about not the shareholders' gain,
but rather the South Tulsa corporate level gain triggered by distributing
appreciated property (here, the Clinpath stock).
To support the barely more than $1 million figure, South Tulsa called
an expert witness to testify about the Clinpath stock merely being worth
the value of the underlying clinical laboratory assets. This seemed like
a nice try, but the Tax Court found it quite succinctly "simply not credible."
In defense of the expert and the South Tulsa shareholders, this million
dollar value was supported (at least arguably supported) by the notion
that Clinpath was then a brand new corporation, and that the goodwill of
the clinical laboratory business had been generated by the South Tulsa
physician/shareholders, not by Clinpath itself.
The court, though, noted that there was a heck of a lot of goodwill
missing somewhere if this argument worked. After all, the physician/shareholders
had testified that the $10,000 each had received for their noncompete agreements
had been reasonable. The Tax Court reasonably asked why these paltry $10,000
payments were made and were reasonable, if the vast goodwill of the clinical
laboratory business really belonged to them? Presumably the physician/shareholders
would have been way better off had they said that the $10,000 payments
were really token, and that a good chunk of the value they received on
the sale of Clinpath to NHL really was for noncompete payments.
Obviously, the noncompete payments to the physician/shareholders
would be taxable as ordinary income, not as capital gain. But if this argument
worked (and perhaps it might have), then at least they would be paying
only one level of tax, albeit at ordinary rates. Presumably, the individual
shareholders would have had to ratchet up their respective goodwill payments
(the aggregate was roughly $4,500,000, represented by the difference between
the IRS' asserted value of $5,530,000 and the South Tulsa argument that
the Clinpath stock was only worth $1,040,000). Instead, the physician/shareholders
said the $10,000 noncompete payments each of them received (reported as
ordinary while the rest of it was reported as capital) was reasonable.
Whether a different handling of this valuation problem would have
made a difference to the result in the case or not, it was hardly surprising,
given the way this was presented, that the Tax Court dismissed the $1,040,000
value and easily found the best evidence of market value to be the actual
sale which occurred immediately after the spin. Come on guys, that seemed
like a no-brainer. Since the Clinpath stock was sold immediately after
the spin for $5,530,000, and since NHL was an independent party that clearly
negotiated at arms' length, that was the value. End of story.
Anti-Morris Trust Rule
Turning back to where we started, let's not forget about Section
355(e), added by the Taxpayer Relief Act of 1997. (Don't you love how arguably
confiscatory provisions are added under the cloak of euphemistic bill names?)
Section 355(e) brackets the asserted spinoff by looking two years before
and two years after a distribution of the controlled corporation's stock.
If there is an acquisition (whether taxable or tax-free) of a 50% or greater
interest in either the distributing corporation or any controlled corporation
during this four-year window, the otherwise good spinoff spoils like an
overripe fruit in the sun.
As M&A Tax Report readers well know by now, Section 355(e) involves
running the gauntlet of just what is a "plan," and that is supposed to
involve an assessment of all the facts and circumstances. There are six
regulatory safe harbors, and they are worth a read. See Temporary Regulations,
T.D. 8960. Of course, it does not require any serious analysis to know
that the South Tulsa situation would never have been even attempted after
the 1997 enactment of Section 355(e).
For those who haven't looked at all of the safe harbors and the status
of regulations under Section 355(e), they are certainly worth a read. For
coverage, see Wood, "Morris Trust Regulations At Last," Vol. 8, No. 3,
M&A Tax Report (October 1999), p. 7. See also Wood, "Morris Trust Regulations
At Last, Part Two," Vol. 8, No. 4, The M&A Tax Report (November 1999),
p. 7.
More Spin News
The spate of spinoffs seems not to be abating, and new phrases are
even being coined. Referring to the current breakup trend, of which Tyco
was merely one big example, one author recently called this Wall Street's
"urge to purge." See Lim, "Wall Street's Urge to Purge," U.S. News and
World Report, Feb. 25/March 4, 2002, p. 32. We've noted Tyco's plans before,
see Wood, "Spins In the News Again," Vol. 10, No. 8, The M&A Tax Report
(March 2002), p. 1. See also Hechinger and Johannes, "Tyco Pledges to Hasten
Breakup Efforts," Wall Street Journal, Feb. 7, 2002, p. A3. TRW is also
in the news for its anticipated split into three pieces following a hostile
bid from Northrup Grumman. See Larsen, "TRW Plans Split After Rejecting
$6bn Bid," Financial Times, March 14, 2002, p. 15.
Dow Corning has also announced plans to split its operations into
two. See Firn, "Silicone Split for Dow Corning," Financial Times, March
6, 2002, p. 18. Circuit City has said it would spin off its profitable
CarMax unit. See Spagat, "Circuit City Cuts Estimates, Citing Inventory
Shortages," Wall Street Journal, Feb. 25, 2002, p. B13. General Electric
Co. is considering splitting off its property and casualty insurance operations.
See "GE May Shed Property-and-Casualty Unit," Wall Street Journal, March
15, 2002, p. A3. Georgia-Pacific Corp. said it plans to split into two
companies to more effectively compete. See Terhune, "Georgia-Pacific to
Split Into Two Firms to Boost Consumer-Products Business," Wall Street
Journal, April 1, 2002, p. C6.
All this, it is hardly surprising, prompts many to note the new bifurcation
trend. And it also affects equity markets. The IPO market had an awfully
slow first quarter in 2002, but the highlights were certainly spinoffs.
The largest offering was from Citigroup, which spun off its Travelers property
casualty insurance unit, raising $3.9 billion in an IPO. See Postelnicu
and Chung, "Spin-offs Hold Sway in IPOs," Financial Times, April 1, 2002,
p. 17. The whole "we are creating shareholder value" mantra is sometimes
questioned, and one recent article gave the unflattering comparison to
spinoffs to create shareholder value as a "lottery." See Lucier and Bellaire,
"Three Steps to a Successful Spin," Financial Times, Feb. 20, 2002, p.
11.
On the other side, there have been some repurchases of spun off companies,
including Tyco's repurchase of some of Tycom, Sabre's repurchase of part
of Travelocity, SBC Communications' repurchase of Prodigy, and so on. A
good collection appears in Larsen, "Reeling In the High-Tech Spin-offs,"
Financial Times, April 4, 2002, p. 15.
Last Word
Given the enactment of Section 355(e), some may dismiss the South
Tulsa case as of purely historical interest. On the other hand, many of
us who have worried about the device test from time to time should find
the case fascinating, even though it does read somewhat like a "how not
to do it" manual. The result in South Tulsa is hardly surprising. Section
355(e) or not, the planning was hardly sophisticated.
Still, we should gather any crumbs of learning about the device test
we can. There have been all too few times when the device test has really
made a lot of sense. One case we commented about a few years ago was Pulliam
v. Commissioner, T.C. Memo 1997-274 (1997). There, the Tax Court found
that the business purpose supporting a spin (a "nondevice" factor) outweighed
evidence of a device. The IRS issued a nonacquiescence. See AOD 1998-007
(Nov. 20, 1998), Tax Analysts Doc. No. 98-33972. See Wood, "Bad 'Device'
Present in Cable & Wireless Deal," Vol. 8, No. 2, The M&A Tax Report
(Sept. 1999), p. 7.
For discussion of the way in which device evidence of a and "nondevice"
interrelate (a tortured use of English to be sure), see Wood, "Devices
Under Section 355: Who, Me?" Vol. 8, No. 3, The M&A Tax Report (Oct. 1999),
p. 6. All in all, the device test is likely to be with us as long as we
continue to have Section 355.
Spinoffs: The Good, the Bad, and the Ugly, Vol. 10, No. 10,
M&A Tax Report (May 2002), p. 1.