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February 5, 2007
NYSBA Considers 'Cash Wreck' in Spinoffs
by Lee A. Sheppard

Full Text Published by Tax Analysts®

Document originally published in Tax Notes
on February 5, 2007.

"Gown wreck." Who knew?

We've talked about the first lady's wardrobe in these pages before. She's taken to dressing like a socialite and now runs the risk of running into another rich woman in the same dress. In December she wore an $8,500 Oscar de la Renta dress — she pays wholesale price — to a White House gala, only to be confronted by three other women in the same dress. She felt she had to change — in the old days, the others would have had to excuse themselves — but the photographers got to her first. (The Wall Street Journal, Jan. 26, 2007, p. W1.)

This never used to happen at the exalted levels of high fashion because rich women wore haute couture — that is, custom-made clothes from a designer's Paris salon, so each dress was different. And designers would "protect" favored customers by not selling too many copies of a ready-to-wear garment. But now designers are selling as many copies as they can to whomever has the cash.

Gown wreck is a purely American phenomenon. American women consider themselves unfashionable unless every item of clothing on their bodies is brand new. American women buy dresses for events, usually within a few weeks of an event. American women also believe that they cannot wear the same garment in public more than once. This foolish spending pattern keeps Seventh Avenue in business.

French women do not suffer from gown wreck. They do not buy new dresses specifically for events. They take the appropriate garment out of the closet and wear it. That garment got into the closet through careful shopping and long-range thinking. What if it isn't new? It probably isn't; it could be a decade old. Why isn't it out of style? Because it was not trendy or gimmicky when it was purchased. Or it was reworked by a seamstress. And when it is worn, the wearer puts her ensemble together in a way that looks current.

Until recently, cheap trendy clothes were not available in Europe, and the clothes that were available were very expensive. So women had to learn how to get the maximum use out of each purchase. There was no such thing as wearing something once. Around here, we've thought long and hard about trying to teach readers to think like French women, and it just can't be done. There's no counseling restraint to Americans.

There is, apparently, no counseling restraint in spinoffs and split-ups either. Call it "cash wreck."

Since the repeal of General Utilities two decades ago, section 355 has garnered a veritable alphabet soup of legislative amendments intended to restrain its use for sales and cash-outs. There are always regulations projects. Huge amounts of IRS resources are expended on giving section 355 rulings. Around here we even have good people who write about section 355 more or less full time, so your correspondent can concentrate on more cosmically important things like skirt lengths.

And yet, as the discussion at the January 23 New York State Bar Association Tax Section annual meeting showed, more cash is sloshing around in spinoffs and split-ups than ever before. Like socialites confronting their husbands about their wardrobe budgets, the perennial question is "how much cash can we have?"

Active Business

The five-year-old active business requirement of section 355(b) is thought to prevent tax-free distributions of corporations stuffed with cash and liquid assets — that is, devices for the distribution of earnings, or vice versa, distributions of businesses when the distributing corporation held only cash.

New section 355(b)(3), added in 2005, allows taxpayers to find an active trade or business anywhere in their controlled groups (defined under only section 1504(a)). It is a taxpayer-favorable rule, except that some taxpayers are holding companies. They previously relied on section 355(b)(2)(A), which protected them. Section 355(b)(3)(A) says that a pure holding company cannot qualify. In Notice 2006-81, 2006-40 IRB 595, the IRS stated that section 355(b)(3) trumps the holding company rule, but it provided an election out.

Well, can you buy the requisite affiliation? Section 355(b)(2)(D) says that the business has to have a five-year history and cannot be a recent purchase. Does that requirement hold for section 355(b)(3)? Can a taxpayer buy its way into compliance, given that the focus of section 355(b)(1) is the situation "immediately after" the distribution? Does the section 355(b)(3) affiliation have to have a five-year history if the taxpayer is allowed to search the group for an active business?

That question has been raised before, and it remains unanswered. The Tax Technical Corrections Act of 2006 (H.R. 6264) would say no, that a recently purchased member cannot be used to satisfy the active trade or business test.

"We're struggling," Mark Countryman, an attorney-adviser in Treasury's office of tax legislative counsel, told New York practitioners. "We're inclined to say look at the group for the whole five-year period you're required to be active — that is, did you gain access to a trade or business within a five-year period?"

Bill Alexander, IRS associate chief counsel (corporate), was more emphatic. "We have the authority to get to the result in the technical corrections bill, at least by regulation," he said.

The expansion doctrine of reg. section 1.355-3(b)(3)(ii), which permits expansion of existing businesses through share purchases despite the literal violation of section 355(b)(2)(D), may no longer be a viable strategy. Any words of comfort here? "The expansion doctrine is still there," said Alexander.

Countryman observed that taxpayers could always more easily expand their businesses by buying assets than by buying shares. Buying assets has never been questioned; buying shares has always been dubious. But the statute allows a taxpayer to buy shares and pretend it is buying assets, unless the taxpayer is buying shares of the company that is to be spun off.

The IRS will not rule on the acquisition of control of a controlled corporation to satisfy the active business test. (Rev. Proc. 2007-3, 2007-1 IRB 108.) The active business regulations project, now nearing its fourth anniversary on the business plan, will be comprehensive, covering section 355(b)(2)(C) and (D), Countryman explained.

Cash Rich

How large must the active business be in proportion to the other assets of the controlled group? Used to be a taxpayer could get a section 355 ruling when an active trade or business accounted for a mere 5 percent of the total fair market value of the gross assets of the corporation. People were in the habit of putting their smaller businesses in their holding companies to qualify them as distributing corporations. (Rev. Proc. 96-43, 1996-2 C.B. 330.)

Now there is no set level. "You tell us whether there's a business there, we look at it," said Alexander. "We're federal civil servants. It doesn't take much to impress us."

Practitioners recognized that there was no proportionality requirement; the active business did not have to account for a very large part of the total assets of either corporation. So section 355(g) was enacted in 2006 to restrain the distribution of cash-heavy controlled corporations, although not to any great extent.

Section 355(g), like everything else these days, is poorly drafted. It defines a controlled corporation with too large a proportion of investment assets as a "disqualified investment corporation" and states that section 355 does not protect split- offs of such corporations. Countryman mused that the IRS has the authority to remove proportionate spinoffs from the ambit of section 355(g).

Too much investment assets is defined as two-thirds of the FMV of the controlled corporation. So an active business need account for only a third of the value. In the new world of section 355(g), there are three types of assets: active trade or business assets, tainted investment assets, and passive assets that are not tainted, like real estate. There may also be trades or businesses that are not five years old.

Section 355(g)(2)(B) does have some rather broad exceptions to its definition of investment assets. What about accounts receivable? Are they assets used in a trade or business? Alexander thought accounts receivable would be an investment asset. "You have a large basket," he said, referring to the two-thirds requirement. "It acts as a cushion."

Back when all those frugal French women bought the gowns they are still wearing, people used to argue about the device test of section 355(a)(1)(B). Practitioners wonder what the relationship between section 355(g) and the device test is. That is, if either a distributing or controlled corporation manages not to be a "disqualified investment corporation," could the split-off nonetheless be a device for the distribution of earnings and profits? Is the device test still relevant?

"The device test has not changed," said Alexander. "If you take out a shareholder in a split-off, that would be a capital gain transaction." That is, the device test does not address split-offs, by and large. It is about the conversion of what would have been a dividend to capital gain. However, Alexander would not promise to give practitioners comfort that the device test would never apply to a transaction that escapes section 355(g).

If the distributing corporation makes a cash dividend distribution before a spinoff, then the spinoff cannot be a device for the distribution of E&P, since they have been distributed already, assuming the E&P have been exhausted, Countryman commented. That is a fashionable transaction at the moment. Device, he added, is a fact-specific inquiry, what with the statute's principal purpose test.

Of course, the ultimate device question is the immediate sale of the shares of one or the other corporation. The much-debated section 355(e) is supposed to handle that problem. Alexander noted that the IRS does not rule on sales, though seekers of rulings are asked to represent that their distribution is not a device. "But nothing says you have to sit still," he added.

Debt Exchanges

Another way to get the equivalent of a lot of cash in a spinoff — that is, for the distributing corporation to monetize its investment in the controlled corporation — is for one of the corporations to load up on debt. There are restrictions on the obvious tactic, which would be to load the controlled corporation with debt. But pushing debt up to the distributing corporation and cash into the controlled corporation is unrestricted. But then what do the parties do with all that debt?

Can the distributing corporation fob it off to a friendly banker? The distributing corporation has to distribute section 368(c) control to its shareholders, but that allows as much as 20 percent of the controlled corporation to be distributed to debt holders. Why involve that friendly banker? Debt holders often don't want equity — that's why they become debt holders. A friendly banker can get them cash, but the question becomes whether the banker's presence would spoil the section 355 party.

The banker would acquire the distributing corporation's debt from the holders for cash. Then the banker would swap the newly acquired debt for debt of the controlled corporation, like any other participant in the spinoff. It is the fourth step that causes the potential problem, when the banker immediately dumps the controlled corporation debt onto the market. Or when the banker swaps distributing corporation debt for controlled corporation shares and then dumps them.

When the bank acquires the distributing corporation debt, it is supposed to have no prior agreement with the distributing corporation to swap that debt for controlled corporation debt or shares. Under LTR 200644010, a 14-day holding period is widely thought to be an acceptable aging period. The 14-day period was in the proposed facts of the first person to ask, Alexander deadpanned. The banker needs to be a real creditor, he explained. But if the seeker of a ruling were to propose a different holding period, "it'd take us longer than 10 weeks to think about something new," he said, alluding to the 10-week processing period for ruling requests.

Well, gee, while the banker is sitting around holding distributing corporation debt, having no prior agreement with the distributing corporation to exchange it for anything, can the banker hedge its exposure? Alexander mused that the distributing corporation should not be the counterparty in such a hedge. Practitioners believe that hedging with third-party counterparties is perfectly acceptable, citing Esmark, Inc. v. Commissioner, 886 F.2d 1318 (7th Cir. 1989), for the proposition that third-party participation helps sustain a planned exchange.

Could the banker premarket the controlled corporation shares that it has no prior agreement with the distributing corporation to exchange for the debt it is holding? Yes, readers, this was a real question. "It's a free country. People are allowed to talk," Alexander said.

Of course, if distributing corporation debt is exchanged for controlled corporation debt, then the fiction propounded by the intercompany debt rules of reg. section 1.1502-13(g)(3) comes into play. That rule states that debt is treated as satisfied for FMV and reissued when it ceases to be intercompany debt. This exchange could be taxable. This problem arises whenever intercompany debt loses its status as intercompany debt.

Jodi Schwartz of Wachtell, Lipton, Rosen & Katz, who chaired the session, argued that the intercompany debt rule should not apply to those cases because the holding of an affiliate's debt is only a temporary step in the debt exchange that is part of the larger spinoff. She would prefer that section 361 govern the debt exchange, making it tax-free.

Alexander demurred. Another perennial on the business plan is a rewrite of the section 1502 intercompany debt regulations, with their model of satisfaction and deemed reissuance. Alexander noted that this model might incorporate "too much fiction." "We will propose new and wonderful intercompany debt regulations on a different model," he said. Ignoring intercompany debt altogether is not in the cards. Nonetheless, he explained that section 361 may not cover the debt exchange in the above-described situations because the issuer may acquire its own debt.

What about refinancing, such as in routine rollovers of commercial paper? Alexander responded that the statutory line of section 361 is "not economic." So the question is what true debt of the distributing corporation is being paid off using shares or debt of the controlled corporation. The distributing corporation cannot use shares or debt of the controlled corporation to raise new money and still enjoy the protection of section 361. Section 361 demands "old and cold" creditors, in the government's view.

The government's thinking about who is an old and cold creditor, he said, has evolved through letter rulings. "It can be circular," Alexander admitted. "We should be policing and tracing. It's very difficult to police. We're not equipped to do it through rulings. We're trying to develop a formula in the ruling process." Asked whether the government cares about related-party debt, he responded, "It can be debt. But we don't want too much of it."

Sponsored Spinoffs

New York City is a place for dog-whistle fashion and also dog- whistle tax planning. A "sponsored spin" is when a new owner, called a sponsor, obtains a chunk of the equity of the controlled corporation before a spinoff.

That chunk is less than 50 percent, because of section 355(d) and (e). The sponsor usually buys debt or equity of the distributing corporation for cash before the distribution. Of course, the sponsor wants to hedge its exposure to the distributing corporation securities before the exchange. Practitioners argue that under Esmark, no particular holding period should be required to make the sponsor a real investor.

The sponsor also wants to have the controlled corporation take on some debt, which can be messy. Very few sponsored spins occur, practitioners note, because lenders do not want to lend to a corporation that is 51 percent controlled by someone else. An alternative version would have the sponsor and the existing public shareholders put a new holding company on top of the distributing corporation. The controlled corporation would be spun off to the holding company, which would do the borrowing. The distributing corporation would be split off to the existing shareholders.

Alexander pointed out that the statute says that the distributing corporation is supposed to have section 368(c) control of the controlled corporation, not to contract control away to a sponsor. "Come up with something that's commercially normal," he said. "Don't be too cute."

Section 355(e) regulations were proposed in 2004. Those rules may go final, Countryman said, but the drafters still need answers to difficult section 351 and partnership questions. The preamble points out that a controlled corporation could put its assets in a subsidiary or partnership with the putative acquirer and then just sit there in a virtual merger. The government might want to impose a tax on the distributing corporation when the controlled corporation is the lesser partner in the deal.

Alexander noted that sooner or later the government will have to answer the questions about redemptions and buybacks under section 355(e). Those are counting issues about whether the sponsor is at or above 50 percent — that is, what is an "acquisition" under the statute? If the sponsor comes in at 49 percent of the controlled corporation and then it redeems enough other holders to push the sponsor above 50 percent, section 355(e) could be easily avoided.

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