Underlying the corporate reorganization provisions of the Code is the principle that it would be inappropriate to tax a transaction as a result of which the participating taxpayers – the corporations and their shareholders – have not sufficiently changed the nature of their investment in the corporation’s assets or business, provided the transaction is motivated by a substantial non-tax business purpose.
One of these reorganization provisions allows a corporation (Distributing) to distribute to some or all of its shareholders the shares of stock of a subsidiary corporation (Sub) on a tax-free basis. In general, such a distribution (a “Corporate Division”) may be made pro rata among Distributing’s shareholders (a “spin-off”), it may be made in exchange for all of the Distributing stock held by certain of its shareholders (a “split-off”), or it may be made in complete liquidation of Distributing (a “split-up”), where the stock of at least two subsidiary corporations is distributed.
There are many bona fide business reasons for a Corporate Division. The distribution of Sub may, for example: enable competing groups of shareholders to go their separate ways; shelter one line of business from liabilities that may arise from the operation of another line; permit the issuance of equity to a key employee in one line of business; facilitate borrowing; or resolve problems with customers or suppliers who compete with a line of business.
In order to secure favorable tax treatment for a Corporate Division, the transaction must satisfy a number of requirements, among which is the requirement that Distributing must distribute stock of a corporation that it controls immediately before the distribution.
For this purpose, “control” is defined as ownership of stock possessing at least 80 percent of the total combined voting power of all classes of Sub stock entitled to vote and at least 80 percent of the total number of shares of each other class of Sub stock.
Given this “control” requirement, what is Distributing to do where it has determined that there are bona fide business reasons for separating from Sub, and that such a separation would satisfy the other requirements for tax-free treatment (including the requirement that both Distributing and Sub be engaged in an “active trade or business”), but where Distributing owns less than 80% of the voting power and/or number of Sub’s issued and outstanding shares?
The IRS has allowed certain recapitalizations of Sub that result in Distributing’s securing the necessary level of control. Some of these recapitalizations, which may themselves be effectuated on a tax-free basis, are illustrated by the following examples:
- Corp M owned all of the voting common stock and 12% of the non-voting preferred stock of Corp N. Disputes arose among the M shareholders, and it was decided that M would distribute its N stock to one group of M shareholders in exchange for all their M stock. To qualify N as a “controlled” corporation, N issued shares of voting common stock to its preferred shareholders, other than M, in exchange for all their non-voting preferred shares in a recapitalization. After the recapitalization, M owned 93 percent of the outstanding N voting common stock and all of the outstanding N nonvoting preferred stock. M then distributed all of its common and preferred N stock to the departing shareholders in exchange for all their M stock.
- A owned all the stock of Corp X, which owned 70 shares of the stock of corporation Y. A also owned the remaining 30 shares of Y stock. A contributed 10 shares of his Y stock to X, and, immediately thereafter, X distributed all of its 80 shares of Y stock to A. The IRS determined that X, the distributing corporation, did not have control of Y immediately before the distribution except in a transitory and illusory sense.
- Corp X owned 70%, and A and B owned the remaining 30%, of the single outstanding class of stock of Corp Y. In exchange for the surrender of all the Y stock, Y issued Class A voting stock to A and B and Class B voting stock to X. The Class A stock issued to A and B represented 20% (a “low-vote” class), and the Class B stock issued to X represented 80% (a “hi-vote” class) of the total combined voting power of all classes of Y voting stock. Following the recapitalization, X distributed all of the Class B stock to its shareholders. The IRS determined that, immediately prior to the distribution, X had control of Y. The transaction was distinguished from the immediately preceding example because the recapitalization resulted in a permanent realignment of voting control of Corp Y.
Over the last several years, the IRS has recognized situations where the recapitalization that secured the necessary level of control had to be undone due to unforeseen but valid business circumstances. Consequently, it has relaxed its historical requirement that the recapitalization result in a “permanent realignment” of Sub’s capital structure in order for Distributing’s “control” to be respected.
Indeed, the IRS has stated that it will not automatically apply the step transaction doctrine to determine whether Sub was a controlled corporation immediately before a distribution solely because of any post-distribution acquisition or restructuring of Sub.
However, in otherwise applying the step transaction doctrine, the IRS has also stated that it will continue to consider all the facts and circumstances, including whether there was a “legally binding obligation” to undo the recapitalization after the distribution, and thereby render the recapitalization a sham.
In other words, even though the control requirement may be satisfied by an acquisition of control that occurs immediately before a distribution, an acquisition of control by Distributing will not be respected if it is transitory or illusory, as where the unwinding of the recapitalization was a foregone conclusion. The acquisition of control must have substance under general federal tax principles. Thus, the IRS may apply the step transaction doctrine to determine if, taking into account all facts and circumstances (including post-distribution events), a pre-distribution acquisition of control has substance such that Distributing has control of Sub immediately prior to a distribution of the Sub stock.
Revenue Procedure 2016-40
In recognition of the fact that determining whether an acquisition of control has substance for federal tax purposes can be difficult and fact-intensive, and that taxpayers may not be able to determine with sufficient certainty whether such an acquisition may proceed as a step toward an otherwise qualifying transaction, the IRS recently issued guidance that identifies certain “safe harbor” transactions in which the IRS will not assert that an acquisition of control lacks substance. [Rev. Proc. 2016-40]
These safe harbors apply to transactions in which–
(1) Distributing owns Sub stock not constituting control of Sub;
(2) Sub issues shares of one or more classes of stock to Distributing and/or to other shareholders of Sub, as a result of which Distributing owns Sub stock possessing at least 80% of the total combined voting power of all classes of Sub stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of Sub;
(3) Distributing distributes its Sub stock in a transaction that otherwise qualifies as a tax-free Corporate Division; and
(4) Sub subsequently engages in a transaction that substantially restores (a) Sub’s shareholders to the relative interests they would have held in Sub had the issuance not occurred; and /or (b) the relative voting rights and value of the Sub classes of stock that were present prior to the issuance.
The IRS will not assert that such a transaction lacks substance, and that therefore Distributing lacked control of Sub immediately before the distribution, if the transaction is also described in one of the following safe harbors:
- No action is taken (including the adoption of any plan), at any time prior to 24 months after the distribution, by Sub’s board of directors, Sub’s management, or any of Sub’s controlling shareholders, that would (if implemented) result in an unwind of the recapitalization.
- Sub engages in a transaction with one or more persons (for example, a merger) that results in an unwind, regardless of whether the transaction takes place more or less than 24 months after the distribution, provided that–
(1) There is no agreement, understanding, arrangement, or substantial negotiations or discussions concerning the transaction or a similar transaction, relating to similar acquisitions, at any time during the 24-month period ending on the date of the distribution; and
(2) No more than 20% of the interest in the other party, in vote or value, is owned by the same persons that own more than 20% of the stock of Sub.
These safe harbors apply solely to determine whether Distributing’s acquisition of control of Sub has sufficient substance for purposes of effecting a tax-free Corporate Division. The certainty they provide is a welcome development.
However, if a transaction is not described in one of the safe harbors, the determination of whether an acquisition of control has substance, and will therefore be respected for purposes of a Corporate Division, will continue to be made under general federal tax principles without regard to the safe harbors. In that case, Distributing and its shareholders should proceed with caution – they should consult their tax advisers – especially given the adverse tax consequences that may be visited upon them if Distributing’s control of Sub is determined to have been illusory.