The Honorable Charles O. Rossotti
Commissioner, Internal Revenue
1111 Constitution Avenue, N.W., Room 3000
Washington, DC 20224

Re: COMMENTS ON GUIDANCE NEEDED UNDER 1997 AMENDMENTS TO SECTION 355 AND 358

Dear Commissioner Rossotti:

I am enclosing comments on the above noted Admendments as prepared by members of the Committee on Corporate Tax. Principal responsibility was exercised by Jasper L. Cummings, Jr., Womble Carlyle Sandridge & Rose, PLLC, Raleigh, NC. Substantive contributions were provided by Julie A. Divola, Pillsbury Madison & Sutro, San Francisco, CA; Andrew J. Dubroff, Ernst & Young, Washington, DC: Eric M. Elfman, Ropes & Gray, Boston, MA; Terrill Hyde, Wilmer, Cutler & Pickering, Washington, DC; Carl Jenks, Cleveland, OH; Joseph Pari, Dewey Ballantine, Washington, DC; Mark J. Silverman, Steptoe & Johnson, Washington, DC; Dana L. Trier, Cleary Gottlieb, et al., New York, NY; Benjamin G. Wells, Houston, TX; Thomas F. Wessel, King & Spalding, Washington, DC. These comments were reviewed by members of our Committee on Government Submissions.

These comments represent the individual views of those members who prepared them and do not represent the position of the American Bar Association or the Section of Taxation.

Sincerely,

Phillip L. Mann
Chair, Section of Taxation
American Bar Association
Washington, DC

Enclosure

cc: The Honorable Donald C. Lubick, Assistant Secretary Tax Policy, Department of Treasury
The Honorable Stuart L. Brown, Chief Counsel, Internal Revenue

The following comments are the individual views of the members of the Section of Taxation who prepared them and do not represent the position of the American Bar Association or the Section of Taxation.

These comments were prepared by individual members of the Committee on Corporate Tax of the Section of Taxation. Principal responsibility was exercised by Jasper L. Cummings, Jr. Substantive contributions were made by Julie A. Divola, Andrew J. Dubroff, Eric M. Elfman, Terrill Hyde, Carl Jenks, Joseph Pari, Mark J. Silverman, Dana L. Trier, Benjamin G. Wells and Thomas F. Wessel. The Comments were reviewed by Robert H. Wellen of the Section's Committee on Government Submissions and by Stuart J. Offer, Council Director for the Committee on Corporate Tax.

Although the members of the Section of Taxation who participated in preparing these Comments may have clients who would be affected by the federal tax principles addressed by these Comments or have advised clients on the application of such principles, no such member (or the firm or organization to which such member belongs) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments.

Contact Person: Jasper L. Cummings, Jr.
(919) 755-2108

Date: April 24, 1998

ABA COMMENTS CONCERNING GUIDANCE UNDER 1997
AMENDMENTS TO SECTIONS 355 AND 358

EXECUTIVE SUMMARY:

The recommendations in these comments include the following:

That safe harbors be established for acquisitions of Controlled or Distributing after a spinoff, where the acquisition has not been negotiated or agreed to at the time of the spinoff.

That safe harbors be provided for acquisitions of stock caused by public trading and issuance and exercises of employee stock options.

That the required notification for commencement of the statutory period for assessment of tax under section 355(e) be established.

That guidance provide that a change of control with respect to one corporation not trigger the application of section 355(e) with respect to another Controlled corporation.

That guidance provide that the attribution rules should apply to determine indirect changes of stock ownership at the highest level.

That certain safe harbors be provided with respect to predecessors of Controlled or Distributing.

That any regulations under sections 355(f) and 358(g) to adjust the basis of affiliated group member stock be prospective only.

That guidance be issued under section 336(e) in connection with section 355(e) transactions.

BACKGROUND: These comments discuss the most important areas of needed guidance under section 1012 of the Taxpayer Relief Act of 1997, which added new Code section 355(e) and (f) and amended Code section 358.

NOMENCLATURE: The transactions governed by section 355 involve at least two corporations, herein "Distributing" and "Controlled"; typically, Distributing controls Controlled and distributes or "spins off" stock of Controlled to some or all of Distributing's shareholders. Distributing can be controlled by yet another corporation, referred to herein as "Parent," which itself may be Distributing (when there is a "double spin," meaning distributions of stock of Controlled both by the first tier subsidiary and by Parent; or a "breakup spin," i.e., a distribution by a first-tier subsidiary of Controlled to Parent, followed by a distribution by Parent to its shareholders of the stock of the first-tier subsidiary; in such cases the first tier subsidiary has made an "internal spin," which may occur without a second spin by Parent).

1. Section 355(e) -- "plan (or series of related transactions)." We understand that the government may be hesitant to define the phrase "plan (or series of related transactions)." Generic definitions of those terms may not be helpful to practitioners in most cases. But we do recommend that the government issue guidance excluding certain situations from the rule of section 355(e), in the form of a Revenue Procedure or preferably a Notice or Revenue Ruling. Specifically, section 355(e) should not apply to cases similar to cases that the government heretofore has not treated as related in the section 355 area, such as in Rev. Rul. 96-30 (but see discussion of this ruling referenced in item 8, below) and as in Reg. section 1.355-2(d)(2)(iii)(D).

There are several justifications for the government to identify safe harbors. First, absent safe harbors, use of section 355 (particularly by public companies) could be unreasonably chilled, for fear that a subsequent tender for Distributing or Controlled within two years would trigger section 355(e). Alternately, the ability of corporations to acquire either Distributing or Controlled after a spinoff could be unreasonably chilled for fear that the target (either Distributing or Controlled from a prior spinoff) possesses a "poison pill" resulting from these statutory changes; that is, Distributing can incur tax if it undergoes a change of ownership after a distribution, and Controlled likely will be obligated to indemnify Distributing if Controlled's change of ownership results in tax under section 355(e) or (f). Finally, Distributing and Controlled could be unreasonably chilled in efforts to issue new stock (either in acquisitions or in other offerings).

Furthermore, safe harbors should serve the positive administrative purpose of eliciting all of the pertinent factors upon advance ruling requests.

We do not represent here that the following suggested safe harbors are exclusive; any guidance embodying such safe harbors should do so nonexclusively.

We currently recommend safe harbors only in cases of a distribution followed by a change in control because we view the reverse situation as involving the more problematic issue of a one party "plan," as discussed in Case 1 below. Even as to cases where the distribution is followed by the change in control, we recommend safe harbors only where the change in control occurs only by the actions of significant parties unrelated to Distributing and Controlled, as illustrated in Case 2(c), below. We believe that traditional step transaction doctrine analysis should be applied in all cases to determine the existence of a "plan (or series of related transactions)."

Consequently, we recommend that substantive guidance in the form of a Notice or Revenue Ruling provide that:

In the case of a section 355(a) distribution followed by an acquisition of stock potentially described in section 355(e), a "plan (or series of related transactions)" as described in section 355(e)(2)(A)(ii) does not include any or all of the following circumstances in existence at the time of the distribution, where a qualifying business purpose for the distribution, unrelated to the acquisition, exists:

an intention that a future acquisition of stock occur, which is held by unrelated persons who might acquire such ownership, without regard to whether such intention is communicated to Distributing, Controlled or related parties, so long as there has not occurred, at any time prior to the distribution, any joint negotiations toward that end (including discussions by both parties relating to an acquisition of stock that was reasonably to be anticipated), or arrangements or agreements that it occur; internal consideration by a target corporation of an unsolicited tender offer or reorganization proposal, to the extent required by the fiduciary duties imposed by state corporate law, shall not be considered to be such joint negotiations;

an understanding on the part of Distributing, Controlled or related parties that by reason of market or industry conditions, unrelated persons might cause an acquisition of stock of Distributing or Controlled after the distribution, absent any negotiations, arrangements or agreements by Distributing, Controlled or related parties toward such acquisition before the distribution; and

internal analysis of possible acquisitions by Distributing or Controlled, or both, that could result in issuance of Distributing stock or Controlled stock, including identification of possible acquisition targets, absent any negotiations, agreements or arrangements at the time of the distribution; incidental or low-level contacts between Distributing or Controlled and potential acquirors or targets will not prevent the safe harbor from applying.

DISCUSSION. We believe that "plan (or series of related transactions)" imports no more than the traditional step transaction doctrine. Such doctrine covers the plan of a single party only when that party has the power to control both steps or to make the second step occur if the first step (which it intends) occurs. The safe harbors recommended above are outside the scope of the traditional step transaction doctrine.

The basic types of transactions. "Plan" as used in section 355(e) can refer to the intent of one party when that one party can cause both the spinoff and the change of ownership. But "plan," without more, should not encompass the intent of one party that does not alone have the power to effect the series of related transactions, the classic case being the spinoff of Controlled by Distributing whose board has reason to believe that a tender may be made for Distributing or Controlled, after the distribution. We believe "plan" does not cover this and similar one-party-intent cases, absent other facts that would satisfy traditional step transaction doctrine analysis, which doctrine is also described by the term "series of related transactions."

Section 355(e) applies both to:

Case (1): a change of ownership of Distributing followed by a distribution, and also to

Case (2): a distribution followed by a change of ownership of either Distributing or Controlled.

We believe as to Case (1) that the terms "plan" and "series of related transactions" can and should be read to have the same meaning, referring to the traditional step transaction doctrine.

Case (1)(a) involves a stock issuance to one person or persons acting in concert in respect of the acquisition of st ock that results in a change of control of Distributing; the plan and intent of Distributing alone (or possibly of the new shareholder(s) above) can control all steps in the related transactions, i.e. Distributing can plan to issue stock and to make the distribution. (But this Case is generally irrelevant, because it will often be subject to section 355(d) and not section 355(e)).

Case (1)(b) involves acquisition of Distributing stock from current shareholders by an unrelated party; the plan and intent of the unrelated party alone normally can control all steps in the related transactions or can control a second step distribution contingent on the success of its intent to acquire control. The cooperation of Distributing in the subsequent distribution is irrelevant to the acquiror's plan, assuming a sufficiently high level of corporate control. Section 355(e) could apply, if section 355(d) does not apply.

We do not here recommend safe harbors as to Case 1 because of the fact-specific nature of the application of the step transaction doctrine.

In Case (2), where the change of control follows the distribution, neither "plan" nor "series of related transactions" should be read to mean the plan of one party unless that party can control all steps in the related transactions or can control the second step if the intended first step occurs. Important guidance is supplied by the fact that in the closely related section 355(d)(7)(B) the term "plan or arrangement" seems clearly to refer to a commonly held plan or arrangement. See also, T.D. 8642, 1996-1 CB 126-127 (the term "plan or arrangement" in proposed regulations under section 704(c)(1)(B) was designed to incorporate step transaction principles).

Case (2)(a) involves a change of ownership by a stock issuance (as in a public offering) of Distributing following the distribution; the plan and intent of Distributing can control all steps, which should be tested under traditional step transaction doctrine analysis.

Case (2)(b) involves a change of ownership by a stock issuance (as in a public offering) of Controlled following the distribution; literally Distributing may not control all related steps, but interrelationship may be proved; in this case we believe that traditional step transaction doctrine analysis can be applied to relate the transactions.

Case (2)(c) involves a change of ownership resulting from an acquisition, of either Distributing or Controlled by an unrelated party; the plan of any one party cannot control all steps, although a common plan can be proved under traditional transaction doctrine analysis.

LEGISLATIVE HISTORY. Nothing inconsistent with the foregoing analysis appears in the legislative history. The President's 1998 Fiscal Year Budget Proposal contained a provision similar to that ultimately enacted. It specifically was not to apply to "unrelated" transactions, "not pursuant to a common plan or arrangement," including public trading and hostile acquisitions. Description of Revenue Provisions Contained in the President's Fiscal Year 1998 Budget Proposal, Prepared by the Staff of the Joint Committee on Taxation, p. 74 (Feb. 10, 1997).

The Senate and House Reports describe their respective bills' references to a plan (or series of related transactions) as a "plan or arrangement in existence on the date of distribution." They also state the Committees' intent to prescribe a rule for "cases in which it is intended that new shareholders will acquire ownership in a business in connection with a spinoff . . . ." The Conference Report repeats only the first quoted phrase in its summary of the bills (but the Blue Book uses the intent language at p. 198). These two statements might be read to imply that, unlike the President's proposal, the bills could have been aimed at a division/change of ownership combination that was "intended" and "planned" by a potential acquiror of Distributing or Controlled or some other unrelated party. We do not find that implication to be necessary or appropriate, both on its face and in light of the foregoing analysis.

TRADITIONAL STEP TRANSACTION DOCTRINE ANALYSIS/SIMILAR CODE AND REGULATION PROVISIONS. The Code and Treasury Regulations commonly refer to "transaction and series of related transactions," but prior to this amendment apparently have not referred to "part of a plan (or series of related transactions) . . . ." Thus far, the Regulations apparently have not undertaken to define "series of related transactions," evidently relying on traditional step transaction analysis.

We believe that in Case 2(c) the presence of either a plan or a series of related transactions should at most invoke the "end result" version of the step transaction analysis, as well as other versions. The Regulations currently describe a type of the "end result" step transaction analysis in Reg. section 1.355- 2(d)(2)(iii)(D) in connection with the "device" test under section 355, and explain what constitutes a sale of stock that is "negotiated or agreed upon before the distribution," i.e., that "was discussed by the buyer and the seller before the distribution and was reasonably to be anticipated by both parties." This also could be described as a commonly conceived, agreed and held "plan." Similarly, Rev. Rul. 96- 30, 1996-2 CB 37, implies that only where there have been "negotiations or agreements" for a transaction between the corporate parties will a transaction subsequent to a spinoff be integrated with the spinoff, despite the fact that the possibility of the subsequent transaction was "recognized by the management of D and C at such time [the time of the distribution of C]." We have recommended that Rev. Rul. 96-30 be obsoleted on other grounds, as referenced below.

These approaches are not inconsistent with authorities under section 302(b)(2)(D), which states that the "substantially disproportionate" redemption rule will not apply:

to any redemption made pursuant to a plan the purpose or effect of which is a series of redemptions resulting in a distribution which (in the aggregate) is not substantially disproportionate with respect to the shareholder.

We understand that a spinoff could be effected with the suspicion, understanding, or even knowledge (based on an unsolicited offer) on the part of Distributing that the spinoff might or could trigger an attempted or actual change of ownership. However, presumably every nontaxable spinoff is effected for valid business purposes as required for ruling purposes by Rev. Proc. 96-30. The presence of such valid business purposes should suffice to eliminate the presence of a "plan" where the anticipation of a change of ownership is not the result of any negotiation or agreement of Distributing or related parties, except where such business purpose for the spinoff is to facilitate a change of ownership of Distributing or Controlled (as by a substantial IPO or acquisition).

2. Section 355(e) -- Acquire 50 percent. While detailed guidance ultimately may be needed, we do not suggest at this time a detailed mechanism for measuring 50% ownerships changes, because the existence of such a change is not the sole or triggering requirement for application of the rule (except to the extent of the presumption), in contrast to the ownership change rule of section 382. Instead, we recommend that emphasis be placed on identifying the needed relatedness of the transactions so as to limit the occasions for measurement of ownership change.

We recommend that guidance state that the ownership change triggering section 355(e) excludes:

(1) trading among less than five percent shareholders (not
acting according to a common plan or arrangement of the
shareholders; see Reg. section 1.382-3(a)); and

(2) issuances and exercises of employee stock options and other
employee stock awards.

3. Section 355(e) -- Presumption of Plan/Statutory Period for Assessment.

We do not understand the statutory presumption of existence of a plan to place any duty on Distributing to report income under section 355(e), where Distributing believes it has sufficient grounds to rebut the presumption. Rather, we understand the enlargement of the statutory period for assessment to be the consequence of failing to report the transaction (whether or not the presumption period applies).

Section 355(e)(4)(E) of the Code provides that, "[i]f there is an acquisition to which [section 355(e)(1)] applies," the statutory period for the assessment of any deficiency attributable to any part of the resulting recognized gain shall not expire prior to the expiration of three years from the date the Secretary is notified by the taxpayer of the distribution subject to such gain recognition. The statute affords the Secretary the authority to provide, by regulation, the form of notice that will commence the running of such statutory period for the assessment of a deficiency.

One literal interpretation of section 355(e)(4)(E) would be that the statutory period for assessment of a deficiency arising from the application of section 355(e)(1) with respect to any distribution, even a distribution that a taxpayer reasonably does not believe is subject to such section, would never expire absent notice to the Secretary that section 355(e)(1), in fact, applied. This interpretation likely was not intended by Congress, which typically precludes taxpayer relief from assessment under a statute of limitations only for extreme conduct such as fraud or a willful attempt to evade tax. See section 6501(c)(1) and (2).

Section 355(e)(4)(E) presumably contemplates notice to the Secretary of any relationship between the distribution of the stock of Controlled and any prior or subsequent acquisition of Controlled or Distributing. That is, the statutory period for assessment should be extended where the Commissioner otherwise cannot reasonably be expected to have an opportunity to audit non- compliance. See section 6501(e)(1)(A)(ii) (excluding from amounts treated as omitted from gross income any amount disclosed in the return in a manner adequate to apprise the Secretary of the nature and amount of such item). Accordingly, we recommend that notice apprising the Secretary of (1) the nontaxable distribution as presently required by Reg. section 1.355-5(a), and (2) of the occurrence of any prior or subsequent acquisition known to have occurred during the presumption period (including a statement that such transactions are entirely unrelated), should be sufficient notice to the Secretary to commence the running of the statutory period for assessment with respect to the distribution and such identified prior or subsequent acquisition. Having been provided such information, the Secretary can fairly be expected to evaluate whether further inquiry should be made concerning the application of section 355(e)(1).

Under our recommended approach to the administration of section 355(e)(4)(E), notice with respect to a specified acquisition and distribution would not commence the statutory period of assessment for the same distribution and any other acquisition. The commencement of the statutory period of assessment for the distribution and another acquisition would require a separate notification to the Secretary.

4. Section 355(e) -- More than 1 controlled corporations.

We recommend promulgation of the following rule:

Ordinarily, section 355(e)(2)(A)(ii) refers only to the Controlled corporation that is distributed by Distributing and acquired in the series of transactions (if Distributing is acquired, then all distributions of Controlled corporations would be subject to the recognition rule). Where more than one Controlled corporation is distributed in the series of transactions, and section 355(e) is applicable due to the change of ownership of one of those corporations, then section 355(e)(1) shall apply only to the stock of the Controlled corporation whose ownership changed.

The regulatory authority in section 355(e)(5)(A) should be exercised to make clear that section 355(e)(1) generally refers only to the Controlled corporation whose stock is distributed in the section 355 transaction. Of greatest concern is section 355(e)(2)(A)(ii), which literally provides that section 355(e)(1) applies when there is a change of ownership of "any Controlled corporation." Presumably this is intended to refer only to the Controlled corporation that is distributed by Distributing. Otherwise, for example, the sale of Controlled 2 by Distributing after spinning off Controlled 1 would trigger gain on Controlled 1 stock; in no event should this be the result.

Secondly, where there are distributions of multiple controlled corporations, the change of ownership of one should not cause section 355(e)(1) to apply to all.

Section 355(e) -- Aggregation and attribution. The aggregation and attribution rules often will be applied to prevent a change of ownership, and regulations should illustrate this fact.

AGGREGATION RULE. The aggregation rule will apply to prevent a change of ownership being caused by stock transfers between persons who would be aggregated. There may be some uncertainty whether section 355(e)(4)(C)(i) was intended to import section 355(d)(7)(A) for all purposes of section 355(e). We believe it should, both because the contrary view reflects a hypertechnical reading that seems to conflict with normal techniques of statutory drafting (that is, "for purposes of this subsection" does not change this subsection from (d) to (e) when the aggregation rule of subsection (d) is imported into subsection (e)), and because it makes sense not to view as an acquisition the receipt of stock previously owned under the aggregation rules.

ATTRIBUTION RULES. The operation of the statutory provisions in section 355(e) and the attribution rules remain conceptually confusing and should be addressed through either expansive regulations or a redrafting of the statute itself, to apply the exception for indirect retention of control at the highest level of ownership. The basic operative provision of the statute, section 355(e)(2)(A), requires both, under section 355(e)(2)(A)(i), a distribution to which section section 355 or 356 apply and, under section 355(e)(2)(A)(ii), an "acquisition directly or indirectly of stock representing a 50 percent or greater interest" of the distributing or controlled corporation stock. Section 355(e)(3)(A) in turn provides that certain acquisitions "shall not be treated as described in paragraph (2)(A)(ii)."

A significant source of conceptual confusion relates to the level of ownership to which the threshold acquisition test should apply and, in this connection, how the attribution rules interact with the "acquisition" concept. Another source of confusion is the operation of the exception contained in section 355(e)(3)(A)(iv) to treatment of a transaction as an acquisition -- again in terms of the level of ownership at which the exception should apply.

In general, the conceptual confusion caused by the statutory scheme appears to be derived from the fact that the statutory draftspersons have avoided adopting an explicit section 382 approach to the statute -- that is, an approach that determines whether the relevant acquisition has occurred during a fixed time period by looking, in general, at the highest level of ownership. We believe that ultimately the most straightforward approach to making the statute workable would be to adopt such an approach and to rely on the necessity of finding a "plan" in order to prevent the statute from being over inclusive.

Three interrelated issues are posed by the statutory scheme with respect to this broad set of questions.

APPLICATION OF ATTRIBUTION RULES. The first issue is how the attribution rules apply to determine whether there is a "direct" or "indirect" acquisition of a 50 percent or greater stock interest. Assume for example the following facts:

Distributing has conducted a trade or business for five years and, in addition, owns all the stock of Controlled, which has conducted a trade or business for five years. Assume further that the stock of Distributing is 80 percent owned by Parent and 20 percent owned by X corporation, and that individual A owns all the stock of Parent and individual B owns all the stock of X corporation. Assume that Distributing distributes all the stock of Controlled to X in a splitoff, and that pursuant to a pre-arranged plan individual E buys all the stock of Parent from A. The question is whether there has been an "indirect" acquisition of a greater than 50 percent interest of Distributing under the statute, subject to the application of an exception, if any.

Guidance should make clear that the attribution rules govern stock acquisition as well as "holding." The attribution rule contained in section 355(e)(4)(C) states that section 318(a)(2) "shall apply in determining whether a person holds stock or securities in any corporation." In other words, the statutory attribution rule itself does not state explicitly that it is applicable for purposes of giving content to "acquisition," direct or indirect. Compare section 355(d)(8)(B). We presume, however, that, in fact, the attribution rule is applied in connection with determining whether an "indirect acquisition has occurred. Assuming that the attribution rule of section 318(a)(2)(C) is so applied, there would be an "indirect" acquisition of 50 percent or more of Distributing stock by E in the example, and the statute would become operative unless an exception were applicable. However, because section 355(e) has no language directly analogous to section 355(d)(8)(B), this interpretation should be clarified by regulations.

Guidance should make clear that "indirectly" refers to the attribution rule itself. We also presume that the limits of "indirect" acquisition are determined by the technical scope of the attribution rule itself. Thus, as section 355(e)(3)(B) states that "[e]xcept as provided in regulations, section 318(a)(2)(C) shall be applied without regard to the phrase 50 percent or more in value . . .," the limits of the indirect acquisition concept would presumably be determined accordingly.

A corollary of this approach to the statutory scheme, which should be made clear in guidance, is that an "acquisition" would not be deemed to occur if, through operation of the attribution rules, the person in question held the stock before the transaction in question. Assume, for example, the following facts:

Parent, a publicly-held U.S. corporation, owns all the stock of Distributing corporation, a U.S. corporation, which in turn owns all the stock of FS corporation, a foreign corporation. Distributing first distributes all the stock of FS corporation to Parent and Parent then distributes all the FS corporation stock to the public shareholders of Parent, with both distributions qualifying under section 355 but for the application of section 355(e).

The issue is whether the second spin transaction is an acquisition by the public shareholders of Parent with respect to the first spin (i.e., the distribution of FS by Distributing to Parent). If the second spin transaction were an acquisition, the statute should apply but for the application of the exceptions. The second spin should not be viewed as such an "acquisition" because the Parent shareholders, through operation of the attribution rules, held the FS stock before the transaction.

WHETHER STATUTE APPLIED AT MORE THAN ONE LEVEL. The second question is whether the statutory provision is, prior to application of the exceptions contained in section 355(c)(3)(A), applied at potentially more than one level of ownership and triggered if there is the requisite 50 percent change at any such level, irrespective of whether the ultimate indirect ownership changes. The answer appears to be yes, which necessitates the further analysis herein. Section 355(e)(2)(A)(ii) applies if one or more persons acquire "directly or indirectly" (emphasis supplied) the requisite 50 percent stock interest. Thus, the statute appears literally to apply, prior to application of the exceptions in section 355(e)(3)(A), to a direct acquisition even though there was no increase in ownership viewed from the alternative point of view of ultimate indirect ownership.

Assume, for example, the following facts derived from the legislative history:

Individual A owns all the stock of Distributing, which owns all the stock of Controlled. All the stock of Controlled is distributed to A in a transaction that otherwise qualifies under section 355. As part of a plan, A then drops all the stock of Controlled down into H holding company in exchange for all the H stock.

The question is has H "directly" acquired the stock of Controlled in a transaction that triggers the statute, subject to the exceptions contained in section 355(e)(3). One analysis of this case would be that, as a threshold matter, no acquisition has occurred, irrespective of the application of the exceptions in section 355(e)(3)(A), because there was no increase in A's ownership of Controlled, and H's ownership increase is irrelevant because the acquisition analysis should only be applied at the ultimate level of ownership, i.e., the A level. The Conference Report in Example 2 appears to suggest to the contrary, however, that the statute does apply, subject to the 50 percent common control except of section 355(e)(3)(A)(iv), presumably because H has made a 50 percent direct acquisition even though A's ultimate ownership has not changed.

APPLICATION OF EXCEPTIONS. Assuming that a "direct" acquisition has occurred in the above case and that there is thus an "acquisition" within the meaning of section 355(e)(2)(A)(ii) unless an exception applies, the application of the exceptions contained in section 355(e)(3)(A) is highly important. In the case of the holding company example described above, the relevant exception from the perspective of the statutory drafters appears to be section 355(e)(3)(A)(iv). See Example 2 of the Conference Report.

Section 355(a)(3)(A)(iv), in its current form, provides that the following transaction will not be treated as described in section 355(e)(2)(A)(ii):

(iv) The acquisition of stock in a corporation if shareholders
owning stock directly possessing –

(I) more than 50 percent of the total combined voting power
of all classes of stock entitled to vote, and

(II) more than 50 percent of the total value of all classes
of stock, in the distributing corporation or any controlled
corporation before such acquisition own directly or
indirectly stock possessing such vote and value in such
distributing or controlled corporation after such
acquisition.

This exception has proved to be quite troublesome, and technical corrections to the exception have been proposed. See Section 8(b)(2)(B) of the Tax Technical Corrections Bill of 1997 (the "Technical Corrections Bill"); H.R. 2645 and Description of the Chairman's Mark of the Tax Technical Corrections Act of 1997 ("Description of the Chairman's Mark"), p. 31.

There are actually two problems with section 355(e)(3)(A)(iv) in its current form. The one that has been focused upon by commentators is that the exception has no requirement that each of the shareholders in question own any specific percentage of stock after the transaction. In other words, the exception appears to permit very large shifts in ownership among a given group of owners so long as the group of shareholders before the transaction continues to own, in aggregate, 50 percent or more of the relevant stock afterwards. The statutory language proposed in the Technical Corrections Bill would address this problem with the following language, which would focus on the extent to which the percentage of stock ownership of current direct or indirect owners does not decrease:

(iv) The acquisition of stock in the distributing corporation or any controlled corporation to the extent that the percentage of stock owned directly or indirectly in such corporation by each person owning stock in such corporation immediately before the acquisition does not decrease.

The second problem with the current section 355(e)(3)(iv) is that, like section 355(e)(2)(A)(ii), it appears to apply at any level of ownership. Thus, it appears possible to argue on the face of the statute that the statute is not operative if there is common control at any one level even through 50 percent or more of the ultimate ownership has passed. Consider again as an illustration the example described above.

Distributing owns all the stock of Controlled, and the five year trade or business requirement are satisfied as to both corporations. Assume that 80 percent of the stock of Distributing is owned by X corporation and 20 percent by Y corporation. Individual A owns all the stock of X and individual B owns all of the stock of Y corporation. Distributing spins off the stock of Controlled to Y in a non prorata splitoff. Immediately thereafter, in a planned transaction, individual E buys all the stock of A in X.

If the analysis of indirect acquisition described above is accepted, there has been, prior to application of section 355(e)(3)(A), an "indirect" acquisition by E in this example. But literally read the exception currently contained in section 355(e)(3)(A)(iv) would appear potentially to apply because the same shareholder, X, owns directly 80 percent of the stock in Distributing before and after the transaction. (The splitoff distribution to Y should not implicate the statute because of the exception contained in section 355(e)(3)(ii) (acquisition of stock in controlled corporation by reason of holding stock in distributing corporation)).

The language contained in the Technical Corrections Bill seems to correct this problem but seems to contain the opposite problem -- i.e., it appears to be under inclusive (as an exception) because it appears to require that there be no decrease in ownership at any level of ownership. In other words, the exceptions would not apply if there has been too large of a decrease in the percentage of stock owned directly or indirectly in such corporation by a person or persons owning stock immediately before the acquisition.

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