COMMENTS ON REV. RULS. 96-30,
75-406 AND 70-225

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 Mark J. Silverman, Thomas F. Wessel, Eric M. Elfman, and Benjamin G. Wells. 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: February 9, 1998

COMMENTS ON REV. RULS. 96-30, 75-406 AND 70-225

EXECUTIVE SUMMARY OF RECOMMENDATIONS

We recommend:

That Rev. Ruls. 75-406 and 96-30 be declared obsolete.

That guidance be issued making clear that the requirement of section 355(a)(1)(D) that the distributing corporation (herein "D") distribute 80% control of the controlled corporation (herein "C") will not be violated by any post-distribution change of ownership of C, whether or not such change was negotiated or agreed to before the distribution, and whether or not section 355(e) applies.

That the Service change Rev. Rul. 70-225 to remove the implication that the two-step transaction there involved is to be reordered, and to state that where the shareholders of D do not have more than 50% control of C "immediately after" the Type D reorganization then (1) the transaction creating C fails to qualify under section 368(a)(1)(D) or section 351(c)(2); (2) D recognizes gain or loss (subject to section 267) on its transfer of property to C; (3) section 355(e) applies to the distribution of C stock; but (4) the D shareholders receiving C stock are entitled to nonrecognition treatment under section 355.

BACKGROUND.

REV. PROC. 96-39.

Rev. Proc. 97-53 modified the annual no-ruling revenue procedure, Rev. Proc. 97-3, to delete an item that had been added by Rev. Proc. 96-39. That revenue procedure had provided in part as follows:

BACKGROUND:

. . . . Section 355(a) of the Internal Revenue Code applies to distributions to a shareholder with respect to stock, or to a security holder in exchange for securities, of stock or securities of a controlled corporation by the distributing corporation immediately before the distribution. In cases in which there have been negotiations, agreements or arrangements with respect to transactions or events which, if consummated before the distribution, would result in the distribution of stock or securities of a corporation which is not controlled by the distributing corporation, the Service intends to study further the proper evaluation of the facts and circumstances to determine whether the requirements of section 355 are satisfied.

PROCEDURE:

Rev. Proc. 96-3 is amplified by adding to Section 5 the
following:

Section 355. -- Distribution of Stock or Securities of a controlled Corporation. -- Whether a distribution of stock or securities is described in section 355(a)(1) if there have been negotiations, agreements or arrangements with respect to transactions or events which, if treated as consummated before the distribution, would result in the distribution of stock or securities of a corporation which is not controlled by the distributing corporation (or, if stock is retained by the distributing corporation, in a distribution of an amount of stock not constituting control).

IRS POSITIONS

REV. RUL. 75-406.

Rev. Proc. 96-39 followed closely in time, and presumably was prompted by, Rev. Rul. 96-30, which modified Rev. Rul. 75-406. Rev. Rul. 75-406 had held that a spinoff by D of C for a business purpose, followed by a "real and meaningful" vote by public shareholders in favor of an all stock merger of C with an acquiring corporation undertaken for a different business purpose, would not affect the application of section 355 to the distribution of C by D.

The focus of Rev. Rul. 75-406 differed from the focus of Rev. Rul. 96-30. Rev. Rul. 75-406 did not discuss the requirement that D distribute "control" of C, the issue in Rev. Rul. 96-30. Rather, it specifically dealt with whether the subsequent merger violated either the "device" rule or the continuity of shareholder interest rule applicable to a spinoff under section 355. It found no such violation of either rule for the same reason: the continuing interest of the D shareholders in the business of C through their interest in the acquiring corporation. The Ruling went on to state that the shareholders' ownership of the C stock was real and meaningful ownership due to the public shareholder vote, while also noting the separate business purpose for the spinoff. Apparently these facts went to the requirement of section 355 that the shareholders "receive" the distribution of C stock; otherwise, these facts were irrelevant

REV. RUL. 96-30.

Rev. Rul. 96-30 modified Rev. Rul. 75-406 without discussion. Rev. Rul. 96-30 undertook to analyze the type of transaction at issue in Rev. Rul. 75-406, but specifically in light of the section 355 requirement that D distribute "control." Rev. Rul. 96-30 modified the facts of Rev. Rul. 75-406 by stating that there "had been no negotiations [apparently between the acquiror and either D, C or the shareholders] or agreements relating to the transaction involving C and [Acquiring], although an acquisition of C was a possibility recognized by the management of D and C at such time." Thus, the inference of Rev. Rul. 96-30 is that the "real and meaningful" shareholder vote and separate business purpose might not be enough to save the transaction described in Rev. Rul. 75-406 from violating the section 355 requirement that control be distributed.

Rev. Rul. 96-30 relied for this view on the application of substance-over-form analysis in Commr. v. Court Holding Company, 324 U.S. 331 (1945) and United States v. Cumberland Public Service Co., 338 U.S. 451 (1950). Those cases involved liquidating distributions and subsequent shareholder sales of the property received, by shareholders of closely held corporations. In Court Holding Co. the corporation was treated as having made a taxable sale rather than a nontaxable liquidating distribution, where an oral agreement to sell the property was called off so that the sale could be made by its shareholder after the distributions. But the opposite result was allowed in Cumberland where the corporation refused to make the sale because it wanted to avoid the corporate tax.

The practical difficulty of distinguishing between these two fact patterns was a principal reason for the adoption of prior section 337, which allowed the liquidating corporation to make tax exempt sales of assets prior to liquidation under certain circumstances. See Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders paragraph 10.05[5][a] (Warren, Gorham & Lamont 1994). We believe that in enacting section 355(e) Congress indicated its intent that this difficult distinction should not be controlling in connection with spinoffs.

DISCUSSION.

TRA 1997.

In the 1997 Act, Congress looked at a variety of possible events following a section 355 distribution and decided that if a 50% test provided in section 355(e) is satisfied, there should be neither corporate nor shareholder tax (assuming other section 355 requirements are met). If the 50% test is failed, the only consequence is to be a corporate level tax, either imposed by section 355(e) or resulting from the failure to satisfy section 368(a)(1)(D), as long as the "device" and continuity of interest tests are satisfied. That is, it is clear from the provisions enacted and the accompanying legislative history that the TRA 1997 changes to section 355 reflected a fundamental choice by Congress to impose only a corporate level tax on the transfer by D (be it of assets to C or of C stock to D shareholders) when the D shareholders do not maintain more than 50% control of C in a qualifying section 355(a) distribution, as a result of a post-distribution transaction, no matter how pre-determined that post-distribution transaction may be.

LEGISLATIVE HISTORY.

Both the House and the Senate Reports to TRA 1997 note the existence of Rev. Rul. 96-30 and Rev. Proc. 96-39 in their discussions of "Present Law." H.Rep. No. 148, 105th Cong., 1st Sess. 213 n. 92 (1997); S. Rep. No. 33, 105th Cong., 1st Sess. 139 n. 87 (1997); House Conf. Rep. No. 220, 105th Cong., 1st Sess. 224 n. 11 (1997). See also Joint Committee on Taxation's General Explanation of Tax Legislation Enacted in 1997, pp. 197-205. All three Committee reports address the effect of the legislation on this matter by these words:

The [House] bill does not change the present-law requirement under section 355 that the distributing corporation must distribute 80 percent of the voting power and 80 percent of each other class of stock of the controlled corporation. It is expected that this requirement will be applied by the Internal Revenue Service taking account of the provisions of the proposal regarding plans that permit certain types of planned restructuring of the distributing corporation following the distribution, and to treat similar restructurings of the controlled corporation in a similar manner. Thus, the 80-percent control requirement is expected to be administered in a manner that would prevent the tax-free spin-off of a less-than-80-percent controlled subsidiary, but would not generally impose additional restrictions on post-distribution restructuring of the controlled corporation if such restrictions would not apply to the distributing corporation.

IMPACT ON REV. RUL. 96-30.

We believe that Congress intended that the "additional restriction" implied by Rev. Rul. 96-30 (the potential reordering of the steps) be removed. Rev. Rul. 96-30 implies an additional restriction on some post-distribution restructuring of C that would result in the ownership of C by the distributees FALLING BELOW 80%. No such restrictions would apply to D, which is subject only to section 355(e), requiring that there not be a related 50% change of ownership of D.

The statutory changes themselves evidence that Congress intended to allow post-distribution restructurings of the sort described in Rev. Rul. 96-30, but without its "additional restriction." As noted, the Act imposes a corporate-level tax if a 50% change of ownership in D or C occurs in connection with the spinoff. This amendment itself changes the results in Rev. Rul. 75- 406 and Rev. Rul. 96-30 (both involving a reduction to 25% of the historic shareholder ownership of C), if sufficient relatedness of the transactions existed. Moreover, the Act lowers from 80% to more than 50% the ownership of C that the distributee shareholders must have "immediately after" the distribution for purposes of section 368(a)(1)(D) and section 351(c)(2), in order to allow contemplated stock issuances and acquisitions by C and other transactions that heretofore have violated the statutory control requirement.

The following examples may be helpful in understanding the Congressional intent. Assume that all requirements of section 355 are met except as they might be affected by the transactions involving Acquiring.

EXAMPLE 1. D distributes the stock of pre-existing C to its shareholders. Then, as part of the plan, Acquiring merges into C. After the merger, the former shareholders of C own 30% of C. Here, new section 355(e) applies, thus triggering gain to D, because the distribution and the subsequent acquisition and change in control of C were parts of a plan. But it is evident that Congress did not intend to disqualify the distribution at the shareholder level under a Court Holding Co. theory. Otherwise the statutory pattern would be nonsensical, i.e., corporate level tax is imposed only if there is a plan, but if there is a plan, then section 355 does not apply at all, and tax is imposed at both levels.

EXAMPLE 2. Same as Example 1, except that the shareholders of C retain 60% of the stock of C. Here section 355(e) does not apply and it would be anomalous to invoke a nonstatutory doctrine to tax the transaction at both the corporate and shareholder levels. The Committee Reports confirm this analysis, stating that "the difference in treatment of certain transactions following a spinoff, depending on whether the distributing or controlled corporation engages in the transaction, should be minimized." H.Rep. No. 148, supra at 214; S. Rep. No. 33, supra at 140.

Rev. Rul. 96-30 should be declared obsolete to reject its implication that the steps can be reordered for purposes of the section 355 requirement that control of C be distributed. Such change would not undercut the government's thinking on step transactions generally, because TRA 1997 and the legislative history make the distribution of control test for spinoffs a special case.

OTHER ISSUES.

Obsoleting Rev. Rul. 96-30 raises at least two related issues: (1) possible obsoleting of Rev. Rul. 75-406, and (2) possible obsoleting or modification of Rev. Rul. 70-225.

REV. RUL. 75-406.

The Committee Reports' statements require the obsoleting of Rev. Rul. 75-406 as well as Rev. Rul. 96-30. That is, it should be possible to have a pre-committed diminution of the post-distribution ownership of a pre-existing C by the historic D shareholders, subject only to the requirements of section 355(e), as well as the "device" and continuity of interest tests. Thus, reliance on a separate shareholder vote serves no purpose and is itself an "additional restriction" that Congress intends to eliminate.

Rev. Rul. 75-406 reflected the substance-over-form analysis of the sort used in Court Holding and Cumberland Public Service (although those cases involved closely held corporations in which a separate shareholder vote likely could never be meaningful). Nevertheless, form generally controls absent other considerations, particularly in Subchapter C, and Congress certainly can direct when form must control, and has done so in connection with its enactment of section 355(e). Congress has said that a formal distribution of the stock of an 80% controlled subsidiary is just what it appears to be; any subsequent related transactions will be policed by specific rules Congress has put in place, and so no effort need be made to search for the substance of these transactions in order to upset the formal distribution of 80% control. Thus, to the extent Rev. Rul. 75- 406 was concerned with distribution of "control," that concern is satisfied by section 355(e). To the extent Rev. Rul. 75-406 was concerned with the device test, that concern is addressed by Reg. section 1.355-2(d)(2)(iii)(E), stating that a stock for stock reorganization following a section 355 division is not a "sale or exchange" for purposes of the device test. The continuity of shareholder interest concerns of 75-406 can continue to be addressed as they were there.

Finally, Rev. Rul. 75-406 is no longer correct to the extent it requires two independent business purposes, one for the spinoff and the second for the subsequent change of ownership. In Rev. Rul. 75-406, the business purpose for the spinoff was to satisfy a government divestiture order. It was separate from the merger and its business purpose. A business purpose still will be required for the corporate division under section 355. That business purpose requirement may be satisfied even if the transaction results in a reduction of the shareholders' interest below 80%.

EXAMPLE. D owns all the stock of C. C needs to raise capital. It is determined that the most efficient way to raise this capital is by a public offering of new C stock amounting to 25% of its capital, but that, for the offering to succeed, D must spin off C. This spinoff should satisfy the distribution of control test. Treating the offering as taking place before the spinoff would not make sense. C would not engage in the offering as a D subsidiary and D does not retain any C stock. Consequently, the substance of the transaction is not properly viewed as a distribution of only 75% of the C stock. (The same analysis would apply if the restructuring were a tax-free acquisition of or by C.) For this reason, obsoleting of Rev. Rul. 75-406 to follow Congressional guidance will not violate step transaction principles.

REV. RUL. 70-225.

Rev. Rul. 70-225 involved the application of section 368(a)(1)(D) to a spinoff of C to the sole shareholder of D, followed by a stock for stock acquisition of C by a publicly held Acquiring. The facts assumed the existence of an integrated plan whereby the shareholder of D could not retain beneficial ownership of the stock of C, but must dispose of it in the related reorganization. Like Rev. Rul. 96-30, this ruling reordered the steps and treated the acquisition as having occurred first, with D exchanging assets for the stock of Acquiring, which was then distributed to D's shareholder; presumably, the ruling treated Acquiring as having contributed the assets acquired from D to newly formed C. The ruling did not have to assess the existence of indirect control of C by D's shareholder for purposes of section 368(a)(1)(D) through ownership of the stock of Acquiring because the ruling did not treat D as creating C at all.

Without addressing whether or not the shareholders of D can assert control of C through their ownership of Acquiring, we recommend that the Service obsolete the approach of Rev. Rul. 70-225 that reorders the transaction. Such a change will permit D to distribute control of C for purposes of section 355(a)(1)(D), thus creating parity with the spinoff of an existing C as discussed above.

We recommend that the Service modify Rev. Rul. 70-225 to delete the statement: "Section 368(a)(1)(B) of the Code is not applicable to the transaction, since in effect R transferred part of it assets to T in exchange for a part of the T stock, rather than T having acquired all the stock of a previously existing corporation solely in exchange for its own voting stock." Concomitantly, we recommend that the conclusion in the ruling be changed to provide that D (there "R") recognizes gain or loss on the asset exchange for C stock because sections 351(c)(2) and 368(a)(1)(D) do not apply, D recognizes any gain or loss in the stock of C because section 355(e) applies (presumably with no additional gain or loss), section 355(a) applies to the receipt of the C stock by D shareholders and section 354 applies to the exchange of C stock for stock of Acquiring (there "T").

EXAMPLE: D transfers to newly formed C assets for stock and distributes the stock of C to its shareholders in a transaction qualifying under section 355(a). In a pre-arranged transaction, X acquires all of the C stock in exchange for 1% of its voting common stock. The D shareholders thus fail to have control of C immediately after the distribution. Sections 368(a)(1)(D) and 351(c)(2) do not apply and D recognizes gain or loss in its assets transferred to C; C takes a fair market value basis in the assets; section 355(e) applies to the distribution of stock but no gain is recognized by D because it has a cost basis in that stock: the D shareholders recognize no gain or loss on their receipt of stock of C or on their exchange of C stock for X stock.

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