Mr. Donald C. Lubick
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
4204 MT
Washington, D.C. 20220

Re: Comments on Section 355 Legislation Proposed by the Clinton
Administration

Dear Mr. Lubick:

Enclosed is a response to the Administration's proposal to tax certain distributions under Section 355 of the Internal Revenue Code prepared by individual members of the American Bar Association. Section of Taxation. Corporate Tax Committee. This proposal supplements comments previously submitted (copy enclosed) by individual members of the Corporate Tax Committee on Section 355 Legislation proposed by the Clinton Administration. Those comments suggested that the Administration's proposal to tax Section 355 distributions that are effectively "dispositions" of a business was unduly broad in that the general class of transactions that would be taxable under the Administration's proposal did not constitute more of a "disposition" of a business than other transactions that would remain non-taxable. We believe that the enclosed proposal more clearly targets those distributions that may be viewed as in effect "dispositions" of businesses. 1% easily administrable and is consistent with other provisions in the Code.

The attached proposal would require gain recognition under certain circumstances at the corporate-level in connection with a disposition otherwise qualifying under Section 355, combined with a change in control of either the distributing corporation or the controlled corporation to the extent that the corporation undergoing the change in control has liabilities in excess of tax basis. This proposal avoids the very difficult issues of (1) determining the appropriate level of leverage in a corporation, (2) tracing debt proceeds generally, and (3) treating new debt differently from old debt.

The draft proposal was prepared by Jasper L. Cummings, Jr., Eric M. Elfman, Robert P. Hanson, Robert H. Wellen and Mark L. Yecies and represent the individual views of those persons that participated in the drafting, and do not represent the position of the American Bar Association or the Section of Taxation. The proposal has not been reviewed by the Committee on Government Submissions (although the earlier comments on the Clinton Administration's proposal was reviewed by the Committee on Government Submissions), but are being forwarded to you now in light of time pressures.

Although members of the Corporate Tax Committee who participated in the development of the attached proposal have clients who would be affected by the proposed legislation, no member (or, to the knowledge of the member, no firm of a member) has been engaged by a client to influence a government decision or policy determination with respect to this proposed legislation.

We would be pleased to meet with you and your colleagues to discuss this proposal at your convenience.

Very truly yours,

Eric M. Elfman
Ropes & Gray
Boston, Massachusetts

Enclosures

cc: Jasper L. Cummings, Jr., Esq.
Mark L. Yecies, Esq.
Robert H. Wellen, Esq.
Robert P. Hanson, Esq.
Stuart J. Offer, Esq.
Kenneth W. Gideon, Esq.
Pamela F. Olson, Esq.

Ms. Diane Jones

PROPOSAL FOR LEGISLATION TO TAX CERTAIN DISTRIBUTIONS

OF CONTROLLED CORPORATION STOCK UNDER SECTION 355

THAT ARE EFFECTIVELY DISGUISED SALES

ISSUE: In connection with an otherwise tax-free distribution under Section 355, the combination of (1) the leveraging of a corporation, (2) separating the debt and underlying cash or other assets associated with the debt, and (3) a subsequent change in control of the leveraged corporation has the potential to be viewed effectively as a "disposition" of a business without the associated corporate-level tax.

PROPOSAL: The proposal would require gain recognition under certain circumstances at the corporate-level in connection with a distribution otherwise qualifying under Section 355, combined with a change in control of either the distributing corporation or the controlled corporation. In such an event, the distributing corporation would be required to recognize gain (if any) in an amount equal to the excess of: (1) the aggregate liabilities of the affiliated group (as defined in Section 1504(a) (without regard to any exceptions in Section 1504(b)) with respect to which a change in control occurs, over (2) the aggregate tax basis of the assets of that group, both determined immediately after the Section 355 distribution.

In determining whether there is a change in control of either the distributing corporation or the controlled corporation, there are a number of alternative tests that could be used, including the one set forth in the Administration's proposal, but we would urge that whatever test is used be easy to administer and apply. cf., Section 382. In this regard, the critical aspect of the change in control is the separation of economic ownership as between the distributing corporation and the controlled corporation. Thus, for example, if a change in control of the distributing corporation (including the controlled corporation) occurs before a Section 355 distribution, the change in control should not generate taxable gain under this proposal (at least if the new owners of the distributing corporation participate equally in the Section 355 distribution).

The proposal should be effective prospectively to allow deals in progress to be completed without being affected by the proposal.

DISCUSSION: The proposal is an easily administrable rule imposing tax on spin-offs combined with a change in control where there are liabilities in excess of basis in the affiliated group of the corporation with respect to which the change in control occurs. This combination of circumstances is designed as a surrogate to identify situations where a disposition may be viewed as occurring. The proposal avoids the very difficult issues of (1) determining the appropriate level of leverage in a corporation, (2) tracing debt proceeds generally, and (3) treating new debt differently from old debt. Generally, there would be an excess of liabilities over basis if the debt is separated from the underlying cash or other assets associated with the debt either through distributions of contributions to other corporations, or a loss or other deduction occurs. The proposal may impose tax in instances which are not effectively dispositions, but we believe the proposal is much more targeted than the Administration's proposal.

We feel that the proposal balances an easily administrable rule imposing a tax in those instances which may be viewed as a "disposition" of a business, without fully taxing any change in control transaction and thereby taxing and discouraging many legitimate corporate combinations. In today's environment, market forces are driving acquiring corporations to focus on core businesses and spin off non-core businesses, and we believe the tax law should not discourage this trend.

OTHER ISSUES:

1. There should be a concomitant step-up in basis in assets of the corporation(s) whose asset basis and liabilities determines the gain. The stepped-up basis of any asset should not, however, exceed its fair market value. We believe that this corporation(s) is the deemed purchaser of the business and therefore the right party to get
the step-up in basis, but recognize that the proposal does not consistently impose a tax on the deemed seller. We chose to impose the tax on the distributing corporation because it is most likely the common parent corporation in an affiliated group filing a consolidated federal income tax return, and there likely would be several liability for each member of the group. You might want to examine whether a more conceptually pure alternative is preferable.

2. How is aggregate asset basis and aggregate liabilities determined when there is an affiliated group of corporations? Do you look through to the underlying asset basis of each corporation and ignore stock basis or can an election be made to count stock basis in appropriate circumstances? Is affiliated group the right test?

3. The gain triggered under this proposal should be coordinated
with and not duplicate any gain otherwise recognized under existing Sections 355(d), 357(c), and 361(b) or under the excess loss account rules of Treas. Reg. section 1.1502-19.

EXAMPLES:

The following examples illustrate the application of the above proposal:

EXAMPLE 1: Corporation D has two business (1 and 2) with a value of $60X and $40X, respectively. Each business has a net asset basis of $10X. Unrelated Corporation P desires to acquire business 2 but not business 1. In anticipation of the transaction, D borrows $30X, and contributes the proceeds of that borrowing, along with the assets of business 1 to newly formed Corporation C. D distributes the C stock to its shareholders pro rata. Thereafter, the stock of D is acquired by P solely in exchange for voting stock of P with a value of $10X in a transaction qualifying as a reorganization described in Section 368(a)(1)(B). Under the proposal, on these facts, D would recognize gain in the amount of $20X, the excess of the liabilities of D ($30X) over the basis of its assets of ($10X).

EXAMPLE 2: Corporation D owns all of the stock of Corporation C. The basis of the C stock in the hands of D is $40X, and the net basis of C's assets is $10X. C borrows $30X from third party lenders and distributes the proceeds as a dividend to D. Thereafter, D distributes all of the stock of C to its shareholders pro rata. C subsequently undertakes an initial public offering of an amount of its stock representing a change in control, as defined. Under the proposal, on these facts, upon the change in control of C, D would recognize gain in the amount of $20X, the excess of the liabilities of C ($30X) over the basis of the assets of C ($10X).

EXAMPLE 3: Corporation D owns all of the stock of Corporation C. C conducts two businesses (1 and 2) with a value of $60X and $40X, respectively. Each business has a net asset basis of $10X. D's basis in the C stock is $20X. C borrows $50X from third party lenders and contributes the proceeds of the borrowing, along with the assets of business 2 to newly formed Corporation S, the stock of which is distributed to D. Thereafter, D distributes the stock of C to its shareholders pro rata. Subsequently C issues to new investors an amount of stock representing a change in control, as defined. Under the proposal, on these facts, upon the change in control of C, D would recognize gain in the amount of $40X, the excess of the liabilities of C ($50X) over the basis of the assets of C ($10X).

COMMENTS CONCERNING LEGISLATION PROPOSED BY
PRESIDENT CLINTON TO REQUIRE GAIN RECOGNITION ON
CERTAIN DISTRIBUTIONS OF CONTROLLED CORPORATION STOCK

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 of the Section of Taxation. Those who contributed to these comments may not necessarily agree in all respects with the conclusions expressed.

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 Eric M. Elfman and Robert H. Wellen. The Comments were reviewed by William J. Wilkins of the Section's

Committee on Government Submissions and by Stuart J. Offer, the Council Director for

the Committee on Corporate Tax.

Although members of the Section of Taxation who participated in the preparation of these comments 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 member (or, to the knowledge of the member, no firm of a member) has been engaged by a client to influence a government decision or policy determination with respect to the specific subject matter of these comments.

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

Date: May 15, 1996

COMMENTS CONCERNING LEGISLATIONPROPOSED BY

PRESIDENT CLINTON TO REQUIRE GAIN RECOGNITION ON

CERTAIN DISTRIBUTIONS OF CONTROLLED CORPORATION STOCK

SUMMARY

The proposal extends current IRC section 355(d) to impose corporate-level tax on certain tax-free distributions of a controlled corporation's stock under IRC section 355, where the direct and indirect shareholders of the distributing corporation (during the two-year period prior to the distribution) as a group do not retain control (at least 50 percent by vote and value) of each of the distributing and controlled corporations for a two-year period after the distribution. For this purpose, transactions "unrelated" to the distribution are disregarded. The proposal extends current IRC section 355(d) in two ways: (1) it adds non-purchase stock acquisitions to the transactions which can cause corporate-level recognition by the distributing corporation if they occur within two years before the corporate separation; and (2) it adds a new requirement prohibiting "related" transactions during a two-year period after the separation. The proposal apparently was aimed principally at Morris Trust¹ transactions, but it would affect many other types of transactions as well. The proposal would be effective for distributions after March 19, 1996, unless certain events occurred on or before that date.

We believe that the proposed statutory change is unwise and represents poor tax policy. Although the rationale for the proposal is to tax distributions that are effectively "dispositions" of a business, we do not believe that the class of transactions that will be made taxable by the legislation constitutes more of a "disposition" of a business than other transactions that will remain non-taxable. Indeed, looked at from the standpoint of the distributing corporation, all spin offs constitute a "disposition." From the shareholders' standpoint, most of the transactions covered by the proposal result in a dilution of percentage interest of the shareholders in a larger entity, rather than a "disposition". Even if it were possible to distinguish the transactions taxed under the proposal from untaxed transactions, we find no policy justification for the imposition of a corporate-level tax without a corresponding increase in tax basis of the underlying assets in the controlled corporation.

Given the current complexity of the Internal Revenue Code, we would hope that legislative changes would be limited to circumstances where it is necessary to close off abusive transactions or to further a strong tax policy goal. We see no abuse being corrected here, nor do we see a strong tax policy goal.

Finally, although we understand the need in President Clinton's Proposed Fiscal 1997 Budget for a fixed effective date for revenue estimation purposes, we believe that the proposed retroactive effective date is unwarranted in the case of legitimate nonabusive transactions that we believe are being affected by the current proposal. We would hope that the Treasury Department will issue an announcement similar to the statement released on March 29, 1996, by Senate Finance Committee Chairman William V. Roth, Jr., and House Ways and Means Committee Chairman Bill Archer to the effect that Treasury would not oppose a prospective effective date crafted by Congress.

COMMENTS

1. NO ABUSE.

The proposal affects legitimate transactions that are not abusive. As drafted, the proposal would impose corporate-level tax with respect to the following transactions:

EXAMPLE 1: X is a privately held company with two divisions, A and B. Y desires to acquire X by merger but does not want division B. X incorporates division B into S and spins off S to its shareholders and X then is the survivor of a merger with Y's newly created subsidiary. X's shareholders receive 40% of the outstanding Y stock. The spinoff qualifies under IRC section 355, but X will recognize the gain built into the S stock. S will not obtain a step up of its asset basis and X shareholders will not recognize gain or loss on the distribution or the merger consideration and will take an exchanged basis in Y stock.

EXAMPLE 2: X will spin off S, its software subsidiary, because S has non-tax needs to conduct its business apart from X and to raise capital by an IPO. X shareholders will receive S common and preferred; S will issue more than 50% of its outstanding common in the IPO to obtain the needed capital infusion, in a transaction "related" to the IRC section 355 division. The spin-off will be taxable to X, but not to its shareholders and neither S (nor X) would receive a basis step-up in any asset due to the X gain recognition.

EXAMPLE 3: X is a publicly-traded holding company with two operating subsidiaries, S-1 and S.2. On 1/1/97, Y acquires X by merger of X into Y for Y stock equal to 40% of Y's outstanding stock. On 12-31-98, (within 2 years of 1-1-97, in a "related" IRC section 355 transaction, Y spins off S-1 to the Y shareholders, pro rata. Y will recognize the gain built into the S-1 stock; S-1 will not obtain a step-up in its asset basis; Y shareholders will receive the stock of S-1 tax-free, with an exchanged basis. X could have spun off S-1 without application of the corporate-level tax, assuming no acquisition by Y occurred.

We do not believe that the transactions described in the Examples above could be characterized as "abusive," unless the failure to collect three levels of tax on a corporate distribution is considered abusive. If there are transactions which Treasury believes are abusive, we believe that they are likely subject to attack under existing law or by exercise of Treasury regulatory authority.

2. MORRIS TRUST TRANSACTIONS ARE APPROPRIATE.

The proposal apparently was aimed principally at Morris Trust transactions, but it would affect many other types of transactions as well. Under the facts of this case, the Fourth Circuit approved the tax-free spinoff of "unwanted assets" prior to an acquisitive tax-free reorganization. The IRS has agreed with the Morris Trust case in Rev. Rul. 68-603, 1968-2 C.B. 148. Although the proposal would not apply to the facts in the Morris Trust case since the shareholders of the distributing corporation received over 50% of the stock of the merged corporation, that level of shareholder ownership has not, however, been considered essential. Further, this structure has proven to be a durable and useful one, facilitating many business combinations that otherwise may not have occurred. No good reason appears now for foreclosing those transactions where there is dilution of the distributing corporation's shareholders' interest or imposing an additional tax on such transactions. Indeed, in the context of a tax-free acquisition, market forces are driving acquiring corporations to focus on core businesses and spin off non- core businesses, and enactment of the proposal could impede this process.

3. LACK OF CONSISTENT POLICY.

The Treasury explanation of the reason for the legislative changes is that "corporate nonrecognition under IRC section 355 should not apply to distributions that are effectively dispositions of a business." Of course, all IRC section 355 transactions are a "disposition of a business" by the distributing corporation, whether or not the shareholders of the distributing corporation thereafter are diluted in their ownership of stock of the distributing or controlled corporations. Thus, we must look for an unstated rationale for taxing this one particular group of IRC section 355 transactions.

The proposal may be intended as a "defense" of General Utilities² repeal. However, we do not believe that the transactions described by the proposal implicate General Utilities to any significant extent greater than any other group of transactions described in IRC section 355. The classic General Utilities distribution resulted in shareholders receiving a fair market value basis in corporate assets at no tax cost to the distributing corporation on the gain built in to the distributed asset. That, of course, is not involved here. Rather, the corporate asset gain will continue to be built into the assets in the hands of a controlled and distributing corporation, and the shareholders' built-in gain will continue in the stock of the acquiring corporation received in the following reorganization transaction.

Since the proposed legislation would amend IRC section 355(d), it is possible that Treasury views the transactions described in the current proposal as simply an extension of the transactions described in current IRC section 355(d). IRC section 355(d) currently imposes corporate-level tax on transactions involving an acquisition followed by a distribution; the proposed legislation would tax transactions (among others) involving a distribution followed by an acquisition. Thus, it is possible that Treasury reasoned that the order of the steps should not provide a different tax result. The analogy is faulty, however. The problem addressed by current IRC section 355(d) is the potential that an acquiror could obtain a stepped-up basis in the stock of the distributing or controlled corporation, thereby permitting a disposition of the corporation without tax. No such possibility exists with respect to the transactions caught under the proposed legislation. Indeed, the inappropriate tax result addressed by the 1990 amendments to IRC section 355 (stepped-up basis in stock without corporate-level tax) is now to be reborn as a taxpayer penalty, imposing corporate-level tax without providing a stepped-up basis in either stock or assets.

4. AREA WELL POLICED.

Corporate divisions are better policed than other corporate transactions generally, given the heightened business purpose requirement and the prevalence of advance rulings. Indeed, a purpose of Rev. Proc. 96-30, 1996-19 I.R.B. 8, is to encourage submission of requests for rulings under IRC section 355. Thus, it seems less appropriate to trigger gain in these transactions than in reorganizations generally.

5. EFFECTIVE DATE.

Finally, although we understand the need in President Clinton's Proposed Fiscal 1997 Budget for a fixed effective date for revenue estimation purposes, we believe that the proposed retroactive effective date is unwarranted in the case of legitimate nonabusive transactions that we believe are being affected by the current proposal. We would hope that the Treasury Department will issue an announcement similar to the statement released on March 29, 1996, by Senate Finance Committee Chairman William V. Roth, Jr. and House Ways and Means Committee Chairman Bill Archer to the effect that Treasury would not oppose a prospective effective date crafted by Congress.

FOOTNOTES