Proposed regulations provide guidance regarding certain aspects of spinoffs and reorganizations

More specifically, the Proposed Regulations contain substantive guidance with respect to spinoffs eligible for nonrecognition under section 355, including guidance addressing: (i) when the distributing corporation’s retention of stock of the controlled corporation is in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax for purposes of section 355(a)(1)(D)(ii), (ii) the definition and scope of a “plan of distribution,” (iii) when section 361(b)(3) and (c)(3) apply to transfers to creditors of the distributing corporation, and (iv) when a controlled corporation’s assumption of liabilities of the distributing corporation will not be treated as money or other property received by the distributing corporation under section 357(a). Furthermore, the Proposed Regulations contain new and enhanced requirements for a “plan of reorganization” for purposes of section 368 and requirements that must be satisfied in order for a transaction to be properly included within the plan of reorganization for purposes of section 368. Finally, the Proposed Regulations make other changes to the regulations promulgated under sections 355, 357, 361, and 368 in order to modernize such regulations.²

Taxpayers engaging in spinoffs and reorganizations eligible for nonrecognition will want to review the Proposed Regulations to better understand (i) the impact of the Proposed Regulations on such transactions, and (ii) the revised documentation that will be required for such transactions.

The Proposed Regulations with substantive guidance are generally effective for transactions occurring after the finalization and publication of the Proposed Regulations in the Federal Register and the transaction has been announced, approved, or entered into. The Proposed regulations regarding new filing requirements are effective for taxable years ending after the finalization and publication of such Proposed Regulations in the Federal Register.

Provisions related to spinoffs under Section 355

The Proposed Regulations presume a distributing corporation’s retention of stock of the controlled corporation in connection with a separation under section 355 to be pursuant to a plan having as one of its principal purposes the avoidance of federal income tax for purposes of section 355(a)(1)(D)(ii).

• However, this presumption may be rebutted if the taxpayer:
  • Either (i) satisfies six requirements safe harbor,³ or (ii) establishes to the satisfaction of the Commissioner that the requirements under a general facts and circumstances test are satisfied;⁴ and
  • The distributing corporation and the members of its affiliated group vote any retained stock in the controlled corporation in proportion to the votes cast by the controlled corporation’s other shareholders that are unrelated to the distributing corporation and the members of its affiliated group.
• The Proposed Regulations require a taxpayer to establish its “plan of distribution” for distributions to which section 355(a)(1)(D) and (c) is intended to apply.⁵
• The Proposed Regulations provide that a taxpayer may treat a distribution as part of a plan of distribution if certain requirements are satisfied.⁶
• · The Proposed Regulations contain specific requirements that must be satisfied in order for a distributing corporation’s transfer of property to its creditors to be treated as a transfer by the distributing corporation in pursuance of the plan of reorganization for purposes of section 361(b)(3) (nonrecognition on transfer of property) and section 361(c)(3) (nonrecognition on distribution of property).⁷
  • First, the creditor must be a “qualified creditor.”
    • For this purpose, a qualified creditor is any creditor of the distributing corporation that: (i) holds “eligible distributing corporation debt” (as discussed in more detail below) and (ii) is not related (within the meaning of section 267(b) or section 707(b)(1)) to the distributing corporation, the controlled corporation, or another person that is related to the distributing corporation or controlled corporation.⁸
  • Second, the distributing corporation debt that is satisfied must be “eligible distributing corporation debt.” Eligible distributing corporation debt is defined as debt of the distributing corporation that is: (i) historic distributing corporation debt,⁹ (ii) qualifying trade payables,¹⁰ or (iii) direct issuance debt.¹¹
  • Third, the amount of distributing corporation debt that can be eliminated under section 361(b)(3) and (c)(3) cannot exceed an amount equal to: (i) the lesser of (A) the aggregate amount of distributing corporation debt,¹² and (B) the aggregate amount of distributing corporation debt, as computed under an eight-quarterly average test, measured as of the close of each of the eight fiscal quarters that end immediately before the “earliest applicable date,”¹³ less (ii) the aggregate amount of debt of the distributing corporation that the controlled corporation assumes pursuant to the plan of reorganization.
  • Finally, the transfer by the distributing corporation must be carried out as part of a “qualifying debt elimination transaction.”
    • A qualifying debt elimination transaction includes: (i) a “qualifying original creditor exchange” (as defined in Proposed Regulations Section 1.361-5(e)(2)), (ii) a “qualifying intermediate exchange transaction” (as defined in Proposed Regulations Section 1.361-5(e)(3)) or (iii) a “qualifying direct issuance transaction” (as defined in Proposed Regulations Section 1.361-5(e)(4)).
• Under the Proposed Regulations, the amount of consideration that the distributing corporation is treated as transferring to its creditors in a qualifying debt elimination transaction is reduced by the amount of eligible distributing corporation debt that is “transitorily eliminated.” The Proposed Regulations contain an “expects or is committed to undertake” standard in order to determine whether debt is transitorily eliminated,¹⁴ but provide for exceptions for certain ordinary course borrowings and unexpected circumstances borrowings.¹⁵
• The Proposed Regulations provide updated rules regarding the payment of certain indemnity or other payments in an acquisitive reorganization.
  • In general, the Proposed Regulations would provide that, if a transferee corporation (i.e., the purchasing corporation or the controlled corporation) makes a payment to satisfy an assumed liability that results in the transferor having any legal or practical dominion or control over any part of the payment, then such payment is considered money or other property under the operative Code provision.
  • However, an indemnity payment will not be considered to be a liability in which the transferor has legal or practical dominion or control where: (i) the transferee is legally prohibited from assuming the liability, (ii) the indemnification agreement requires the transferor to first satisfy the obligation that is the subject of the indemnification agreement before the transferor is permitted to receive payment from the transferee, and (iii) the transferor is in the same net economic position it would have been in if the transferee corporation legally were allowed to assume the liability.
  • Furthermore, payments that are not made pursuant to an indemnity agreement qualify for an exception from the general rule where: (i) the payment is dedicated to the satisfaction of a liability of the transferor identified in an agreement or the plan of reorganization, (ii) the payment is made to an independent trustee or escrow agent that is not affiliated with the transferor, (iii) the payment is not made to any account of the transferor (or person through which the transferor could direct the payment), (iv) the transferor and transferee treat any income, gain, or loss on the payment proceeds as income, gain, or loss to the transferee corporation, and (v) any excess of the payment amount (and any income or gain thereon) over the amount paid to satisfy the liability reverts to the transferee corporation.
• Subject to limited exceptions, the assumption of liabilities of the distributing corporation in a divisive reorganization will not be treated as money or other property received by the transferor in accordance with section 357(a) where: (i) the liabilities to be assumed are described in a plan of reorganization, (ii) the liabilities were incurred in the ordinary course of business of the distributing corporation, (iii) the assumption of such liabilities is necessary to ensure the transfer to the controlled corporation of all liabilities properly associated with the business assets transferred to that corporation and result in the controlled corporation assuming liabilities in an amount that properly relates to its business operations, and (iv) any distributing corporation debt assumed must qualify as historic distributing corporation debt or a distributing corporation trade payable.
• The Proposed Regulations (REG-112261-23) contain updated reporting requirements for “covered filers”¹⁶ with respect to separations under section 355 by including a Form 7216 (Multi-Year Reporting Related to Section 355 Transactions) with their U.S. federal income tax returns for the period beginning in the covered filer’s taxable year in which the first distribution occurs, and ending in the fifth taxable year of the covered filer after the taxable year in which the distribution of control occurs.
  • The IRS draft Form 7216 requires that covered filers provide information regarding additional parties to the transaction, the control requirement, the distribution requirement (for distributing corporations only), the active trade or business requirement, the device prohibition, section 355(e), section 355(g)(1)(B), continuing relationships between the distributing and controlled corporations, certain international issues, the assumption of distributing liabilities, the satisfaction of distributing debt (for distributing corporations only), money and other property transferred by the controlled corporation to the distributing corporation (distributing corporation only), and certain other items.¹⁷

Provisions related to reorganizations under Section 368

• The Proposed Regulations significantly modify the existing requirements for a “plan of reorganization.”¹⁸ Under the Proposed Regulations, a plan of reorganization could be determined in several different manners: (i) a taxpayer could prepare a plan of reorganization, a single, comprehensive document that satisfies certain requirements (described in more detail below) that the taxpayer files with its U.S. federal income tax return for the taxable year that includes the date of the reorganization; (ii) a plan of reorganization of the taxpayer that is corrected by the Commissioner; or (iii) a plan of reorganization that is identified by the Commissioner.
  • The Proposed Regulations require that a taxpayer-prepared plan of reorganization be contained in a single, comprehensive document that: (i) identifies all parties to the reorganization, (ii) identifies all transactions properly included in the plan of reorganization, (iii) identifies all liabilities (including debt) to be assumed by the acquiring corporation and the creditors of those liabilities, (iv) identifies all debt of the target corporation that will be satisfied, (v) describes the intended U.S. federal income tax consequences of the transaction(s), (vi) describes the business purpose for each transaction, (vii) establishes that the readjustments involved in the transactions are undertaken to facilitate the continuance of the business of a corporation a party to the reorganization, and (viii) is finalized and adopted by the party to the reorganization prior to the first step of the reorganization.
  • Furthermore, taking into account all facts and circumstances, all parties to the reorganization must complete the plan of reorganization as expeditiously as practicable. A reorganization will be presumed to be completed as expeditiously as practicable where all parties to the reorganization complete the plan of reorganization within the 24-month period beginning on the date of the first step of the plan of reorganization.
• The Proposed Regulations contain three requirements that must be satisfied for a transaction to be treated as properly included in the plan of reorganization.
  • First, under the “definite intent” requirement, prior to the first step of a plan of reorganization, one or more parties to the reorganization must evidence a definite intent¹⁹ to carry out the transaction, as evidenced through a written commitment in one or more official records²⁰ of a party.
    • The existence of contingencies or conditions will not be conclusive for purposes of determining whether this requirement is satisfied.
    • The mere contemplation that a transaction may be carried out would not be sufficient for the taxpayer to satisfy this requirement. However, the Proposed Regulations provide that the contemplated possibility standard may be applied by the Commissioner for purposes of the correction or identification of a plan of reorganization.
  • Second, under the “proximate relationship” requirement: (i) a transaction is part of the plan of reorganization to which the “definitional provisions”²¹ apply only if, on its own or part of a series of transactions, such transaction is necessary to satisfy one or more requirements of a definitional provision or is an integral part of a series of transactions carried out to satisfy the definitional provision intended to apply to the reorganization (as evidenced by a written commitment in one or more official records), or (ii) a transaction is part of the plan of reorganization to which the “operative provisions”²² apply only if, on its own or as part of a series of transactions, such transaction would not occur but for the reorganization or is an integral part of a series of transactions carried out to satisfy the requirements of the definitional provision intended to apply to the reorganization (as evidenced by a written commitment in one or more official records).
    • The independent significance of a transaction does not preclude the satisfaction of the proximate relationship requirement.
    • Additionally, a transaction that takes place in close temporal proximity to one or more other transactions is not properly included in a plan of reorganization unless federal income tax principles would apply to determine that the transaction was in substance part of the plan of reorganization.
  • Finally, under the business purpose consistency requirement, a transaction, on its own or as part of a series of transactions, must be consistent with and directly related to one or more business purposes of the reorganization (such as by directly furthering one or more such business purposes).
• The taxpayer’s failure to comply with any particular requirement or procedure set forth in Proposed Regulation Section 1.368-4 (which would appear to include: (i) the requirements for a plan of reorganization and (ii) the requirements that must be satisfied in order for a transaction to be properly treated as part of the plan of reorganization) does not, on its own, prevent a transaction or a series of transactions from being considered part of the plan of reorganization, qualifying as a reorganization under section 368 or qualifying for nonrecognition treatment (in whole or in part) under an operative provision (e.g., sections 354 through 361).²³

Effective date of proposed regulations

• The Proposed Regulations regarding substantive qualification for the relevant provisions are generally effective for transactions or exchanges occurring after the finalization and publication of the Proposed Regulations in the Federal Register, but only if the earliest of the following dates with respect to the transaction occurs after the date of such finalization and publication: (i) the date of the first public announcement of the transaction, (ii) the date of entry by the taxpayer into a written agreement, (iii) the date of approval by the board of directors of the taxpayer, (iv) the date of a court order (or a plan confirmed, or a sale approved, by an order of a court) in a title 11 or similar case, where the taxpayer was a debtor in a case before such court or (v) the date a ruling request is submitted to the IRS.
• The Proposed Regulations regarding filing requirements are generally applicable to taxable years ending after the date of final publication; however, Treasury and the IRS reserved an alternative applicability date for yet to be determined items.

Footnotes

1. Unless otherwise indicated, all “section” references contained herein are to sections of the Code.

2. The Proposed Regulations also reference several subjects which are under consideration for future guidance. For example, the Proposed Regulations state that Treasury and the IRS plan to provide solvency requirements in updated guidance relating to the active trade or business requirement under section 355.

3. The requirements for the safe harbor are as follows: (i) there be a specific business purpose for the retention of the stock of the controlled corporation at the time of the adoption of the plan of distribution or reorganization and at all times during the retention, (ii) stock of the controlled corporation is widely held, (iii) there is a limited overlap of directors between the distributing and controlled corporations, (iv) continuing agreements between the distributing and controlled corporations are at arm’s-length (or terminated within two years of the distribution), (v) the plan of distribution or reorganization must reflect a definite intent to dispose of all the retained stock within five years, and (vi) the disposition of the retained stock must not result in less federal income tax than if the stock had been distributed in the first distribution.

4. The requirements are as follows: (i) the distribution resulted in a genuine separation, (ii) the retention does not allow the distributing corporation (or its affiliated group) to exercise practical control over the controlled corporation (or its affiliated group), (iii) there is a sufficient corporate business purpose for the retention of the stock of the controlled corporation and (iv) the disposition of the retained stock by the distributing corporation does not result in less federal income tax to the distributing corporation than would have been due by it if the stock of the controlled corporation was distributed in the first distribution.

5. The requirements for a plan of distribution closely track the requirements for a plan of reorganization, which are discussed in more detail below.

6. These requirements closely track the requirements for determining that a transaction is properly included in the plan of reorganization, which are discussed in more detail below.

7. In relevant part, section 361(a) provides that no gain or loss shall be recognized to a corporation if such corporation is a party to a reorganization and exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in anther corporation a party to a reorganization. Section 361(b) provides the general rules for when gain (but not loss) is recognized in exchanges not solely in kind. Where other property is received and is distributed, then no gain or loss is recognized. Section 361(b)(1)(A). If, however, the corporation retains the property, then gain (but not loss) is recognized to the lesser of the amount of other property received and not distributed and the gain realized in the transaction. Section 361(b)(1)(B). Section 361(b)(3) provides that a distribution to creditors of other property received in the exchange shall be considered a distribution. Section 361(c) provides that the distribution itself of “qualified property” shall not result in the recognition of gain or loss to the corporation if distributed to its shareholders in pursuance of the plan of reorganization. Section 361(c)(3) provides that a distribution to a creditor shall be considered a distribution to a shareholder.

8. However, the Proposed Regulations contain a limited exception to the general prohibition on distributions to creditors that are related to the distributing corporation or a person that is related to the distributing corporation provided three specific requirements are satisfied. First, the property must be transferred to a creditor that is neither a distributing corporation related person nor a related person with regard to a distributing corporation related person no later than the end of the 12-month period beginning on the date the distributing corporation receives money or other property (or, if qualified property (i.e., property described in section 361(a)), then in an expeditious manner pursuant to the plan of reorganization. Second, all debt for which the property is exchanged must be in existence as of the earliest applicable date and such debt must qualify as historical distributing corporation debt. Finally, each transaction, creditor, and debt satisfied with the property must be identified and described in the plan of reorganization with regard to the section 355 transaction.

9. Historic distributing corporation debt is debt of the distributing corporation that (i) is incurred by the distributing corporation prior to the “earliest applicable date” (the earliest of the three dates: (x) the date of the first public announcement of the transaction, (y) the date the distributing corporation entered into a written agreement to effectuate the transaction and (z) the date the distributing corporation’s board of directors approved the transaction) and (ii) has an original term that ends after the date of the exchange and is identified in the plan of reorganization. However, a debt refinancing exception would treat debt incurred after the earliest applicable date as historic debt of the distributing corporation where: (A) the distributing corporation is refinancing historic distributing corporation debt or refinancing a refinanced historic distributing corporation debt, (B) the refinanced historic distributing corporation debt was not incurred as part of a plan to incur debt in addition to historic distributing corporation debt in anticipation of the reorganization, (C) the distributing corporation must engage in a qualifying debt elimination transaction under Proposed Regulations Section 1.361-5(e)(3) or (4) to eliminate that refinanced historic distributing corporation debt and (D) the qualifying debt elimination transaction must be described and identified in the plan of reorganization. Furthermore, a revolving credit agreement to which the distributing corporation is a debtor may qualify as a historic distributing corporation debt in certain instances.

10. Qualifying trade payables are trade payables of the distributing corporation trade payables where: (i) such trade payables are described in the plan of reorganization and are incurred in the ordinary course of business of the distributing corporation and (ii) the satisfaction of such trade payables is necessary to ensure the allocation to the controlled corporation of all liabilities properly associated with the business assets transferred to the controlled corporation and to result in the controlled corporation being allocated liabilities in an amount that properly relates to its business operations.

11 Direct issuance debt is defined as a transaction, or series of transaction (or similar transaction or series of transactions) in which (i) the distributing corporation incurs distributing corporation debt with a creditor after the earliest applicable date, (ii) the distributing corporation uses the proceeds of the newly incurred distributing corporation debt (directly or indirectly) to repay historical distributing corporation debt, and (iii) the new creditor exchanges that newly incurred distributing corporation debt for controlled corporation stock or securities held by the distributing corporation.

12. Proposed Regulations Section 1.361-5(c)(3) contains a detailed mechanism to calculate the aggregate amount of distributing corporation debt.

13. The earliest applicable date is defined as the earliest of: (i) the date of the first public announcement of the divisive reorganization (as defined under Treasury Regulation Section 1.355-7(h)(10)), (ii) the date the distributing corporation entered into a written agreement to effectuate the divisive reorganization or a similar transaction, and (iii) the date the distributing corporation’s board of directors approved the divisive reorganization or a similar transaction.

14. Eligible distributing corporation debt is treated as having been “transitorily eliminated” where the distributing corporation (or a related person) replaces, after the earliest applicable date, with a borrowing that the distributing corporation (or related person) either expects or is committed to undertake before the applicable date.

15. This exception includes: (i) non-ordinary course borrowings that result from (A) an event unrelated to the reorganization and not in the ordinary course of business of the distributing corporation and (B) changed circumstances that were not expected prior to the control distribution date, and (ii) borrowings incurred in the ordinary course of business of the distributing corporation (or the related person).

16. A “covered filer” includes: (i) a distributing corporation or a person that, immediately before the first distribution, was a United States shareholder with respect to a controlled foreign corporation that is the distributing corporation, (ii) a controlled corporation or a person that, immediately before the first distribution, was a United States shareholder with respect to a controlled foreign corporation that is the controlled corporation; (iii) a significant distributee or a person that, immediately before the first distribution, was a United States shareholder with respect to a controlled foreign corporation that is a significant distributee; or (iv) any other person required by the Commissioner to file Form 7216 (or any successor form) in instructions, guidance, or publications published in the Internal Revenue Bulletin. The term “covered filer” also would include any successor (within the meaning of section 381(a) of the Code) to an entity described in the preceding sentence.

17. The purpose of these reporting requirements was to provide the IRS more visibility into transactions that intend to qualify under section 355 and related provisions and administer the Code in such transactions.

18. In general, several Code sections require a transaction to be in pursuant of a plan of reorganization in order to qualify for nonrecognition. For example, section 354 provides that no gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in another corporation a party to a reorganization. Similarly, section 361 applies to a corporation’s transfer of assets in exchange for stock of another corporation in pursuance of the plan of reorganization, and any transfers and distributions of “other property” qualify under section 361 if they are transferred or distributed in pursuant of such plan.

19. Definite intent is not otherwise defined in the Proposed Regulations.

20. The term “official records” includes a contract or other written agreement to which the taxpayer is a party, a resolution or other document authorized by the taxpayer’s board of directors, or other document filed with the SEC or other federal regulatory agency. Notably, filings with state and foreign regulatory agencies would not be official records.

21. The definitional provisions are largely those identified in section 368(a). See Proposed Regulations Section 1.368-1(c)(2)(i).

22. The operative provisions are largely those which provide that the party does not recognize gain or loss in the transaction: sections 354 through 361. See Proposed Regulations Section 1.368-1(c)(2)(ii).

23. This language appears to be an implied safe harbor—in other words, failure to satisfy these requirements still allows a taxpayer to rely on case law and other authority to identify that a plan of reorganization existed, or a transaction was pursuant to a plan of reorganization despite not meeting the literal requirements of the Proposed Regulations. We hope that in finalizing these regulations Treasury and the IRS clarify that this is the intended effect.