A spinoff or other distribution by a company of subsidiary stock is not always tax free, due to the anti-Morris Trust rules under Code Sec. 355(e).The code requires that a distributing parent corporation recognize gain on an otherwise tax-free spinoff of its controlled subsidiary's stock, if this is done "as part of a plan (or series of related transactions)" to have one or more persons acquire a 50 percent or greater interest in either the parent or the controlled corporation.

Reduced to simpler terms, it prevents a spinoff or similar distribution from helping fund an acquisition. Complications result primarily because acquisitions for these purposes are not restricted to purchase transactions. An acquisition occurs if one or more persons directly or indirectly acquire 50 percent or more of the vote or value of the stock of the controlled or distributing corporation pursuant to a plan or arrangement.

Since the inception of Sec. 355(e) in 1997, planners have been concerned that tax may be unexpectedly triggered by transactions taking place within certain industries, especially those in which many of the same investors and business participants keep reappearing. Planners want some degree of certainty that happenstance acquisitions or acquisitions for legitimate business purposes don't impose an unexpected tax burden or litigation costs.

The concern for most corporate owners is not "gaming the system" by trying to play a transaction as close to the line as possible. Rather, it is how to safeguard against tripping over the rules by failing to prove that there was no "plan (or series of related transactions)."

Final regs to the rescue?

Fortunately, final regulations under Sec. 355(e) have been issued this past month that help reduce a substantial amount of anxiety surrounding distributions that happen to coincide with acquisitions. The new final regs try to accomplish this goal by expanding the safe harbor transactions, refining its list of favorable facts and circumstances, and providing other bright-line rules to determine whether a distribution and an acquisition are part of a plan.

The final regs continue to attempt to strike what some regard as an impossible balance between policing anti-Morris Trust rules while not penalizing some distributing transactions. The drafters state plainly that ease of administration was a critical factor in refining the rules. Final regs, issued in part because 2002 temporary regs were about to automatically expire, improve upon the situation. They set forth a nonexclusive list of factors that may indicate whether there is a "plan," and provide a list of safe harbor transactions that will not be treated as part of a plan.

The Internal Revenue Service addresses several transactional variations in the final regulations. The results are mixed in giving practitioners a workable set of rules. As is usually the case with guidance on corporation control issues, the regulations go on for pages. Our hope here is to identify some of the places in which knowledge of the rules can help structure the transaction in anticipation of IRS scrutiny.

Notable changes

In the case of an acquisition, other than one involving a public offering after a distribution, the distribution and the acquisition can be considered part of a plan only if there was an agreement, understanding or substantial negotiations regarding the acquisition or a similar acquisition at some time during the two-year period ending on the date of the distribution.

In such cases, the existence of an agreement, etc., regarding the acquisition or a similar acquisition at some time during the two-year period ending on the date of the distribution, although not necessarily fatal, tends to show that they are part of a plan.

The final regs refine this rule by requiring that, to taint the distribution, the agreement must be made by an officer or director of the parent or controlled corporation or by a controlling shareholder (including their agents) with the company that is acquiring the interest in the subsidiary corporation.

The regs also modify the two-year safe harbor to protect pre-distribution acquisitions of the parent that occur before the first "disclosure event." A disclosure event for this purpose is a communication by the parent, subsidiary or other controlled corporation, or an outside advisor, that discloses the possibility of a distribution to the acquirer or any other outside party.

For this rule to apply, the acquisition must occur after public announcement of the distribution, and no discussions by the parent or subsidiary with the acquiror should have taken place before the public announcement. This safe harbor, however, is not available for acquisitions by a controlling shareholder or a 10 percent shareholder of the acquired corporation at any time between acquisition and distribution, since such person could have had inside knowledge.

The final regs also create a new safe harbor for acquisitions that occur before a pro rata distribution where they are not likely to be part of a plan. Such will be assumed to be the case if a public announcement of the distribution was made prior to the acquisition, and no discussion by the distributing or controlled corporation took place with the acquirer before the public announcement.

Public offerings

In interpreting Code Sec. 355(e), the IRS distinguishes between public and nonpublic offerings and uses different factors to analyze these two areas. The final regs strive for more clarity than in the temporary regulations principally by providing a definition of a public offering. This definition clarifies that a public offering for this purpose is an offering of stock for cash. An offer of stock for stock or other property is not treated as a public offering. An initial public offering, however, meets the definition.

The IRS also has provided new safe harbors for public offerings, depending on whether the stock being acquired is listed. If the stock is listed, the safe harbor protects an acquisition before the distribution if the acquisition occurs before the first "public announcement" of the distribution. If the stock is not listed, the safe harbor applies if the acquisition occurs before the first "disclosure event" regarding the distribution.

Many of the rules and safe harbors refer to acquisitions involving a public offering that are "similar" to the actual acquisition. These rules prevent the parties from making minor changes in the terms to prevent the application of the rules. The final regs clarify when an actual acquisition is similar to a potential acquisition.

Other revisions

One change in the final regulations closes down a loophole found in the temporary regs. The IRS reported that compensatory options were being used to prevent a stock acquisition from being part of a plan of distribution. As a result, the final rules take back this exception and will treat compensatory options as options.

On a brighter note, however, the safe harbor that applies to stock acquired by a person providing services to the parent or the subsidiary was expanded to apply to a person providing services to a corporation that is not the parent or subsidiary.

Conclusions

Now that general M&A activity is picking up, the taxpayer-friendly final regulations seem to have come at an opportune time. However, even though many of the new rules and safe harbors especially protect against unexpected acquisitions, the adage about "he who helps himself" applies.

Whenever either a spinoff, a split-up or an acquisition is planned, each of the factors and safe harbors within the final regs should be examined. Reliable "paper trails" should be constructed in conjunction with that examination to disprove "a plan (or series of related transactions)." While the final regs provide the tools, they must be picked up and used by the corporate planner to be effective.

George G. Jones, JD, LL.M, is managing editor of federal and state tax, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst of federal and state tax, at CCH Inc.

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