The Circular Flow Doctrine and Type D Cross-Border Reorganizations

A Divisive Type D reorganization under Section 355 allows certain distributions by one corporation (the “distributing corporation”) to its shareholders of stock or securities in another corporation (the “controlling corporation”) to be tax-free to the shareholders, and also to be tax-free to the distributing corporation. Type D reorganizations typically involve corporate divisions. Corporate divisions are transactions in which a single corporate enterprise is divided into two or more separate corporations that remain under the same ownership. A division is accomplished when a parent corporation known as “the distributing corporation” distributes to its shareholders stock or securities of one or more controlled subsidiaries.

Spin-Offs

In a spin-off, the distributing corporation distributes stock of a controlled corporation (a subsidiary) to its shareholders. This subsidiary may be either a recently created subsidiary through a transfer or assets in return for stock or an existing subsidiary.

Split-Offs

A split-off is similar to a spin-off except that the parent’s shareholders receive stock in the subsidiary in return for some of their stock in the parent corporation.

Split-Ups

In a split-up, the corporation transfers all of its assets to two or more new corporations (controlled corporations) in return for stock, which is then distributed to the shareholders of the parent corporation in return for all of the parent stock.

Basic Requirements of Section 355 and Divisive Type Reorganizations

A Type D reorganization under Section 355 allows certain distributions by one corporation (the “distributing corporation”) to its shareholders of stock or securities in another corporation (the “controlled corporation”) to be tax-free to the shareholders, and also to be tax-free to the distributing corporation. However, in order for a corporate division to be accomplished on a tax free basis, it must satisfy the rules of Section 355 and 368(a)(1)(D). These requirements are explained briefly below.

Distributing Corporation Must be Controlled Corporation Prior to Corporate Division

Nonrecognition under Section 355 is limited to corporate distributions of stock of a controlled corporation. Such distributions of stock in a controlled subsidiary to shareholders of the parent in the eyes of the Internal Revenue Code reflects “mere change in forms.” To qualify for Section 355 nonrecognition treatment, the distributing corporation must either distribute all of the stock of the controlled corporation held immediately before the distribution or enough stock to constitute control. IRC Section 355(a)(1)(D).

Section 355(a)(1)(A) provides that in order for a spin-off to qualify for Section 355 treatment, the distributing corporation must distribute stock of “a corporation…which it controls immediately before the [spin-off].” The stock distributed must consist either of all of the stock of the subsidiary, or an amount of stock constituting control within the meaning of Section 368(c). Under Section 368(c), control is defined as ownership of at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of all other classes of stock of the corporation. The distributing corporation must distribute either (1) all the stock and securities of the controlled corporation owned by the distributing corporation immediately before the distribution or (2) an amount of the controlled corporation’s stock constituting control and establish to the satisfaction of the IRS that the retention of the controlled corporation’s stock or securities is not part of a plan having one of its principal purposes of the avoidance of federal income tax.

Transaction Must be Entered for a Valid Business Purpose

A transaction will not qualify as a tax-free reorganization unless it is motivated by a business purpose apart from tax avoidance. Treas. Reg. 1.368-1(c). The business purpose requirement will be satisfied if the distribution is motivated, in whole or in part, by one or more corporate business purposes. Such a purpose is a non-federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group of which the distributing corporation is a member. Treasury regulations also provide that, if a corporate business purpose can be achieved through a non-taxable transaction that does not involve the distribution of stock of a controlled corporation and which is neither impractical nor unduly expensive, then the distribution is not carried out for that corporate business purpose. See Treas. Reg. Section 1.355-2(d)(3). See, e.g., Treas. Reg. Section 1.368-2(b)(5), Example (3), which provides “Corporation X is engaged in the manufacture and sale of toys and the manufacture and sale of candy. The shareholders of X wish to protect the candy business from the risks and vicissitudes of the toy business. Accordingly, X transfers the toy business to new corporation Y and distributes the stock of Y to X’s shareholders. Under applicable law, the purpose of protecting the candy business from the risks and vicissitudes of the toy business is achieved as soon as X transfers the toy business to Y. Therefore, the distribution is not carried out for a corporation business purpose.

The business requirement is an independent requirement, so that even if a reorganization is not used for a tax avoidance purpose (e.g., it was not a “device” for the distribution of earnings), the transaction will not qualify if there was no business purpose for the transaction. Moreover, a corporate business purpose will not be treated as sufficient if the corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of controlled corporate stock and which is neither impractical nor unduly expensive. Treas. Reg. Section 1.355-2(b)(3)-2(b)(5).

The Income Tax regulations include a number of examples of valid corporate business purposes, including a pro rata distribution motivated by a desire to comply with legal requirements (e.g., a court anti-trust order), a non-pro rata distribution permitting different shareholder groups to focus on different business lines and thereby resolve shareholder conflicts, the separation of a regulated business from an unregulated business where it is impossible to achieve the separation without distributing the stock of the regulated business, and a pro rata distribution to enable a key employee to invest in the business of either the distributing or controlled entities. The regulations also identify corporate business purposes that are not sufficient for a tax-free reorganization, or including limitation of liability where liability protection could be achieved without a reorganization. Treas. Reg. Section 1.355-2(b)(5).

In addition to the regulations promulgated under Section 355, Rev. Proc. 96-30, Appendix A, prior to its amendment in Rev. Proc. 2003-48, provided a non-exclusive list of business purposes for a tax-free reorganization transaction, which include: to facilitate the retention of a key employee, to facilitate a stock offering, to facilitate borrowing, to reduce costs, to enhance the fit and focus of the distributing and controlled corporation’s respective business, to reduce the competition between the businesses, to facilitate an acquisition of the distributing corporation, to facilitate an acquisition by the distributing or controlled corporation, and to reduce the risks by separating a risky business from a less risky business. Over the course of time, however, cases and published rulings have acknowledged other valid purposes such as the reduction of state of foreign tax liability, a desire to resolve or reduce the impact of chronic labor union problems, and decreasing competition between the businesses for capital. See Rev. Rul. 89-101, 1989-2 C.B. 67; Rev. Rul. 76-187, 1976-1 C.B. 97; Priv. Ltr. Rul. 9823052 (Mar. 11, 1998).

The Treasury Regulation provides that a shareholder purpose is not a corporate business purpose for purposes of a tax-free reorganization. However, in cases where the shareholder purpose is closely aligned with a corporate business purpose, the business purpose requirement should be satisfied. This is supported by treasury regulation Section 1.355-2(b)(5), Example 2, which provides:

Corporation X is engaged in two businesses: The manufacture and sale of furniture and the sale of jewelry. The businesses are of equal value. The outstanding stock of X is owned equally by unrelated individuals A and B. A is more interested in the furniture business, while B is more interested in the jewelry business. A and B decide to split up the businesses and go their separate ways. A and B anticipate that the operations of each business will be enhanced by the separation because each shareholder will be able to devote his undivided attention to the business in which he is more interested and more proficient. Accordingly, X transfers the jewelry business to new corporation Y and distributes the stock of Y to B in exchange for all of B’s stock in X. The distribution is carried out for a corporate business purpose, notwithstanding that it is also carried out in part for shareholder purposes.

The IRS addressed a similar case in Rev. Rul. 2003-52. In the Revenue Ruling, a family farm corporation was divided with two motives in mind. First, the two shareholders, who were siblings, were in disagreement as to whether the corporation should focus more on the livestock or grain aspects of the business going forward. Thus, dividing the business would allow the siblings to devote their undivided attention and apply a consistent business strategy to the particular business of his or her interest. Second, the parents had estate planning goals in mind and wanted to promote family harmony. The IRS found the first motive to be a corporate business purpose and the second motive to be a shareholder purpose. Despite the second motive being a shareholder purpose, the IRS held that the distribution satisfied the business purpose requirement because it was “motivated in substantial part by a real and substantial non-federal tax purpose that is germane to that purpose.”

Active Business Test

“Active conduct” of a trade or business requires the corporation to perform “active and substantial management and operational functions.” Treas. Reg. Section 1.355-3(b)(2)(iii). The “definition” Section in Section 355(b)(2) offers virtually no guidance on the meaning of words “active conduct of a trade or business.” Moreover, the regulations make only a modest contribution. According to the regulations, a corporation is engaged in a “trade or business” if:

“A specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such a group include every operation that forms a part of, or step in, the process of earning income or profit. Such a group of activities ordinarily must include the collection of income and payment of expenses.” IRC Section 355(b)(1)(A).

Whether or not the corporation is actively, as opposed to passively, engaged in a trade or business will depend upon the facts and circumstances. To be considered an active trade or business, however, the corporation generally is “required itself to perform active and substantial management and operational functions.” Treas. Regs. Section 1.355-3(b)(2). Activities performed by outsiders, such as independent contractors, are not considered as performed by the corporation. “Active conduct” does not include the holding of stock, securities, raw land or other purely passive investments, or the ownership (including leasing) of real or personal property used in a trade or business unless the owner performs significant services with respect to the operation and management of the property. Treas. Reg. Section 1.355-3(b)(2)(iv).

Five-Year History Rule

Section 355(b)(2)(B) provides that the active business of distributing and controlled corporations must have been conducted for at least five years prior to the spin-off. The assets of the business must not have been acquired within that period in a transaction that is taxable to the seller and the business must not have been conducted by a corporation which controlled (i.e., 80% of the stock) of which was acquired by P or a distributee corporation in a taxable transaction.

Transaction Should Not be a Device to Distribute Earnings and Profits

To qualify for tax-free treatment under Section 355(a)(1)(B), a spin-off transaction must not be used principally as a device for the distribution of earnings and profits of the distributing or controlled corporation. A distribution does not qualify as tax-free under Section 355 if it is used principally as a device for the distribution of the earnings and profits. Whether a transaction is a “device” is determined based upon all the facts and circumstances, including, but not limited to, the existence or absence of specified “device factors” and “non-device factors” set forth in the regulations. Treasury Regulation Section 1.355-2(d)(2) lists several device factors which include, among others: 1) a pro rata distribution; 2) a subsequent sale or exchange of the stock of distributing or controlled; and 3) the nature and use of the assets of the distributing and controlled corporations immediately after the distribution. Treasury Regulation Section 1.355-2(d)(3)(i) lists as non-device factors: 1) a corporate business purpose; 2) the fact that the distributing corporation is publicly traded and widely held; and 3) if the distribution is to domestic shareholders that would be exempt from taxation on such distribution if it were taxable

Continuity of Interest

The continuity of interest regulations promulgated under Section 355 state that one or more persons who, directly or indirectly were the owners of the enterprise prior to the spin-off. Thus, businesses existing prior to the separation should be continued subsequent to the separation

Tax Consequences

If all the requirements for a tax-free division are satisfied, the shareholders should not recognize any gain or loss associated with the transaction. In the case split-offs and split-ups, each of which involves an exchange of stock or securities by the shareholders, Section 358(a) provides that the basis of the stock received shall be the same as the stock surrendered, decreased in the amount of any boot received and increased by the amount of gain or amount treated as divided. In regards to spin-offs, Section 358(c) deems the transaction to be an exchange in which stock of the distributing corporation retained is considered first as surrendered and then received back in the exchange. The effect of such a transaction is to allocate the basis of the stock owned after the distribution with the fair market values on the date of distribution. A corporation distributing stock of a controlled subsidiary in a transaction meeting the requirements of Section 355 should realize no gain or loss on the distribution.

Plan of Reorganization

A Type D reorganization must occur pursuant to a plan in order to qualify as a reorganization under Section 368. Treas. Reg. Section 1.368-1(c), 1.368-2(g). Prior to implementing a reorganization, a written plan should be entered into by all shareholders.

Section 312

Section 312 of the Internal Revenue Code generally provides that a corporation’s earnings and profits are decreased by the amount of money distributed by such corporation. In the context of distributions of money subject to Section 356(b), such a distribution should adjust the distributed E&P downward prior to the E&P adjustment that ensue pursuant to Sections 312(h) and 367(b) of the Internal Revenue Code. The method of allocating E&P depends on whether or not the controlled corporation is a newly-formed corporation receiving assets from the distributing corporation in a reorganization pursuant to Section 368(a)(1)(D). In such cases where the controlled corporations are newly-formed, the distributing corporation “generally” allocates its positive E&P between itself and the controlled corporation in the ratio that the fair market value of the distributed assets bears to the retained.

Circular Cash Flow Doctrine

Under the circular flow of cash doctrine, case moves amongst a group of interrelated companies, usually to accomplish a business purpose, but, at the end of the series of transactions, the cash ends up where it began. Generally, circular cash flow transactions do not affect the economic position of the parties, because the cash circulates back to where it started. Therefore, the intermittent steps of the transaction are disregarded. The IRS has consistently ruled that circular flows of cash should be disregarded as transitory steps in various types of corporate transactions.

In Revenue Ruling 74-564, a parent corporation (“Parent”) contributed cash, to satisfy capitalization requirements, and shares of its voting common stock to Z, a corporation formed by Parent for the purpose of merging Z into corporation R. S corporation owned ninety-eight percent of the stock of R corporation. Parent owned all of S corporation’s outstanding stock. The cash transferred by Parent to Z corporation and then by Z corporation to R corporation, was then transferred from R corporation to S corporation and finally from S corporation to Parent. The IRS ruled that the circular flow of cash should be disregarded.

In PLR 9746053, the IRS ruled that transfers of an unsecured interest bearing note through a chain of holding companies were circular and transitory steps and would be disregarded for U.S. federal income tax purposes.

For a circular cash transfer to be disregarded for U.S. federal tax purposes, the transferor generally must receive the same amount of cash back as it originally contributed. This point is illustrated by Revenue Ruling 83-142. That ruling involved, X, a U.S. corporation, which owned all of the stock of FY, a corporation formed under the laws of foreign country FC. For valid business reasons, FY proposed to transfer one of its businesses to FZ, a newly-formed FC corporation, in exchange for all of the FZ stock. Immediately thereafter, FY distributed all of the FZ stock to X in a transaction that was intended to qualify under Section 355 (that was subject to Section 356 as discussed below). The exchange of the FY business for the FZ stock was intended to qualify as a reorganization within the meaning of Section 368(a)(1)(D). The Ruling states that under FC law, X was required to purchase the FZ stock from FY at its fair market value rather than being able to receive the FZ stock as a distribution from FY. Therefore, as part of the transaction, X paid to FY an amount of money equal to the fair market value of the FZ stock (the “FMV Amount”). FY then made a cash distribution to X that under FC law was treated as a dividend and subject to withholding tax. The amount of the distribution to X was great enough to allow X to receive, after payment of the withholding tax to FC, the FMV amount. Thus, to enable payment of the FC withholding tax, the distribution was grossed up. The withholding tax imposed by FC was a creditable income tax under Section 901 that would be claimed by X.

The IRS ruled that the payment by X to FY equaled the fair market value of the FZ stock and the dividend distribution by FY to X was a circular flow of cash to the extent that X’s payment was returned by FY. This circular flow of cash was a transitory step that had no federal income tax consequences. However, FY’s distribution included the additional cash gross up so that X received the FMV Amount. This additional cash gross up was a distribution deemed to be received by X along with the FZ stock and constituted money received by X within the meaning of Section 356(b). In sum, the distribution of the cash by FY to X was disregarded to the extent it represented a return of cash received by FY from X. The deemed return included country FC withholding taxes. The amount of the distribution representing the gross up to allow X to receive the FMV Amount, after deduction to the FC withholding taxes was a distribution of money subject to the rules of Section 301 by application of Section 356. Thus, if FY had made a distribution of the FMV Amount with no gross up so that X would have received a distribution equal to the FMV Amount less the FC withholding tax, the dividend should have been avoided. The IRS has also held that transactions that involve transitory steps to comply with the laws of a foreign jurisdiction, but that ultimately achieve the result of a spinoff under Section 355, will be treated according to the ultimate result as a Section 355 transaction entitled to nonrecognition treatment.

The IRS ultimately upheld the Section 355 spinoff in Revenue Ruling 83-142. However, in cases where there is a circular loop of cash that has no real economic alteration for the parties involved in the reorganization, the IRS may disregard the reorganization for U.S. tax purposes. The IRS may also use the so-called step-transaction doctrine to disallow the reorganization.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.