By Anthony Diosdi
There are many good business reasons that a corporate group may decide to enter a corporate division transaction to separate one or more trades or businesses from another distinct trade or business. The three types of corporate divisions are commonly known as spinoffs, split-offs, and split-ups. Such corporate divisions are also referred to as demergers or Type D reorganizations. To illustrate the elements of these transactions, assume that Alexis and Bob each own 50 percent of the stock of Diverse Corporation (“D”), which for many years has operated a winery and a cattle ranch as separate divisions. For reasons to be elaborated below, the shareholders wish to divide the business into two separate corporations on a tax-free basis. From a tax perspective, the possibilities are:
Spin-off, Assume that to comply with new state regulations, D is required to operate the chicken ranch and winery as separate corporations. To accomplish the division, D forms a new corporation, Steak, Inc., contributing the assets of the cattle ranch. It then distributes the stock of Steak pro rata to Alexis and Bob, who emerges as equal shareholders in each corporation. Because a spin-off involves a distribution of property to shareholders without the surrender of any stock, it resembles a dividend.
Split-off. Alexis and Bob desire to part company, with Alexis operating the winery and Bob the cattle ranch. To help them go their separate ways, D again forms a new corporation, Steak, Inc., contributing the assets of the cattle ranch. D then distributes the stock of Steak to Bob in complete redemption of his D stock. Alexis becomes the sole shareholder of D, which now owns only the winery, and Bob is the sole owner of the cattle ranch. If Alexis and Bob did not want to part company, D could have made a pro rata distribution of the cattle stock in redemption of an appropriate amount of D stock. A Split-offs often resembles corporate redemptions of stock.
Split-up. To comply with a new state regulation, D is required to terminate its corporate existence and divide up its two businesses. The fission is accomplished by D forming Vineyard, Inc. and Steak, Inc., contributing the winery assets to Vineyard and the cattle ranch assets to Steak. D then distributes the stock of the two new corporations pro rata to Alexis and Bob in exchange for all their D stock. Because D had distributed all of its assets and dissolved, this transaction resembles a complete liquidation.
As these examples demonstrate, spin-offs, split-offs, and spin-offs can be classified for tax purposes in two different ways: as a tax-free corporate division or as a taxable transaction. In order to qualify as tax-free to the shareholders, the division must satisfy the requirements of Section 355 and its accompanying judicial doctrines. In general, Section 355 allows a corporation with one or more businesses that have actively conducted for five years or more to make a tax-free distribution of the stock of a controlled subsidiary (or subsidiaries) provided that the transaction is being carried out for a legitimate business purpose and is not being used principally as a device to bail out earnings and profits. In the absence of Section 355, a spin-off likely would be treated as a dividend under Section 301; a split-off would be tested for dividend equivalency under the redemption rules in Section 302; and a split-up ordinary would be treated as a complete liquidation under Section 331.
There is one more piece to this introduction to the puzzle. In each of the examples above, Diverse Corporate was a domestic corporation. In today’s global economy, corporations have operations all over the world. Thus, demergers often take place in the foreign context. As its name suggests, a demerger is the converse of a merger; whereby a single corporation divides into two or more corporations with each corporation taking a portion of the assets and liabilities that were held by the single corporation immediately prior to the demerger.
A corporate division in the case of such a multinational group raises difficult issues because the goal is for the parent corporation to be able to spin off a subsidiary that owns a group of companies and to retain the other business line directly or through a series of subsidiary corporations. Specifically, the question raised is how best to disentangle the business in each local country subsidiary. Dividing a foreign corporate subsidiary entails the complete transfer of one business line to a new sister corporation of the subsidiary. There are a plethora of issues that must be considered. To better understand the technical requirements for a tax-free corporate division, it is helpful to understand the background of Section 355 before diving into the international tax issues such transactions often raise.
Basic Requirements of a Section 355
Tax-free spinoffs or demergers (a demerger is the converse of a merger; whereby a single corporation divides into two or more corporations with each corporation taking a portion of the assets and liabilities that were held by the single corporation immediately prior to the transaction) 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. In order for a corporate division to be accomplished on a tax free basis, it must meet the requirements of Section 355 and 368. The distributing corporation must distribute to its shareholders the stock or securities of a “controlled corporation” – a corporation that the distributing corporation “controls” immediately before the distribution. See IRC Section 355(a)(1)(A). For this purpose, “control” is defined by Section 368(c), which requires ownership of 80 percent of the total combined voting power and 80 percent of the total number of shares of all classes of stock, including nonvoting preferred stock.
The distributing corporation must distribute all the stock or securities of the controlled corporation that the distributing corporation holds or, alternatively, an amount of stock sufficient to constitute “control” within the meaning of Section 368(c). See IRC Section 355(a)(1)(D). If any stock or securities of the controlled corporation are retained, the distributing corporation must establish to the satisfaction of the IRS that the retention is not pursuant to a plan having tax avoidance as one of its principal purposes.
Both the distributing corporation and the controlled corporation – or in a split up, both controlled corporations- must be engaged immediately after the distribution in an actively conducted trade or business which has been so conducted throughout the five-year period ending on the date of the distribution. See IRC Section 355(a)(1)(C); (b). That business must not have been acquired within the five-year predistribution period in a taxable transaction. Moreover, the distributing corporation must not have purchased a controlling stock interest in a corporation conducting the business in a taxable transaction during the five-year predistribution period.
A Section 355 transaction must also satisfy the “active conduct” of trade or business test. “Active conduct” of a trade or business requires the corporation to perform “active and substantial management and operational functions.” See Treas. Reg. Section 1.355-3(b)(2)(iii). 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 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.
In addition, to qualify for tax-free treatment under Section 355(a)(1)(B) of the Internal Revenue Code, 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. 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 in the regulations. Specifically, Section 355 explicitly demands that “the transaction was not used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both.” Frequently described as the “device requirement,” this condition is a nutshell statement of the general concern of Section 355. In fact, it is in the regulations pursuant to the “device” requirement that one finds perhaps the best statement of the underlying concern. The regulation states that “Section 355 recognizes that a tax-free distribution of the stock of a controlled corporation presents a potential for tax avoidance by facilitating the avoidance of the dividend provisions of the Internal Revenue Code through the subsequent sale or exchange of stock of one corporation and the retention of the stock of another corporation.” See Treas. Reg. Section 1.355-2(d)(1).
Finally, the corporate separation must satisfy the continuity of interest rules. As applied in the tax-free separation context, continuity requires that one or more prior owners own, in the aggregate, “an amount of stock establishing a continuity of interest in each of the modified corporate forms in which the enterprise is conducted after the separation.” See Treas. Reg. Section 1.355-2(c)(1). In other words, if one corporate enterprise is separated into three distinct corporations, the continuity of interest requirement must be met with regard to each of the three entities resulting from the separation.
The Interplay Between Section 368(a)(1)(D) and Section 355
A Type D reorganization involves transfer of “all or a part of [a corporation’s] assets to another corporation if immediately after the transfer, the transferor, or one or more of its shareholder…., or any combination thereof, is in control of the corporation to which the assets are transferred.” A Type D reorganization includes both acquisitive and divisive reorganizations. In general, acquisitive Type D reorganizations involve a transfer of all of the assets and a subsequent distribution of stock or securities pursuant to the requirements for nonrecognition purposes. On the other hand, a divisive reorganization involves a transfer of part of the assets and a subsequent distribution of stock or securities pursuant to the requirements for nonrecognition under Section 355.
The IRS has provided guidance on the distribution requirements for Section 368(a)(1)(D) reorganizations when no stock of the controlled corporation is transferred by the distributing corporation to its shareholders. Under a literal reading of Section 368(a)(1)(D), such a distribution would be required. However, as indicated above, the IRS takes a substance over form approach to the distribution requirement and instead deems the transaction to have followed the literal steps found in the statute. The IRS has provided guidance on transactions where cash is contributed by the shareholders to the controlled corporation, which is used to purchase assets from the distributing corporation and finally distributed back to the shareholders. As discussed below, the circular flow of cash generally is disregarded when analyzing whether the transaction qualifies as a Section 368(a)(1)(D) transaction.
In determining whether a transaction meets the requirements of Section 355 and 368(a)(1)(D), the Internal REvenue Service or IRS has ruled that the substance of the overall transaction, and not the particular form of any one aspect of the transaction or order of the steps, will control the treatment of the exchange as a spin-off entitled to nonrecognition treatment. For example, in Rev. Rul. 77-191, 1977-1 C.B. 94, the taxpayer corporation had been engaged in two active businesses. In order to remove restrictions imposed on one business by certain federal laws, the taxpayer distributed all of the assets of that business to its shareholders,in redemption of part of their stock of the taxpayer. Immediately following the distribution and pursuant to an integrated plan, the taxpayer’s shareholders transferred all of the assets received to a newly-organized corporation. Thereafter, the newly-formed recipient corporation conducted the business formerly conducted by the taxpayer.
The form of the taxpayer corporation’s distribution of business assets to its shareholders in Rev. Rul. 77-191 did not technically satisfy the requirement under Section 355(a)(1)(D) that the distributing corporation distribute all of the outstanding stock of the controlled corporation, as the purported “controlled corporation” did not yet exist at the time of the distribution. The distribution would, rather, meet the technical definition of a taxable liquidation under Section 311. The IRS held that, while the distributing corporation did not actually distribute stock of a controlled corporation, the transaction when viewed together with the immediate contribution of those assets to a newly formed controlled corporation should be treated as a Section 355 spinoff. The IRS observed:
“The tax consequences of a business transaction are properly determined by the substance of the transaction and not by the form in which it is cast. A transaction must be viewed as a whole. The true nature of a transaction cannot be disguised by mere formalisms that exist solely to alter tax liabilities.” See Commissioner v. Court Holding., 324 U.S. 331 (1945).
Additionally, the IRS noted that the statutory intent of the Internal Code would be frustrated by such a formalistic interpretation of the facts under review, as Section 331 was not intended was not intended to apply to a divisive transaction that ultimately resulted in splitting a single corporation into two or more corporations owned by the shareholders of the original corporation. “Under these circumstances,” the IRS held, “Section 355 is the governing provision.” The IRS determined that the new corporation as a wholly-owned subsidiary, transferred the assets of the business to the new corporation, and then distributed the stock of the new corporation pro rata to the taxpayer’s shareholders in exchange for part of their stock in the taxpayer, and that this series of steps “is a typical corporate split-off described in Section 368(a)(1)(D) and 355 of the Internal Revenue Code. See Tax-Free Spinoffs in the International Context, Baker & McKenzie, Miami (2016).
The IRS has applied Rev. Rul. 77-191 in private letter rulings to determine that the overall substance of a transaction, as evidenced by the final result of the step and not the particular steps undertaken to effect the transaction, should determine whether a transaction is treated as a Section 355 spinoff entitled to nonrecognition treatment. In Priv. Ltr. Rul. 200703030, the taxpayer, the common parent of a consolidated group, owned a disregarded limited liability company (LLC 1) and all of the stock of the distributing corporation. The distributing corporation owned three disregarded limited liability companies (LLCs 2, 3, and 4), which, in turn, owned a number of controlled corporations. The taxpayer proposed to achieve the ultimate effect of a Section 355 spinoff by merging LLCs 2, 3 and 4 with and into LLC 1, with LLC 1 surviving. These mergers resulted in the parent corporation owning, for U.S. federal income tax purposes, all of the stock of the controlled corporations. The IRS held that Rev. Rul. 77-191 applied and that the transaction would be treated as though the distributing corporation distributing corporation distributed all of the stock of the controlled corporations to its parent, notwithstanding the fact that no actual distribution of the controlled corporations’ stock to the parent occurred.
Tax Consequences to Shareholders
Section 367(e)(1) provides that, in the case of a distribution described in Section 355 by a U.S. corporation to a foreign person, gain is to be recognized under principles similar to those of Section 367. Since the foreign distributee in a Section 355 distribution may be an individual, partnership, trust or estate, as well as a foreign corporation, recognition of gain to the distributing corporation may not be achieved, as it is in the other exchanges enumerated in Section 367(a)(1), in a Section 355 distribution by simply not treating a foreign corporation as a corporation for purposes of Section 355. Accordingly, Section 355 distributions are dealt with specifically in the regulations.
The regulations establish, as a general rule, that if a U.S. corporation distributes stock or securities of a corporation in a transaction that otherwise qualifies under Section 355(a) to a person who is not a “qualified U.S. person,” the distributing corporation recognizes gain (but not loss) under Section 367(e)(1). A “qualified U.S. person” for this purpose is U.S. citizen, resident alien or corporation. If the distributed corporation is a controlled foreign corporation of which the distributing corporation is a U.S. shareholder, part or all of the taxable gain may be treated as a dividend under Section 1248 or Section 951A. This gain-recognition rule will apply only to U.S. distributing corporation’s distribution of the stock or securities of a foreign corporation. Thus, the regulations provide that a U.S. distributing corporation does not recognize gain under this rule on the distribution of the stock or securities of a U.S. corporation. See Treas. Reg. Section 1.367(e)-1(c).
If the U.S. distributing corporation does trigger this gain-recognition rule by distributing the stock or securities of a foreign corporation to distributees who are not qualified U.S. persons in a Section 355 transaction, the gain recognized by the distributing corporation is the excess of the fair market value of the stock or securities distributed to such distributees (determined as of the time of the distribution) over the corporation’s adjusted basis in such stock or securities.
Nonoubound Corporate Divisions
Section 355 describes a number of corporate division transactions in which a corporation distributes at least 80 percent of the stock of a corporation that it controls, within the meaning of Section 368(c), and which do not involve an outbound transfer covered by Section 367(e)(1). The distribution may take the form of a spin-off- split-off or split-up and, if an asset transfer to a controlled corporation is involved, it may constitute a Type D reorganization.
In general, only corporate divisions in which assets begin and end in foreign corporations or begin in foreign corporations and end in U.S. corporations are subject to the Section 367(b) regulations. On the other hand, any outbound Section 355 distributions by a U.S. corporation to a non-U.S. person of the stock or securities of a controlled corporation that is a foreign corporation gives rise to the recognition of gain to the distributing corporation as an outbound transaction. By contrast, if the U.S. corporation distributes the stock or securities of a controlled corporation that is a U.S. corporation, gain recognition is not triggered under Section 367(e)(1).
Distribution by U.S. Corporations
Under the Section 367(d) regulations, when a U.S. corporation distributes stock of a controlled corporation that is a foreign corporation, whether the U.S. corporation must recognize gain depends on whether the distributee is an individual or corporation. If the distributee is an individual, the controlled corporation is not considered to be a corporation and, consequently, the distributing corporation is required to recognize any gain realized on the distribution. If however, the distributee is a corporation, the controlled corporation is considered to be a corporation and, consequently, the U.S. distributing corporation does not recognize gain on the distribution.
Distribution by Foreign Corporation
If a distribution is made by a foreign corporation that is not a controlled foreign corporation to a U.S. shareholder, the normal rules applying a Section 355 distribution are applicable, and no gain is recognized to the distributing corporation or the exchanging shareholder. If the distribution is made by a controlled foreign corporation, then the distributee’s Section 1248 (determined on a hypothetical exchange of stock in the distributing or controlled corporation) or Section 951A amount must be taken into account with respect to the distribution.
Dividing a multinational corporation raises a plethora of issues including the tax consequences discussed in this article. In addition, the following issues not discussed in this article should be considered in a cross-border division:
1) How to structure a corporate division in the most efficient manner from a foreign tax perspective (taking into account the tax laws of the foreign countries a multinational corporation is incorporated);
2) Consideration should be given to having to transfer corporate assets from one corporation to another corporation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals. He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or email@example.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.