By Anthony Diosdi
Corporate divisions involve the breaking of one corporation into multiple corporations. Such a transaction can be either taxable or tax-free. Corporate divisions tend to come in three basic flavors: spin-off, split-off, and split-up. Each variation involves a slightly different type of distribution of stock or securities. In general, if the transaction successfully runs the gauntlet of Internal Revenue Code Section 355, the tax treatment to the shareholders and the corporation will be the same regardless of whether the transaction is a spin-off, split-off, or split-up.
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 “spun off” through the parent corporation’s transfer of assets in return for stock or an existing subsidiary. The shareholders in a spin-off generally receive a pro rata share of the controlled corporation’s stock and do not transfer anything in return for this stock. If the transaction fails to qualify for no recognition under Section 355 of the Internal Revenue Code, the distribution is treated as a dividend to the shareholder distributes to the extent of the corporation’s earnings and profits and any gain on the distribution of the appreciated assets is taxable to the distributing corporation. See IRC Section 301.
A split-off is very much like 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. In other words, the transaction is structured more like a redemption than a dividend. If the transaction fails to qualify for Section 355 non recognition treatment, the distribution will be subject to the redemption provisions of Internal Revenue Code Section 302. Consequently, the redemption distribution might be treated by the shareholders either as a dividend under Section 302 of the Internal Revenue Code or a sale or exchange redemption under Internal Revenue Code Section 302(a).
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. If the transaction fails to qualify for Section 355 non recognition, the distribution will be treated as a complete liquidation to the shareholders, who will report gain or loss based upon the difference between the fair market value of the stock received and their basis in the original corporation’s stock. In addition, the corporation would be taxable on any gain upon a distribution of assets in complete liquidation. See IRC Section 336.
Overview of Internal Revenue Code Section 355
A distribution of stock or securities in a controlled corporation will be eligible for Section 355 non recognition treatment only if it meets numerous statutory and non statutory requirements.
1. Control immediately before the distribution- the distributing corporation must distribute solely stock or securities of a corporation which it controls immediately before the distribution; See IRC Section 336.
2. Distribution requirement– the distributing corporation must distribute all of the stock and securities in the controlled corporation held immediately before the distribution. See IRC Section 355(a)(1)(D)(i). As an alternative, the distributing corporation may distribute an amount sufficient to constitute control. In such a case, however, the distributing corporation must also establish that any retention of stock was not in pursuance to a tax avoidance plan;
3. Trade or business requirement– both the distributing corporation and the controlled corporation must be engaged immediately after the distribution in the active conduct of a trade or business. The “trade or business” requirement actually incorporates both a post-distribution and a pre-distribution rule since the statutory definition of an “active trade or business” requires that the corporation’s trade or business have been “actively conducted throughout the five-year period ending on the date of the distribution. See IRC Section 355(b)(2)(B).
4. Non-device requirement– the transaction was not used principally as a device to distribute earnings and profits of the distributing corporation, the controlled corporation, or both. See IRC Section 355(a)(1)(B).
In addition to these statutory requirements, Internal Revenue Code Section 355 incorporates several judicially developed requirements paralleling those required for the reorganization provisions generally. These include business purpose, continuity of the business enterprise, and continuity of proprietary interest requirements. See Treas. Reg. Section 1.355-2(c).
The Requirements of Section 355
Internal Revenue Code Section 355(a)(1)(A) provides that in order for a spin-off, split-off, or split-up for Section 355 tax-free treatment, the distributing corporation must distribute stock or securities of “a corporation which it controls immediately before the [spin-off, split-off, or split-up].” 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 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of all other classes 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 Internal Revenue Service (“IRS”) that the retention of the controlled corporation’s stock or securities is not part of a plan having one of its principal purposes being the avoidance of federal income tax.
1 Transaction Must be Entered for a Valid Business Purpose
The distribution must be carried out for a bona fide corporate business purpose. The business purpose requirement under Section 355 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. The business purpose requirement is an independent requirement of Internal Revenue Code Section 355, so that even if a spinoff is not used for a tax avoidance purpose, the transaction will not qualify under Section 355 if there was no business purpose for the transaction.
2. Active Business Test
Each of the distributing corporation and the controlled corporation must and the controlled corporation must each be engaged in the active conduct of a trade or business immediately after the spin-off. Specifically, Section 355 requires that 1) both the distributing corporation and the controlled corporation be engaged, immediately after the distribution, in the active conduct of a trade or business, 2) each such post-distribution business must have been actively conducted throughout a five-year period ending on the date of the distribution, and 3) each such post-distribution business must not have been acquired, directly or indirectly, by a purchase or other transaction in which gain or loss was recognized during the five year period.
To be engaged in the conduct of a “trade or business,” each corporation must engage in a specific group of activities for the purpose of earning income or profit and the activities included in such a group must include every operation that forms a part of, or a step in, the process of earning income or profit. The determination is made on the basis of all the facts and circumstances. The Treasury Regulations exclude two types of activities from qualifying as an active trade or business: 1) holding stock, securities, land or other property for investment purposes; and 2) owning and operating 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. See Treas. Reg. Section 1.355-3(b)(4)(iv).
Internal Revenue Code Section 355(b)(2)(B) provides that the active business of the distributing and controlled corporations must have been conducted for at least five years prior to the spin-off. The fact that a business has undergone changes in the five-year period is immaterial, so long as the changes are not fundamental enough to constitute the acquisition or adoption of a new business that does not satisfy the five-year period requirement. See Treas. Reg. Section 1.355-3(b)(3).
3. Spinoff 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. 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 “no-device factors” stated in the regulations. See Treas. Reg. Section 1.355-2(d).
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. A pro rata distribution among the shareholders of the distributing corporation presents the greatest potential for the avoidance of the dividend provisions of the Internal Revenue Code and, in contrast to other distributions, is more likely to be used principally as a device. If there is a sale or exchange of stock of the distributing or the controlled corporation after the distribution, the shorter the period of time between the distribution and such subsequent sale or exchange and the greater the percentage of stock sold or exchanged after the distribution, the stronger the probability that the IRS will determine the transaction is a device.
Treasury Regulation Section 1.355-2(d)(3)(i) lists as non-device factors: 1) a corporation 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. Treasury Regulation Section 1.355-2(d)(5)(ii) also provides that a distribution is ordinarily not considered to have been used principally as a device if 1) the distributing and controlled corporations have no accumulated earnings and profits at the beginning of their respective taxable years; 2) the distributing and controlled corporations have no current earnings and profits as of the date of the distribution; and 3) no distribution of property by the distributing corporation immediately before the separation would require recognition of gain resulting in current earnings and profits for the taxable year of the distribution.
4. Continuity of Interest
The continuity of interest regulations under Section 355 require that one or more persons who, directly or indirectly, were the owners of the enterprise prior to the spin-off own, in the aggregate, an amount of stock sufficient to establish 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).
5. Continuity of Business Enterprise
Businesses existing prior to the separation should be continued subsequent to the separation. Pursuant to the regulations, the controlled corporation is treated as holding all of the business and assets of all members of its qualified group. A qualified group is defined as one or more chains of corporations connected through stock ownership with the acquiring corporation, but only if the acquiring corporation owns directly stock meeting the requirements of Section 368(c) in at least one other corporation, and stock meeting the requirement of Section 368(c) in each of the corporations (except the acquiring corporation) is owned directly by one of the other corporations. See IRC Section 1.368-1(d)(4)(ii). Section 368(c) defines the term “control” to mean the ownership of at least 80 percent of the total combined voting power of all classes of stock entitled to vote, and 80 percent of the total number of shares of all other classes of stock of the corporation. Therefore, the controlled corporation is attributed the business, assets and liabilities of its controlled subsidiary, where the distributing corporation transferred the subsidiary stock to the controlled corporation resulting in the controlled corporation owning a controlling interest in such subsidiary and of the controlled subsidiary’s controlled subsidiaries.
6. Transaction Must Not Amount to a Distribution of Disqualified Stock
A spin-off may be considered a disqualified distribution if any person holds “disqualified stock” in either the distributing or the controlled corporation and such stock represents a fifty percent or greater interest in such a corporation. For these purposes, the term “fifty percent or greater interest” is defined as stock possessing at least fifty percent of the total combined voting power of all classes of stock entitled to vote or at least fifty percent of the total value of shares of all classes of stock. See IRC Section 335(d).
The term “disqualified stock” is defined as 1) any stock in the distributing corporation that was acquired by purchase during the five-year period ending on the date of the distribution, or 2) any stock in the controlled corporation acquired by purchase at any time during the five-year period ending on the date of the distribution or received in the distribution to the extent attributable to the distribution on any stock of the distributing corporation by purchase during the five-year period. The regulations provide three exceptions to the above general rule: 1) an acquisition of stock in a corporation in exchange for an 80 percent stock interest in another corporation; 2) cash transferred as part of an active trade or business; and 3) transfers between members of the same affiliated group. See Treas. Reg. Section 1.355-6(d)(3)(iii)-(v).
7. Not Part of a Plan Described in Section 355(e)
Under Section 355(e), if a Section 355 otherwise applies to a spin-off but the spin-off is part of “a plan or series of related transactions” pursuant to which one or more persons acquire directly or indirectly a “50-percent or greater interest,” measured either by total combined voting power or the total combined value of the shares in the distributing corporation or the controlled corporations, the distributing corporations must recognize gain on the shares of controlled corporation that are distributed.
8. Neither Corporation Should be a Disqualified Investment Corporation
Internal Revenue Code Section 355(g) provides that a distribution will not qualify as a tax-free distribution under Section 355 if the distribution is part of a transaction after which either the distributing corporation or a controlled corporation is a disqualified investment corporation and a person holds immediately after the transaction a 50 percent or greater interest in any corporation and a person holds immediately after the transaction a 50 percent or greater interest in any disqualified investment corporation not so held immediately before the transaction. A corporation will be a disqualified investment corporation not so held immediately before the transaction. A corporation will be treated as a disqualified investment corporation if the fair market value of its investment assets is two-thirds or more of the fair market value of all of its assets. The term “investment assets” includes: 1) cash; 2) any stocks or securities in a corporation; 3) any interest in a partnership; 4) any debt instrument or other evidence of indebtedness; 5) any option, forward or futures contract, notional principal contract, or derivative; 6) foreign currency; and 7) any similar asset. See IRC Section 355(g)(2)(B)(i). Stocks issued by a corporation with respect to which the distributing or the controlled corporations own directly or indirectly 20 percent or greater stock interest represented by vote and value is not, per se, considered to be an investment asset. However, in such cases, the distributing or controlled corporation is treated as owning a proportionate share of the 20 percent or more owned and controlled corporation’s assets.
9. Plan of Reorganization
A Section 355 tax-free reorganization must occur pursuant to a plan. This means, prior to the implementation of a tax-free Section 355 reorganization, a written plan should be entered into by the parties.
Tax Consequences to Shareholders
A shareholder who transfers stock in connection with a reorganization and receives stock or other assets in return has realized a gain to the extent that the value of the stock or other assets received exceeds the shareholder’s basis in the stock transferred.Similarly, the shareholder has realized a loss to the extent that the shareholder’s basis in the stock transferred has realized a loss to the extent that the shareholder’s basis in the stock transferred exceeds the value of the stock or assets received in the exchange. Absent a special nonrecognition rule, gains and losses realized from these exchanges generally would be recognized for tax purposes pursuant to Sections 61(a)(3) and 1001. Losses would be recognized pursuant to Section 1001.
The Section 354 nonrecognition rule contains several parallels to the Section 351 nonrecognition rule applicable to incorporation transactions. The initial motivating policy behind each of the provisions is similar; that is, providing nonrecognition to exchanges (whether as part of the reorganization or reorganization) that reflect “merely a change in form.” In addition, a shareholder who receives nonrecognition treatment under either Section 351 or Section 354 takes a substitute basis in the stock or securities received pursuant to Section 3658. One significant distinction between Sections 351 and 354, however, is that Section 354 only permits nonrecognition upon receipt of “stock or securities” while Section 351 only permits nonrecognition upon receipt of stock. Moreover, a second significant distinction between Sections 351 and 354 is that the shareholders in the 351 context must receive a quantum of stock representing “control” whereas the shareholder of a target may receive only a minuscule ownership in the acquiring corporation and yet to be entitled to nonrecognition treatment.
While Section 354(a)(1) establishes a general nonrecognition rule, limitations are set forth in Section 354(a)(2). Nonrecognition is not available to the extent that the principal amount of any securities received exceeds the principal amount of securities surrendered. See IRC Section 354(a)(2)(A)(i). In other words, an exchange of securities for the same principal amount of securities is a reorganization will be a tax-free exchange Any excess securities that the shareholder receives will be considered boot and will be taxable. Similarly, if any securities are received and no securities are surrendered, the securities received also will be considered taxable. See IRC Section 354(a)(2)(A)(ii).
Shareholder Receipt of Boot Under Section 356
The nonrecognition language of Section 354 itself is rigid. It requires that the exchange of stock or securities in one corporate party to a reorganization must be solely for stock or securities in the same corporation or another corporate party to a reorganization. This strict requirement is loosened by Section 356, which provides that if Section 354 would apply, but for the fact that something other than stock or securities is received, “then gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of….money and the fair market value of…other property.” See IRC Section 356(a)(1)(B). For purposes of Section 356, the term “other property” includes “nonqualified preferred stock” unless the preferred stock was permitted to be received tax-free in a Section 368(a)(1)(E) recapitalization of a family-owned corporation. Thus, to the extent that shareholders receive any “boot” or property other than property permitted to be received tax-free under Section 354, the “boot” will be taxable under Section 356 to the extent of realized gain. Anybexcess securities or “nonqualified stock” received as described in Section 354(a)(2) will be considered “boot” for purposes of Section 356.
Tax Consequences to the Corporation in a Reorganization
Absent special rules, a corporation that transfers property in return for stock or securities of another corporation realizes gain or loss from the exchange under Section 61(a)(3) and 1001. In addition, corporations that distribute property to shareholders realize, and ordinarily must recognize, gains or losses. Gains and losses generally are recognized upo liquidating distributions under Section 336. In the case of nonliquidating distributions, Section 311 requires recognition of gain, but does not permit losses. A special nonrecognition rule is provided in Section 361 for a corporate “party to a reorganization” that “in pursuance of a plan of reorganization” exchanges property in return for stock or securities of another corporate “party to the reorganization.” See IRC Section 361(a). Even if the corporation receives property other than stock or securities in the exchange, the receiving corporation will not be required to recognize gain if the other property is distributed pursuant to the plan of reorganization. See IRC Section 361(b). Finally, the corporation is entitled to nonrecognition treatment on distributions to shareholders of certain qualified property in connection with the reorganization. See IRC Section 361(c).Thus, a properly properly structured corporate reorganization will be tax-free to the participating corporations.
In addition, under Section 1032, no gain or loss is recognized when a corporation receives money or property in exchange for its own stock. Thus, a corporation that acquires stock or assets in a tax-free reorganization generally will not recognize gain or loss.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
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 also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. 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.