Over the last three months, public statements by U.S. Treasury and Internal Revenue Service officials have suggested that they are in the process of significantly revising the rules governing tax-free spin-offs, split-offs and similar transactions.  While some of these changes are, strictly speaking, procedural rules for obtaining IRS private letter rulings ("PLRs"), they may nonetheless significantly affect which transactions may occur without tax to either distributing corporations or their shareholders.

Expanded Ruling Program

One change, involving the scope of the PLRs the IRS is willing to issue, has already gone into effect.  In Revenue Procedure 2024-03, released at the beginning of the year, the IRS announced that it would reverse its longstanding policy not to rule on issues relating to either “device” (described below) or “Section 355(e)” (which causes a spin-off to be taxable to the distributing corporation if it is part of a plan in which there is a 50% or greater change in the ownership of either the distributing or newly spun-off corporation, often called the “spinco”).  Both are fact-specific inquiries, and the IRS’s willingness to grant rulings that will cover these issues will provide greater certainty for taxpayers (who previously needed to rely on opinions of tax advisors to ensure they did not run afoul of these two provisions).

Debt-for-Equity Exchanges and Retained Stock

Additionally, the IRS is planning more comprehensive changes to the procedures for applying for PLRs for tax-free spin-offs.  As part of this revision, a number of IRS officials have alluded to forthcoming modifications to the IRS’s rules and practice governing rulings on debt-for-equity exchanges and the post-spin retention of spinco stock.

Debt-for-Equity. In many tax-free spin-offs, the distributing company may distribute spinco stock not only to its shareholders but also to its creditors, effectively repaying debt with spinco stock.  (A similar rule applies to exchanges of distributing company debt for newly issued debt securities of the spinco.)  While this exchange of debt for equity can be effected via private negotiation with, or tender offers to, existing creditors, distributing companies generally find it easier to adopt either an “intermediated” exchange (where an intermediary, generally a financial institution, acquires the distributing company’s existing debt in anticipation of exchanging it for spinco stock) or a “direct” issuance (where the distributing corporation issues new debt, repaying existing indebtedness with the proceeds, and shortly thereafter agrees to exchange the new debt for spinco stock).  Various IRS officials have indicated that the forthcoming ruling policy may also address the circumstances in which these transactions may be effected tax-free—and in particular may limit taxpayers’ ability to engage in direct issuance transactions.

Retention. To qualify for tax-free treatment, a distributing corporation must not only always distribute an amount of stock constituting “control” of the spinco, but also distribute all of the spinco stock it owns unless it receives IRS approval to retain some spinco stock.  The IRS will issue a PLR approving such a retention only if the taxpayer has demonstrated that the retention does not have a tax avoidance purpose.  IRS officials have suggested that the revised ruling procedures may modify the IRS’s policy in granting this approval.  In particular, the IRS may draw a sharper distinction between true “retention” of spinco stock (which can last for an extended period of time—sometimes for years—following which any subsequent disposition of the retained stock would be taxable) and temporarily holding back some spinco stock before disposing of it tax-free as part of a plan with the spin-off (such as waiting several months after distributing some spinco stock to shareholders in order to allow trading in spinco stock price to settle, before disposing of the remaining shares in a debt-for-equity exchange).  Previously, taxpayers had been able to receive “backstop” retention rulings that allowed them to retain spinco stock without causing the entire spin-off to become taxable; for example, in the event that market conditions precluded a planned debt-for-equity exchange.  Under the new policy, however, taxpayers seeking a ruling may be forced to choose between a “retention” ruling and one allowing for deferred “plan” distributions.  As the New York State Bar Association noted in a recent report, such a change could deter companies from attempting transactions involving debt-for-equity exchanges, since a failed exchange could jeopardize the tax-free treatment of the entire transaction.

Regulations on Active Trade or Business and Device

Lastly, the IRS and Treasury have indicated that they may release new substantive Treasury Regulations regarding the “active trade or business” and “device” requirements for tax-free spin-offs.  For a spin-off to be tax-free, both the distributing company and the spinco must conduct an “active trade or business” (ATB) that has been conducted for five years.  The current regulations date to 1989, and have not been updated to take into account a number of significant changes to the ATB requirement subsequently enacted by Congress or adopted by the IRS.

Additionally, as noted above, a tax-free spin-off cannot be used as a “device” for the distribution of earnings and profits—in other words, to disguise what would otherwise be a taxable dividend.  Whether a spin-off is a “device” is a factual inquiry.  Current regulations provide a set of nonexclusive “device factors” and “nondevice factors,” without much guidance as to how to weigh the various factors against one another or how they relate to other requirements for a tax-free spin-off.  In particular, one factor weighing in favor of a finding of device is the “existence of assets that are not used in a trade or business,” including cash and liquid assets in excess of reasonable needs of a business.  In 2016, the Treasury proposed revised regulations that would have replaced this relatively vague factor with a strict “per se” rule that would cause a spin-off to lose its tax-free treatment if the ratio of business assets to nonbusiness assets of the distributing company differed by a specified amount from the equivalent ratio of the spinco, or if the ratio for either company exceeded 66.67%.  These proposed regulations were never finalized, however, and comments by IRS officials suggest that new device regulations will not contain this “per se” rule, but may contain more detailed and concrete rules on how to apply the device test.

There is still uncertainty as to the exact contours of each of these changes, and no concrete timeline has been proposed for when they will be publicly announced.  When they are, however, be sure to read about them here in BrassTax.