On January 13, the U.S. Treasury and Internal Revenue Service released long-awaited proposed regulations governing the treatment of certain features of tax-free corporate spin-off and split-off transactions.  The IRS and Treasury’s stated aim was to provide generally applicable guidance for spin-off transactions in areas lacking specific legal rules taxpayers and their advisors can rely on in structuring their corporate separation transactions.  In the absence of these rules, taxpayers have instead been forced to seek IRS guidance largely through private letter rulings issued to specific taxpayers, often under vague or informal ruling policies that frequently have left even the taxpayers seeking the rulings uncertain as to precisely what terms the IRS would find acceptable until relatively late in the process of structuring a transaction.

The proposed regulations are voluminous and contain not only provisions addressing a number of features of spin-off transactions, but also some provisions that may affect how tax-free reorganizations are conducted and organized more generally.  While the proposed regulations represent a broader view of certain issues on which the IRS has not recently been willing to issue private letter rulings, on balance they take a very narrow view of which capital reallocation and debt relief transactions the IRS finds acceptable in connection with a spin-off or split-off.  Topics addressed in the proposed regulations include:

• Liability Assumptions. Frequently in spin-off transactions, the corporation making the distribution to its shareholders (“Remainco”) will cause the corporation it is distributing (“Spinco”) to assume some of its existing liabilities. In some cases, this assumption may occur because of a logical connection between the liabilities and Spinco (for example, where Spinco assumes trade payables of Spinco’s business or debt encumbering property transferred to Spinco in connection with the spin).  In others, however, it may also occur simply because Remainco can no longer sustain its historic debt level without the benefit of Spinco’s assets and revenues and needs Spinco to assume its “share” of the combined business’s indebtedness.  The proposed regulations contain rules detailing the circumstances under which Spinco may assume Remainco’s liabilities—and strictly limit the circumstances under which Remainco can reborrow thereafter—without Remainco incurring gain.

• Intermediated Exchanges and Direct Issuances. In certain spin-off transactions, Remainco is permitted to distribute both Spinco stock to its shareholders and also either stock or newly issued debt of Spinco to its creditors—effectively repaying its existing debt with Spinco stock or debt.  While this exchange of Remainco debt for Spinco debt or equity can be effected via private negotiation with or tender offers to existing creditors, Remaincos have generally found it easier to adopt either an “intermediated” exchange (in which an intermediary, generally a financial institution, acquires Remainco’s existing debt in anticipation of exchanging it for Spinco stock or debt) or a “direct issuance” transaction (where Remainco issues new debt, repaying existing indebtedness with the proceeds, and shortly thereafter agrees to exchange the new debt for Spinco stock or debt). The IRS’s view on whether and the circumstances under which either of these two techniques is permissible has shifted over the years, and the proposed regulations provide detailed guidance on how each can be effected, including a 30-day holding period for qualifying debt before a spin-off.  While the proposed regulations represent a more permissive policy than that embodied in some of the IRS’s most recent ruling guidelines, they nevertheless significantly narrow the parameters of the sorts of debt-for-equity and debt-for-debt exchanges that the IRS will accept, compared with the sorts of transactions the IRS has historically blessed in private letter rulings.
• Retentions and Delayed Distributions. While many spin-off transactions are effected by Remainco simply distributing 100% of its stock of Spinco at the same time, others may entail Remainco distributing only a portion of the Spinco stock it owns, holding back the rest either temporarily in order to distribute later in a subsequent transaction also intended to be tax-free (for example, in connection with a debt-for-equity exchange described above), or for a longer period of time (for example, where Remainco must retain some Spinco stock that has been pledged as collateral for a loan).  Historically, the IRS has drawn a bright line between these two scenarios, and more recently even required taxpayers to choose between the two at the beginning of the transaction in order to obtain a letter ruling.  The proposed regulations, by contrast, impose a single set of rules and safe harbors that would apply to all spin-offs in which Remainco does not distribute all of its Spinco stock on the same day, and allow taxpayers to detail prioritized disposition alternatives.
• New “Plan” Standards. In order for a corporate transaction to qualify as tax-free, the parties involved must adopt (depending on the type of transaction) a “plan of reorganization” or “plan of distribution.”  Determining the scope and nature of the plan can sometimes be critical because only transaction steps occurring “pursuant to” the plan will qualify for tax-free treatment.  While (in the case of corporate reorganizations) the requirement to adopt a “plan of reorganization” has existed for decades, the proposed regulations set forth for the first time a safe harbor setting out in detail how taxpayers should adopt and document their plan in order for the IRS to recognize it, as well as rules detailing how much time a taxpayer will need to complete all steps of a plan.  A taxpayer may detail certain alternative steps in its plan, but once it has begun taking the steps set forth in the plan, it cannot thereafter be amended absent an “identifiable, unexpected and material change in market or business conditions.”  While the rules regarding plans of distribution and reorganization were both clearly drafted and announced in the context of “divisive” reorganizations undertaken in connection with spin-off transactions, the rules regarding plans of reorganization could also be read to apply much more broadly, including to acquisitive reorganizations such as tax-free mergers, and it remains to be seen whether the IRS will seek to apply them in a wider context.
• New Reporting Requirements. In addition to documentary requirements for plans of reorganization and distribution, the IRS and Treasury also issued proposed regulations for reporting spin-off transactions on a new Form 7216 (itself recently published in draft form). The proposed Form 7216 requires extensive disclosure regarding the spin-off transaction, including key information regarding how the spin-off meets the legal requirements for tax-free treatment and what other transactions are being undertaken in connection with it, including liability assumptions, debt exchanges and retentions of Spinco stock.  Form 7216 would need to be filed each year for five years following the spin-off transaction to allow the IRS to monitor how the taxpayer has been complying with the relevant tax rules and the taxpayer’s own plan of distribution (and plan of reorganization, if applicable).  Taxpayers will also be required to file their plans of reorganization and/or distribution with the IRS in order to avail themselves of the safe harbor described above.

The proposed regulations must first go through the notice-and-comment rulemaking process before they can be finalized and enacted into law, and they will apply to spin-off transactions occurring only after the date they are published as final.  IRS personnel, however, have indicated that taxpayers may rely on them in seeking private letter rulings in advance of their finalization and that the IRS will immediately use the proposed regulations in evaluating requests for private letter rulings.  In the meantime, we plan to explore in more detail the proposed changes in future editions of Brass Tax.