IRS Issues “No-Rule” Orders on Several Sec. 355 Transactions

Editor: Mary Van Leuven, J.D., LL.M.

Corporations & Shareholders

The IRS recently put an abrupt halt to its ruling practice with respect to several transactions in the Sec. 355 area for which rulings had previously become routine. Rev. Proc. 2013-3 (the annual “no-rule” revenue procedure) declares those transactions “under study.” This item discusses three transactions covered by the no-rule revenue procedure.

For a stock distribution to qualify under Sec. 355, the distributing corporation (Distributing) must have ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock (Control) of the corporation whose stock is being distributed (Controlled) (Secs. 355(a)(1)(D) and 368(c)).

Recapitalization Into Control

The first no-rule area prohibits ruling on whether a corporation is a controlled corporation within the meaning of Sec. 355 if the corporation underwent a recapitalization into high-vote/low-vote stock in anticipation of the distribution.

In 1969, the IRS issued Rev. Rul. 69-407, in which, in anticipation of a distribution of the stock of Controlled that was intended to qualify under Sec. 355, Controlled recapitalized its common stock (its only class of stock outstanding) into high-vote/low-vote shares. The recapitalization did not change the proportionate interests that the Controlled shareholders held in Controlled, but it altered their proportionate voting rights. As a result of the recapitalization, Distributing, which previously held 70% of the stock of Controlled, held 80% of the total combined voting power of the common stock of Controlled (i.e., a sufficient amount to have Control). The IRS respected the recapitalization-into-Control transaction, noting that the recapitalization resulted in a permanent realignment of voting control.

Since it issued Rev. Rul. 69-407, the IRS’s position on recapitalizations into Control has evolved and become increasingly permissive, with more recent letter rulings allowing recapitalizations into Control even when a potential unwinding of the high-vote/low-vote structure was contemplated (as long as it was not compelled) (see, e.g., Letter Rulings 201123030, 201116001, and 201007050).

However, Rev. Proc. 2013-3 announced that the IRS will no longer issue letter rulings or determination letters on:

[w]hether a corporation is a “controlled corporation” within the meaning of §355(a)(1)(A) if, in anticipation of a distribution of the stock of the corporation, a distributing corporation acquires putative control of the controlled corporation (directly or through one or more corporations) in any transaction (including a recapitalization) in which stock or securities were exchanged for stock having a greater voting power than the stock or securities relinquished in the exchange, or if, in anticipation of a distribution of the stock of the putative controlled corporation, such corporation issues stock to another person having different voting power per share than the stock held by the distributing corporation.

IRS representatives in panel discussions have indicated that the new prohibition may be even broader than is apparent from the language in the no-rule revenue procedure. Although the no-rule revenue procedure refers only to “whether a corporation is a ‘controlled corporation,’ ” IRS representatives have indicated that the IRS will not issue any rulings at all with respect to a transaction that involves a controlled corporation that has a high-vote/low-vote structure, unless the taxpayer can represent that the high-vote/low-vote structure was not put in place in anticipation of the distribution. (One might question whether taxpayers could make such a representation when Controlled has a historical high-vote/low-vote structure that was put in place with the idea that the corporation may, at some point, want to undertake a distribution.) Thus, according to IRS representatives, the IRS will not issue single-issue rulings on any such transaction.

North-South

The second no-rule prohibition is on whether the IRS will respect transfers in a so-called north-south transaction as separate.

A north-south situation occurs when a distribution from a corporation (north) occurs contemporaneously with a contribution to that corporation (south). The issue is whether the two transfers should be respected as separate or integrated into a single exchange. Depending on the context, integrating the two transactions could lead to adverse tax consequences.

In such cases prior to Rev. Proc. 2013-3, the IRS regularly issued rulings that the two transfers would not be integrated when the taxpayer was able to represent that there was “no regulatory, legal, contractual or economic compulsion or requirement” to make part or all of the contribution as a condition to the distribution (see, e.g., Letter Rulings 201229002 and 201136009).

However, Rev. Proc. 2013-3 now prohibits issuing letter rulings or determination letters on

[w]hether transfers of stock, money, or property by a person to a corporation and transfers of stock, money, or property by that corporation to that person (or a person related to such person) in what are ostensibly two separate transactions (so-called “north-south” transactions), at least one of which is a distribution with respect to the corporation’s stock, a contribution to the corporation’s capital, or an acquisition of stock, are respected as separate transactions for Federal income tax purposes.

The good news for taxpayers is that IRS representatives have indicated that, in this area, unlike recapitalizations into Control, the IRS still will entertain single-issue rulings that do not address particular issues covered by the no-rule revenue procedure. The bad news for taxpayers is that the language of the no-rule revenue procedure appears to cover a broader range of issues than one might expect. For example, this no-rule area is not limited to contributions and distributions between the same parties. Rather, it covers, on the second transfer, a transfer to the transferor “(or a person related to such person).” This parenthetical phrase could cause the no-rule revenue procedure to cover a broad range of transactions.

Leveraged Spinoff Transactions

The third no-rule area prohibits rulings on whether either Sec. 355 or Sec. 361 applies to a distribution of stock or securities of Controlled in exchange for, or in retirement of, debt of Distributing issued in anticipation of the distribution.

This no-rule area is aimed at a common leveraged spinoff transaction in which debt is allocated between Controlled and Distributing in connection with a Sec. 355 distribution through a securities-for-debt exchange or a stock-for-debt exchange. For example, Distributing issues debt to a lender. Distributing then drops assets into Controlled in exchange for Controlled stock or Controlled securities. Then, Distributing effectively retires its newly acquired debt by distributing the Controlled securities or stock to the lender in exchange for the Distributing debt, while it distributes the remaining Controlled stock to its shareholders in a purported Sec. 355 distribution.

Prior to Rev. Proc. 2013-3, the IRS routinely ruled, pursuant to Sec. 361(c), that Distributing would not recognize gain or loss on the transfer of the Controlled stock or securities in exchange for Distributing’s debt if certain conditions were satisfied. Initially, the IRS issued such rulings only when the Distributing debt that was exchanged for Controlled stock or securities was “old and cold,” and only when Distributing did not increase its debt in contemplation of the transactions “other than in the ordinary course of its business as necessary to meet its working capital and similar needs” (see, e.g., Letter Ruling 200345050).

However, more recently, the IRS issued such rulings when the Distributing debt was issued “at least five days before the declaration date of the Distribution and at least fourteen days prior to the Distribution,” based on a representation that the amount of Distributing debt exchanged for Controlled stock or securities did not exceed the average of Distributing’s outstanding third-party indebtedness during the year prior to the Sec. 355 distribution (measured based on specified intervals) (Letter Ruling 201232014; see also Letter Ruling 200936022).

Rev. Proc. 2013-3 now prohibits issuing letter rulings or determination letters on “[w]hether either §355 or §361 applies to a distributing corporation’s distribution of stock or securities of a controlled corporation in exchange for, and in retirement of, any putative debt of the distributing corporation if such distributing corporation debt is issued in anticipation of the distribution.”

IRS representatives have indicated that, while the IRS does not intend to provide a bright-line test on what is considered “in anticipation of the distribution,” the IRS will be skeptical of any debt issued after a deal is announced. In addition, IRS representatives have indicated that ordinary-course transactions, such as routine issuance commercial paper, could be treated as “in anticipation of the distribution.” In this area, as with north-south transactions, IRS representatives have indicated that the IRS will still be willing to entertain single-issue rulings that do not address particular issues covered by the no-rule revenue procedure.

EditorNotes

Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP. This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.