Hook Stock and Sec. 355: Did a Distribution Occur?

Editor: Greg A. Fairbanks, J.D., LL.M.

Corporations & Shareholders

On Oct. 11, the IRS issued a letter ruling addressing the tax effects of a proposed Sec. 368(a)(1)(D)/Sec. 355 spinoff, which included a distribution on “hook stock.” In Letter Ruling 201341004, the IRS ruled that the distributing corporation’s failure to distribute all of the controlled stock was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax, as set forth in Sec. 355(a)(1)(D)(ii). By invoking this exception to the requirement that the distributing corporation must distribute “all of the stock and securities in the controlled corporation,” the IRS implicitly held that a distribution on hook stock should not be respected.

Hook Stock in General

Regs. Sec. 1.7874-1 defines hook stock for purposes of calculating tax on the inversion gain of expatriated entities. More broadly, the term hook stock is used to describe stock of a corporation that is held by an entity in which the corporation, indirectly or directly, holds an interest. The most common example of hook stock is stock of a parent corporation held by the parent corporation’s subsidiary.

Hook stock arises from various types of transactions. For example, an acquiring corporation (most likely a publicly traded one) may purchase a target entity that already holds an interest in the acquiring corporation. An affiliated group may enter into an inversion transaction whereby the old parent continues to hold stock in the new parent. It could also arise when a subsidiary purchases the stock of the parent corporation from a third-party or from the parent.

Because hook stock is commonly parent corporation stock held within a consolidated group, it is often confused with treasury stock. Unlike treasury stock, hook stock provides its owner with the various indicia of stock ownership—voting rights, dividend rights, and liquidation rights (see Himmel, 338 F.2d 815 (1964)), although some states may not allow hook stock to vote. When a corporation makes a pro rata distribution, the distributing corporation makes a distribution to the hook stock shareholders, whereas it would not make a distribution on the treasury stock.

Letter Ruling 201341004

In Letter Ruling 201341004 (the facts and steps have been simplified for purposes of this item), a wholly owned subsidiary (Subsidiary) of a parent corporation (Parent) established a grantor trust under Sec. 671 (at the end of the ruling, the grantor trust is referred to as a “rabbi trust”). The grantor trust held assets on Subsidiary’s behalf to satisfy obligations under three unfunded deferred compensation plans. Among the assets the grantor trust held was stock in the parent corporation (i.e., hook stock).

Parent proposed a series of transactions whereby it would spin off one of its business lines to its shareholders. First, Subsidiary formed a new corporation, Controlled, and contributed certain business assets to Controlled in exchange for Controlled’s outstanding stock. Next, Subsidiary distributed Controlled’s stock to Parent. After entering into certain financing transactions, Parent distributed all of Controlled’s stock pro rata to its shareholders. Because Subsidiary held Parent’s stock in trust, Subsidiary received Controlled’s stock (likely less than 20% of the outstanding stock) as part of the spinoff.

In its ruling, the IRS held that Parent would recognize no gain or loss on the distribution of Controlled stock to its shareholders. Further, the IRS concluded that the Controlled stock received by Subsidiary was not “in pursuance of a plan having as one of its principal purposes the avoidance of U.S. federal income tax within the meaning of section 355(a)(1)(D)(ii).”

The Distribution Requirement of Sec. 355

Sec. 355 permits a distributing corporation to distribute the stock of controlled corporations to its shareholders if certain requirements are met. In general, the requirements are: (1) The distributing corporation must have control immediately before the distribution; (2) the distribution is not principally used as a device for the distribution of earnings and profits; (3) the distributing corporation and controlled corporation are engaged in an active trade or business immediately after the distribution (with exceptions); and (4) the distributing corporation distributes “all of the stock and securities in the controlled corporation held by it immediately before the distribution” (Sec. 355(a)(1)(D)(i)).

Sec. 355(a)(1)(D)(ii) offers an exception to the “all of the stock and securities” rule. A distributing corporation can still receive tax-free treatment under Sec. 355 if (1) the distributing corporation distributes an amount of stock in the controlled corporation constituting control within the meaning of Sec. 368(c); and (2) the distributing corporation establishes to the IRS’s satisfaction that retaining any controlled stock was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax.

History of Rulings on Sec. 355(a)(1)(D)(ii)

Prior to Letter Ruling 201341004, the IRS issued a number of letter rulings analyzing “principal purpose” under Sec. 355(a)(1)(D)(ii). Generally, these rulings involved cases where the parent corporation did not formally distribute “all of the stock and securities in the controlled corporation.” Some of the reasons cited for retaining stock in the spun-off corporation were maintaining the distributing corporation’s value (Letter Ruling 7905084); raising future capital (Letter Rulings 8405017 and 199909027); maintaining the distributing corporation’s borrowing capacity, financial flexibility, or high credit (Letter Rulings 8520096, 8908075, and 200137011); relieving capital allocation issues (Letter Rulings 200944026 and 201330007); and reducing potential liabilities from foreign claims (Letter Ruling 8927078).

The IRS has also issued Sec. 355(a)(1)(D)(ii) rulings when the distributing corporation essentially made a distribution of some controlled stock to itself (see Letter Rulings 9752024, 199941017, 200534006, 200611003, 200702033, 200802009, and 201032017). In these rulings, the stock was held in grantor trusts. Though not explicitly stated in the rulings, the parent corporations appeared to directly own the grantor trusts. Because grantor trusts are generally disregarded for federal tax purposes, the IRS, it seems, disregarded the parent corporation’s distribution to itself and thus analyzed the “principal purpose” of the retention under Sec. 355(a)(1)(D)(ii).

Implication of Letter Ruling 201341004: Hook Stock Was Not Respected

The facts of Letter Ruling 201341004 are distinguishable from the above letter rulings because (1) the taxpayer did in fact distribute all its ownership in Controlled and (2) the hook stock shareholder was a subsidiary of the parent corporation, not the parent corporation itself. If the IRS would have respected the form of the distribution and treated the hook stock shareholder as an actual shareholder, it would seem that an analysis of “principal purpose” under Sec. 355(a)(1)(D)(ii) would be unnecessary.

The IRS may have invoked Sec. 355(a)(1)(D)(ii) in its ruling under one or more theories, including that (1) the taxpayer did not substantively meet the “all of the stock or securities” test because the consolidated group received controlled stock in the distribution; and/or (2) hook stock shareholders are not respected as shareholders for this purpose.

In any case, it is noteworthy here that the IRS simply did not respect the separate existence of the hook stock and/or hook stock shareholder. The authors are not aware of any other circumstances where the existence of hook stock was completely ignored.

Respecting the Existence of Hook Stock and Hook Stock Problems

Many practitioners have disagreed about whether the consolidated return regulations should adopt a single-entity or separate-company approach to intercompany transactions. The regulations have, generally, favored a separate-company approach. As such, hook stock shareholders are often respected as shareholders of the parent corporation. Because of possible abuses with this approach, a number of rules limit the potential advantages of hook stock. (The discussions in this section assume that the hook stock is held by a direct or indirect subsidiary of the parent corporation and that the parent corporation and subsidiary are members of a consolidated group.)

Distributions of hook stock: Generally, under Regs. Sec. 1.1502-13(f)(2), intercompany distributions between consolidated members are eliminated. This exclusion, however, applies only if the recipient shareholder incurs a negative basis adjustment in the stock of the entity making the distribution under Regs. Sec. 1.1502-32. Because a hook stock shareholder would not incur a negative adjustment on distributions of parent corporation stock, the hook stock shareholder may not eliminate the dividend, and must instead generally recognize dividend income on the intercompany distributions (assuming the parent corporation has earnings and profits). It appears that the hook stock shareholder may take a dividend-received deduction (DRD) on the dividend income received from a parent corporation for federal income tax purposes. However, it is uncertain whether the hook stock shareholder should obtain a 100% DRD or an 80% DRD (a discussion of this issue is beyond the scope of this item). Further, some states do not allow a DRD, thus creating the possibility of full income recognition in those states.

Because of concerns over dividend leakage, as described above, a parent corporation might decide not to pay a dividend on hook stock even though it pays dividends to its other shareholders. Such a decision could lead to unintended consequences. For example, if the hook stock is of the same class as the parent corporation’s other shareholders, the IRS could assert that there is a deemed dividend on the hook stock, thus giving rise to the dividend leakage issues discussed above.

Moreover, to account for the fact that no dividend was actually paid on hook stock, it could be asserted that the hook stock shareholder is then deemed to distribute the deemed dividend up the chain and back to the parent corporation—to account for the actual end result. The subsequent distributions up the chain would then cause an unfortunate negative basis adjustment in the stock of the hook stock shareholder. On the other hand, the failure to make distributions on the hook stock could result in the IRS asserting that the hook stock has been canceled, thus causing any inherent gain in the hook stock to be triggered (see below).

Gains but not loss on hook stock: Under Regs. Sec. 1.1502-13(f)(6)(i)(A), all losses recognized on hook stock are permanently disallowed. Consequently, the sale of hook stock outside the consolidated group at a loss would result in a permanent disallowance of the loss. If the stock were sold outside of the consolidated group at a gain, however, the consolidated group would fully take into account the gain.

If the hook stock were sold from one member of the consolidated group to another member, it appears that any loss on the sale would be disallowed and the basis of the stock would be stepped down to fair market value—notwithstanding that the transaction otherwise qualifies as an intercompany transaction. Instead of selling the hook stock, the parent corporation could try to sell the stock of the subsidiary holding built-in loss hook stock. Regs. Sec. 1.1502-13(f)(6)(i)(B), however, requires a hook stock shareholder that leaves a consolidated group to recognize an immediate reduction in the basis of the hook stock. Again, any loss associated with the write-down is a permanently disallowed loss and will reduce the parent corporation’s basis in the subsidiary immediately before disposition. As such, the parent corporation would not receive any benefit from selling the subsidiary that holds the built-in loss hook stock.

How to eliminate built-in gain hook stock: As described above, a sale of the hook stock would generate gain but not loss. A cancellation of the hook stock is treated as a distribution of the hook stock to the parent corporation. The deemed distribution of the stock creates a recognized gain under Sec. 311(b), and the gain is immediately triggered under Regs. Sec. 1.1502-13 because the subject of the intercompany transaction—the built-in gain hook stock—is eliminated (i.e., it leaves the consolidated group). Accordingly, care should be taken, for example, to ensure that the group’s legal department does not simply cancel hook stock as a cleanup measure. Consequently, there are few alternatives to eliminating built-in gain hook stock without triggering the built-in gain.

The most widely used method for eliminating built-in gain hook stock without triggering the gain is to liquidate the subsidiary holding the hook stock into the parent corporation in a tax-free liquidation under Sec. 332 (or a tax-free upstream merger of the subsidiary). A tax-free downstream merger of the parent corporation into the subsidiary would also eliminate the hook stock without triggering the gain, but few consolidated groups are willing to eliminate the parent corporation (see Letter Ruling 200731025, in which a taxpayer used an intergroup Sec. 355 split-off to remove hook stock, and Letter Ruling 201007045, in which a taxpayer used a busted (i.e., taxable) Sec. 351 exchange with a Sec. 338(h)(10) election (presumably, the purchase price compensated for the hook stock gain)).

Conclusion

Given the discussion above regarding the various rules related to hook stock, it appears there is a significant history of the IRS and Treasury respecting the existence of hook stock and the ownership of hook stock by a separate party. Accordingly, Letter Ruling 201341004 represents a departure from this history as the IRS seems to disregard the existence of the hook stock and/or the existence of the hook stock shareholder as a separate shareholder.

The IRS did not state its rationale for disregarding the existence of the hook stock, and a letter ruling may not be used or cited as precedent (Regs. Sec. 301.6110-7(b)). Further, given the history of rulemaking that respects the existence of hook stock, it would be unwise, based on a single letter ruling, to ignore the existence of hook stock when analyzing the impact of a transaction involving hook stock. Taxpayers would be well-advised to seek a letter ruling when considering a transaction involving hook stock that is not otherwise set forth in regulations or elsewhere. In any case, the analysis in Letter Ruling 201341004 opens up a new way of thinking about hook stock—which is simply to disregard its existence.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.