Policy fluctuations and reconsiderations in the corporate tax realm are as guaranteed as death and, of course, taxes. This discussion explores certain provisions that were subject to intense examination many years ago, namely, provisions relating to the repeal of the General Utilities doctrine, but may again face scrutiny. In this regard, on Oct. 13, 2017, the IRS announced changes to its private letter ruling policies. The announcement described four areas that the IRS will change its approach to, as summarized below:
- The IRS will no longer rule on the redetermination of character for gross receipts in an intercompany transaction in connection with a worthless stock loss under Sec. 165(g)(3)(B).
- The IRS will base all rulings relating to delayed distributions in connection with a purported Sec. 355 transaction on the facts and circumstances surrounding the transaction.
- The IRS will increase scrutiny for transactions involving a contribution of assets to an entity, a spinoff of that entity, and the cessation of the contributing entity through a liquidation or merger (i.e., a "drop-spin-liquidate" or "drop-spin-merge" transaction) and similar transactions.
- The IRS will increase scrutiny of transactions in which an entity undergoes a conversion as a means of distributing assets to its parent, and undergoes a subsequent conversion to separate the remaining assets from its parent (i.e., a "convert-reconvert" transaction).
This discussion focuses on the last two items on this list, as closer scrutiny of these transactions implicates the government's concerns over General Utilities repeal.
General Utilities repeal
The General Utilities doctrine was derived from the Supreme Court's decision in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), which permitted a corporation's distribution of appreciated property to its shareholders without recognition of gain. Because of concerns over tax avoidance, lawmakers sought to repeal the General Utilities doctrine over the years. A series of limitations on the doctrine followed, culminating in its repeal in the Tax Reform Act of 1986, P.L. 99-514. Nonrecognition treatment was preserved, however, for Sec. 332 liquidations, Sec. 355 spinoffs, and Sec. 368 tax-free reorganizations. To carry out the repeal, Congress enacted Sec. 337(d), authorizing the IRS to issue regulations necessary or appropriate to facilitate the repeal, including regulations on the above nonrecognition provisions.
The IRS's announcement suggests that transactions such as the drop-spin-liquidate, drop-spin-merge, and convert-reconvert transactions specified in the announcement may connect with General Utilities repeal, as the end result of those transactions is a separation of assets from corporate solution without recognition of corporate-level gain. These mechanisms are further explained below.
Drop-spin-liquidate and drop-spin-merge transactions
Drop-spin-liquidate and drop-spin-merge transactions involve so-called born-to-die entities, or entities that are formed as part of the same plan that contemplates their elimination. A basic example of such a transaction is shown through the following fact pattern.
Example 1: Parent owns Sub, which has two assets or groups of assets, Asset A and Asset B. Sub forms Controlled and contributes Asset A to Controlled (the "drop" step). Next, Sub distributes the stock of Controlled to Parent in a transaction otherwise qualifying for Sec. 355 treatment (the "spin" step). Finally, Controlled liquidates into Parent (the "liquidate" step).
The end result of this transaction is that an asset originating with Sub (i.e., Asset A) ends up directly owned by Parent. The IRS's concern would seem to be that under a step-transaction analysis, Controlled might be disregarded as a transitory entity, with the transaction then being viewed as a direct Sec. 301 distribution by Sub of Asset A to Parent — in which case Sub would recognize gain under Sec. 311(b). In the case of a merger of Controlled into a sister corporation (i.e., other subsidiary of Parent), the recast presumably would be a distribution of Asset A to Parent, followed by a contribution of Asset A to the sister corporation.
Such a recast would not necessarily result in immediate corporate-level taxation. For example, if Parent and Sub are members of a consolidated group, the Sec. 311(b) gain that would otherwise be recognized is deferred under Regs. Sec. 1.1502-13. Nevertheless, even where gain recognition would be deferred, it is possible that the IRS would still argue for the recast, to preserve the location of any Sec. 311 gain for recognition upon deconsolidation, or in the event that Asset A leaves the intercompany group.
That said, the IRS has consistently ruled that form should be respected in cases of a merger into a sister corporation or a liquidation into the parent corporation, even if Controlled was created as part of the overall transaction (see, e.g., IRS Letter Rulings 201746022, 201445008, 201441010, 201408017, and 201032017). In Rev. Rul. 98-27, the Service set forth the position that a transitory controlled corporation should be respected, and further explained this position in Rev. Rul. 2003-79, stating that the controlled corporation should be considered independently from the distributing corporation in determining whether an acquisition of the controlled corporation will qualify as a tax-free reorganization.
A typical convert-reconvert transaction can be demonstrated by the following example:
Example 2: Parent owns Sub, which owns Asset A and Asset B. Sub converts to a disregarded entity (DRE), such as a limited liability company, resulting in a deemed liquidation/distribution of its assets to Parent. The DRE then makes an actual distribution of Asset A to Parent (which is ignored for tax purposes). After this actual distribution, the DRE then either converts back to a corporate entity or makes an election to be treated as a corporate entity for tax purposes.
Under current law, assuming the valid business purpose and other reorganization requirements are met, the transaction likely would be characterized as an "upstream" reorganization under Sec. 368(a)(1)(C), followed by a transfer of Asset B to a newly formed subsidiary (Newco) under Sec. 368(a)(2)(C) (see Regs. Sec. 1.368-2(k), discussed below).
The announcement suggests that the IRS has some concerns over this transaction. One might speculate that the IRS would view Newco as a mere alter ego of Sub or a successor in a Sec. 368(a)(1)(F) reorganization, such that the net effect of the transaction would be a Sec. 311 distribution of Asset A from Sub to Parent (followed by a sideways reorganization). However, such a recast would seem to run headlong into Regs. Sec. 1.368-2(k), which states that a transaction that otherwise qualifies as a reorganization under Sec. 368(a) shall not be disqualified or recharacterized as a result of one or more subsequent transfers (or successive transfers) of assets or stock. Because the Treasury regulations specifically allow for the subsequent transfer inherent in the convert-reconvert transaction described above, a change in policy on those transactions would seem to require amending Regs. Sec. 1.368-2(k), a relatively long-standing provision that was drafted post-General Utilities repeal.
The IRS's October announcement denotes a potential shift in the Service's interaction with tax professionals. The announcement appears to be unique in nature. Formal changes to rulings policy are usually embodied in a revenue procedure, with IRS personnel on occasion commenting publicly about informal trends or nuances. That said, more disclosure about interim rulings practices from the IRS is better than less. Clear directional indications are always appreciated, and a more formal method of communication can only aid in the tax community's understanding of the IRS's current thinking. As for the content of the announcement as it relates to General Utilities repeal, it goes without saying that few areas in corporate tax have been as examined as this one has. Nonetheless, it is not necessarily a bad thing to go back and take a second look. In the interim, further developments will be awaited.
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Jacob Puhl is a manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax group.
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