Inflation Reduction Act implications for Sec. 355 distributions

Editor: Christine M. Turgeon, CPA

The 2022 enactment of the Inflation Reduction Act, P.L. 117-169, brought several important changes to the Code. This item examines the implications for distributions described in Sec. 355(a) that follow from the introduction by the Inflation Reduction Act of the stock repurchase excise tax and the corporate alternative minimum tax (AMT).

Stock repurchase excise tax

New Sec. 4501(a) imposes an excise tax on stock repurchases made by a U.S. corporate taxpayer, the stock of which is traded on an established securities market (a covered corporation). The tax is equal to 1% of the fair market value of any covered corporation stock repurchased (within the meaning of Sec. 4501(c)) during a tax year. Following enactment of the tax, questions arose as to whether distributing corporation stock surrendered in a split-off — i.e., a Sec. 355 distribution in which stock of a distributing corporation is exchanged for stock of a controlled corporation — would be treated as a “repurchase” by a covered corporation for purposes of the new excise tax.

By contrast, a pro rata spinoff transaction in which no distributing corporation stock is surrendered does not involve a repurchase for purposes of the tax. Thus, while it is clear that a distribution of controlled corporation stock may be treated as income tax–free under Sec. 355(a) regardless of whether stock of the distributing corporation is surrendered in exchange, the application of the stock repurchase tax to exchanges of distributing corporation stock would have put split-off transactions at a disadvantage compared to spinoff transactions.

On Dec. 27, 2022, Treasury and the IRS issued Notice 2023-2, providing interim guidance on the application of the stock repurchase tax, pending the publication of proposed regulations. Under the notice, the tax is calculated based on certain redemptions described in Sec. 317(b) (which are included as repurchases under the notice) and “economically similar transactions.” For these purposes, the notice initially describes the exchange of distributing corporation stock in a Sec. 355 split-off as an economically similar transaction. As a result of treating the split-off as a repurchase, the distributing corporation stock surrendered is included in a taxpayer’s stock repurchase excise tax base for purposes of calculating its liability.

Although the approaches to spinoff transactions and split-off transactions diverge under the notice, the impact is mitigated by an exception for qualifying property. That is, to the extent that repurchased stock is exchanged for property that can be received without the recognition of gain or loss pursuant to Secs. 354 and 355, the taxpayer’s base is reduced.

Thus, where a distributing corporation’s shareholders receive only stock of the controlled corporation in a split-off transaction, the repurchase of distributing corporation stock is fully offset by the distribution of qualifying property, and there should be no net impact to the distributing corporation’s stock repurchase excise tax base. In such cases, the implications of a split-off are consistent with those of a pro rata spinoff. However, a split-off still may give rise to a stock repurchase tax liability to the extent that cash or other property is distributed in the transaction. The tax applies to repurchases by covered corporations occurring after Dec. 31, 2022.

Corporate AMT

Under Sec. 55(a) as amended by the Inflation Reduction Act, certain corporate taxpayers (applicable corporations) are subject to an AMT equal to 15% of adjusted financial statement income (AFSI) (over any corporate AMT foreign tax credit) for any tax year beginning after Dec. 31, 2022. On Dec. 27, 2022, Treasury and the IRS issued Notice 2023-7, providing interim guidance on the application of the corporate AMT, pending the publication of proposed regulations.

Among other topics, Notice 2023-7 provides guidelines for determining when a transaction may give rise to AFSI. For these purposes, a Sec. 355 distribution in which no gain or loss is recognized is a “covered nonrecognition transaction.” Thus, although a Sec. 355 distribution may give rise to financial statement gain or loss, that amount is excluded for purposes of calculating AFSI and therefore should not affect the corporate AMT liability of the distributing corporation’s group. Any resulting increase or decrease to the financial statement basis of the transferred assets likewise is excluded for purposes of calculating the AFSI of the controlled corporation.

The controlled corporation is defined by the notice, in part, as a corporation that is or is treated as the corporation, the stock of which is distributed, on the applicable financial statement for the distributing corporation’s group. The “is treated as” language presumably is intended to account for situations such as reverse spinoffs, in which the entity that is the controlled corporation for legal purposes is treated as the distributing corporation for financial accounting purposes (and vice versa), based on such factors as their relative size. Thus, for purposes of the corporate AMT, the financial accounting characterization of a spinoff, and not the legal form of the transaction, is treated as controlling which entity is viewed as the distributing corporation and the controlled corporation.

Finally, Notice 2023-7 provides guidelines for allocating AFSI between corporations in a financial reporting group when one member deconsolidates. This allocation is a key issue because AFSI is used in determining whether a corporation is subject to the corporate AMT. However, although a controlled corporation is allocated a portion of the AFSI of the distributing corporation’s group, the notice does not provide for a corresponding reduction to the group’s AFSI. In other words, a portion of the group’s AFSI is replicated in the controlled corporation.

Although this rule of allocation and replication is consistent with the treatment of other divestitures under the notice, it seems to reach an anomalous result in the spinoff or split-off context. Specifically, a domestic applicable corporation under Sec. 59(k)(1) generally is one with average AFSI in excess of $1 billion over the measuring period — indicating that the tax is designed to apply to large corporations. Thus, sound tax policy may conclude that the sale of a business for cash should have no impact on whether a taxpayer is an applicable corporation for purposes of the tax.

Sec. 355 transactions, by contrast, are divisive in nature. They necessarily involve a reduction in corporate size as the assets of a distributing corporation are split between it and a controlled corporation. Viewed in this light, replication of the AFSI of the distributing corporation’s group distorts the corporate AMT base. To more accurately reflect the base, a corresponding reduction to the AFSI of the distributing corporation’s group would be required, followed by a redetermination of applicable corporation status for both the distributing corporation and the controlled corporation.

Editor Notes

Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City. For additional information about these items, contact Turgeon at christine.turgeon@pwc.com. Contributors are members of or associated with PricewaterhouseCoopers LLP.