IRS Provides Safe Harbors for Acquisition of Control in Certain Corporate Transactions

Recognizing that determining whether an acquisition of control has substance for federal tax purposes can be difficult and fact intensive, the IRS issued guidance on Friday that provides safe harbors for corporations, under which the IRS will not assert that a distributing corporation lacks control of another corporation within the meaning of Sec. 355(a)(1)(A) (Rev. Proc. 2016-40). The IRS is also rescinding the prohibition on issuing letter rulings on transactions that involve acquisition of putative control.

Sec. 355(a)(1)(A) provides that, for a distribution to qualify for nonrecognition treatment, the distributing corporation must distribute stock or securities of a corporation (the controlled corporation) it controls immediately before the distribution. For this purpose, "control" is defined as 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 each other class of stock of the corporation.

The IRS says it is concerned that, in some cases, taxpayers may not be able to determine with sufficient certainty whether an acquisition has substance for federal tax purposes, and so will not proceed with transactions that otherwise satisfy the requirements of Sec. 355. To resolve this uncertainty, the IRS provides safe harbors in Rev. Proc. 2016-40, which describes transactions in which the IRS will not assert that an acquisition of control lacks substance.

Rev. Proc. 2016-40 applies to transactions in which:

1. A distributing corporation owns another corporation's stock not constituting control of the other corporation;
2. The other corporation issues shares of one or more classes of stock to the distributing corporation and/or to other shareholders of the other corporation (the issuance), as a result of which the distributing corporation owns stock of the other corporation possessing at least 80% of the total combined voting power of all classes of the other corporation's stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the other corporation;
3. The distributing corporation distributes its stock in the other corporation in a transaction that otherwise qualifies under Sec. 355 (the distribution); and
4. The other corporation subsequently engages in a transaction that, actually or in effect, substantially restores (a) the other corporation's shareholders to the relative interests, direct or indirect, they would have held in the other corporation (or a successor to the other corporation) had the issuance not occurred; and/or (b) the relative voting rights and value of the other corporation's classes of stock that were present prior to the issuance (an unwind).

The IRS will not assert that a transaction that matches one of these four transactions lacks substance, and that therefore the distributing corporation lacked control of the other corporation immediately before the distribution, within the meaning of Sec. 355(a)(1)(A), if the transaction is also described in one of the following safe harbors:

1. No action is taken (including the adoption of any plan or policy), at any time prior to 24 months after the distribution, by the other corporation's board of directors, the other corporation's management, or any of the other corporation's controlling shareholders (as defined in Regs. Sec. 1.355-7(h)(3)) that would (if implemented) actually or effectively result in an unwind.
2. The other corporation engages in a transaction with one or more persons that results in an unwind, regardless of whether the transaction takes place more or less than 24 months after the distribution, provided that:
   1. There is no agreement, understanding, arrangement, or substantial negotiations (within the meaning of Regs. Sec. 1.355-7(h)(1)) or discussions (within the meaning of Regs. Sec. 1.355-7(h)(6)) concerning the transaction or a similar transaction (applying the principles of Regs. Secs. 1.355-7(h)(12) and (13), relating to similar acquisitions), at any time during the 24-month period ending on the date of the distribution; and
   2. No more than 20% of the interest in the other party, in vote or value, is owned by the same persons that own more than 20% of the stock of the other corporation. For purposes of this safe harbor, ownership is determined by application of the constructive ownership rules of Sec. 318(a) as modified by Sec. 304(c)(3), ‎except that for purposes of applying Secs. 318(a)(3)(A) and (B), the principles of Sec. 304(c)(3)(B)(ii) (without regard to Sec. 304(c)(3)(B)(ii)(I)) apply. 

The IRS warns that the safe harbors provided in the revenue procedure apply solely to determine whether an acquisition of control has substance for purposes of Sec. 355(a)(1)(A). Further, they apply only to the transactions described in section 3 of the revenue procedure. The IRS says that no inference should be drawn from the revenue procedure regarding the application of any federal tax principles outside the scope of the revenue procedure.

—Alistair Nevius (anevius@aicpa.org) is The Tax Adviser's editor-in-chief.