For a spinoff to be tax free, IRC Section 355 generally requires both the distributing and controlled corporations to be engaged in an active trade or business. On July 15, 2016, the IRS and U.S. Department of the Treasury issued proposed regulations under Section 355 that provide guidance about the active trade or business requirement and the nondevice requirement. The proposed regulations have been issued following the IRS expressing its concern regarding spinoffs where either the distributing or controlled corporation holds a substantial amount of investment assets and a relatively small amount of active trade or business assets, which is not consistent with the intent of Section 355 and, instead, represents a device for the distribution of earnings and profits. If the distribution is viewed as a device for distributing earnings and profits, the transaction does not qualify as a tax-free spinoff.
While the IRS focused its concerns on whether investment assets have substantial value in relation to the value of overall assets and qualifying business assets, the proposed regulations focus on business assets and nonbusiness assets and introduce the concept of a nonbusiness asset percentage. Under the proposed regulations, the nonbusiness asset percentage of a corporation would be calculated by dividing the fair market value of its nonbusiness assets by the fair market value of its total assets measured immediately after the distribution. Nonbusiness assets are all assets other than business assets. Business assets generally are defined as assets used in an active trade or business and include cash and cash equivalents held as a reasonable amount of working capital. Business assets also include assets required (by binding commitment or legal requirement) to be held for regulatory purposes or to provide for exigencies related to the active business, including assets to hold or secure or otherwise provide for a financial obligation reasonably expected to arise from an active business as well as assets held to implement a binding commitment to expend funds to expand or improve an active business.
The proposed regulations would adopt the IRS’ position that distributing and controlled corporations each are required to have active business assets that constitute at least 5 percent of the fair market value of total assets. However, while 5 percent is the minimum threshold for business assets, the larger the percentage of nonbusiness assets, the stronger the evidence of device. For purposes of evaluating the nonbusiness asset percentage, if the percentage of the fair market value of nonbusiness assets of both the distributing and controlled corporation is less than 20 percent, then the ownership of nonbusiness assets generally will not be considered to be evidence of device.
By contrast, the proposed regulations would instruct that a difference in the nonbusiness asset percentages of the distributing and controlled corporations must be evaluated carefully to determine if the transaction is a device for the distribution of earnings and profits. To this end, the larger the difference, the stronger the evidence of device. However, the proposed regulations would create a safe harbor that applies if the difference in the nonbusiness asset percentages for the distributing and controlled corporations is less than 10 percent, or, alternatively, if the difference is attributable to a need to equalize the value of the distributed stock of the controlled corporation in a non-pro rata spinoff.
The proposed regulations also would create the presumption of a device if the difference between the nonbusiness asset percentage of distributing and controlled corporations fits within three bands:
Band 1: Applies if one corporation’s nonbusiness asset percentage is 66 2/3 percent or more, but less than 80 percent, and the other corporation's nonbusiness asset percentage is less than 30 percent
Band 2: Applies if one corporation’s nonbusiness asset percentage is 80 percent or more, but less than 90 percent, and the other corporation's nonbusiness asset percentage is less than 40 percent
Band 3: Applies if one corporation's nonbusiness asset percentage is 90 percent or more and the other corporation's nonbusiness asset percentage is less than 50 percent
Section 355 spinoffs with nonbusiness assets that are outside the safe harbors and the device presumption would have to be evaluated under a facts-and-circumstances test.