New Guidance Affecting Spinoffs: IRS and Treasury Department Issue New Proposed Regulations

Sullivan & Cromwell LLP - July 18, 2016

On July 14 and 15, 2016, the Internal Revenue Service (the “IRS”) and the Treasury Department issued new guidance affecting spinoffs.

The first set of guidance consists of proposed regulations (the “Proposed Regulations”) clarifying the application of the “device” prohibition and the “active trade or business” (“ATB”) requirement for tax-free spinoffs. The Proposed Regulations are generally consistent with the concerns described by the IRS in Notice 2015-59 (the “Notice”), issued in September 2015, and the “no rule” policy with respect to certain spinoffs put forth in Revenue Procedure 2015-43 (the “2015 Revenue Procedure”), issued concurrently with the Notice. The new rules of the Proposed Regulations include:

  • A new “per se” test for the determination of whether a distribution is a “device” if the “Nonbusiness” assets (defined below) represent more than 66 2/3% of the total assets of either the distributing or controlled corporations and there is a significant difference (i.e., skew) in the Nonbusiness Asset Percentage (defined below) between the distributing and the controlled corporations (or among multiple controlled corporations), with only limited exceptions.
  • As part of the “facts and circumstances” test under the device prohibition, the presence of Nonbusiness assets and a skewing of such Nonbusiness assets between the distributing and controlled corporations are each evidence of device, unless:
    • the relative value of the Nonbusiness assets to the total assets of the distributing and controlled corporations (the “Nonbusiness Asset Percentage”) is less than 20%; or 
    • with respect to the skew,
      • the difference in the Nonbusiness Asset Percentage between the corporations is less than 10%; or
      • the distribution is non-pro rata and the skew is attributable to a need to equalize the value of the stock distributed and the value of the stock or securities exchanged by distributees.
  • A separate requirement, under the ATB tests, that the size of the qualifying ATB of the distributing corporation and controlled corporation be greater than 5% of the total gross asset value of such corporation (similar to what was re-imposed as a requirement to obtain a ruling in the 2015 Revenue Procedure).
  • No exemption for internal spinoffs from the new tests.
The Proposed Regulations will apply to transactions occurring on or after the date the regulations are published as final regulations in the Federal Register, with grandfathering for certain transactions that are set in motion before that date.

The second set of guidance, issued on July 15, 2016 as Revenue Procedure 2016-40 (the “2016 Revenue Procedure”), provides a safe harbor that respects “recapitalization into control” transactions (often through the use of high-vote/low-vote stock) as long as, generally, such recapitalizations are not unwound within two years of the spinoff or are only unwound as the result of an unplanned combination with a third party.