Rev. Proc. 2014-3 provides that the IRS won’t issue rulings on “the treatment or effects of hook equity, including as a result of its issuance, ownership, or redemption.” It defines hook equity as “an ownership interest in a business entity (such as stock in a corporation) that is held by another business entity in which at least 50 percent of the interests (by vote or value) in such latter entity are held directly or indirectly by the former entity.”
But a recent ruling involved hook stock and predated the no-rule. LTR 201404002 involved a surprising but somewhat common use of Section 355 to eliminate hook stock. It requires the invention of yet another spinoff term—this time, the split-down. The split-down refers to the fact that the stock of the Controlled corporation will be exchanged (split) with a subsidiary of the Distributing corporation that happens to be a shareholder of Distributing, meaning it holds hook stock.
D-2, a foreign corporation, owns Controlled (U.S.) and it also owns D-1 (foreign), which owns D-4 (U.S.), which owns stock of D-2 (the hook stock). D-2 exchanges the stock of Controlled for the hook stock held by D-4. As a result, the hook stock is eliminated and two U.S. subsidiaries of this foreign group are combined. It is highly likely that D-4 acquired the hook stock in preparation for this very result.
D-4 also spun off another U.S. subsidiary, C-3. The business purpose for the split-down was to facilitate that spinoff. The IRS ruled that the split-down qualified under Section 355.
This ruling is the first to use the term split-down. It is not clear, but the likely purpose for eliminating the hook stock was to make certain that D-2 was in the affiliated group of its parent, D-5, which was also to make a spinoff in the combined transactions. Being in an affiliated group means a corporation’s active trade or business can be counted for purposes of Section 355, thus easing that requirement for a spinoff.
If the hook stock were 30 percent of the stock of the corporation immediately below D-5, it might not be affiliated with D-5, because D-5 did not own 80 percent control of one member of the group. The IRS should not have had much trouble issuing the ruling to the extent the issue was affiliated because the corporations could not avoid being affiliated.
It also is not surprising that the IRS allowed a corporate subsidiary to be moved down another chain of corporation by way of a Section 355 transaction. Section 355 transactions have become the go-to vehicle for subsidiary relocation in internal spins.
Reg. Section 1.355-2(b)(3) provides: “If a corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of stock of a controlled corporation and which is neither impractical nor unduly expensive, then, for purposes of paragraph (b)(1) of this section, the separation is not carried out for that corporate business purpose.”
The stock of Controlled could have been moved into D-4 tax free through capital contributions. But that would not have eliminated the hook stock. The taxpayer did not represent that there was no nontaxable alternative. Taxpayers seldom give that representation, but sometimes they do.
Hook stock, including hook equity of a partnership, can arise for “innocent” reasons and tax-motivated reasons. An innocent reason would be an acquisitive reorganization in which the target had some of the acquirer’s stock. A high–profile, tax-motivated reason is the Killer B transaction, where the parent stock is bought from the parent, but then spent in another transaction, so it does not remain as hook stock.
The circular ownership issues should be manageable, as shown by this last ruling on hook stock.
For more information, contact Jack Cummings at (919) 862-2302.
This advisory is published by Alston & Bird LLP’s Federal Tax practice area to provide a summary of significant developments to our clients and friends. It is intended to be informational and does not constitute legal advice regarding any specific situation. This material may also be considered attorney advertising under court rules of certain jurisdictions.