LTR 201542004 at first seems to involve a standard spinoff for the purpose of pursuing a reverse Morris Trust combination of Controlled with a Merger Partner, with the “significant issue” for ruling being a proposed swap of Controlled debt for Distributing debt, which has been bought up by an investment banker. But the facts are quite odd and more seems to be going on.
Reverse Morris Trust
After the spin, a Merger Sub of Merger Partner will merge into Controlled, and evidently Controlled shareholders will get the majority of the stock of Merger Partner. However, the transfer agent will hold the Controlled stock and Distributing’s shareholders will never receive it; they will just get Merger Partner stock. The IRS ruled that the Controlled stock would be deemed distributed and then exchanged.
Distributing may receive new debt securities of Controlled in the D reorganization creating Controlled. Distributing plans to have an investment banker buy up Distributing debt, hold it for at least five days, and then agree to swap it for Controlled debt at least 14 days after the bankers bought the Distributing debt. This 5/14 day arrangement has been treated as a safe harbor by the IRS in earlier rulings to qualify the investment bankers as true holders of the Distributing debt. This ruling shows that taxpayers still feel uncomfortable in proceeding on this basis without a ruling and that rulings can be obtained.
Inevitably in a D reorganization preceding a spinoff, Controlled will assume some liabilities. Such assumptions are treated like cash distributions, reducing the basis in the stock of Controlled. The basis of the Controlled stock is important to Distributing, because it often wants to pull actual cash out of Controlled, but in certain cases that cash will be taxable to the extent the cash exceeds the basis of the stock.
So the IRS ruled that liabilities assumed that had not yet been deducted or entered into basis did not count to reduce the basis in the stock of Controlled. This should not have been in doubt under Section 358(d)(2). But the taxpayer wanted to be assured that Controlled could deduct those items when they accrued in the future and the IRS so ruled.
Generally cash received from Controlled by Distributing can be paid to Distributing’s creditors without causing Distributing to recognize gain on the D reorganization, with one exception: not if the cash or other boot exceeds the basis of the stock of Controlled. The excess is taxable under Section 361(b)(3). Because Distributing expected to receive cash in excess of stock basis (basis that was larger because those contingent assumed liabilities had not yet matured), it admitted it might recognize gain.
This is an interesting example of wanting so badly to extract cash from a corporation to be spun off that Distributing is willing to pay tax for the privilege; or maybe Distributing has lots of net operating losses.
The Continuing Relationships
The ruling described an unusual amount of post-spin continuing relationships between Distributing and Controlled. Initially Distributing is Controlled’s main customer. The two corporations will share facilities and buy and sell from each other for an “undetermined long-term period.” These are not transitional services. If the business purpose for the spin had been “fit and focus,” such arrangements would not be allowed, at least not if there were a significant common shareholder. Evidently the Morris Trust business purpose was controlling.
The most unusual part of the plan relates to the pension liabilities of the Distributing group to be assumed in the Morris Trust merger by the Merger Partner group. Distributing contemplated transferring assets and liabilities of the Controlled pension plan to the Merger Partner, but contemplated the possibility that it transferred too much assets. If so, Merger Partner would have to pay back the excess. Distributing represented that it would treat such pay back as if it had been paid for Controlled stock in a taxable sale, but it would be less than 20 percent of the value of Controlled stock.
It is curious that such repayment could not have been treated as a price adjustment. Introducing the construct of Distributing selling stock it did not sell seems to introduce many uncertainties.
The Chief Counsel issued this spin-off ruling because it still will rule on significant issues. This taxpayer’s issues do not seem all that significant, but perhaps its related issues were. The point for other taxpayers is to continue to evaluate the possibility of rulings on spinoffs, even though they are issued less frequently.
For additional information, call Jack Cummings at 919.862.2302.
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