On June 4, TRW Automotive Inc. filed an S-1 registration statement with the SEC to formally split from parent company TRW Inc. The spinoff, as expected, is conditioned on obtaining an IRS ruling that the separation is tax free both to TRW and its shareholders. Note that if the ruling cannot be timely obtained, then TRW will likely seek an opinion of counsel.
On the surface, the spinoff seems to meet all of the Sec. 355 requirements. Indeed, the active business test appears to be met, and the separation seems to be undertaken for a nonfederal income tax purpose that is germane to the business of the controlled corporation.
What’s unusual, however, is that the S-1 candidly discusses the possibility that a subsequent sale or exchange of TRW Inc. or TRW Automotive stock could cause the transaction to be viewed differently. That is, viewed principally as a device for the distribution of earnings and profits. Such a finding would render the spinoff taxable at both the distributing corporation and recipient shareholder levels.
Further, the S-1 brings to light another potential change in the tax treatment. The document acknowledges the possibility that an acquisition of 50 percent or more of either company’s stock, according to a plan that encompasses the separation, could, under Sec. 355(e)—the anti-Morris Trust rule—cause the separation to be taxable at the corporate level, but not at the recipient shareholder level.
Since the IRS’s April 23 publication of the revised temporary regulation Sec. 355(e), the rules have become exceedingly more liberal. In short, a post-spinoff acquisition cannot be considered part of a prohibited plan unless there was an agreement, understanding, arrangement, or substantial negotiations, regarding the acquisition or a similar acquisition. Furthermore, the agreement, etc., would have had to taken place during the two-year period ending on the date of the separation. Absent such an agreement, Sec. 355(e) will not operate to vitiate the spinoff.
That is the case even if discussions about the acquisition—defined here as talks that don’t rise to the level of substantial negotiations—took place prior to the separation. This is also the case if there was, on the part of TRW, a “reasonable expectation” that such an acquisition would—subsequent to the spinoff— take place.
Although the rules under Sec. 355(e) were liberalized, the device rules were not concomitantly adjusted. The regulations (Reg. Sec. 1.355-2(d)(2)) tell us that a sale or exchange of the stock by the parent or the subsidiary, after the distribution, is evidence of a device. The strength of this device factor is a function of the amount of stock that is so sold and the temporal proximity of the sale and the distribution.
More ominously, the regulations state that such a sale or exchange, pursuant to an “arrangement negotiated or agreed upon” before the distribution, is substantial evidence of a device. What’s more, a sale or exchange is pursuant to such an arrangement if: 1) enforceable rights to buy or sell existed before the distribution; or 2) such a sale was, merely, discussed before the distribution and was reasonably to be anticipated.
Accordingly, mere discussions and reasonable expectations are sufficient, if a sale occurs, to create substantial evidence of a device. The device rules, therefore, are now exceedingly more stringent than the anti-Morris Trust rule.
Recall that the anti-Morris Trust rule is activated only by an acquisition after the distribution that is, in turn, pursuant to a pre-distribution agreement. Fortunately, the device rules can be rendered inoperative even in the face of pre-distribution discussions regarding an acquisition.
A post-distribution exchange of stock for stock, pursuant to a tax-free reorganization, is not regarded as a sale or exchange for purposes of the device test. This is true when no more than an insubstantial amount of gain is recognized from the exchange because only a de minimis amount of “boot” is employed. In addition, a post-distribution exchange is not considered a sale or exchange when the acquisition step is undertaken solely (or at least primarily) for stock of the acquiring entity, and the device test ceases to be a threat to the tax-favored nature of the spinoff. See Rev. Rul. 75-406.