Business Purpose Wiggle Room

Repurchases don't always thwart the ''stock offering'' business purpose for tax-free spin-offs.

For a spin-off to qualify for tax-free treatment a few things have to happen. To start, the “control” and “active business” requirements must be met. Furthermore, the device test must be overcome, and the distributing corporation must doll out enough stock in the distributed corporation to constitute control of that distributed company.*

In addition, there must be a business purpose for the separation. The business purpose must be a real and substantial, non-federal tax purpose that is germane to the business of the distributing corporation, the distributed corporation, or the affiliated group to which the distributing corporation belongs.

There’s more: the distribution must be the last resort for solving the business problem. In other words, it must be established that the business problem cannot be solved by another tax-free transaction, that: (1) does not involve a distribution; and (2) is neither impractical nor unduly expensive. See, in this regard, Rev. Rul. 72-530.

In Rev. Proc. 96-30, the IRS set forth a “non-exclusive” list of business purposes that would, if the other requirements were satisfied, elicit a favorable ruling with respect to a spin-off. These purposes include, facilitating a borrowing; providing an equity interest to one or more employees; achieving significant cost savings the ever popular “fit and focus”; assuaging the concerns of customers who are, concurrently, competitors with respect to other businesses conducted by the members of the group; and facilitating acquisitions.

In addition, the Rev. Proc. 96-30 list includes “facilitating a stock offering.” Here’s how it would work: Corp. P owns Corp. S. The latter must raise capital to operate or expand the business. The parties decide that an equity offering would be the most effective way to raise such capital. However, Corp. S’s banker informs management that an offering will raise more funds per share if, in connection with the offering, the market is apprised that Corp. S will be separated from Corp. P.

The banker knows that, historically, the market prefers “pure play” companies that are not burdened by a controlling corporate shareholder. In addition, experience tells the banker that an equity offering usually must occur within one year of when the spin-off ruling is obtained. But, there could be a practical snag: Due to unforeseen circumstances, it may not be a favorable time for a Corp. S equity offering.

Even if the Internal Revenue Service grants an extension to complete the offering, the agency will insist — on the threat that the ruling regarding the spin-off will be revoked — that the offering, eventually, take place.

Witness the situation explained in LTR 200316038. A corporation that functioned as a distributed corporation promised the IRS that it would “use” its stock to acquire assets subsequent to the spin-off. The spin-off was undertaken, at least in part, “to improve the corporation’s ability to use its stock for these purposes.” Therefore, specified amounts of stock had to be so used within a fixed period following the separation. The corporation complied with the issuance requirements imposed by the ruling on a timely basis.

However, “due to circumstances not anticipated at the time of the distribution,” the corporation also re-purchased, within the same time frame in which it issued new stock, what appears to be a comparable amount of stock. LTR 200316038 (a supplemental ruling) reaches what Lehman Brothers believe to be the proper and equitable result.

The letter states that the repurchases do not affect the amount of equity that the corporation was (bound) to issue. Therefore, the original spin-off ruling was not imperiled. Thus, we find this case and opinion enlightened and entirely appropriate. Why? The repurchases were triggered by events not anticipated at the time of the spin-off. So the impact of issuing stock in a less-than-favorable environment to secure a spin-off ruling can be undone through a repurchase of a comparable amount of the issuer’s stock.

*

Footnote:If any stock (or securities) is retained by the distributing corporation, it must establish — to the IRS’s satisfaction — that such retention (of stock and/or securities) is not part of a plan having as one of its principal purposes the avoidance of tax. See Sec. 355(a)(1)(D) and Rev. Rul 75-321.

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