Will Tax Insurance Catch On?

An IRS moratorium on private letter rulings could spark corporate interest in tax opinion coverage.

Last Friday, tax-free spin-offs got a whole lot more… well… taxing.

On that day, the Internal Revenue Service officially ceased issuing private letter rulings (PLRs) for tax-free transactions. Experts say the year-long pilot program, a dramatic policy shift for the IRS, could lead corporate executives to scuttle spin-offs that don’t concretely meet the government’s strict guidelines for tax-free status.

Corporate executives, and their tax advisors, often use PLRs as assurance that proposed spin-off transactions will qualify for tax-free status under Sec. 355 of the IRS Code. The code states, among other things, that there must be a legitimate business purpose underpinning a spin-off to merit tax-free status. In other words, the transaction cannot be a tax-avoidance scheme.

In the past, PLRs have given executives an extra layer of comfort regarding the “business purpose” test, which some tax experts say is subjective in nature. The benefit of passing the test is obvious: it assures a company — and its shareholders — won’t be subject to capital gains taxes. Generally, a company that uses a Sec. 355 vehicle doesn’t recognize gains or losses. Therefore, it isn’t subject to the attendant taxes when the corporation distributes the stock of a controlled subsidiary to its original shareholders as part of a spin-off deal.

The danger of getting it wrong, says Lewis Steinberg, a tax attorney and partner at Cravath, Swaine & Moore LLP, is equally obvious: A corporation could be hit with a massive, after-the-fact tax bill. That nasty little scenario can happen if the stock of a spun-off subsidiary appreciates at the time of the transaction, and the parent is stripped of its tax-free status for failing any one of the Sec. 355 criteria.

With the new year-long moratorium on PLRs, corporate executives won’t know whether a spin-off fails to meet the IRS standard until the transaction is audited — usually two or three years after a deal has closed.

The uncertainty surrounding tax-free spin-offs is forcing some corporates to rethink plans for spins-offs. Those that forge ahead without a PLR will likely look for some sort of safety net to limit liability. Indeed, experts say, the added risk now surrounding tax-free spin-offs may lead to increased interest in a relatively obscure insurance policy, called tax-opinion insurance.

Says Robert Willens, a tax expert at Lehman Brothers: “Canceling PLRs is exactly the kind of situation that leads companies to find other means of protection.”

All Stretched Out

To date, only a handful of companies have purchased tax-opinion policies, which generally pay tax penalties, fines, and interest. Georgia-Pacific was one of the first large-cap companies to buy the coverage, forking out $25 million in June 2001 for a policy for Plum Creek Timber Co. The insurance indemnified up to $500 million in tax liabilities for a $3.8 billion spin-off/merger deal between a subsidiary called The Timber Co. and Plum Creek Timber Co, both real estate investment trusts (REITs).

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