Sprint Corp. is evaluating its options concerning Nextel Communications, its wholly-owned subsidiary. Apparently, one of those options is a spin-off of Nextel’s stock to Sprint’s shareholders. Can such a spin-off be accomplished on a tax-free basis?
Although it’s far from clear, such a tax-free spin-off could very likely occur.
Let’s consider the facts. Spring acquired Nextel on August 12, 2005. The transaction was structured as a “forward triangular merger” in which Nextel was merged with and into a newly-created subsidiary of Sprint. In the merger, the Nextel shareholders were compensated with a combination of cash and shares of voting and non-voting Sprint common stock.
The amount of cash issued in the merger was about $969 million. But the vast majority of the consideration was in the form of Sprint common stock, which was valued, as of the date of closing, at approximately $35.6 billion. The merger qualified as a reorganization under Sec. 368(a)(1)(A) and Sec. 368(a)(2)(D) of the Internal Revenue Code.
Accordingly, those shareholders of Nextel who realized a gain on the exchange were required to recognize that gain but in an amount not more than the cash received. Further, since the transaction qualified as a reorganization, Sprint’s basis in the stock of the subsidiary that houses Nextel’s business was, at the start, equal only to Nextel’s “net basis” in its assets.
Thus, although Sprint “spent” nearly $37 billion in acquiring Nextel, its basis in the stock of the corporation conducting Nextel’s business is, undoubtedly, only a fraction of that amount. Thus, if Sprint were to dispose of Nextel via a distribution of its stock to its shareholders, Sprint would almost certainly realize a gain on the distribution. If the spin-off met the requirements for tax-free treatment, Sprint would avoid having to recognize the distribution.
The merger consideration included cash in order to insure that Nextel’s shareholders would not own as much as 50 percent of Sprint’s stock immediately after the merger. (Had Sprint issued just stock in the merger, the Nextel shareholders would have emerged with a majority of S’s stock).
Sprint thought it was important to keep the Nextel shareholders’ ownership to less than 50 percent to insure that the spin-off by Sprint of its ILEC business, which occurred shortly after the merger, qualified for tax-free treatment. Had the Nextel shareholders emerged with a majority of S’s stock, the spin-off might well have been taxable (at the Sprint level) because the spin-off would have been regarded under the tax code as part of a plan or series of related transactions pursuant to which “one or more persons” (the former Nextel shareholders) acquired stock representing a 50 percent (or greater) interest in either or both of the distributing corporation, Sprint, and the controlled corporation (the subsidiary to which the ILEC assets were conveyed and whose stock was distributed).
Is the “Five-Year Rule” Violated?
In order for a spin-off to qualify for tax-free treatment, the requirements set forth in Sec. 355 of the Internal Revenue Code must each be met. One such requirement is known as the “active business” requirement. Thus, both the distributing corporation, Sprint, and the controlled corporation, Nextel, must be engaged, immediately after the distribution, in the active conduct of at least one trade or business.
In addition, the trade or business relied upon to meet the active business requirement must have been actively conducted throughout the five-year period ending on the date of the distribution. Further, under Sec. 355(b)(2)(C), a trade or business relied upon to meet the requirements of Sec. 355(b) must not have been acquired by the distributing corporation, the controlled corporation, or any member of the affiliated group during the five year period ending on the date of the distribution unless it was acquired in a transaction in which no gain or loss was recognized.
Here, however, a trade or business on which the parties would be relying to meet the requirements of Sec. 355(b)—the business conducted by Nextel—was acquired by the controlled corporation within the five-year period ending on the date of distribution (the business was acquired in the merger effected in August, 2005) and in a transaction in which gain or loss was recognized in whole or in part. In light of the fact that the merger consideration consisted partly of cash, the shareholders of Nextel were required, to the extent of the cash, to recognize the gains they realized on the exchange.
Thus, arguably, since the Nextel business was acquired in a “tainted” manner (in a transaction occurring within the past five year in which gain or loss was recognized in whole or in part), the Nextel business can’t be relied upon to meet the requirements of Sec. 355(b) until five years have elapsed from the time of the closing of the original merger.
Nevertheless, despite the seeming violation of Sec. 355(b)(2)(C), there are still some legitimate questions to be answered regarding the impact of the merger on Sprint’s ability to complete, before August, 2010, a tax-free spin-off of N. Thus, the regulations provide that a trade or business acquired, directly or indirectly, within the five-year period ending on the date of distribution in a transaction in which the basis of the assets acquired was not determined in whole or in part by reference to the transferor’s basis does not qualify under Sec. 355(b)(2) even though no gain or loss was recognized by the transferor.
The issue is whether the obverse of this statement is also true. If it is then a trade or business acquired within the five-year period ending on the date of distribution in a transaction in which the basis of the acquired assets was determined by reference to the transferor’s basis does qualify under Sec. 355(b)(2) even though gain or loss was recognized by the transferor.
Here, the basis of Nextel’s assets in the hands of the subsidiary Sprint formed to acquire those assets was, in fact, determined, in whole, by reference to its basis in the hands of Nextel. Moreover, no gain or loss was recognized by the transferor. In this case, Nextel, the transferor of the assets, did not recognize gain on the conveyance of its assets, even though cash was received in partial payment for those assets, because such cash was distributed by Nextel to its shareholders in pursuance of the plan of reorganization.
Thus, a case can be made that the provisions of Sec. 355(b)(2)(C) would not be violated should a “prompt” (one occurring within five years of the merger) spin-off of Nextel be attempted by Sprint. The underlying policy which animates Sec. 355(b)(2)(C) would, arguably, not be breached here because Sprint, through its subsidiary, inherited Nextel’s basis in its properties and the transferor, Nextel, did not recognize gain or loss in the transaction because the transferor distributed the cash received in the exchange to its shareholders in pursuance of the reorganization plan. Moreover, it appears that Professors Bittker and Eustice recognize the subtleties of this rule. Their treatise on corporate taxation, Federal Income Taxation of Corporations and Shareholders contains the following passage:
Section 355(b)(2)(C)”does permit the acquisition of a trade or business in a tax-free transaction…However, the use of boot (cash) in an otherwise tax-free exchange might disqualify the transaction, at least if the transferor…recognizes gain…Less clear is the case where the transferor’s boot gain goes unrecognized because (as here) the transferor completely liquidates…”
Moreover, it now appears that the Internal Revenue Service agrees with this nuanced approach to the application of both Sec. 355(b)(2)(C) and its “sister” section, Sec. 355(b)(2)(D). Thus, in a letter ruling issued on June 12, 2007, T Corporation merged with and into P Corporation in a transaction in which 80 percent of the consideration consisted of P stock with the balance consisting of cash.
T’s shareholders, but not T, were thus required to recognize, up to the amount of cash they received, the gain they realized on the exchange. In the merger, P acquired all of the stock of D Corporation, which was owned by T. D was actively engaged in two trades or businesses and, for business reasons, it was decided, shortly after the merger, to separate those businesses.
This was done by means of a spin-off in which D contributed one of the businesses to a newly-formed corporation, in exchange for all of its stock, and distributed such stock to P, its controlling shareholder, in exchange for a portion of the latter’s stock in D.
The IRS found in its letter ruling that the split-off satisfies the requirements of Sec. 355. That was so even though the requirements of Sec. 355(b)(2)(D) were, on the surface at least, clearly violated. Under Sec. 355(b)(2)(D), the trade or business relied upon to meet the requirements of Sec. 355(b) must have not have been indirectly acquired during the five-year period ending on the date of the spin-off in a transaction in which gain or loss was recognized in whole or in part and which consisted of the acquisition of control of the corporation (here, D) directly engaged in the trade or business (to be relied upon for purposes of the active business test).
That happy conclusion was reached because the basis of the assets of the business relied upon to meet the active business test was not “stepped up” as a result of the merger and because, here, the “transferor” (D), as opposed to the transferor’s shareholders, did not (even though boot was received in the merger) recognize gain or loss in the transaction.
Thus, since the conclusions the IRS reached in its ruling seem equally applicable to Sprint—should it decide to spin-off Nextel—Sprint can, well before August 2010 if it chooses, spin off Nextel on a tax-efficient basis. The authorities support the proposition that such a spin-off wouldn’t run afoul of the active- business test even though, undoubtedly, the trade or business (upon which the parties would be relying to satisfy such test) was acquired within the five-year period ending on the date of the spin-off in a transaction in which gain or loss was recognized (although by the shareholders of the transferor as opposed to the transferor of the business) in whole or in part.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.