“Cross-Border” Spin-offs Can Be Tax-Free

If a company successfully jumps through an impressive – and complex – set of hoops, it can reap the rewards.

In a private letter ruling issued by the Internal Revenue Service earlier this year, the agency provided guidance on when a spin-off of a foreign subsidiary by an American company can be considered a tax-free transaction. The letter’s guidance took the form of a hypothetical situation involving a foreign corporation, which we will call Psi Corp., that is engaged directly and indirectly in the active conduct of several businesses.

To be sure, Psi owns all of the stock of Delta Corp., a domestic corporation, and Delta, in turn, is engaged in the active conduct of businesses Alpha and Beta. Although Alpha and Beta operate within the same industry, and are run by the same management, they differ substantially in a number of ways. These differences have resulted in “systemic problems,” including competition for management time and financial resources. Accordingly, to achieve “fit and focus,” Delta will transfer the assets of Beta to a new domestic corporation, ChiCorp, in exchange for all of the latter’s stock.

Delta will then distribute ChiCorp’s stock to parent Psi in exchange for a portion of Psi’s stock in Delta. The IRS ruled that the distribution would be tax-free both at the shareholder level and, even though the distributee is a foreign person, at the distributing corporation level.1 It is this latter holding that merits some analysis.

The analysis starts with tax code Section 367(e)(1) and Regulation Section 1.367(e)-1(b). Under those rules, if a domestic corporation (Delta) distributes qualified stock2 of a domestic or foreign corporation to an entity (Psi) that is not a U.S. person, then the domestic corporation must recognize the gain (but not loss) on the distribution. Fortunately, there are several exceptions to this recognition rule, and Delta was able to bring itself within one of them.

WillensFinal“The final exception, however, precisely describes the distribution example provided by the IRS, with the result that Delta will not recognize gain on the distribution of ChiCorp’s stock.” — Robert Willens

Under Regulation Section 1.367(e)-1(c), the gain is not recognized by a domestic corporation if, immediately after the distribution, both the distributing (Delta) and controlled (ChiCorp) corporations are “U.S. Real Property Holding Corporations.” This exception was not available to Delta.

The regulation also states that a gain shall not be recognized by the domestic corporation if two conditions are met: (1) the stock of the controlled corporation (ChiCorp), with a value of more than 80% of the outstanding stock of the corporation, is distributed with respect to one or more classes of the outstanding stock of the distributing corporation that are “regularly traded” on an established securities market in the United States; and (2) at the time of the distribution, the distributing corporation does not know (or have reason to know) that the subject foreign distributee owns — directly or constructively — more than 5% (by value) of a class of stock of the distributing corporation. This exception could not be availed of by Delta.

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