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.
“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.
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 to Psi, as per Section 355. The final exception provides that a gain is not recognized by a domestic corporation making a distribution of stock of a domestic corporation to a foreign distributee if there are 10 or fewer foreign distributees for which nonrecognition is claimed — and each such distributee is either an individual or a corporation
If the foreign distributee for which nonrecognition is claimed is a foreign corporation, as is the case here, the foreign distributee must be directly or indirectly engaged in the active conduct of a trade or business. (Note that the distributee must be considered a foreign corporation immediately after the distribution, and at all times until the close of the 60-month period following the end of the taxable year of the distributing corporation in which the distribution is made.)
In addition, for this exception to apply, immediately after the distribution the stock of the distributing corporation must have a value at least equal to the value of the distributed stock of the controlled corporation.
Further, immediately after the distribution — and at all times until the close of the aforementioned 60-month period — the foreign distributee must be incorporated in a foreign country that maintains a comprehensive income-tax treaty with the United States. Moreover, at all times until the close of the 60-month period, the foreign distributee must own all of the stock of each of the distributing and controlled corporations that it owned immediately after the distribution.
What’s more, the distribution cannot be one in which the distributing corporation goes out of existence. Finally, the distributing corporation, in order to take advantage of this exception, must file an agreement (“a gain recognition agreement”) to recognize gain (should the terms of the gain recognition agreement be breached) with its tax return for the year in which the distribution is made.
This is an impressive array of requirements that must be met to avail a company of this final exception to gain recognition. Each requirement was satisfied here, with the result that Delta’s distribution of ChiCorp’s stock to Psi, under Section 355, did not give rise to the recognition by Delta of the gain inherent in its ChiCorp stock.
Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See LTR 200922028, February 20, 2009.
2 Under Section 355.