In late January, the Internal Revenue Service released a determination related to the tax treatment of post-spin-off payments. The memorandum came from the agency’s Detroit area field office, and discussed a situation involving two unnamed companies, which we believe to be Ford Motor Co. and car interior supplier Visteon Corp.
In the IRS memo, X Corp. (CarCo) transferred to Z Corp. (PartsSupplier) certain CarCo entities, assets, and liabilities in Year 2. CarCo then distributed the PartsSupplier stock it received in the exchange to its shareholders in a transaction that qualified as a tax-free spin-off. The business purpose “supporting” the spin-off was compelling: to alleviate competitive barriers to expanding the business (conveyed to PartsSupplier) beyond sales to CarCo, and to overcome competitive barriers to CarCo making purchases from third-party automotive suppliers.
CarCo was subject to a collective-bargaining agreement covering its hourly employees. Accordingly, CarCo and PartsSupplier agreed, in connection with the spin-off, that PartsSupplier would “lease” the hourly employees who had been working in the spun-off facilities. CarCo assigned its hourly employees to PartsSupplier, but remained responsible for the payment of wages and the provision of all employee benefits. In consideration for the assignment of employees, PartsSupplier agreed to reimburse CarCo for all direct wage and benefit costs. Further, CarCo and PartsSupplier executed a “tax-sharing agreement,” under which CarCo agreed that the reimbursements it received from PartsSupplier would constitute income. The IRS is holding CarCo to its agreement.1
CarCo did not argue that the reimbursements do not constitute income. Instead, it contended that the reimbursements “arose because of the tax-free spin-off” and, therefore, are excludable from gross income. The company argued that its claim for refund is supported by the Supreme Court’s decision in Arrowsmith v. Commissioner, 344 US 6 (1952). The IRS disagreed.
Arrowsmith, the IRS noted, governs cases in which a subsequent unknown or unexpected event occurs and the proper tax treatment of that event can be determined only after reference to an earlier transaction. Here, however, there is no subsequent event in which tax treatment is related to the tax-free spin-off.
In order to prevail in tax court, CarCo must show an integral relationship between the tax-free spin-off and the employee-assignment reimbursements. The Arrowsmith doctrine is premised on the idea that, if the transactions are sufficiently related, the tax consequences should be the same as if the prior and subsequent transactions had occurred at the same time.2
“CarCo now seeks to repudiate [a] portion of the tax-sharing agreement. The IRS would not permit it to do so.” — Robert Willens
The IRS concluded that in this case, the reimbursements are not sufficiently related to the tax-free spin-off, so as to be excluded from CarCo’s income. The mere contemporaneous execution of the spin-off transaction and employee-assignment agreement is not enough to make the two transactions integrally related. The purpose of the employee-assignment agreement appears to be tied to obtaining the union’s approval for the spin-off, rather than integrally related to the spin-off transaction itself. Moreover, CarCo and PartsSupplier were not required by Sections 351, 355, or 368 of the tax code to enter into the employee-assignment agreement to effectuate the spin-off. In any event, none of those provisions would grant nonrecognition treatment to payments received under the agreement.
In summary, the IRS concluded that CarCo “has failed to show that the reimbursements are part and parcel of the tax-free spin-off” and, therefore, CarCo must include the reimbursements in its gross income.
In the tax-sharing agreement, CarCo and PartsSupplier expressly agreed that CarCo would recognize the reimbursements as income. CarCo now seeks to repudiate that portion of the tax-sharing agreement. The IRS would not permit it to do so.
When a party seeks to undo the tax consequences of an agreement, courts frequently limit the challenge because the taxpayer freely entered into the contract and, therefore, should be held to its bargain.
If a tax-sharing agreement misstates or improperly applies the law in allocating the parties’ tax burdens and benefits, the IRS is not bound by the agreement’s terms. Here, however, having determined that the reimbursements are not excluded from CarCo’s income, the IRS is simply attempting to hold the company to its agreement. We can think of no situation in which CarCo would be allowed to repudiate the agreement, observed the IRS. Regardless, it continued, the law clearly requires that the reimbursement be included in income. As a result, CarCo’s arguments were all found wanting, and the refund it sought was denied.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See FAA 20100301F, May 15, 2009.
2 If the reimbursements were treated as received simultaneously with the spin-off, they would not, ipso facto, be excluded from X’s gross income. Instead, the reimbursements would be treated as “other property or money” received in a reorganization and, in order to avoid tax consequences with respect to such “boot,” the money would have to be distributed by CarCo to its shareholders (and its creditors) “in pursuance of the plan of reorganization.” See Section 361(b).