How Two Parties Can Each Own 80% of a Company

The IRS rules that a corporate taxpayer forced to transfer its voting rights to an independent trustee can still qualify for a tax-free spin-off.

Could structuring a subsidiary in a way required to obtain U.S. security clearance threaten a company’s ability to garner a tax-free spin-off? That’s a question a defense contractor, an airline, or even a media company might well have pondered before selling off a subsidiary. Pondered, that is, until the Internal Revenue Service issued a ruling last month that clarified that a company wouldn’t be jeopardized for spinning off stock held for it as part of a “proxy agreement” struck to keep the homeland safe.

Before the ruling, LTR 201005022, was released on February 5, corporate executives might well have wondered about the tax consequences of proxy structures set up to avoid direct foreign ownership of certain vital U.S. industries. Under such structures, a parent company grants a proxy holder (perhaps a bank or a blue-ribbon panel) the voting rights of a subsidiary’s shares.

To perform a tax-free spin-off, the parent company must own at least 80% of the voting power of the stock. But if the parent company had entered into a proxy arrangement that put all those voting rights into the hands of an independent third party, it would be logical for parent-company executives to think: “We don’t have enough voting stock to do a tax-free spin-off.”

In the IRS ruling released last month, a proxy arrangement had been agreed upon by: the foreign owner of a U.S. parent company, the U.S. parent company, a “distributing company” owned by the U.S. parent company, a subsidiary owned by the distributing company, and a group of proxy holders. Under the agreement, the distributing company would provide all the stock of the subsidiary to the U.S. parent company, with the distributions intended to qualify as tax-free spin-offs.

The subsidiary’s business requires security clearances from the federal government in order to operate. Because of the indirect foreign ownership of the subsidiary, the U.S. Treasury Department requires the subsidiary to be “insulated” from foreign ownership, control, or influence.

Willens 03-14-2011

In order to insulate the subsidiary, the parties to the proxy agreement granted the voting rights related to the subsidiary’s stock to the proxy holders, each of whom became members of the subsidiary’s board. The proxy holders, however, aren’t permitted to take certain “major corporate actions” without the distributing company’s express written approval. Moreover, while the stock is subject to the proxy agreement, the distributing company will be entitled to receive any cash dividends that are distributed.

While the IRS offered no explanation for its ruling on the proposed structure, it concluded that, notwithstanding the proxy agreement, the subsidiary stock owned by the distributing company possesses at least 80% of the total combined voting power of all classes of the subsidiary’s stock entitled to vote. Hence, even though for nontax purposes the proxy holders owned at least 80% of the voting rights, for tax purposes the parent company owned the 80% required for a spin-off. By means of a paradox, the service appears to have bridged a difficult divide between tax rules and nontax rules.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

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