The General s Orders?

Transcription

1 The General s Orders? Reconciling General Utilities Repeal with the Nonrecognition Provisions of Subchapter C University of Chicago Law School 70th Annual Federal Tax Conference November 3, 2017 Moderator: Eric Solomon, Ernst & Young LLP Lead Panelist: Bill Alexander, Skadden, Arps, Slate, Meagher & Flom LLP* Panelists: Kathleen Ferrell, Davis Polk & Wardwell LLP; Gordon Warnke, Linklaters LLP; Robert Wellen, Associate Chief Counsel (Corporate), Internal Revenue Service * Mr. Alexander would like to thank Tom Wood for his assistance in preparing this presentation.

2 General Utilities & Operating Co. v. Helvering Initial Step 1: General Utilities distributes appreciated Islands Edison stock to its shareholders Shareholders Shareholders IE Stock General Utilities General Utilities IE Stock IE Stock Step 2: Shareholders sell the Islands Edison stock to a third party Final Shareholders IE Stock Cash Buyer Shareholders Buyer General Utilities IE Stock General Utilities Cash IE Stock 1

3 General Utilities Doctrine Although the precise holding of the case has been debated, the General Utilities decision was interpreted to stand for the proposition that a corporation was not taxable on the distribution of appreciated property to its shareholders In 1954, Congress codified the General Utilities doctrine by enacting corporate-level nonrecognition rules for nonliquidating distributions (old section 311), liquidating distributions (old section 336), and liquidating sales (old section 337) In an environment with a significant tax rate differential for dividends and capital gains, the General Utilities doctrine opened the door to tax avoidance A doctrine of liquidation-reincorporation was developed to impede the ability of corporations and shareholders to arbitrage these different rates 2

4 General Utilities Doctrine As a result, business owners who operated a business in corporate form were often faced with very strong tax incentives to turn the business over to a new owner, either by liquidating the corporation or by causing the corporation its sell its assets and distribute the proceeds in liquidation If the corporation held appreciated property, the General Utilities doctrine permitted that appreciation to escape taxation permanently at the corporate level The corporation s shareholders (or a third-party acquirer) would obtain a stepped-up, fair market value basis in the assets, in many cases resulting in a stream of additional depreciation, depletion, or amortization deductions that could be used to offset income generated by the business in the future Simultaneously, the old corporation s other tax attributes (including earnings and profits) were eliminated From a tax perspective, the only price of this basis step-up and attribute elimination was typically a single capital gains tax imposed on the corporation s shareholders 3

5 General Utilities Repeal The General Utilities doctrine was steadily eroded over time by Congress and the courts Congress repealed the General Utilities result for nonliquidating redemptions in 1969, for partial liquidations in 1982, and for almost all other nonliquidating distributions in 1984 By 1986, corporate-level gain recognition was the general rule for nonliquidating distributions of appreciated property, and the General Utilities doctrine was largely confined to liquidating transactions Congress repealed what was left of the General Utilities doctrine in the Tax Reform Act of 1986 ( TRA 1986 ) The core General Utilities repeal provisions, sections 311(b) and 336(a), generally require corporate-level gain recognition on all nonliquidating and liquidating distributions of appreciated property Congress also eliminated old section 337, a companion provision that allowed tax-free asset sales within a year after the adoption of a plan of liquidation 4

6 Tax Reform Act of 1986 In repealing the General Utilities doctrine, Congress affirmatively preserved corporate-level nonrecognition treatment for section 332 liquidations, section 355 distributions, and reorganizations TRA 1986 also included various provisions designed to buttress the core General Utilities repeal provisions Section 337(d) provides a broad grant of regulatory authority to enforce the purposes of General Utilities repeal Section 1374 imposes a corporate-level tax on dispositions of built-in gain assets within a specified period (currently five years) following a C-to-S conversion transaction 5

7 Tax Reform Act of 1986 The legislative history to TRA 1986 offers incomplete and somewhat conflicting accounts of the intended scope and purposes of General Utilities repeal In explaining the grant of regulatory authority in section 337(d), the legislative history states that General Utilities repeal is designed to require the corporate level recognition of gain on a corporation s sale or distribution of appreciated property, irrespective of whether it occurs in a liquidating or nonliquidating context Congress indicated that its principal objective in repealing the General Utilities doctrine was to prevent taxpayers from extracting appreciated property from corporate solution with a stepped-up basis while avoiding a corporate-level tax Congress believed that this result undermined the corporate tax base and tended to encourage economically irrational behavior liquidating transactions that would not make sense absent a free basis step-up in the assets sold or distributed 6

8 Mirror Subsidiary Liquidations Step 1: Purchaser capitalizes Sub 1 and Sub 2 with cash Step 2: Sub 1 and Sub 2 purchase the Target stock from Seller Seller Cash Purchaser Cash Seller Cash Cash Purchaser Target Sub 1 Sub 2 Target Stock Stock Sub 1 Sub 2 Wanted Assets Unwanted Assets Wanted Assets Unwanted Assets Step 3: Target liquidates, distributing its wanted assets to Sub 1 and its unwanted assets to Sub 2 Final Purchaser Purchaser Sub 1 Sub 2 Sub 1 Sub 2 Target Wanted Assets Unwanted Assets Wanted Assets Unwanted Assets 7

9 Mirror Subsidiary Liquidations In the immediate aftermath of TRA 1986, many corporations began employing mirror subsidiary liquidations and similar techniques to facilitate bust-up planning in connection with mergers and acquisitions In the mirror subsidiary liquidation technique, taxpayers took the position that the attribution rule of Reg applied for purposes of section 337(c), such that the liquidating target recognized no corporate-level gain even if neither mirror subsidiary was an 80% distributee individually This technique allowed the acquirer to package the target s unwanted assets into a newly formed subsidiary whose stock had a fair market value basis and could be sold outside of the acquirer s affiliated group at no corporate-level tax cost 8

10 Mirror Subsidiary Liquidations The legislative history to TRA 1986 indicates that Congress was aware of this technique when it repealed the General Utilities doctrine but was unsure about whether and how issue should be addressed Many practitioners, and at least some policymakers, concluded that mirror subsidiary liquidations did not violate the purposes of General Utilities repeal because the liquidating target s assets remained in corporate solution (and did not receive a stepped-up basis) Other variants of mirror subsidiary transactions quickly developed, including techniques relying on section 355 distributions, section 304 transactions, and consolidated return investment adjustments Some observers speculated that as much as 90% of high-profile M&A transactions after TRA 1986 included some element of mirror structuring 9

11 1987 Anti-Mirror Legislation In the Omnibus Budget Reconciliation Act of 1987 ( OBRA 1987 ) and the Technical and Miscellaneous Revenue Act of 1988, Congress enacted a number of technical amendments intended to shut down mirror subsidiary transactions Section 337(c) was amended to provide that a corporation s status as an 80% distributee is determined without regard to any consolidated return regulation Section 355(b)(2)(D) was amended to provide that section 355 does not apply if control of Distributing was acquired by a corporate distributee during the five-year period preceding the distribution Section 304 was amended to require appropriate adjustments to stock basis and E&P in certain intragroup section 304 transactions Around the same time, the Treasury Department and the IRS issued Notice 87-14, the first overture in the consolidated return loss disallowance saga 10

12 1987 Anti-Mirror Legislation The legislative history to OBRA 1987 indicates that these changes were intended to promote neutrality among old owners and new owners of corporations and to prevent tax considerations from motivating economically irrational behavior Mirror subsidiary transactions allowed a buyer to achieve what a seller could not selectively disposing of a portion of the target s assets outside of the affiliated group without incurring an immediate corporate-level tax The fact that those assets remained in corporation solution was perceived as inadequate to prevent this type of trafficking abuse Separately, OBRA 1987 also added new section 384, another antitrafficking provision related to General Utilities repeal Section 384 generally limits the use of an acquiring corporation s preacquisition losses to offset built-in gain in the target s assets to the extent such gain is recognized during the five-year period following the acquisition 11

13 Weak and Strong Forms of General Utilities Repeal The scope of General Utilities repeal has often been debated in terms of its weak form and its strong form The weak form requires corporate-level gain recognition when appreciated property is distributed or transferred and receives a stepped-up basis in the hands of the distributee or transferee This is perhaps more accurately described as the primary policy of General Utilities repeal The strong form is sometimes described as requiring corporate-level gain recognition whenever appreciated property, in whatever form, leaves the economic unit of the affiliated group The post-tra 1986 history of General Utilities repeal, including the 1987 anti-mirror legislation, demonstrates that the strong form is really an anti-trafficking policy focused on maintaining parity between old owners and new owners of corporations It is perhaps more useful to think of the strong form as the secondary policy of General Utilities repeal The remainder of this presentation adopts this nomenclature of primary policy and secondary policy 12

14 The Primary Policy The primary policy of General Utilities repeal focuses on preventing appreciated property from leaving the corporate tax base without a corporate-level tax General Utilities repeal is primarily about protecting the double tax regime of Subchapter C and ensuring that at least one layer of corporate-level tax is paid on appreciated property held in corporate solution The primary policy is not about timing (i.e., accelerating corporate-level gain recognition) For example, General Utilities repeal tolerates installment sales, like-kind exchanges, and the deferral regime for outbound investments However, many of the mechanical provisions that serve the primary policy take the form of timing rules that operate by accelerating corporate-level gain recognition For example, the core provisions implementing the primary policy, sections 311(b) and 336(a), apply not only to domestic C corporations but also to many entities that are not subject to corporate-level tax, including S corporations, foreign corporations, and tax-exempt entities Moreover, sections 311(b) and 336(a) require immediate corporate-level gain recognition on a taxable distribution of appreciated stock even though the issuer s underlying assets remain in corporate solution (and even where the distributee is itself a corporation) 13

15 The Primary Policy Most of the legislative and administrative rules issued under the auspices of General Utilities repeal should be understood as enforcing its primary policy Examples include: Sections 311(b) and 336(a) (the core General Utilities repeal provisions) Section 1374 (built-in gain rules for C-to-S conversion transactions) Reg (d)-4 (generally imposing a corporate-level tax on transfers of assets from taxable corporations to tax-exempt entities) Reg (d)-7 (extending the section 1374 regime to C-to-RIC and C-to-REIT conversion transactions) Sections 355(h) and 856(c)(8) (generally prohibiting section 355 distributions involving the separation of a REIT from a C corporation) Section 367(a)(5) (imposing a corporate-level tax on certain outbound asset transfers unless the foreign transferee is controlled by five or fewer domestic corporations and stock basis adjustments are made to preserve the built-in gain in the transferred assets) Section 367(e) (imposing a corporate-level tax on outbound section 332 liquidations and section 355 distributions) Section 732(f) (requiring stock basis adjustments where a partnership distributes an affiliated subsidiary to a corporate partner) Temp. Reg (d)-3T (imposing a corporate-level tax in May Company partnership transactions) 14

16 Stock Versus Hard Assets The primary policy of General Utilities repeal appears to tolerate the removal of appreciated stock (as opposed to non-stock or hard assets) from the corporate tax base There are multiple formulations of the primary policy, none of which requires a corporate-level tax on the disposition of another corporation s stock, including in transactions that result in permanent elimination of any outside gain in the stock Stock represents an indirect interest in the issuer s underlying assets; the primary policy seeks to ensure that income generated by those assets is subject to at least one tier of corporate-level tax Setting aside external market factors, appreciation in stock generally reflects (1) corporate earnings that have already been subject to corporate-level tax and/or (2) unrealized appreciation in assets that will be subject to corporate-level tax in the future 15

17 Stock Gain and Triple Tax For better or worse, our corporate tax system has never developed a uniform or logically consistent approach to taxing stock dispositions by corporations, such as a participation exemption regime Our system starts with a general presumption that stock dispositions are taxable at the corporate level, creating the potential for multiple corporate-level taxation of the same corporate earnings (i.e., triple tax ) This potential for triple tax is mitigated with a hodgepodge of mini participation exemptions, including express nonrecognition rules, specific relief provisions, and various self-help techniques The primary policy of General Utilities repeal protects the double tax regime of Subchapter C, but it does not call for more than one tier of corporate-level tax on the same corporate earnings 16

18 Stock Gain and Triple Tax In repealing the General Utilities doctrine, Congress left in place a number of escape valves from the triple tax problem Congress preserved the most important provisions of prior law intended to ameliorate triple tax the consolidated return regime, the dividends received deduction, and section 338(h)(10) Congress authorized regulations under section 336(e) to extend deemed asset sale treatment to subsidiary stock dispositions beyond the scope of section 338(h)(10) Congress preserved nonrecognition treatment in section 332 liquidations and section 355 distributions, both of which have the result of permanently eliminating one corporation s built-in gain in another s stock; it also indicated implicit approval of downstream reorganizations, which have the same effect Each of these escape valves carries its own terms and conditions, and there is no particular magic to 80/80 affiliation with the issuing corporation The 80% DRD requires 20/20 stock ownership; the 70% DRD has no minimum ownership requirement Section 355 has an 80% voting power requirement but no value requirement Downstream reorganizations have no minimum ownership requirement Sections 332 and 337 require 80/80 stock ownership but permit a corporate shareholder to buy into (or out of) affiliation in anticipation of a liquidation 17

19 The Secondary Policy Unlike its primary policy, the secondary policy of General Utilities repeal is a timing rule aimed at preventing an undue deferral of corporate-level tax The provisions implementing the secondary policy are designed to address trafficking situations in which technical rules apply differently to new owners (i.e., buyers) versus old owners (i.e., sellers) of corporations The 1987 anti-mirror legislation, often viewed as the high-water mark of General Utilities repeal, is the clearest articulation of the secondary policy The secondary policy is also policed by section 355(d), a provision enacted in 1990 that is best understood as a refinement of the antimirror amendments to section 355(b)(2)(D) The secondary policy does not seek to accelerate corporate-level gain recognition or impose a triple tax result in situations that do not present a trafficking abuse 18

20 Subchapter C Nonrecognition Provisions As a general matter, nonrecognition rules permit deferral of tax in exchanges and distributions that result in a mere realignment and continuation of shareholders original ownership interests in modified corporate form These are transactions, in other words, that are insufficiently sale-like to be taxed currently As noted, TRA 1986 expressly preserved corporate-level nonrecognition treatment for section 332 liquidations, section 355 distributions, and reorganizations Corporate-level nonrecognition in section 332 liquidations was justified on the grounds that, after the liquidation, the liquidating subsidiary s assets and attributes are retained within the economic unit of the affiliated group Corporate-level nonrecognition in section 355 distributions and reorganizations was justified on the grounds that such transactions merely effect a readjustment of shareholders continuing interests in the corporation in modified form and subject to certain statutory and other constraints (i.e., essentially the same policy rationale that justifies shareholder-level nonrecognition) Section 337(d) authorizes the Treasury Department to issue regulations to ensure that the purposes of General Utilities repeal are not circumvented through the use of the Subchapter C nonrecognition provisions As the post-tra 1986 history of section 355 illustrates, section 337(d) does not call for the displacement of the Subchapter C nonrecognition provisions unless a transaction contravenes the primary or secondary policy of General Utilities repeal 19

21 Section 355 and General Utilities Repeal Before General Utilities repeal, the policy directives of section 355 were concerned almost exclusively with shareholder-level dividend avoidance For example, section 355(a)(1)(B) the device test provides that a transaction intended to qualify under section 355 must not be used principally as a device for the distribution of earnings and profits of Distributing, Controlled, or both The device test is designed to prevent taxpayers from using section 355 as a means of disguising dividends and bailing out corporate earnings at capital gains rates or through a recovery of basis It was codified more than three decades before the repeal of the General Utilities doctrine and has virtually nothing to do with corporate-level tax considerations After General Utilities repeal, section 355 is one of the few remaining provisions that permits the distribution of appreciated property without corporate-level gain recognition Congress has since made several modifications to section 355 to address corporate-level tax considerations in spin-offs and split-offs, including techniques that were perceived to be inconsistent with General Utilities repeal 20

22 Section 355 and General Utilities Repeal As part of the 1987 anti-mirror legislation, Congress amended section 355(b)(2)(D) to provide that section 355 does not apply if control of Distributing was acquired by a corporate distributee during the five-year period preceding the distribution In 1990, Congress enacted section 355(d) because of concerns that section 355(b)(2)(D) was insufficient to prevent the use of section 355 to facilitate mirror-type bust-up transactions Section 355(d) denies corporate-level nonrecognition treatment if, immediately after the distribution, any person holds (either directly or by attribution) stock representing a 50% or greater interest in Distributing or Controlled that is attributable to stock acquired by purchase during the five-year period preceding the distribution Like the anti-mirror amendments to section 355(b)(2)(D), section 355(d) is driven by the secondary policy of General Utilities repeal; it is intended to prevent taxpayers from using section 355 to dispose of subsidiaries in sale-like transactions, or to obtain a fair market value basis in the stock of Distributing or Controlled that could reduce the tax liability otherwise incurred upon a subsequent disposition of such stock, without incurring corporate-level tax on the distribution 21

23 Section 355 and General Utilities Repeal Section 355(e) denies corporate-level nonrecognition treatment if the distribution is part of a plan (or series of related transactions) pursuant to which one or more persons acquire directly or indirectly stock representing a 50% or greater interest in Distributing or Controlled Section 355(e) was enacted because Congress was concerned that a section 355 distribution coupled with a 50% or greater change of control of Distributing or Controlled resembled a corporate-level sale of the retained or distributed business Although it addresses corporate-level tax considerations, section 355(e) is arguably not about enforcing General Utilities repeal per se, but rather about policing the line between section 355 distributions and sales of subsidiaries 22

24 Section 355 and General Utilities Repeal Section 355(g) denies nonrecognition treatment to both Distributing and its shareholders if (1) Distributing or Controlled is a disqualified investment corporation immediately after the transaction, and (2) any person holds, immediately after the transaction, a 50% or greater interest in any disqualified investment corporation, but only if such person did not hold, directly or indirectly, a 50% or greater interest in the corporation immediately before the transaction Although section 355(g) substantially limits one route for a corporate shareholder to avoid a triple tax result with respect to an appreciated stake in another corporation, this provision is principally about shareholder-level tax considerations Because cash-rich split-offs typically present no potential for avoiding dividend taxation through a bailout of corporate earnings, Congress felt that a new statutory backstop to the device test was needed 23

25 Section 355 and General Utilities Repeal Enacted as part of the Protecting Americans from Tax Hikes Act of 2015, section 355(h) generally provides that a distribution will not qualify under section 355 if either Distributing or Controlled is a REIT Under a companion provision, section 856(c)(8), Distributing and Controlled (and their respective successors) are generally prohibited from making a REIT election for any taxable year beginning before the ten-year anniversary of a section 355 distribution In 2016, the Treasury Department and the IRS issued temporary regulations intended to address perceived gaps in sections 355(h) and 856(c)(8) (Temp. Reg (d)-7T(f)) The temporary regulations generally apply if Distributing or Controlled engages in a C-to-REIT conversion transaction during the 20-year period beginning 10 years before a section 355 distribution If the conversion transaction occurs after the distribution, the converting company is required to make a deemed sale election If the distribution occurs after the conversion transaction, Distributing is generally required to recognize any remaining built-in gain in the converted property 24

26 Section 355 and General Utilities Repeal Unlike the anti-mirror amendments to section 355(b)(2)(D), these REIT-specific rules enforce the primary policy of General Utilities repeal Congress and the Treasury Department concluded that the section 1374 regime that generally applies to C-to-REIT conversion transactions does not adequately protect the corporate tax base where the conversion transaction is facilitated by a section 355 distribution Query why Congress has not felt the need to address the ability of a C corporation to spin off a corporation that elects to be taxed as an S corporation or a RIC Are existing section 355 requirements sufficient safeguards in these contexts? 25

27 Case Study: Corporate Combining Transactions Initial Downstream Merger: Parent merges with and into Issuer; Parent shareholders exchange Parent stock for newly issued Issuer stock Parent Shareholders Parent Shareholders Issuer Shareholders 90% 10% Parent Issuer Shareholders 90% 10% Parent Issuer Issuer Upstream Merger: Issuer merges with and into Parent; Issuer shareholders exchange Issuer stock for newly issued Parent stock Final Parent Shareholders Parent Shareholders Issuer Shareholders Issuer Shareholders Parent 90% 10% Surviving Corporation Issuer 26

28 Corporate Combining Transactions At one time prior to General Utilities repeal, the IRS attempted to argue that a downstream merger of a holding company into an unaffiliated subsidiary was tantamount to a taxable liquidation of the holding company and should be taxed accordingly This argument was roundly rejected by the courts (see, e.g., Commissioner v. Gilmore s Estate) The IRS eventually conceded that upstream and downstream transactions between non-affiliates could qualify as reorganizations See, e.g., Rev. Rul (upstream merger of 79% owned subsidiary into its parent; valid A reorganization); Rev. Rul (acquisition of holding company s assets by its 5% owned operating company; valid C reorganization) Rev. Rul was cited in the legislative history to the 1988 amendments to section 361, suggesting that Congress intended these types of reorganizations to survive General Utilities repeal 27

29 Corporate Combining Transactions In 1994, the Treasury Department and the IRS announced a section 337(d) guidance project and related no-rule policy regarding corporate combining transactions involving unaffiliated corporations (Rev. Proc ) The guidance project was closed in 1996 (Notice 96-6) The IRS removed the no-rule policy in 1999 (Rev. Proc. 99-3) The IRS has since issued a number of private letter rulings on downstream reorganizations (including one issued earlier this year, PLR ) Why did the Treasury Department and the IRS decide against issuing adverse guidance on corporate combining transactions? Why has the IRS continued issuing favorable rulings on these types of reorganizations? 28

30 Corporate Combining Transactions Does the combination of Parent and Issuer present General Utilities repeal concerns? Neither format of this transaction (upstream or downstream) implicates the primary policy of General Utilities repeal because the assets of Issuer (and any assets of Parent other than its Issuer stock) remain in corporate solution after the transaction, and those assets have the same basis in Issuer s hands as they did before the transaction As noted, the primary policy does not require a corporate-level tax on the disposition of another corporation s stock, including in transactions that result in permanent elimination of the outside gain in the stock The combination transaction bears none of the hallmarks of the sort of trafficking abuse targeted by the secondary policy A combination of Parent and Issuer does not result in disparate treatment of old shareholders and new shareholders, nor does it facilitate the selective disposition of appreciated property without corporate-level gain recognition 29

31 Corporate Combining Transactions Taxing Parent on the built-in gain in its Issuer stock would result in multiple corporate-level taxation of the same corporate earnings The built-in gain in the Issuer stock ought to reflect (1) corporate earnings that have already been realized and/or (2) unrealized appreciation in Issuer s assets As noted, General Utilities repeal does not call for more than one tier of corporate-level tax on the same corporate earnings In lieu of an upstream or downstream reorganization, Parent could simply purchase all of Issuer s remaining stock and cause Issuer to liquidate The liquidation would qualify for shareholder-level nonrecognition treatment under section 332, eliminating the built-in gain in Parent s historic block of Issuer stock There is nothing in the legislative history of General Utilities repeal suggesting that Congress intended to disturb this result or the inherently elective nature of section

32 Case Study: Spin-offs with Stock of Single Issuer Initial Distributing Shareholders Step 1: Distributing contributes Issuer stock and a five-year ATB to Controlled Distributing Shareholders Issuer Shareholders 90% 10% Distributing Issuer Shareholders 90% 10% Distributing Issuer Stock + ATB Issuer Issuer Controlled Step 2: Distributing distributes the Controlled stock to its shareholders Final Distributing Shareholders Controlled Stock Distributing Shareholders Distributing Distributing Controlled Issuer Shareholders Issuer Shareholders Controlled 10% 90% 90% 10% Issuer Issuer 31

33 Spin-offs with Stock of Single Issuer In Notice , the Treasury Department and the IRS suggested that, apart from any device issues related to Controlled s asset composition, this type of transaction may also present policy concerns from a General Utilities repeal perspective What are the potential General Utilities repeal concerns here? The spin-off does not implicate the primary policy of General Utilities repeal because the assets of Controlled (including the Issuer stock) remain in corporate solution after the transaction, and those assets have the same basis in Controlled s hands as they did in Parent s hands before the transaction The spin-off bears none of the hallmarks of the sort of trafficking abuse targeted by the secondary policy; it does not result in disparate treatment of old shareholders and new shareholders, nor does it facilitate the selective disposition of appreciated property without corporate-level gain recognition 32

34 Spin-offs with Stock of Single Issuer While Controlled s asset composition is relevant to the device test, the fact that most of Controlled s value is attributable to the Issuer stock an asset unrelated to an actively conducted trade or business is largely irrelevant from a General Utilities repeal perspective General Utilities repeal is agnostic as to the nature and quality of the appreciated property in question; it does not distinguish between a distribution of appreciated investment assets and a distribution of appreciated business assets In fact, because of Controlled s ownership of an appreciated stake in an unaffiliated corporation, imposing a corporate-level tax on the spin-off would result in multiple corporate-level taxation of the same corporate earnings The built-in gain in the Issuer stock ought to reflect (1) corporate earnings that have already been realized and taxed to Issuer and/or (2) unrealized appreciation in Issuer s assets that will be taxed to Issuer in the future Again, General Utilities repeal does not call for more than one tier of corporate-level tax on the same corporate earnings 33

35 Spin-offs with Stock of Single Issuer The separation of a significant stake in Issuer from Distributing s other assets could increase the likelihood of a combination of Issuer and Controlled at some point after the spin-off For example, the parties could (1) actually combine in an upstream or downstream reorganization or (2) effectively combine by having Issuer acquire the stock of Controlled, with Controlled retaining its stake in Issuer as hook stock Such a transaction would either eliminate the built-in gain in Controlled s Issuer stock (in the case of an upstream or downstream reorganization) or result in long-term or permanent deferral of such gain (in the case of an effective combination) Of course, the ability of Issuer and Controlled to consider a postdistribution combination transaction is policed by section 355(e) and Reg

36 Spin-offs with Stock of Single Issuer Does a section 355 distribution involving the separation of an interest in a single issuer present different or more serious General Utilities repeal concerns than a combination transaction that is not preceded by a section 355 distribution? Sections 355(h) and 856(c)(8) suggest that the use of a section 355 distribution may exacerbate General Utilities repeal concerns presented by a transaction facilitated by the distribution, but this can only be the case if that other transaction (e.g., a C-to-REIT conversion transaction) implicates the policies of General Utilities repeal As discussed in the first case study, upstream and downstream reorganizations involving unaffiliated corporations whether or not facilitated by a section 355 distribution appear to be fully consistent with General Utilities repeal Moreover, what if there is no later combination transaction at all, and Controlled simply trades on its own as an independent public company (functioning largely as a shadow investment in Issuer)? Is a combination transaction so unnecessary that it is appropriate to tax the spin-off? 35

37 Case Study: Convert-Reconvert Transactions Initial Step 1: Sub converts to a disregarded LLC ( Sub LLC ) Parent Parent Sub Sub LLC Asset A Asset B Asset A Asset B Step 2: Sub LLC distributes Asset B to Parent Step 3: Sub LLC reincorporates ( New Sub ) Parent Asset B Parent Sub LLC New Sub Asset B Asset A Asset B Asset A 36

38 Convert-Reconvert Transactions Under section 368(a)(2)(C) and Reg (k), where a subsidiary liquidates into its parent in what would otherwise qualify as a section 332 liquidation, and the parent reincorporates a sufficient amount of the subsidiary s assets to prevent a complete liquidation, the transaction is treated as an upstream reorganization followed by a separate contribution of the reincorporated assets by the parent to the new subsidiary Generally, the Sub-New Sub conversion-reconversion is treated as an upstream C reorganization followed by a contribution of Asset A by Parent to New Sub This type of convert-reconvert transaction has been aided by several developments over the years following General Utilities repeal Proliferation of state law LLCs Check-the-box entity classification regulations Administrative repeal of the Bausch & Lomb doctrine (Reg (d)(4)) Expansive no recharacterization rule of Reg (k) 37

39 Convert-Reconvert Transactions: Alternative Format Initial Step 1: Sub contributes Asset A to New Sub Parent Parent Sub Asset A Sub Asset A Asset B New Sub Asset A Asset B Step 2: Parent merges with and into Sub, with Sub surviving Final Parent Sub Sub New Sub Asset B New Sub Asset B Asset A Asset A 38

40 Convert-Reconvert Transactions On October 13, 2017, the IRS announced that it will increase its scrutiny and analysis of convert-reconvert transactions and similar reorganizations Do these transactions present General Utilities repeal concerns? Any concerns about the Sub-New Sub conversion-reconversion appear to be about the scope of Reg (k) and whether there is a sufficiently material change in Sub to constitute a realization event, particularly if New Sub is incorporated in the same state as Sub The transaction arguably resembles an outright distribution of appreciated property (Asset B) by Sub to Parent, but should that resemblance entail immediate corporate-level gain recognition? 39

41 Convert-Reconvert Transactions These transactions do not implicate the primary policy of General Utilities repeal Although Asset B has been pushed up from Sub to Parent, Asset B (1) remains in corporate solution after the transaction, (2) has the same basis in Parent s hands as it did in Sub s hands before the transaction, and (3) continues to reside within the same economic unit (Parent s affiliated group) following the restructuring The secondary policy does not call for accelerated corporate-level gain recognition merely because the unrealized appreciation in Asset B has shifted positions within the Parent group The transaction does not create any potential for a tax-free bust-up of Sub s assets and does not result in disparate treatment of old shareholders and new shareholders 40

42 Case Study: Internal Born-to-Die Transactions Step 1: Distributing contributes assets to newly formed Controlled Step 2: Distributing spins off Controlled to Parent Parent Parent Controlled Stock Sub Distributing Sub Distributing Assets Controlled Controlled Assets Step 3: Controlled merges with and into Sub, with Sub surviving Final Parent Parent Sub Controlled Distributing Sub Distributing Assets Assets 41

43 Case Study: Internal Born-to-Die Transactions Step 1: Distributing contributes assets to newly formed Controlled Step 2: Distributing spins off Controlled to Parent Parent Parent Controlled Stock Distributing Distributing Assets Controlled Controlled Assets Step 3: Controlled merges or liquidates into Parent Final Parent Parent Distributing Controlled Distributing Assets Assets 42

44 Internal Born-to-Die Transactions Prior to the enactment of section 355(e), the IRS s position was that the distribution of a newly formed corporation could not qualify for tax-free treatment if the corporation was subsequently acquired in a reorganization as part of the plan, the theory being that the acquisition resulted in a violation of the control requirement of section 355(a)(1)(D) The IRS reversed its position on so-called born-to-die situations following the enactment of section 355(e) Based on the legislative history to section 355(e), Rev. Rul provides that the IRS will not apply any formulation of the step transaction doctrine to determine whether the distributed corporation was a controlled corporation immediately before the distribution under section 355(a) solely because of any postdistribution acquisition or restructuring of the distributed corporation, whether prearranged or not Rev. Rul indicates that a newly formed Controlled will be respected as a separate corporation for purposes of sections 355(a)(1)(D) and 368(a)(1)(D) even if a post-distribution restructuring causes Controlled to cease to exist 43

45 Internal Born-to-Die Transactions Absent Rev. Rul , an internal born-to-die transaction could be recharacterized as a taxable transaction The sideways variant ( drop-spin-merge ) could be recharacterized as a contribution of assets by Distributing to Sub followed by a distribution of Sub stock by Distributing to Parent Similarly, the upstream variant ( drop-spin-liquidate ) could be recharacterized as an outright distribution of assets by Distributing to Parent The rationale of Rev. Rul and Rev. Rul is not logically limited to situations in which Controlled is merged or combined with an otherwise unrelated entity after a section 355 distribution Should Morris Trust-type transactions in an intragroup context be treated differently than external transactions? Is it clear that Congress intended to turn off the step transaction doctrine in purely internal transactions? 44

46 Internal Born-to-Die Transactions On October 13, 2017, the IRS announced that it will increase its scrutiny and analysis of drop-spin-merge, drop-spin-liquidate, and similar transactions Do these transactions present General Utilities repeal concerns? It could be argued that the drop-spin-liquidate format is simply too similar to the facts of Gregory v. Helvering to be respected for purposes of section 355, but such an argument would seem to be driven by section 355 policies, not General Utilities repeal concerns The drop-spin-liquidate format arguably resembles an outright distribution of appreciated property by Distributing to Parent, but should that resemblance entail immediate corporate-level gain recognition? 45

47 Internal Born-to-Die Transactions These transactions do not implicate the primary policy of General Utilities repeal Although some of Distributing s assets end up moving to a brothersister subsidiary (in the drop-spin-merge format) or to Distributing s parent (in the drop-spin-liquidate format), the transferred assets (1) remain in corporate solution after the transaction, (2) have the same basis in the hands of Sub or Parent as they did in Distributing s hands before the transaction, and (3) continue to reside within the same economic unit (Parent s affiliated group) following the restructuring Where sections 355(d) and (e) do not apply, the secondary policy does not call for accelerated corporate-level gain recognition merely because the unrealized appreciation in the transferred assets has shifted positions within the Parent group The transaction does not create any potential for a tax-free bust-up of Distributing s assets and does not result in disparate treatment of old shareholders and new shareholders 46

48 Concluding Observations There has been a need to distinguish between dividends and reorganizations under the federal income tax since 1918 General Utilities repeal may provide an added incentive to ask whether existing law draws the right distinctions between taxable section 301 distributions, on the one hand, and tax-free reorganizations, section 355 distributions, and section 332 liquidations, on the other General Utilities repeal does not, however, provide useful policy criteria for drawing such distinctions; those can only be found in the policies of the preexisting Subchapter C provisions 47