Recent Developments in Corporate Tax - Jones Day Slide Presentation.pdf · Recent Developments in Corporate Tax Scott M. Levine Jones Day Washington D.C. Lori A. Hellkamp Jones Day

Recent Developments in Corporate Tax

Scott M. LevineJones Day Washington D.C.

Lori A. HellkampJones Day Washington D.C.

Todd R. MillerJones Day Detroit

Tax Executives InstituteDearborn, Michigan

October 25, 2016

Agendag

• The Final and Temporary Section 385 Regulations Released October 13, 2016Overview departures from the proposed regulations effective dates– Overview, departures from the proposed regulations, effective dates

– New documentation requirements– Drafting Intercompany lending agreements and other practical considerations

under the new section 385 regulationsunder the new section 385 regulations– The funding rules

• Worthless Stock Loss Deductions – A Primer and Open IssuesWorthless Stock Loss Deductions A Primer and Open Issues

• Income Tax Accounting – Recent Guidance

• Section 355 Spin-offs – The 2016 Proposed Regulations

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The New Section 385 RegulationsThe New Section 385 Regulations

O er ieOverview

• Section 385, Overview of Proposed and Final Regulations, and Definitions, p g ,• The Bifurcation Rule: Prop. Treas. Reg. Section 1.385-1(d)• The Documentation Rules: Treas. Reg. Section 1.385-2• The Transaction Rules: Treas Reg Sections 1 385 3 and 3T• The Transaction Rules: Treas. Reg. Sections 1.385-3 and -3T

• Section 385(a) provides Treasury with the authority to issue regulations as may be necessary or

Section 385

appropriate to:

– Determine whether an instrument is debt or equity for purposes of this title, and

– Bifurcate an instrument as part debt and part equity.

• Section 385(b) includes the following non-exhaustive list of factors that may be taken into account in determining whether an instrument is debt or equity for U.S. tax purposes:

– Whether the instrument includes a written unconditional promise to pay a sum certain and fixed interest rate

– Whether the instrument is subordinated to, or given preference over, other indebtedness

– The issuer’s debt-to-equity ratio

– Whether the instrument is convertible into the issuer’s stock; and

– The relationship between holding stock of the issuer and the instrument.

• Section 385(c) states that the issuer’s characterization of an instrument at the time of issuance is binding on the holder, but not the IRS, unless the holder discloses the inconsistent treatment, and provides Treasury with authority to require information necessary to carry out the provisions of the subsection.y y q y y p

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• Proposed regulations (REG-108060-15) issued on April 4, 2016 under section 385 (the “Proposed

Proposed Regulations: Overviewp g ( ) p , ( p

Regulations”) included rules:

– Providing the IRS with the ability to bifurcate an instrument as part debt and part stock

– Setting forth documentation and maintenance requirements that must be satisfied for a related-party i t t t b h t i d d bt f U S tinstrument to be characterized as debt for U.S. tax purposes

– Subject to certain exceptions, re-characterizing related-party debt instruments as stock for all U.S. tax purposes when issued: (i) as a distribution, (ii) in exchange for related-party stock (e.g., section 304 sale), (iii) as consideration in an internal asset reorganization (e.g., a boot D reorganization), or (iv) to fund a distribution, acquisition of related-party stock, or boot in an internal asset reorganization; and

– Providing treatment for when related-party debt comes into or leaves a U.S. consolidated group.

• The rules of the Proposed Regulations applied without regard to whether (i) the parties are domestic or foreign, or (ii) the corporate group effected an inversion.foreign, or (ii) the corporate group effected an inversion.

• The Proposed Regulations treated members of a U.S. consolidated group as a single entity, and thus did not apply to debt between consolidated group members.

• The Proposed Regulations provided that, when finalized, they would be applicable to debt instruments i d f A il 4 2016issued on or after April 4, 2016.

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• The documentation requirements and bifurcation provisions would generally be effective for certain d bt i t t i d d d i d ft th l ti bli h d fi l

Proposed Regulations: Overview (cont’d)

debt instruments issued or deemed issued after the regulations were published as final.

• The re-characterization provisions (including those addressing the treatment of U.S. consolidated groups) would generally be effective for certain “debt instruments”—i.e., an interest treated as debt under section 1275(a) and Treas. Reg. section 1.1275-1(d)—issued on or after April 4, 2016, and to any debt ( ) g ( ) p , , yinstrument treated as issued before April 4, 2016, as a result of a check-the-box election filed on or after April 4, 2016.

• The re-characterization provisions, however, included limited transition rules providing that a debt i t t i d ft A il 4 2016 th t ld b h t i d t k d th l tiinstrument issued on or after April 4, 2016 that would be re-characterized as stock under the regulations would be treated as debt until 90 days after the regulations were finalized; on the 90th day any outstanding instruments would be deemed exchanged for stock.

• Instruments issued on or after April 4, 2016 included:p

– Instruments issued before April 4, 2016 but that were subject to amendment on or after that date resulting in a deemed exchange of the instrument under section 1001; and

– Instruments arising on or after April 4, 2016 under intercompany debt facilities (e.g., cash sweep arrangements, draw downs under revolving credit facilities, etc.) in existence prior to April 4, 2016.

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Final Regulations: Overview• Final and temporary regulations (T D 9790) issued on October 13 2016 under section 385Final and temporary regulations (T.D. 9790) issued on October 13, 2016 under section 385

(the “Final Regulations”) implemented portions of the Proposed Regulations with significant changes, including:

• Eliminating the bifurcation rule.

• Exempting cash pools and short-term loans from the recharacterization provisions of the general rule and funding rule, discussed below:

• In response to feedback regarding the treatment of cash pools, cash sweeps, and short-term loans, the Final Regulations generally provide exemptions for cash pools and cash sweeps as well as loans that are short-term in both form and substance.

• Exempting certain types of issuers including foreign corporations:• Exempting certain types of issuers, including foreign corporations:

• The Final Regulations generally exempt from the application of these rules debt instruments issued by S corporations, certain RICs and REITs, foreign corporations, and certain partnerships.

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p , p p

Final Regulations: Overview (cont’d)• Expanding exceptions for ordinary business transactions, including: p g p y g

• Expanding the exception for distributions of E&P (“E&P”) to include all future earnings;

• Allowing corporations to net distributions and acquisitions against certain capital contributions; and

• Excepting acquisitions of stock associated with employee compensation plans.

• Easing documentation requirements:

• The Final Regulations require documentation to be in place as of the deadline (with extensions) for filing the tax return for the relevant year; and

• The documentation requirements only apply to instruments issued on or after January 1, 2018.

• Many of these items were reserved in the Final Regulations and the subject of a request for further comments, so future guidance may eliminate or modify some of these exceptions

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exceptions.

Some Relevant Definitions in the Proposed Regulations• Expanded Group (“EG”): a section 1504(a) affiliated group determined:Expanded Group ( EG ): a section 1504(a) affiliated group determined:

− Without regard to section 1504(b) (which prohibits certain types of corporations from being considered “includible corporations” (i.e., an EG includes foreign corporations, tax-exempts, RICs and REITs, among others));

− Changing the requisite ownership threshold from “at least 80% vote and value” to “at least 80% vote or value”; and

− Allowing the common parent to own directly or indirectly (determined by applying the rules of section 304(c)(3)) at least 80% of the vote or value of at least one includible corporation.

• Applicable Instrument (“AI”): any interest issued or deemed issued that is in form a debt instrument.

• Expanded Group Instrument (“EGI”): an AI an issuer of which is one member of an EG and the holder of which is another member of the same EG, a disregarded entity (“DRE”) owned by a member of the same EG or a Controlled Partnership with respect to the same EG.

• Controlled Partnership: A partnership in which 80% or more of the capital or profits interests are owned directly or indirectly by one or more members of the EGowned, directly or indirectly, by one or more members of the EG.

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Expanded Group in the Proposed Regulations –Example

Discussion• Under the Proposed Regulations, P2, S1, S2, and

S3 ll id d b f th EG

P1Other

Partners

1%99% S3 were all considered members of the same EG, applying section 318(a)(3)(A).

• Commentators recommended limiting attribution under section 318(a)(3)(A) to situations where the partnership and the partner are highly related

S1PRS

%%

the partnership and the partner are highly related.• As described below, this issue has been

eliminated in the Final Regulations because attribution under section 318(a)(3) has been removed. Therefore, neither PRS nor P2 are

P2 S2

e oved. e e o e, e t e S o a econsidered as owning any of the stock of S1.

S3

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Significant Changes to Relevant Definitions in the Final Regulations

Si ifi t h i th Fi l R l ti i l d• Significant changes in the Final Regulations include:• Foreign corporations, S corporations, and certain RICs

and REITs are excluded from the regulations;and REITs are excluded from the regulations;• Indirect ownership rules are modified, including the

elimination of downward attribution;• Guidance provided regarding overlapping EGs and hook

stock; and• Brother-sister groups with non-corporate owners

eliminated (potentially unclear in the Proposed R l ti d di th f t tt )

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Regulations depending on the fact pattern).

Exclusion of Certain Issuers

S i l d d f h d fi i i f EG b• S corporations are excluded from the definition of an EG member.

• The documentation rules and transaction rules generally do not apply to debt instruments issued by foreign corporationsdebt instruments issued by foreign corporations.

• Foreign corporations remain EG members for other purposes.

• RICs and REITs can no longer be parents of EGs, although they can still be EG members.

T i i ill i l d d i h EG h• Tax-exempt organizations are still included in the EG, however.

• These changes resolve certain ancillary issues discussed below.

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Revised Definitions in the Final Regulations

E d d G (“EG”) h i f ti ( th th S ti ) t d• Expanded Group (“EG”): one or more chains of corporations (other than S corporations) connected through stock ownership with a common parent corporation that is not an S corporation, RIC, or REIT, but only if—

• The EG parent owns, directly or indirectly, at least 80% vote or value in at least one of the other corporations; and

• At least 80% of the vote or value in each of the other corporations (except the EG parent) is owned directly or indirectly by one or more of the other corporations.

• Indirect Ownership is determined by applying the constructive ownership rules of section 318(a)Indirect Ownership is determined by applying the constructive ownership rules of section 318(a) except—

• Family attribution and downstream attribution do not apply;

• Threshold for upstream attribution from corporations is reduced to 5%; and

• Option attribution only applies if the options are reasonably certain to be exercised (as described in Treas. Reg. section 1.1504-4(g)).

• Covered Member: Certain domestic corporations that are members of an EG.

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Treas. Reg. Section 1.385-1(c)(4)(vii) Example 1—Overlapping EGs

Description• P has two classes of common stock outstanding: Class A

and Class B.

• X directly owns all shares of P’s Class A common stock,

YX

ywhich is high-vote common stock representing 85% of the vote and 15% of the value of the stock of P.

• Y directly owns all shares of P’s Class B common stock, which is low vote common stock representing 15% of the vote and 85% of the value of the stock of P.

Class A Stock85% Vote15% Value

Class B Stock15% Vote

85% Value

• P directly owns 100% of the stock of S1.

Discussion

• X is the parent of the EG that includes X, P, and S1.

• Y is the parent of the EG that includes Y P and S1

P

• Y is the parent of the EG that includes Y, P, and S1.

• X and Y are not members of the same EG because X does not directly or indirectly own any stock of Y and Y does not directly or indirectly own any stock of X.

S1

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Treas. Reg. Section 1.385-1(c)(4)(vii) Example 3—Hook Stock

Description• P owns 50% of the stock of S1.

• S1 owns 100% of the stock of S2.

• S2 owns the remaining 50% of the stock of S1.

P

Discussion

• Because P owns 50% of the stock of S1, P constructively owns 50% percent of the stock of S2.

• Because P constructively owns 50% of the stock of S2, P constructively owns 50% of the stock of S1 held by S2 (25% of

S1

50%50%

y y (the stock of S1 outstanding).

• Because P constructively owns an additional 25% of the stock of S1, P constructively owns an additional 25% of the stock of S2.

• Because P constructively owns an additional 25% of the stock of S2, P constructively owns an additional 25% of the stock of S1 S2 , yheld by S2 (12.5% of the stock of S1 outstanding).

• Through iterative calculations, P ultimately winds up owning (actually or constructively) 100% of the stock of S1.

S2

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Treas. Reg. Section 1.385-1(c)(4)(vii) Example 4—Hook Stock

Description• P and X each own 25% of the stock of S1P and X each own 25% of the stock of S1.• S1 owns 100% of the stock of S2.• S2 owns the remaining 50% of the stock of S1.Discussion• Because P owns 25% of the stock of S1, P constructively owns 25%

t f th t k f S2

XP

percent of the stock of S2. • Because P constructively owns 25% of the stock of S2, P constructively

owns 25% of the stock of S1 held by S2 (12.5% of the stock of S1 outstanding).

• Because P constructively owns an additional 12.5% of the stock of S1, P constructively owns an additional 12 5% of the stock of S2

S1

25%

50%

25%

constructively owns an additional 12.5% of the stock of S2.• Because P constructively owns an additional 12.5% of the stock of S2, P

constructively owns an additional 12.5% of the stock of S1 held by S2 (6.25% of the stock of S1 outstanding).

• Through iterative calculations, P ultimately winds up owning (actually or constructively) only 50% of the stock of S1.constructively) only 50% of the stock of S1.

• The same analysis applies to X.Questions• Does P ultimately wind up owning (actually or constructively) exactly

50% of the stock of S1 or almost 50% of the stock of S1?• A P d S1 b f th EG if P 40% f th t k f S1

S2

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• Are P and S1 members of the same EG if P owns 40% of the stock of S1, X owns 10% of the stock of S1, and S2 owns 50% of the stock of S1?

Potential Future Guidance

• The Final Regulations reserved and further comments were requested on:

• The application of the regulations to foreign issuers; and

• The treatment of brother sister groups without a corporate owner• The treatment of brother-sister groups without a corporate owner.

• If future guidance is released addressing these issues, it will not apply to interests issued before the date of such guidance.

Q i• Questions

• What types of circumstances involving foreign issuers are of concern to the Government?

• What types of brother-sister groups are of concern to the Government?

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The Bifurcation Rule: i (d)Prop. Treas. Reg. Section 1.385-1(d)

Prop. Treas. Reg. Section 1.385-1(d): Bifurcation

G l R l Th IRS bif t t i i t t b t l t d ti i t t d bt• General Rule: The IRS may bifurcate certain interests between related parties into part debt and part equity “to the extent an analysis, as of the issuance of the [interest], of the relevant facts and circumstances concerning the [interest] . . . under general federal tax principles results in a determination that the [interest] is properly treated for federal tax purposes as indebtedness in part and stock in part”

• Although the IRS may bifurcate certain interests into debt and equity components in the above circumstances, the issuer of the interest, the holder of the interest and any other person relying

th h t i ti f th i t t f f d l t i d t t t th i t ton the characterization of the interest for federal tax purposes are required to treat the interest consistent with the issuer’s initial characterization. Thus, for example, a holder may not disclose on its return under section 385(c) that it is treating the interest as indebtedness in part or stock in part if the issuer treats the interest as indebtedness

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Treas. Reg. Section 1.385-1(e): Bifurcation

• The Final Regulations reserved on the treatment of an instrument asThe Final Regulations reserved on the treatment of an instrument as indebtedness in part and stock in part.

• This eliminates many concerns, including:Th bif ti l did t ti l t l t d d f it li ti• The bifurcation rule did not articulate clear standards for its application;

• Special rules were needed for debt issued by partnerships and disregarded entities; and

• It was unclear why the rule was limited to related-party debt.

I ddi i d i d d i l di• In addition, numerous recommendations are rendered moot, including:• The rule should be limited to thin capitalization cases;

• The rule should only apply above a specified dollar threshold;

• The rule should only apply when a significant fraction of the debt would be characterized as equity; and

• Safe harbors should be provided.

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• The preamble to the Final Regulations requests comments on the bifurcation rule.the bifurcation rule.

• Questions• What types of guidance is the Government contemplating with respect to the

bifurcation rule?

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The Documentation Rules: T R S ti 1 385 2Treas. Reg. Section 1.385-2

The Documentation Rules under the Proposed

T R i 1 385 2 f h i i h h ld d i i i d

Regulations

• Treas. Reg. section 1.385-2 sets forth minimum threshold documentation, timing, and maintenance requirements (collectively referred to herein as the “documentation requirements”) that must be satisfied regarding the preparation and maintenance of documentation and information with respect to an EGI.

• The documentation requirements are intended to enable an analysis to be made as to whether an EGI is appropriately treated as debt or stock for federal tax purposes.

• Failure to satisfy the documentation requirements generally means an EGI is stock.

− The type of stock (e.g., common or preferred) is based on the EGI’s terms and conditions.

• If the documentation requirements are satisfied, then the EGI must still be analyzed under U.S. tax principles to determine whether it is treated as debt or stock for federal tax purposes; for example, the EGI could be recharacterized as stock (i) under case law, or (ii) under the transaction rules of Prop. Treas. Reg. section 1.385-3 (now Treas. Reg. sections 1.385-3 and -3T).3 ).

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• Only applies to EGIs issued by Covered Members (a “Covered EGI”).

Final Regulations: Significant Changes

• Debt instruments issued by foreign corporations, S corporations, partnerships, and certain RICs and REITs are no longer subject to these rules.

• Timely preparation requirement for documentation extended to the time the issuer’s federal income tax return is filed (taking into account all applicable extensions)income tax return is filed (taking into account all applicable extensions).

• Where the EG demonstrates a high degree of compliance with the documentation requirements, failure to satisfy such rules with respect to a given EGI results in a rebuttable presumption of stock treatment, rather than per se recharacterization.p p , p

• Certain EGIs issued by certain regulated entities are treated as satisfying the documentation requirements if the EGI contains terms required by a regulator of the issuer in order to satisfy regulatory capital or similar rules.

• Rules for revolving credit facilities and cash pools clarified.

• Same credit analysis can be used to satisfy these requirements for multiple EGIs issued by the same issuer.

• Requirements only apply to instruments issued on or after January 1, 2018.

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• The Final Regulations clarified the definition of an Applicable Interest (“AI”) that was provided in the Proposed

Applicable Interests

Regulations.

• An AI is any:

• Interest that is issued or deemed issued in the legal form of a debt instrument; or

• Intercompany payable and receivable documented in a ledger accounting system open account• Intercompany payable and receivable documented in a ledger, accounting system, open account intercompany debt ledger, trade payable, journal entry or similar arrangement if no written legal instrument or written legal arrangement governs the legal treatment of such payable and receivable.

• An AI is not any:

S l h t t t d i d bt d d f d l t i i l• Sale-repurchase agreement treated as indebtedness under federal tax principles;

• Intercompany obligation as defined in Treas. Reg. section 1.1502-13(g)(2)(ii) or debt instrument issued by a member of a consolidated group that is held by another member of the same consolidated group;

• Production payment treated as a loan under section 636(a) or (b);

• “Regular interest” in a real estate mortgage investment conduit (“REMIC”) described in section 860G(a)(1);

• Debt instrument that is deemed to arise under Treas. Reg. section 1.482-1(g)(3) (including adjustments made pursuant to Revenue Procedure 99-32, 1999-2 C.B. 296); orp )

• Any other instrument or interest that is specifically treated as indebtedness for federal tax purposes.

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Th d t ti i d d T R ti 1 385 2(b)(2) i l d itt d t ti

Documentation Required

• The documentation required under Treas. Reg. section 1.385-2(b)(2) includes written documentation evidencing:

– an unconditional obligation to pay a sum certain;

– creditor’s rights;g

– a reasonable expectation that the issuer intended to, and would be able to, repay the EGI; and

– payments of principal or interest (or, in the event of default, a holder’s reasonable exercise of diligence and judgment of a creditor).

• The required documentation must be timely prepared in accordance with detailed timing rules provided under Treas. Reg. section 1.385-2(c)(4).

− In general, under the Final Regulations, the documentation requirements must be satisfied by the time the issuer’s federal income tax return is filed (taking into account all applicable extensions).

• The required documentation must be maintained for all taxable years that the EGI is outstanding and until the period of limitations expires for any return with respect to which the treatment of the EGI is relevant.

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• Regulated Entity Safe Harbor: The documentation requirements are deemed satisfied for the

New Safe Harborsg y q

following EGIs so long as documentation necessary to establish that the EGI is one of the following EGIs is prepared and maintained and at the time of issuance it is expected that the EGI will be paid in accordance with its terms:

• An EGI issued by a regulated financial company (as defined in Treas. Reg. section 1.385-3(g)(3)(iv) and discussed below) that contains terms required by a regulator of that entity in order to satisfy regulatory capital or similar rules that govern resolution or orderly liquidation of the issuer; andorderly liquidation of the issuer; and

• An EGI issued by a regulated insurance company (as defined in Treas. Reg. section 1.385-3(g)(3)(v) and discussed below) that requires the issuer to receive approval or consent of an insurance regulatory authority prior to making payments of principal or interest on the EGI.

• Market Trading Safe Harbor: Documentation of a kind customarily used in comparable third-party transactions treated as indebtedness for federal tax purposes may be used to satisfy the of sum certain and creditor’s rights requirementssatisfy the of sum certain and creditor s rights requirements.

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Anti-Avoidance and No Affirmative Use

• Anti-Avoidance: If an AI that is not an EGI is issued with a principal purpose of avoiding Treas. Reg. section 1.385-2, the instrument will be treated as an EGI subject to Treas. Reg. section 1 385 2section 1.385-2.

• No Affirmative Use: The Proposed Regulations provided that the documentation rules did not apply if failure to satisfy the documentation requirements had a principal purpose ofnot apply if failure to satisfy the documentation requirements had a principal purpose of reducing the U.S. tax liability of any member of the same EG as the issuer and the holder or any other person relying on the EGI being characterized as debt. This rule was removed and reserved on in the Final Regulations. What does this mean for taxpayers?

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• Failure to satisfy the documentation requirements with respect to a given Covered EGI (an “Undocumented

Rebuttable Presumption

EGI”) generally results in the Undocumented EGI being characterized as stock per se.

• This rule only creates a rebuttable presumption that the instrument is stock if the EG demonstrates a high degree of compliance with the documentation requirements.

• A high degree of compliance exists if, during the calendar year in which the failure occurs, one of two tests isA high degree of compliance exists if, during the calendar year in which the failure occurs, one of two tests is satisfied:

1) The average total adjusted issue price of all Undocumented EGIs outstanding as of the close of each calendar quarter is less than 10% of the average total adjusted issue price of all Covered EGIs outstanding as of the close of each calendar quarter.

2) If no Undocumented EGI has an issue price in excess of $100 million, the average total number of Undocumented EGIs outstanding as of the close of each calendar quarter is less than 5% of the total number of all Covered EGIs outstanding as of the close of each calendar quarter. The threshold is increased to 10% if no Undocumented EGI has an adjusted issue price in excess of $25 million.

• Increases in the adjusted issue price or number of outstanding Covered EGIs with a principal purpose of satisfying these requirements are disregarded under an anti-stuffing rule.

• The presumption that an Undocumented EGI is stock can be rebutted if the taxpayer clearly establishes that there are sufficient common law factors present to treat the EGI as indebtedness, including that the issuer intended to create indebtedness when the EGI was issued.

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Reasonable Cause and Ministerial Error Rules

• The Proposed Regulations provided that a failure to satisfy the documentation requirements could be disregarded where there was reasonable cause for such failure, applying the principles of Treas. Reg. section 301.6724-1.

Th Fi l R l ti f th id th t if th bl ti li th• The Final Regulations further provide that if the reasonable cause exception applies, the taxpayer must satisfy the documentation requirements with respect to the relevant EGIs within a reasonable time.

• Question: What constitutes a “reasonable time” for this purpose?Q W p p

• The Final Regulations also provide that if a taxpayer discovers and corrects a ministerial or non-material failure or error in complying with the documentation requirements before the IRS discovers such failure, the failure will not be taken into account in determining whether the documentation requirements are satisfied.

• Question: What constitutes a “ministerial or non-material failure or error”?

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Partnerships and Disregarded Entities

• The Proposed Regulations provided that EGIs issued by Controlled Partnerships and disregarded entities (“DREs”) were subject to the documentation rules.

• Further, the Proposed Regulations provided that an Undocumented EGI issued by a Controlled Partnership or DRE was treated as equity in the issuing Controlled Partnership or DRE, rather than the corporate owner q y g p por owners of such issuer.

• The Final Regulations provide that an Undocumented EGI issued by a DRE, the owner of which is a Covered Member, is treated as stock in the Covered Member rather than the DRE.

If the Co ered Member has limited liabilit ith respect to the debt of the DRE onl the financial• If the Covered Member has limited liability with respect to the debt of the DRE, only the financial position of the DRE, and not the Covered Member, is relevant for purposes of determining the issuer’s ability to repay the EGI.

• The documentation rules do not apply to debt instruments issued by partnerships (or DREs owned by hi ) b h i id l l d b i i d b C ll d P hipartnerships), but the anti-avoidance rule may apply to debt instruments issued by Controlled Partnerships

(or their DREs) where the requisite intent is found.

• Similarly, a debt instrument issued by a Covered Member and held by a Controlled Partnership is not an EGI.

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Revolvers, Cash Pools and Multiple EGIs Issued

• The Proposed Regulations required a separate credit analysis for each individual draw under a credit f ili h li h i il

by the Same Issuer

facility, cash pooling arrangement or other similar arrangement.

• Similarly, the Proposed Regulations required separate credit analysis for each EGI issued by the same issuer.

h i l l i li i h b f di l i d• The Final Regulations limit the number of separate credit analyses required.

• A credit analysis generally satisfies the reasonable expectation of repayment requirement for all draws during the period beginning on the relevant date of the analysis and ending on the earlier of one year and a “Material Event” of the issuerearlier of one year and a Material Event of the issuer.

• Similar rules apply where multiple EGIs are issued by a single issuer.

• Notional cash pools are subject to these rules to the extent they would be treated as EGIs issued directly between EG membersdirectly between EG members.

• In addition, the documentation of sum certain and creditor’s rights must be updated for any credit facility, cash pooling arrangement or other similar arrangement if such arrangement is amended to provide for an increased maximum amount of principal or to permit an additional entity to borrow (but only with respect to EGIs issued by the new borrower).

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Revolvers, Cash Pools and Multiple EGIs Issued by the Same Issuer (cont’d)

• Material Event means, with respect to an entity, that:

• The entity comes under the jurisdiction of a court in a case under Title 11 or a receivership foreclosure or similar proceeding;a receivership, foreclosure, or similar proceeding;

• The entity becomes insolvent within the meaning of section 108(d)(3);

Th tit t i ll h it li f b i• The entity materially changes its line of business;

• The entity sells, leases or otherwise disposes of 50% or more of the total fair market value of certain of its non-inventory assets; or

• The entity consolidates or merges into another person that does not assume liability for the entity’s outstanding EGIs.

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Revolvers, Cash Pools and Multiple EGIs Issued by the Same Issuer—Example

FactsFacts

1) USP wholly owns CFC.

2) USP purchases supplies from CFC on credit (the “Trade Payables”).

3) USP repays the Trade Payables within 90 days.USP

Discussion

• Under the Final Regulations, the Trade Payables appear to be EGIs subject to the Documentation Rules.

• Because the Trade Payables arise pursuant to the intercompany f h h f li h l l i l

CFC

Sale of Supplies

Trade Payables

agreement for the purchase of supplies, the rules relating to revolvers and cash pooling arrangements appear to apply.

• Question: Assuming that the intercompany agreement is consistent with agreements that would be entered into between third parties, does the Market Trading Safe Harbor apply for purposes of the sum certain and creditor’s rights requirements?

• Question: What types of credit analysis would be appropriate to support a reasonable expectation to repay these types of trade payables?

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Facts

Treas. Reg. Section 1.385-2(h)—Example

• USS1, USS2 and FP are members of the same EG. USS1 and USS2 timely file their federal income tax returns on September 15 of each year.

• USS1 issues an EGI (“EGI A”) to FP on February 1 in Year 1. USS1 issues an EGI (“EGI B”) to USS2 on July 1 in Year 1. USS1 issues another EGI (“EGI C”) to FP on February 1 in Year 2.

• USS1 prepares a credit analysis on September 1 in Year 2 concluding that as of July 1 in Year 1, USS1 would be able to pay interest and principal on an amount greater than the combined principal amounts of EGI A, EGI B and EGI C.

• There are no Material Events of USS1 during Year 1 or Year 2• There are no Material Events of USS1 during Year 1 or Year 2.

Discussion

• The documentation requirements are not satisfied with respect to EGI A because no credit analysis was prepared with a relevant date on or before the issuance of EGI A.

• The documentation requirements are satisfied with respect to EGI B because a credit analysis was prepared with a relevant date on or before the issuance of EGI B before the filing of USS1’s federal income tax return for Year 1.

• The documentation requirements are satisfied with respect to EGI C because a credit analysis was prepared with a relevant date within a year prior to the issuance of EGI C before the filing of USS1’s federal income tax return forrelevant date within a year prior to the issuance of EGI C before the filing of USS1 s federal income tax return for Year 1.

36

• The documentation requirements only apply to an EGI if:

Threshold Requirements and Other Provisionsq y pp y

– The stock of any EG member is traded on, or subject to the rules of, an “established financial market” within the meaning of Treas. Reg. section 1.1092(d)-1(b),

O th d t th AI fi t b EGI th EG’ t t l t d $100 illi– On the date the AI first becomes an EGI, the EG’s total assets exceed $100 million on any “Applicable Financial Statement” (defined by Treas. Reg. section 1.385-2(d)(1)), or

On the date the AI first becomes an EGI the EG’s total annual revenue exceeds $50– On the date the AI first becomes an EGI, the EG s total annual revenue exceeds $50 million on any Applicable Financial Statement.

• The Final Regulations provide guidance regarding the application of the threshold requirement where there are overlapping or multiple Applicable Financial Statementsrequirement where there are overlapping or multiple Applicable Financial Statements.

• If the issuer characterizes the EGI as debt, the issuer, the holder, and any other person relying on that characterization must treat the EGI as indebtedness for all federal tax purposes; the IRS however is not bound by such characterizationpurposes; the IRS, however, is not bound by such characterization.

37

• In general, the Final Regulations retain the rule from the Proposed Regulations that a

Significant Modificationsg g p g

significant modification of an EGI pursuant to Treas. Reg. section 1.1001-3 constitutes the issuance of a new EGI for purposes of the Documentation Rules.

• New credit analysis is required for an EGI that undergoes a significant modification.

• The preamble to the Final Regulations specifically provides that the Documentation Rules are applied before the application of Treas. Reg. section 1.1001-3(f)(7)(ii)(A) (which generally disregards a deterioration in the creditworthiness of the issuer for purposes of determining whether an instrument is debt or stock following a significant modification).

• New documentation of the sum certain and creditor’s rights requirements is not required unless the significant modification relates to an alteration to the terms of the EGI reflected in an express written agreement or written amendment to the EGI.

• Does this exception apply to an EGI that is issued before January 1, 2018, and undergoes a significant modification after that date?

38

Financially Troubled IssuersFacts

1) FP loans money to USS1 in exchange for a note (“USS1 Note”).

2) USS1 has third-party creditors.

3) USS1 enters financial difficulties and becomes unable to pay all of its debts.FP

4) The USS1 Note is modified as part of a workout with USS1’s third-party creditors.

Discussion

• Under the Final Regulations, if the modification constitutes a significant modification under Treas Reg section 1 1001 3 the workout constitutesUSS1

1) Cash for USS Note

Third-party debt Third-

Party modification under Treas. Reg. section 1.1001-3, the workout constitutes a new testing date for the issuer’s ability to repay the instrument.

• This may result in the instrument being recharacterized as stock, even though the financial deterioration of the issuer would otherwise have been disregarded under Treas. Reg. section 1.1001-3(f)(7)(ii)(A).

Party Creditors

• Commentators recommended that a modification subject to Treas. Reg. section 1.1001-3(f)(7)(ii)(A) be exempt from the retesting requirement so as to avoid discouraging debt workouts.

• The preamble to the Final Regulations explains that these recommendations were rejected and that Treas. Reg. section 1.385-2

39

j gapplies before Treas. Reg. section 1.1001-3(f)(7)(ii)(A).

EGI Becomes a Non-EGIFacts

1) USS2 loans money to USS1 in exchange for a note (“USS1 Note”).

2) The USS1 note is recharacterized as stock under the documentation rules.

3) USS1 has E&P in excess of the adjusted basis of the USS1 Note.

4) USS2 sells the USS1 Note to a third partyFP

Thi d 4) USS2 sells the USS1 Note to a third party.

Discussion

• Under the Final Regulations, the USS1 Note treated as stock is deemed exchanged for a debt instrument immediately before the instrument is transferred to the third party.USS1 4) Sale of

Third Party

USS2• This results in a deemed distribution by USS1 to USS2 under section

302(d) even though no property is distributed to USS2. This result may also raise unsettled issues regarding what happens to the basis that USS2 had in the USS1 Note that was recharacterized as stock.

• Commentators recommended that the deemed exchange of the USS1 Note

USS11) Cash

for USS1 Note

4) Sale of US1 Note

USS2

Commentators recommended that the deemed exchange of the USS1 Note treated as stock for a debt instrument take place immediately after the transfer to the third party.

• The preamble to the Final Regulations explains that these recommendations were rejected so as to avoid causing the treatment of the third-party purchaser to be impacted by the documentation rules

40

purchaser to be impacted by the documentation rules.

Non-EGI Becomes an EGIFacts

1) Corp 1 owns 20% of the stock of Corp 2 and Corp 3 owns 80% of the stock of Corp 2.

2) Corp 1 loans money to Corp 2 in exchange for a note (“Corp 2 Note”).Corp 3Corp 1

3) Sale of Corp 2 Stock

3) Years after the issuance of the Corp 2 Note, Corp 1 acquires the rest of the Corp 2 stock from Corp 3.

Discussion

• Under the Final Regulations, the Corp 2 Note must satisfy the documentation rules as of the date Corp 1 acquires the remainder of

80%20%

documentation rules as of the date Corp 1 acquires the remainder of the Corp 2 stock, even though the Corp 2 Note was issued at a time when Corp 1 and Corp 2 were not under common control.

• Commentators recommended that the relevant date for purposes of the documentation rules be restricted to eliminate instances in which a non EGI becomes an EGI beca se s ch instr ments o ld ha e

2) Cash for Corp 2 Note

Corp 2

a non-EGI becomes an EGI because such instruments would have been negotiated at arm’s length.

• The preamble to the Final Regulations explains that these recommendations were rejected because after the instrument becomes an EGI, the issuer and holder may not follow the terms and

diti f th i t t

41

conditions of the instrument.



• Debt not in form; and

Th ffi i l• The no affirmative use rule.

• Questions

• Is the Government considering applying the Documentation Rules to instruments that are not in form debt?

• What does it mean for taxpayers that the regulations reserve on the noWhat does it mean for taxpayers that the regulations reserve on the no affirmative use rule?

42

Best Practices:Intercompany Lending

The Transaction Rules: Treas Reg Sections 1 385 3 and 3TTreas. Reg. Sections 1.385-3 and -3T

Prop. Treas. Reg. Section 1.385-3—Overview

Th t ti l d P T R ti 1 385 3 ld t t t k t i• The transaction rules under Prop. Treas. Reg. section 1.385-3 would treat as stock certain interests held by an EG member that would otherwise be treated as debt for federal tax purposes—i.e., the interest satisfied the documentation requirements of the Proposed Regulations and would otherwise be treated as debt.

• A debt instrument, or portion thereof, treated as stock under Prop. Treas. Reg. section 1.385-3 would be treated as such for all federal tax purposes.

• The transaction rules would provide a general rule applicable to certain note distributions and similar transactions, as well as a funding rule applicable to certain note issuances undertaken to fund certain distributions and similar transactions.

• Both the general rule and the funding rule would be subject to certain limited exceptions.

45

Treas. Reg. Sections 1.385-3 and -3T—Overview• Treas. Reg. section 1.385-3 generally contains the rules issued in Prop. Treas. Reg. section g g y p g

1.385-3 (with significant modifications) except for (1) expanded ordinary course exceptions (including cash pooling) and (2) treatment of disregarded entities and partnerships, both of which are located in Treas. Reg. section 1.385-3T.

• Although the overarching general rule and funding rule of Prop. Treas. Reg. section 1.385-3 have been retained, additional (generally taxpayer-favorable) operating rules have been added in response to comments.

• The limited exceptions introduced in the Proposed Regulations are significantly expanded, and new exceptions have been added.

• Treas Reg sections 1 385-3 and -3T apply only to Covered Debt Instruments (defined• Treas. Reg. sections 1.385-3 and -3T apply only to Covered Debt Instruments (defined below), thereby excluding foreign issuers and S corporations.

• Rules regarding the treatment of instruments issued and held by Controlled Partnerships were substantially revised Those revisions are not described in this presentationwere substantially revised. Those revisions are not described in this presentation.

46

Definition of a “Covered Debt Instrument”

• The general rule and funding rule apply only to a “Covered Debt Instrument,” which is any debt instrument issued after April 4 2016 that is issued by a Covered Member and isApril 4, 2016 that is issued by a Covered Member and is not:

1. A qualified dealer debt instrument;1. A qualified dealer debt instrument;

2. An excluded statutory or regulatory debt instrument; or

3. Issued by a regulated financial company or regulated insurance company.

47

The General Rule: Treas. Reg. Section 1.385-3(b)(2)

• Unless an exception applies, a Covered Debt Instrument issued to aUnless an exception applies, a Covered Debt Instrument issued to a member of the issuer’s EG is treated as stock if it is issued:

1. In a distribution with respect to a corporation’s stock;

2. In exchange for the stock of a member of the same EG (“EG Stock”), other than in an “exempt exchange”; or

3. In exchange for property in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the issuer’s EG immediately before the reorganizationis a member of the issuer’s EG immediately before the reorganization receives the debt instrument with respect to its stock in the transferor corporation.

48

The General Rule: Treas. Reg. Section 1.385-3(b)(2) (cont’d)

• Under Treas Reg section 1 385-3(g)(11) an “exempt exchange” is:Under Treas. Reg. section 1.385 3(g)(11), an exempt exchange is:

1. In a case where the transferor and transferee of the EG Stock are parties to an asset reorganization, either:

o Section 361(a) or (b) applies to the transferor of the EG Stock and such stock is not transferred by issuance; or

o Section 1032 or Treas. Reg. section 1.1032-2 applies to the transferor of the EG Stock and the stock is distributed by the transferee pursuant to the plan of reorganization;reorganization;

2. The transferor of the EG Stock is a shareholder that receives property in a complete liquidation to which section 331 or 332 applies; or

3. The transferor of the EG Stock is an acquiring entity deemed to issue EG Stock in q g yexchange for cash from an issuing corporation in a transaction described in Treas. Reg. section 1.1032-3(b).

• Liquidations and Treas. Reg. section 1.1032-3 were added as “exempt exchanges” in the Final R l ti i t t th P d R l tiRegulations in response to comments on the Proposed Regulations.

49

General Rule Example 1:

F t

Note Distribution

Facts1) In Year 1, when USS1 has no E&P, USS1

distributes a note to FP (alternatively, USS has E&P but FP is in a jurisdiction with a US tax treaty providing for no withholding tax on

FPtreaty providing for no withholding tax on dividends).

Issues• Absent the application of Treas. Reg. section

1 385 3 the Year 1 note distribution is not taxable

1) Note Distribution

1.385-3, the Year 1 note distribution is not taxable (section 301(c)(3) gain, if any, is not subject to U.S. tax so long as USS is not a USRPHC).

• Interest payments reduce the U.S. tax base and the principal can be repaid without U.S. tax.

USS1

E&P - $0the principal can be repaid without U.S. tax.

Result under General Rule• The note is recharacterized as equity under Treas.

Reg. section 1.385-3(b)(2)(i).

50

Assumption: No exceptions to the general rule are applicable


Facts

Section 304 TransactionFacts1) USS2 acquires the stock of USS1 from FP in

exchange for a note (assume that neither USS1 nor USS2 has any current or accumulated E&P).

Issues

FPNote

Issues• Absent the application of the section 385

regulations, the transaction would constitute a dividend-equivalent section 304(a)(1) transaction that may be treated as a section 301(c)(2) return of USS1

USS1 stockUSS2 y ( )( )

basis.Result under General Rule• The note is recharacterized as equity under Treas.

Reg. section 1.385-3(b)(2)(ii).Reg. section 1.385 3(b)(2)(ii).• The transaction is no longer subject to section

304(a)(1) because USS 2 stock is not “property” under section 317(a). See also Treas. Reg. section 1.385-3(h)(3) Ex. 3.

USS1

( )( )

51



Facts

All Boot D Reorganization

1) USS1 transfers all of its assets and liabilities to USS2 in exchange for a note in a transaction that qualifies as a reorganization under section 368(a)(1)(D).

FP2) Note

Basis = FMV2) Pursuant to the plan of reorganization,

USS1 distributes the note to FP in liquidation. FP has a tax basis in its USS1 stock equal to fair market value.

IUSS1

1) USS 1’s assets for note

USS2Issues• Absent the application of Treas. Reg. section

1.385-3(b)(2), the “dividend-within-gain” limitation of section 356(a)(2) prevents any of the note distribution from being treated asUSS1’ of the note distribution from being treated as a dividend.

Result under General Rule• The note is recharacterized as equity under

T R ti 1 385 3(b)(2)(iii)

USS1’s Assets

USS1’s Assets

Treas. Reg. section 1.385-3(b)(2)(iii).

52


Ancillary Consequences

• Because the regulations rely on section 385, which provides authority to characterize an instrument as debt or equity “for purposes of this title,” q y p p ,recharacterization of debt as equity under the regulations could potentially impact many unrelated transactions.

• Commentators pointed out many of these collateral issues with respect to the Proposed Regulations, some of which are highlighted on the following slide.slide.

53

Ancillary Effects (cont’d)• Examples:

− Deconsolidation of, or application of section 1503(f) limitations to, a domestic subsidiary with debt owed to a foreign EG member.

− Losing “control” for purposes of sections 332, 351, 355, and 368.− Loss of “separate affiliated group” status for purposes of section 355.p g p p p− Altering the potential application of section 304.− Loss of the dividend received deduction under Rev. Rul. 94-28.− Loss of section 902 foreign tax credits and application of section 909 splitter rules.

Potential increase in withholding taxes under applicable tax treaty if interest payments are− Potential increase in withholding taxes under applicable tax treaty if interest payments are recharacterized as dividends.

− Status as a U.S. real property holding company.− Affecting the ability of a company to qualify for treaty benefits under an ownership test in a

limitation on benefits provisionlimitation on benefits provision.− Causing or delaying a section 382 ownership change of a loss corporation.− Eligibility for hedging provisions, such as Treas. Reg. sections 1.954-2(a)(4)(ii), 1.988-5, and

1.1275-6.P t ti ll ti f t t k− Potentially creating fast-pay stock.

54

Ancillary Effects in the Final Regulations• Treas. Reg. section 1.385-3(b)(1) provides that except for one limited exception, any Covered DebtTreas. Reg. section 1.385 3(b)(1) provides that except for one limited exception, any Covered Debt

Instrument treated as stock under Treas. Reg. section 1.385-3(b) is treated as stock for all federal tax purposes.

• The preamble confirms that “the Treasury Department and the IRS have determined that it is appropriate to treat the p rported debt instr ment as stock for all federal ta p rposes ”to treat the purported debt instrument as stock for all federal tax purposes.”

• Some of the ancillary effects are deferred or eliminated due to the narrower scope of the Final Regulations (e.g., sections 902/909 due to the exclusion of foreign issuers, section 1361 due to the exclusion of S corporations).

• The only explicit exception to Treas. Reg. section 1.385-3(b)(1) is contained in Treas. Reg. section 1.385-3(d)(7), which provides that a Covered Debt Instrument treated as stock that is not described in section 1504(a)(4) is not treated as stock for purposes of determining whether the issuer is a member of an affiliated group (within the meaning of section 1504(a)).affiliated group (within the meaning of section 1504(a)).

• This means that debt treated as stock under Treas. Reg. section 1.385-3 does not affect EG membership.

• Does this also apply to other Code provisions that apply section 1504(a) “with modifications” (e.g., section 199(d)(4), 7874(c))?

55

Ancillary Effects Example 1:Impact of Recharacterization on “Control”

Facts1) In Year 1, when FS1 owns 100% of the single class of

voting stock of USS1, USS1 issues a note to FS1 in a distribution.

USP

2) Property

2) In Year 2, USP contributes assets to USS1 for use in USS1’s business in exchange for stock which results in USP owning 80% of the actual vote and value of the stock of USS1 (i.e., not including the note).

2) Property Contribution

FS1 80%

Conclusions• The note is treated as equity under Treas. Reg. section

1.385-3(b)(2)(i).• Assuming the note does not have voting power it1) Note

20%

Assuming the note does not have voting power, it would presumably be treated as non-voting stock, which would cause USP’s contribution of property to fail section 368(c).

USS1

1) Note

56


Ancillary Effects Example 2:

Facts

Dividends Received Deduction

1) USP wholly owns USS1, which has significant E&P. USP and USS1 are not consolidated.

2) In Year 1, USS1 distributes a note to USP (the “USS1 Note”).

3) USS1 pays interest on the USS1 Note.

A l iUSP

Analysis

• The USS1 Note is recharacterized as stock under Treas. Reg. section 1.385-3(b)(2)(i), and so the interest payments on the USS1 Note would be characterized as dividend distributions.

• Section 246(c)(1)(A) requires a 45-day holding period of stock in d t lif f th ti 243 di id d i d d d ti

Distribution of USS1 Note

order to qualify for the section 243 dividends-received deduction with respect to dividends paid on such stock.

• Section 246(c)(4) provides that the holding period is tolled for periods in which the risk of loss is diminished, and Rev. Rul. 94-28 provides that section 246(c)(4) applies to an instrument that affords the holder the rights of a creditor and is not stock for corporate law

Significant E&P

USS1

the holder the rights of a creditor and is not stock for corporate law purposes but is stock for federal income tax purposes.

• Section 246(c)(4) may prevent payments of interest on the USS1 Note from qualifying for the dividends-received deduction.

• This issue is less relevant under the Final Regulations due to the exclusion of foreign issuersexclusion of foreign issuers.

57


Ancillary Effects Example 3:

Facts

Fast-Pay Stock

1) USP wholly owns USS1 and CFC1; USS1 wholly owns USS2 and CFC1 wholly owns CFC2.

2) In Year 1, USS2 purchases the stock of CFC2 from CFC1 in exchange for a note (the “USS 2 Note”)

3) Th USS2 N t h 5 t d i f ll ti i

USP

3) The USS2 Note has a 5-year term and is fully amortizing.

Analysis• The USS2 Note is recharacterized as stock under Treas. Reg.

section 1.385-3(b)(2)(ii), and payments on the USS2 Note would constitute dividends.

USS1CFC2 stock

CFC1

• Because the USS2 Note is fully amortizing, the payments received are economically a return of the holder’s investment, potentially causing the USS2 Note to be considered fast-pay stock under Treas. Reg. section 1.7701(l)-3.

USS2 NoteCFC2USS2

• Treas. Reg. section 1.7701(l)-3 permits the IRS to recharacterize fast-pay stock where it determines that a principal purpose of the arrangement is the avoidance of tax.

• Can such a principal purpose be found here, given that the instrument is formally debt? The preamble to the Final Regulations notes but does not resolve the issue

CFC2

Regulations notes but does not resolve the issue.

58


The Funding Rule: Treas. Reg. Section 1.385-3(b)(3)(i) and (ii) (Prohibited Transactions)• Under the funding rule, a Covered Debt Instrument that is not a qualified short-term debt instrument

(discussed below) is treated as stock to the extent it is issued by a Covered Member of the EG (the “funded member”) to an EG member in exchange for property and such debt is treated as funding one of the following distributions or acquisitions (a “Prohibited Transaction”):

– A distribution of property by the funded member to an EG member other than an “exemptA distribution of property by the funded member to an EG member, other than an exempt distribution”;

– An exempt distribution is (i) a distribution of stock received without recognition of gain under section 354(a)(1) or 355(a)(1), or, if section 356 applies, that is not treated as “other property”

d i 356 (ii) di ib i f i l li id i dor money under section 356; or (ii) a distribution of property in complete liquidation under section 336(a) or 337(a).

– An acquisition of EG Stock (except in an exempt exchange, defined above) by the funded member from an EG member in exchange for property other than EG Stock; org p p y

– An acquisition of property by the funded member in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder that is a member of the funded member’s EG immediately before the reorganization receives “other property” or money within the meaning of section 356 with respect to its stock in the transferor corporationsection 356 with respect to its stock in the transferor corporation.

59

The Funding Rule: Principal Purpose and the

U d l C d D b I i d f di P hibi d

Per Se Rule

• Under a per se rule, a Covered Debt Instrument is treated as funding a Prohibited Transaction if it is issued by the funded member during the 72-month period beginning 36 months before the date of the Prohibited Transaction (the “per se period”)period ).

• If the Covered Debt Instrument in question is not issued by a funded member during the per se period, the determination of whether the Covered Debt Instrument funded the Prohibited Transaction is made based on all the facts and circumstances. A Covered Debt Instrument can fund a Prohibited Transaction regardless of whether it is issued before or after a Prohibited Transaction.

• Some commentators requested that the per se rule be removed or turned into a rebuttable presumption, but it has not been significantly modified from the Proposed Regulations.p g

60

Funding Rule Example 1

Facts1) USS3 acquires the stock of USS1 from FP in exchange

for $100 of cash.

2) In the same year, USS3 borrows $100 from USS2 in exchange for a note (the “USS3 Note”).

FP1) Cash in

exchange for USS1 stock

g ( )

3) Assume that neither USS1 nor USS2 has any current or accumulated E&P.

Result under Funding RuleUSS1 USS3USS2• The USS3 Note is treated as equity in USS3 pursuant to

Treas. Reg. section 1.385-3(b)(3), and the transaction constitutes a dividend-equivalent section 304(a)(1) transaction.2) Cash in

exchange for USS3 Note

USS1

61

Assumption: No exceptions to the general rule or funding rule are applicable

Funding Rule Example 2:

Facts

Leveraged Distribution

1) USS2 has substantial cash and E&P. USS1 has no E&P. In Year 1, USS2 lends cash to USS1 for a USS1 note (“USS1 Note”)

2) In Year 3, USS1 distributes cash to FP.FP2) Cash Distribution 2) In Year 3, USS1 distributes cash to FP.

Assume FP’s basis in its USS1 stock exceeds the distribution amount (and there are no basis blocks)

Analysis

2) Cash Distribution

1) Cash for y• The loan from USS2 to USS1 supplies cash

to USS1 without a corresponding movement of USS2’s E&P.

• Most/all of the distribution could be a tax-

USS1

No E&P

USS2

High E&P

USS1 Note

free return of basis.• USS1 Note is recharacterized as equity

under Treas. Reg. section 1.385-3(b)(3)(i)(A).

62

Assumption: No exceptions to the funding rule are applicable

Funding Rule Example 3:Reorganization

Facts

1) On Date A in Year 1, FS loans $100 to USS2 in exchange for a USS2 note (“USS 2 Note”).

2) On Date B in Year 2, USS2 transfers all of its assets to USS1 in exchange for USS1 stock, and USS2 distributes the USS1 stock received to FP in

FP2) USS1 Stock

liquidation in a reorganization.

Analysis

• The distribution of property by USS2 to FP in the reorganization is an exempt distribution.USS2

1) $100USS1FS

2)• USS2’s acquisition of USS 1 stock is an exempt

exchange.

• FP’s receipt of USS1 stock is not a Prohibited Transaction because FP does not receive any “other property.”

1) $100 for USS2 Note

USS2’

2) USS2 assets for USS1 stock

p p y

• No Prohibited Transaction has occurred, so the funding rule does not apply. Note, however, that USS1 is a successor to USS2, so USS1 is now a funded member with respect to the USS 2 Note. See Treas. Reg. section 1.385-3(h)(3) Ex. 10.

USS2’s Assets

USS2’s Assets

63

g ( )( )Assumption: No exceptions to the funding rule are applicable

Payments on Partially Recharacterized Covered Debt Instruments

• Treas. Reg. section 1.385-3(d)(5) contains new ordering rules for payments on debt partially recharacterized as stock under the general rule or the funding rule.

− In general, a payment with respect to a debt instrument partially recharacterized as stock is treated as made pro rata between the portion treated as stock and the portion treated as debttreated as debt.

− However, a payment that is not required to be made pursuant to the terms of the instrument (e.g., a prepayment of principal) may be designated by the issuer and holder as being with respect to the portion treated as stock or the portion treated as debt.

64

Transactions that Straddle Different EGs (Treas. Reg. section 1.385-3(b)(3)(iii)(D))• In response to comments received with respect to the Proposed Regulations, a Covered Debt

Instrument is not treated as issued by a funded member during the per se period with respect to a Prohibited Transaction if:

1. The Prohibited Transaction occurs prior to the issuance of the Covered Debt ( if h f d d b i d i i h hibi dInstrument (or, if the funded member is treated as engaging in the Prohibited

Transaction of a predecessor or successor, the predecessor or successor is not a member of same EG as the funded member on the date of the Prohibited Transaction);

2 Th P hibit d T ti h th f d d b i b f EG2. The Prohibited Transaction occurs when the funded member is a member of an EG that has a different EG parent than when the funded member issues the Covered Debt Instrument; and

3 On the date of issuance of the Covered Debt Instrument the “recipient member” is3. On the date of issuance of the Covered Debt Instrument, the “recipient member” is not a member of the same EG as the funded member.

o A “recipient member” is the transferee of property in a Prohibited Transaction (including predecessors or successors)(including predecessors or successors).

65

Facts1) In Year 1 UST distributes $100 to FP

Straddle Example

1) In Year 1, UST distributes $100 to FP.2) In Year 3, unrelated USP acquires UST from FP for cash.3) Later in Year 3, CFC 1 loans $100 to UST in exchange for a

note (the “UST Note”).Analysis

U d h P d R l i h f di l ld l

USP

2) UST stock for cash

• Under the Proposed Regulations, the funding rule could apply because FP was a member of UST’s EG when the distribution was made, causing the loan from CFC 1 to UST to be treated as the acquisition of additional UST stock, even though USP would have had no control over, or even knowledge of, the prior distribution to FP.

FP

UST CFC1

• Under Treas. Reg. section 1.385-3(b)(3)(iii)(D), the per se prong of the funding rule does not apply because:

o The Prohibited Transaction (UST’s distribution to FP) occurs prior to the issuance of the UST Note;

o The Prohibited Transaction occurs when UST is a

1) $100 Distribution

UST3) $100 for

UST Note

member of a different EG than when it issues the UST Note; and

o When the UST Note is issued, the recipient member (FP) is not a member of the same EG as the funded member (UST).

N t th t th UST N t ld till b bj t t th f di lo Note that the UST Note could still be subject to the funding rule under the principal purpose prong.

66


Cascading Recharacterizations and Non-Duplication• Certain cascading and duplicative consequences of recharacterization were raised by comments to the

Proposed Regulations.

• In response, the Final Regulations incorporate certain operating rules that avoid particular cascading and duplicative recharacterizations:

o When two or more Covered Debt Instruments may be treated as stock under the funding rule, they are y g ytested under the per se rule based on the order they are issued, with the earliest tested first. Treas. Reg. section 1.385-3(b)(3)(iii)(B).

o When a Covered Debt Instrument may be treating as funding more than one Prohibited Transaction, the Covered Debt Instrument is treated as funding Prohibited Transactions in the order in which they occur,

ith th li t t t d fi t T R ti 1 385 3(b)(3)(iii)(C)with the earliest tested first. Treas. Reg. section 1.385-3(b)(3)(iii)(C).

o When a Covered Debt Instrument is treated as stock pursuant to the funding rule, the Prohibited Transaction that is funded by such Covered Debt Instrument is not recharacterized as a result of the treatment of the Covered Debt Instrument as stock. Treas. Reg. section 1.385-3(b)(3)(vi).

o Except for retesting that occurs when a Covered Debt Instrument leaves the EG (discussed below), a Prohibited Transaction that is treated as funded by a Covered Debt Instrument cannot be treated as funded by a different Covered Debt Instrument, and to the extent a Covered Debt Instrument is treated as funding one Prohibited Transaction, it cannot be treated as funding another Prohibited Transaction. Treas. Reg. section 1.385-3(b)(6).

67

Cascading Recharacterizations and Non-Duplication (cont’d)

• Other cascading and non-duplication rules:

• An acquisition of a Covered Debt Instrument that is treated as stock under the funding rule is not treated as an acquisition of EG Stockunder the funding rule is not treated as an acquisition of EG Stock. Treas. Reg. section 1.385-3(c)(2)(v)(A).

• A transaction described under the general rule is not also a P hibi d T i bj h f di l T RProhibited Transaction subject to the funding rule. Treas. Reg. section 1.385-3(b)(5).

• If a transaction would constitute more than one type of Prohibited Transaction, the funded member is treated as making only a single Prohibited Transaction. Treas. Reg. section 1.385-3(b)(3)(ii).

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Cascading Example

Facts1) In Year 1, FP lends $100 to USS1 for a USS1 note

(“USS1 Note A”).

2) In Year 1, USS1 distributes $100 to FP.

3) In Year 2 USS1 repa s USS1 Note AFP

2) $100 Distribution3) Repay USS1 Note A

3) In Year 2, USS1 repays USS1 Note A.

4) In Year 3, FP lends $100 to USS1 for another USS1 note (“USS1 Note B”).

Analysis• Because the distribution of cash in step 2 is a Prohibited

1) $100 for USS1 Note A

4) $100 for USS1 Note B

pTransaction, USS1 Note A is recharacterized as stock.

• As a result, the repayment of USS1 Note A in Year 2 is a section 302(d) redemption of USS1 stock treated as a distribution with respect such stock, resulting in USS1 Note B being recharacterized as USS1 stock.US 1

• This iterative consequence is not prevented by any provision of the Final Regulations, and is affirmed in the Preamble: “the funding rule could be circumvented if the repayment of a note that is treated as stock were not treated as a distribution.” See Preamble at 119.

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Cascading Example 2

Facts1) In Year 1, USS2 distributes $100 to FP.

2) I Y 2 USS1 l d $100 t USS2 i h fFP

1) C h di ib i 2) In Year 2, USS1 lends $100 to USS2 in exchange for a note (“Note 1”).

3) Later in Year 2, USS3 lends $100 to USS2 in exchange for a note (“Note 2”).

4) In Year 3, USS2 repays Note 1.USS2USS1 USS3

1) Cash distribution

5) In Year 4, USS2 repays Note 2.

Conclusion• The result appears to be the same as in the prior

example—the repayment of Note 1 is a Prohibited Transaction that causes Note 2 to be recharacterized

2) Cash for Note 1 3) Cash for Note 2

) f ) f Transaction that causes Note 2 to be recharacterized. Why is this result appropriate?

4) Repayment of Note 1

5) Repayment of Note 2

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EG Stock Acquisition and Cascading Example

FP1) $100 for USS1 Note

Facts1) In Year 1, FP loans $100 to USS1 for a USS1 note

(“USS1 Note”).

2) In Year 2, USS1 loans $100 to USS2 for a USS2 note (“USS2 N ”)

3) $100 cash distribution

(“USS2 Note”).

3) In Year 3, USS2 distributes $100 cash to FP.

Analysis• USS2’s Year 3 distribution is a Prohibited Transaction

that recharacterizes USS2 Note into stock

USS1 USS2


that recharacterizes USS2 Note into stock.

• Because USS2 Note is stock, USS1 would generally be treated as acquiring EG Stock for cash in Year 2, which would be a Prohibited Transaction that recharacterizes USS1 Note into stock.

• Treas Reg section 1 385-3(c)(v)(A) prevents this• Treas. Reg. section 1.385-3(c)(v)(A) prevents this iterative result by providing that “an acquisition of a Covered Debt Instrument that is treated as stock” under the funding rule is not treated as an acquisition of EG Stock.

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Non-Duplication Example 1FactsFacts1) In Year 1, FP lends $100 to USS1 for a USS1

note (“USS1 Note A”).2) In Year 2, USS1 distributes a $100 note

(“USS1 Note B”) to FPFP

( USS1 Note B ) to FP.Analysis• The distribution of USS1 Note B is described

in the general rule, and is thus recharacterized as stock


2) Distribution of USS1 Note B

as stock.• Pursuant to Treas. Reg. section 1.385-3(b)(5),

the distribution of USS1 Note B cannot also be a Prohibited Transaction for purposes of the funding rule. Therefore, the distributionUSS1 the funding rule. Therefore, the distribution of USS1 Note B is not a Prohibited Transaction that causes USS1 Note A to be recharacterized. See Treas. Reg. section 1.385-3(h)(3) Ex. 1.

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Assumption: No exceptions to the general or funding rule are applicable

Non-Duplication Example 2Facts1) In Year 1, FP lends $200 to DS for a DS note

(“DS Note A”).2) In Year 2, DS distributes $400 to USS1.3) In Year 3 FP lends $300 to DS for another

FP3) $300 for DS Note 2

3) In Year 3, FP lends $300 to DS for another DS note (“DS Note B”).

Analysis• The distribution of $400 in Year 2 causes DS

Note A to be recharacterized as stock underUSS1

1) $200 for DS Note A

2) Distribution of $400 Note A to be recharacterized as stock under

the funding rule.• Due to the non-duplication rules and ordering

rules, only the remaining $200 of the Year 2 distribution not used to recharacterized DSdistribution not used to recharacterized DS Note A can be used to recharacterize DS Note B. Therefore, $200 of DS Note B is recharacterized as stock and $100 of DS Note B continues to be treated as debt. See Treas. R ti 1 385 3(h)(3) E 5

DS

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Reg. section 1.385-3(h)(3) Ex. 5.Assumption: No exceptions to the funding rule are applicable

Treas. Reg. Section 1.1001-3

• The Final Regulations provide guidance regarding when a significantThe Final Regulations provide guidance regarding when a significant modification of an instrument under Treas. Reg. section 1.1001-3 implicates the funding rule– If a Covered Debt Instrument is treated as exchanged for a deemed “new” Covered Debt Instrument– If a Covered Debt Instrument is treated as exchanged for a deemed new Covered Debt Instrument

due to a significant modification, the “new” Covered Debt Instrument is generally treated as issued on the original issue date of the Covered Debt Instrument for purposes of the funding rule.

– However, this special rule does not apply if the modification(s) triggering the deemed exchange include(s):include(s):

o The substitution of the primary obligor

o The addition/deletion of a co-obligor; or

o The material deferral of scheduled paymentso The material deferral of scheduled payments.

– Also note that this special rule only applies to modifications and not refinancings

– If a Covered Debt Instrument is upsized, the portion of the debt instrument attributable to the upsize is treated as issued on the date of the upsize.

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• The funding rule contains provisions addressing predecessor and successor corporations. Generally, f t f d d b i l d f t d f h b

Predecessors and Successors

references to a funded member include references to any predecessor or successor of such member.

• Under these rules:

– A predecessor of a corporation means (i) the distributor or transferor in a section 381(a) transaction in which the corporation is the acquiring corporation, or (ii) Distributing in a section 355 transaction p q g p , ( ) gin which the corporation is Controlled.

– A successor of a corporation is defined as (i) the acquiring corporation in a section 381(a) transaction in which the corporation is the distributor or transferor, (ii) Controlled in a section 355 transaction in which the corporation is Distributing, or (iii) a seller in certain types of subsidiarytransaction in which the corporation is Distributing, or (iii) a seller in certain types of subsidiary stock acquisitions in which the corporation is the acquirer (discussed below).

– The term predecessor does not including Distributing in a section 355 transaction as of the date that Distributing and Controlled are no longer in the same EG. The term successor does not include Controlled in a section 355 transaction as of the date that Distributing and Controlled are no longerControlled in a section 355 transaction as of the date that Distributing and Controlled are no longer in the same EG.

– A corporation may have multiple predecessors or successors.

• The exception for section 355 transactions, and an exclusive definition of predecessor and successor (rather than what it “includes”), were incorporated into the Final Regulations as a result of comments.

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Predecessors and Successors Example Pt. 1Facts

1) In Year 1, FP loans $200 to USS2 for a USS2 note (“USS2 Note”).

2) In Year 2, USS2 forms DS2 and transfer $200 to DS2 in exchange for $150 of DS2 stock and a $50 DS2 note (“DS2 Note”) in a section 368(a)(1)(D) reorganization.

FP

( ) ( )( )( ) g

3) Immediately after step 2, USS2 distributes the stock of DS2 and DS2 Note to FP in a section 355 spin-off.

Analysis

• DS2 Note is treated as stock under the general rule USS2


3) Distribution of DS2 stock and DS2 Note

gbecause it is issued in an asset reorganization and then distributed to FP as part of the plan of reorganization.

• Because DS2 Note is recharacterized under the general rule, its issuance is not treated as a Prohibited Transaction under the non-duplication rules, and does

2) Formation of DS2; $200 for $150 DS2 stock and $50 DS2 Note p ,

not cause USS2 Note to be recharacterized under the funding rule.

• USS2’s acquisition of DS2 stock is an exempt exchange, and USS2’s distribution of DS2 stock is an exempt distribution.

NoteDS2

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Predecessors and Successors Example Pt. 2

FactsFacts

4) In Date A in Year 3, DS2 distributes $200 to FP.

5) In Date B Year 3, USS2 distributes $100 to FP.

Analysis

USS2 d DS2 d / f5) $100 Di t ib ti4) $200 Di ib i • USS2 and DS2 are predecessors/successors of one another because of the spin-off.

• Distributions by USS2 and DS2 are treated as made by each other.

• DS2’s distribution of $200 is a Prohibited Transaction

FP5) $100 Distribution4) $200 Distribution

$50 DS2 Note $200 USS2 Note

S s d st but o o $ 00 s a o b ted a sact otreated as funding USS2 Note. USS2 Note is recharacterized as stock as of Date A. See Treas. Reg. section 1.385-3(h)(3) Ex. 8, 9.

• USS2’s distribution on Date B has no debt to recharacterize and so does not cause any debt to be

USS 2DS 2

recharacterize and so does not cause any debt to be treated as stock.

• If DS2 and USS2 were no longer members of the same EG after the spin-off, DS 2 and USS 2 would cease to be predecessor/successor and DS2’s distribution would not affect the characterization of USS2 Note

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affect the characterization of USS2 Note.Assumption: No exceptions to the general or funding rule are applicable

Predecessors and Successors—Acquisitions of

• If one entity sells EG Stock to another EG member and immediately thereafter the acquirer

Subsidiary Stock

If one entity sells EG Stock to another EG member, and immediately thereafter, the acquirer controls the seller (more than 50% of vote and value) as described in Treas. Reg. section 1.385-3(c)(2)(i)(A), the seller is generally treated as a successor of the acquirer, subject to the following rules:

h ll i l d f h i h f h l f h− The seller is only treated as a successor of the acquirer to the extent of the value of the EG Stock acquired from the seller in exchange for property.

− A Prohibited Transaction by the seller to or from the acquirer is not taken into account for purposes of applying the funding rule to a Covered Debt Instrument of the acquirer.p p pp y g g q

− To the extent that a Covered Debt Instrument of the acquirer is treated as funding a Prohibited Transaction of the seller, the value of the EG Stock sold to the acquirer is reduced by an amount equal to the Prohibited Transaction for purposes of any further treatment of the seller as a s ccessor of the acq ireras a successor of the acquirer.

• Successor status terminates once the seller and the acquirer cease to be members of the same EG.

• This rule complements the subsidiary stock acquisition exception, discussed below, and is an expanded version of a provision in Prop. Treas. Reg. section 1.385-3(d)(9)(ii).expanded version of a provision in Prop. Treas. Reg. section 1.385 3(d)(9)(ii).

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Predecessors and Successor–Timing

• In response to comments, Treas. Reg. section 1.385-3(b)(3)(v)(B) provides that a Covered Debt Instrument issued by a funded member that funds a Prohibited Transaction made by a predecessor or successor is not treated as issued during the

i d lper se period unless:

− The Covered Debt Instrument is issued by the funded member during the period beginning 36 months before and ending 36 months after the date when pe od beg g 36 o s be o e d e d g 36 o s e e d e w eits predecessor or successor became a predecessor or successor; and

− The Prohibited Transaction is made by the predecessor or successor during h i d b i i 36 h b f d di 36 h f i bthe period beginning 36 months before and ending 36 months after it became

a predecessor or successor of the funded member.

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Predecessors and Successors Timing ExampleFacts

1) On Date A in Year 1, FS lends $100 to USS1 in exchange for a USS1 note (“USS Note”).

2) On Date B in Year 3, USS2 distributes $100 to FP.

3) On Date C in Year 10, USS1 merges with and into USS2 in a reorganization.

FP

2) USS2 distributes $100 to FP

g

Results

• The predecessor/successor rule of the Proposed Regulations was written in such a way that it would cause USS1 Note to be recharacterized as stock as a result of the merger of USS1 with and into USS2

1) $100 for USS1 N t and into USS2.

• This is because the merger caused USS2 to be treated as issuing a Covered Debt Instrument and making a Prohibited Transaction within a 36-month period.

• Treas. Reg. section 1.385-3(b)(3)(v)(B) now applies to prevent

USS1 FS USS2Note

3) USS1 merges the issuance of USS1 Note and the Prohibited Transaction from being treated as occurring within the per se period because neither occurred during the 36 months before or after the merger of USS1 into USS2.

• What if USS 1 was a foreign entity, such that it was not a C d M b d USS 1 N C d D b

) ginto USS2

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Covered Member and USS 1 Note was not a Covered Debt Instrument until USS 1 merged into USS 2?

Exceptions Overview• The Proposed Regulations contained certain limited exceptions to the general rule and/or the

funding rule—a current E&P exception, ordinary course exception, subsidiary stock issuance exception, and threshold exception.

• In response to comments, the Final Regulations have generally expanded the foregoing exceptions and added new exceptions.

• Key exceptions now include:− Post-April 4, 2016 E&P exception− Qualified contribution exception− Threshold exceptionThreshold exception− Subsidiary stock acquisition exception− Short-term and ordinary course debt exceptions, including deposits with cash pool headers− Exceptions based on instrument type (e.g., interest-free loans, insurance/reinsurance

)contracts)− Exceptions based on issuer status (e.g., regulated financial companies, regulated insurance

companies)− Exception for straight section 355 distributions− Exceptions for issuances of stock as compensation

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1.1032-3 and Compensatory Stock• Commentators to the Proposed Regulations requested an exception for all transactions p g q p

described in Treas. Reg. section 1.1032-3, but particularly where a purchase of EG Stock was deemed to occur under Treas. Reg. section 1.1032-3(b) and no actual payment for stock was made

• Deemed purchases are now indirectly exempted due to separate recommendation adopted• Deemed purchases are now indirectly exempted due to separate recommendation adopted in the Final Regulations to reduce the amount of distributions or acquisitions described in the general rule or funding rule by “qualified contributions.”

– “Qualified contributions” include a deemed cash contribution under Treas. Reg. section 1.1032-3(b).Q g ( )

• The Final Regulations also adopted exceptions from the general and funding rules in two situations where an actual payment for stock is made:

1. Exception for EG Stock delivered to individuals in consideration for services rendered as an pemployee, a director, or an independent contractor; and

2. Exception for the acquisition of EG Stock by a dealer in securities (within the meaning of section 475(c)(1)) to the extent the EG stock is acquired in the ordinary course of the dealer’s business of d li i itidealing in securities.

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1.1032-3 and Compensatory Stock

Th Fi l R l ti dd ti f th i iti f EG St k b d l i• The Final Regulations add an exception for the acquisition of EG Stock by a dealer in securities (within the meaning of section 475(c)(1)) to the extent the EG Stock is acquired in the ordinary course of the dealer’s business of dealing in securities, but solely to the extent that:

– The dealer accounts for the stock as securities held primarily for sale to customers in the ordinary course of business;

Th d l di f h k i hi i d h i i i h h h ldi f– The dealer disposes of the stock within a period that is consistent with the holding of the stock for sale to customers in the ordinary course of business, taking into account the terms of the stock and the conditions and practices prevailing in the markets for similar stock during the period in which it is held; and

– The dealer does not sell or otherwise transfer the stock to a person in the same expanded group, other than in a sale to a dealer that in turn satisfies the requirements of Treas. Reg. section 1.385-3(c)(2)(iv).Treas. Reg. section 1.385 3(c)(2)(iv).

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E&P Exception• The amount of any distribution or acquisition subject to the general rule or the funding rule are

decreased by the amount of the in-question EG member’s current year E&P described in section 316(a)(2) and its accumulated E&P described in section 316(a)(1), but only to the extent such E&P accumulated after April 4, 2016.

– The reduction is applied to the distributions or acquisitions in the order of occurrencepp q

– This exception in the Proposed Regulations had only covered current E&P. Commentators had noted several concerns with this, including the following:

o A current year E&P exception would have put a premium on, for example, paying note dividends each year (“serial note dividends”) rather than a “bullet” note dividend after several years.

o Since current year E&P is often difficult to determine until after the end of the year, it would have been difficult to know what portion of a current year transaction would be p yexempted under this exception, especially if the transaction occurs early in the year.

o Many countries do not permit distributions of profits in the year in which they are earned, which would have potentially precluded taxpayers from availing themselves of this exception with respect to controlled foreign corporations.this exception with respect to controlled foreign corporations.

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E&P Exception (cont’d)• The exception only applies to E&P accumulated by a corporation while it was an EG member.

• The Final Regulations implement the exception by introducing the concept of a member’s “EG earnings account.”

• The aggregate amount of a Covered Member’s distributions or acquisitions described in the general rule or funding rule in a taxable year during an “EG period” is reduced by the member’s “EG earningsor funding rule in a taxable year during an EG period is reduced by the member s EG earnings account” for the EG period

– “EG period” is the period during which the covered member is a member of an EG with the same EG parent.

– “EG earnings account” with respect to an EG period is the Covered Member’s EG earnings during the period minus the covered member’s EG reductions during the period.

– “EG earnings” are the E&P accumulated by the Covered Member during the EG period (but after April 4, 2016) without regard to any distributions or acquisitions by the Covered Member p ) g y q ydescribed in the general rule or funding rule.

– “EG reductions” are the amounts by which acquisitions or distributions described in the general rule or funding rule were reduced by reason of the EG earnings reduction during the portion of the EG period preceding the taxable year.EG period preceding the taxable year.

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E&P Exception (cont’d)

• The EG earnings reduction is applied to distributions and• The EG earnings reduction is applied to distributions and acquisitions by a Covered Member described in the general rule and funding rule before the reduction for qualified contributions.

Di id d f th EG b t t k i t• Dividends from other EG members are not taken into account in calculating EG earnings of a Covered Member unless attributable to E&P accumulated in a taxable year of the distributing member ending after April 4, 2016 and during its EG period.

86


• A consolidated group has one EG earnings account and only the E&P determined in• A consolidated group has one EG earnings account and only the E&P determined in accordance with Treas. Reg. section 1.1502-33 (with certain modifications) of the common parent of the consolidated group are considered in calculating the EG earnings for the EG period of a consolidated group.

• A consolidated group succeeds to the EG earnings account of a “joining member” (an EG member joining the consolidated group).

• If a “departing member” (an EG member that leaves the consolidated group but remains in the EG) leaves a consolidated group in a distribution under section 355, the EG earnings account of the consolidated group is allocated between the consolidated group and the departing member in proportion to the E&P of the consolidated group and the E&P of the departing member immediately after the g p p g ytransaction.

• No amount of the EG earnings account of a consolidated group is allocated to a departing member that leaves the consolidated group in a transaction other than a di ib i hi h i 3 lidistribution to which section 355 applies.

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• Commentators to the Proposed Regulations had raised concerns regarding the sequencing rule that states that the reduction is applied to the distributions or acquisitions in the order of occurrence.

• The Final Regulations provide that, to the extent an exception applies to exclude or reduce the amount of a distribution or acquisition described in the general rule, the debt instrument issued in the transaction isin the general rule, the debt instrument issued in the transaction is treated as issued by a member in exchange for property solely for purposes of applying the funding rule to the debt instrument and the member (the “funded member rule”).( )

• The funded member rule reduces the impact of the sequencing rule.

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Facts

Funded Member Rule – Example

1) In Year 1, S has expanded group earnings of $50x

2) In Year 1, S distributes $50x cash and a note with a $50x principal amount to P

Conclusionsd h f d d b l if h l l

P • Under the funded member rule, if the general rule distribution is reduced by $50x under the expanded group earnings reduction, S is treated as having been funded by the issuance of the $50x note.

• As a result, the ordering of the distributions does not

$50x note (in Year 1)

$50x cash (in Year 1)

Deemed $50xcash funding

materially affect the consequences of the transactions – either (1) the funding rule distribution occurs first, the amount of the cash distribution is reduced by $50x, and the S note is recharacterized as stock under the general rule, or (2) the general rule distribution occurs first, the amount of the note distribution is reduced by $50x, S is treated as having been

S

Year 1 EG earnings - $50x y , gfunded by the note, and the S note is recharacterized as stockunder the funding rule by reason of the cash distribution.

• In either sequence of events, the S note is recharacterized as stock, whether by reason of the general rule or the funding rule.Assumptions

• S makes no other distributions or acquisitions in Year 1

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• S makes no other distributions or acquisitions in Year 1• S has not been funded by a debt instrument outstanding in Year 1

Proposed Regulations:

• The acquisition of EG Stock is not a Prohibited Transaction for purposes of the funding rule if the funded

Subsidiary Stock Issuance Exception

• The acquisition of EG Stock is not a Prohibited Transaction for purposes of the funding rule if the funded member is transferring property to an EG member in exchange for stock of such member (i.e., the issuer), provided that the funded member holds, directly or indirectly, more than 50% of the stock of the issuer (as measured by vote and value) during the 36-month period following the acquisition.

− Indirect ownership is determined using the principles of section 958(a) without regard to whether an intermediate entity is foreign or domestic—i.e., a different standard than the section 304(c)(3) standard used elsewhere in the Proposed Regulations.

• If the funded member ceases to meet the 50% ownership requirement at any time during the 36-month period (the “cessation date”), the subsidiary stock issuance exception described above ceases to apply, and the acquisition of EG Stock is subject to the funding rule as of the cessation date.

– In applying the per se rule, the EG Stock acquisition may be treated as having been funded by any debt instrument issued during the 72-month period that begins 36 months before the EG Stock acquisition, provided that the debt instrument (if issued prior to the cessation date) is treated as indebtedness as of the cessation date (i.e., it is not already treated as stock).

90

Proposed Regulations:Subsidiary Stock Issuance Exception – Example

Facts

1) On Date A in Year 1 FS lends $100 to USS1 in e change for the1) On Date A in Year 1, FS lends $100 to USS1 in exchange for the USS1 Note, a debt instrument

2) On Date B in Year 1, USS1 transfers $20 of property to CFC in exchange for $20 of CFC stock

3) On Date C in Year 2, FP transfers property to CFC for 60% of the CFC stock

FP 3) FP transfers propertyfor 60% of the CFC stock

CFC stock

Results

• Step 1 and 2 alone - the USS1 Note is not subject to the funding rule because the subsidiary stock issuance exception applies.

The acquisition of CFC stock results from the transfer of b USS1 h f d d b CFC EG

FSUSS11) $100 for USS1 Note

property by USS1, the funded member, to CFC, an EG member and the stock issuer, and

USS1 directly owns more than 50% of CFC’s vote and value.

Step 3, however, results in termination of USS1’s 50% or greater interest in CFC – causing the step 2 CFC stock acquisition to become a Prohibited Transaction As of Date C in Year 2 $20 ofCFC

2) $20 Propertyfor CFC Stock

become a Prohibited Transaction. As of Date C in Year 2, $20 of the $100 USS1 Note is treated as stock under the funding rule because it was issued by USS1, the funded member, to FS, an EG member, during the 72-month period beginning 36 months before FP acquired $20 of CFC stock (USS1 ceased to own 50% or more of the CFC stock within the 36-month period beginning on Date B, Year 1)

CFC

Assumptions • No exceptions other the subsidiary stock issuance apply

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Year 1).• No exceptions other the subsidiary stock issuance apply.

Final Regulations:Subsidiary Stock Acquisition Exception

A i iti f EG St k i t t t d i iti f EG St k f f th l l• An acquisition of EG Stock is not treated as an acquisition of EG Stock for purposes of the general rule or the funding rule if, immediately after the acquisition, the Covered Member that acquires the stock (the acquirer) controls the EG member from which the stock is acquired (the seller), and the acquirer does not relinquish control of the seller pursuant to a plan that existed on the date of the acquisition, other than in a transaction in which the seller and acquirer cease to be members of the same EGtransaction in which the seller and acquirer cease to be members of the same EG.

− Definition of control remains unchanged (50% by vote and value, including indirect section 958(a) ownership but not constructive ownership).

– An acquirer and seller do not cease to be members of the same EG by reason of a complete liquidation described in section 331.

• The acquirer is presumed to have a plan to relinquish control of the seller on the date of the acquisition if the acquirer relinquishes control of the seller within a 36-month period following the date of the acquisition.q

– This presumption may be rebutted by facts and circumstances clearly establishing that the loss of control was not contemplated on the date of the acquisition and that the avoidance of the purposes of the section was not a principal purpose for the loss of control.

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Subsidiary Stock Acquisition Exception—Highlight of Differences

Th ti li f f b th th l l d th f di l• The exception applies for purposes of both the general rule and the funding rule.

• The exception applies to acquisitions of outstanding stock as well as stock by issuance.

• The exception applies to an acquisition of stock in an EG member that is not controlled by th ithe acquirer.

• The strict 36-month rule is replaced with a rebuttable presumption.

• A loss of control pursuant to a cessation of the EG relationship (even if planned at the time of the acquisition) does not prevent the exception from applyingof the acquisition) does not prevent the exception from applying.

• The exception no longer ceases to apply upon the cessation date.

• If the acquirer loses control of the seller after the acquisition pursuant to a plan that existed at the time of the acquisition the exception is treated as never having applied toexisted at the time of the acquisition, the exception is treated as never having applied to the acquisition.

• Why was there a 50% threshold in the Proposed Regulations, and why is it retained in the Final Regulations?

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Final Regulations:Subsidiary Stock Acquisition Exception—Example

FactsFacts

1) FP wholly owns USS1, which wholly owns CFC. FP owns 80% of the stock of FS and CFC owns 20% of the stock of FS.

2) FP lends money to USS1 in exchange for a note (“USS Note A”) in Year 1.

FP

USS1 issues USS1 Note A to FP in exchange for cash

3) USS acquires stock of FS from CFC in exchange for a note (“USS Note B”) in Year 1.

4) At the time of step 3, there is no plan or intent for USS1 to dispose of any of its stock of CFC.

Results

USS1USS1 issues USS1 Note B to CFC in exchange for FS stock

• The acquisition of FS stock by USS1 qualifies for the subsidiary stock acquisition exception because the stock is acquired from an EG member that USS1 controls and there is no plan or intent for USS1 to relinquish such control.

• The issuance of USS1 Note B in exchange for FS stock does not constitute an acquisition of EG member stock under Treas Reg

CFC

80%

exchange for FS stock

20%constitute an acquisition of EG member stock under Treas. Reg. section 1.385-3(b)(2)(ii).

• The acquisition of FS stock does not constitute a funded acquisition of EG member stock under Treas. Reg. section 1.385-3(b)(3)(i)(B).

FS

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Qualified Short-Term Debt Instruments

• A “qualified short term debt instrument” is a covered debt instrument that• A qualified short-term debt instrument is a covered debt instrument that qualifies as any one of the following:

Sh t t f di t T R § 1 385 3T(b)(3)( ii)(A)• Short-term funding arrangement – Treas. Reg. § 1.385-3T(b)(3)(vii)(A)

• Ordinary course loan – Treas. Reg. § 1.385-3T(b)(3)(vii)(B)

• Interest-free loan – Treas. Reg. § 1.385-3T(b)(3)(vii)(C)

• Deposits with a qualified cash pool leader – Treas. Reg. § 1.385-3T(b)(3)(vii)(D)

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Treas. Reg. Section 1.385-3T(b)(3)(vii)(A): Short-Term Funding Arrangement Exception

• Two ways to satisfy the Short Term Funding Arrangement Exception• Two ways to satisfy the Short-Term Funding Arrangement Exception

• Specified Current Assets Test

• 270-Day Test

• In a given tax year, issuer may only use one of the two tests, not both.

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Treas. Reg. Section 1.385-3T(b)(3)(vii)(A)(1): The Specified Current Asset Test• Two Requirementsq

• Requirement 1: Maximum Interest Rate – Interest rate must be arm’s length under section 482 looking to a comparable instrument with a maturity date no longer than (i) 90 days or (ii) the issuer’s “normal operating cycle.”

• Requirement 2: Maximum Outstanding Balance – Applicable covered debt instruments do notRequirement 2: Maximum Outstanding Balance Applicable covered debt instruments do not exceed the maximum of the amounts of “specified current assets” under “applicable accounting principles” on the issuer’s balance sheet as a result of transactions in the ordinary course of business during the subsequent 90-day period or the issuer’s normal operating cycle, whichever is longer.

• DefinitionsDefinitions• “Specified Current Assets” means assets that are reasonably expected to be realized in cash or sold

(including by being incorporated into inventory that is sold) during the normal operating cycle of the issuer.

• “Normal Operating Cycle” generally means the issuer’s normal operating cycle as determined• “Normal Operating Cycle” generally means the issuer’s normal operating cycle as determined under applicable accounting principles.

• “Applicable Accounting Principles” means those applicable to the issuer in preparing its financial statements such U.S. GAAP or IFRS, computed on a consistent basis.

S i l l l h l h d• Special rules apply to cash pool headers.

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Treas. Reg. Section 1.385-3T(b)(3)(vii)(A)(2):The 270-Day Test• Three Requirementsq

• The Covered Debt Instrument must have a term of 270 days or less (or be a revolver) and interest rate must be arm’s length under section 482 looking to a comparable instrument with a maturity date no longer than 270 days;

• The issuer must be a net borrower from the lender for no more than 270 days in the year; andThe issuer must be a net borrower from the lender for no more than 270 days in the year; and• The issuer must be a net borrower under all Covered Debt Instruments issued to any lender that is a

member of the issuer’s EG that otherwise would satisfy the 270-day test (other than ordinary course loans and interest-free loans) for 270 or fewer days during a taxable year.

• Inadvertent Error Exception• Inadvertent Error Exception• Failure to satisfy 270-day test disregarded if failure is reasonable in light of all facts and

circumstances and failure is promptly cured upon discovery. • Reasonable if taxpayer maintains due diligence procedures to prevent such failures, as evidenced by:

• Having written policies and operational procedures in place to monitor compliance with 270-day test; and

• Management-level employees of EG having undertaken reasonable efforts to establish, follow, and enforce such policies and procedures.

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Other Qualified Short-Term Debt Instruments• Interest-Free Loans (Treas. Reg. § 1.385-3T(b)(3)(vii)(C))( g § ( )( )( )( ))

– A Covered Debt Instrument constitutes a qualified short-term debt instrument if the instrument does not provide for stated interest or no interest is charged on the instrument.

• Deposits with Qualified Cash Pool Headers (Treas. Reg. § 1.385-3T(b)(3)(vii)(D))

– A Covered Debt Instrument is a qualified short-term debt instrument if it is a deposit payable by a qualified cash pool header and certain other conditions are met (e.g., it is a demand deposit received q p ( g , pby a qualified cash pool header pursuant to a cash management arrangement and does not have a tax avoidance purpose).

– A qualified cash pool header has as its principal purpose managing a cash-management arrangement for participating EG members, subject to certain conditions.

– A cash-management arrangement is defined as an arrangement the principal purpose of which is to manage cash for participating expanded group members.

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Qualified Contribution Exception

• Newly added to the Final Regulations, Treas. Reg. section 1.385-3(c)(3)(ii) reduces the amount of a distribution or acquisition by a Covered Member for purposes of the general rule and the funding ruleCovered Member for purposes of the general rule and the funding rule by the aggregate fair market value of stock issued by the Covered Member in one or more “qualified contributions” during the “qualified period ” without duplicationperiod, without duplication.

• The qualified contributions reduce distributions or acquisitions in the order of the distributions or acquisitions, regardless of whether those q gdistributions or acquisitions would be subject to the funding rule.

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Qualified Contribution Exception (cont’d)

A “ lifi d t ib ti ” t ti i t ib ti f t th th “ l d d• A “qualified contribution” to a corporation is a contribution of property other than “excluded property,” to the corporation by a member of its EG in exchange for stock.

• The “qualified period” means the period beginning on the later of the start of the following periods:

− The period beginning 36 months before the date of the distribution or acquisition and ending 36 months thereafter; or

− The period during which a Covered Member is a member of an EG with the same EG parent,

and ending on the earliest of the last day of the following periods:

− The period beginning 36 months before the date of the distribution or acquisition and ending 36 months thereafter;

− The period during which a covered member is a member of an EG with the same EG parent; or

− The first taxable year that a Covered Debt Instrument issued by the Covered Member would, absent this exception, be treated as stock under the general rule or the funding rule.

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Qualified Contribution Exception—Excluded Property• A contribution of “excluded property” cannot constitute a qualified contribution. Excluded propertyA contribution of excluded property cannot constitute a qualified contribution. Excluded property

is:

− EG Stock;

− Property acquired by the Covered Member in an asset reorganization from a member of the same EG;

− A Covered Debt Instrument of any member of the same EG;

− Property acquired by the Covered Member in exchange for a Covered Debt Instrument issued by the Covered Member that is recharacterized under the funding rule;the Covered Member that is recharacterized under the funding rule;

− A debt instrument issued by a Controlled Partnership of the Covered Member’s EG; or

− Any other property acquired by the Covered Member with a principal purpose to avoid the purposes of Treas. Reg. sections 1.385-3 or -3T, including an indirect transfer of excluded property.

− Does this last item significantly limit the scope of the qualified contribution exception? Is any cash contributed to a subsidiary to avoid recharacterization treated as excluded property?

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Qualified Contribution Exception—Operating Rules• In addition to contributions of excluded property, certain other contributions are not treated asIn addition to contributions of excluded property, certain other contributions are not treated as

qualified contributions:• A contribution from a corporation that the covered member controls (contribution by subsidiary

to parent).• A contribution from a predecessor or successor or any corporation controlled by that predecessor p y p y p

or successor.• A contribution that does not increase the fair market value of the stock of the contributee.

• Special rules apply to distributions or acquisitions that constitute asset reorganizations:• If a Covered Member acquires the assets of another covered member in a section 381(a) q ( )

transaction, and both parties are members of the same EG, the acquiring member succeeds to the qualified contributions of the acquired member.

• If a Covered Member transfers property to another Covered Member in a Treas. Reg. section 1.312-10(a) transaction (D/355), the transferor’s qualified contributions are allocated in the same

ti E&Pproportion as E&P.• If a Covered Member distributes stock of another Covered Member in a Treas. Reg. section

1.312-10(b) transaction (355 not qualifying as a D), the Covered Member’s qualified contributions are decreased as if it had allocated those contributions in a D/355.

• Other than these rules qualified contributions do not carry over to predecessors or successors• Other than these rules, qualified contributions do not carry over to predecessors or successors.

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Threshold Exception• Under the threshold exception:p

− A Covered Debt Instrument is not treated as stock if, immediately after it would be recharacterized as stock, the aggregate adjusted issue price of Covered Debt Instruments held by members of the issuer’s EG that would be treated as stock but for the threshold

i d d $50 illiexception does not exceed $50 million.− To the extent that the aggregate issue price exceeds $50 million, only the amount of the

Covered Debt Instrument in excess of $50 million is treated as stock.o The removal of this “cliff effect” came about as a result of comments on theo The removal of this cliff effect came about as a result of comments on the

Proposed Regulations.o There appear to be no operating rules explaining the potentially complex effects of

removing the “cliff effect.” Can taxpayers choose which debts are subject to the $50 g p y jmillion exemption? What happens if a taxpayer has two $50M debt instruments, one subject to the threshold exception and one recharacterized as stock, and the excepted instrument is repaid? Does the exception jump to the other instrument and convert it back into indebtedness?into indebtedness?

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Qualified Dealer Debt Instrument• A qualified dealer debt instrument is a debt instrument:

− Issued to or acquired by an EG member that is a dealer in securities (within the meaning of section 475(c)(1)) in the ordinary course of business of dealing in securities;

− Accounted for by the dealer as a security held primarily for sale to customers in the ordinary course of business;

− Disposed of by the dealer within a period of time consistent with the holding of debt p y p ginstruments for sale to customers in the ordinary course of business, taking into account the terms of the debt and the conditions and practices prevailing in the markets for similar instruments; and

− That is not sold or otherwise transferred to another member of the dealer’s EG unless that sale or transfer is to another dealer satisfying the foregoing requirements.

− See Treas. Reg. section 1.385-3(c)(2)(iv) for a complementary exception for acquisitions of EG Stock by dealers, discussed above.

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Excluded Statutory or Regulatory Debt Instrument

A l d d l d b i i d b i h• An excluded statutory or regulatory debt instrument is any debt instrument that is described in any of the following:

− Production payments treated as a loan under section 636(a) or (b);

− A “regular interest” in a REMIC described in section 860G(a)(1);

− A debt instrument deemed to arise under Treas. Reg. section 1.482-1(g)(3) (including adjustments under Rev. Proc. 99-32), see also Treas. Reg. section 1.385-3(c)(2)(iii);

− A stripped bond or coupon described in section 1286, unless it was issued with a principal purpose of avoiding the purposes of Treas. Reg. section 1.385-3 or -3T; or

− A lease treated as a loan under section 467.ease t eated as a oa u de sect o 67.

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Regulated Financial Company• Examples of a regulated financial company include the following (see Treas. p g p y g (

Reg. section 1.385-3(g)(3)(iv)(A) for a full list):

− A bank holding company (as defined in 12 USC 1841);

− A covered savings and loan holding company (as defined in 12 C.F.R. 217.2);

− A national bank;A national bank;

− An insured depository institution (as defined in 12 USC 1813(c)(2));

− A broker or dealer registered with the SEC under 15 USC 78o(b);A broker or dealer registered with the SEC under 15 USC 78o(b);

− A swap dealer (as defined in 7 USC 1a(49)); and

− A small business investment company (as defined in 15 USC 662(3)).p y ( ( ))

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Regulated Insurance Company

A l d i i C d M b h i• A regulated insurance company is a Covered Member that is:

− Subject to tax under subchapter L of chapter 1 of the Code;

D i il d i d d th l f U S t t− Domiciled or organized under the laws of a U.S. state;

− Licensed, authorized, or regulated by one or more states to sell insurance, reinsurance, or annuity contracts to persons other than related persons (within the meaning of section 954(d)(3)) in such states, but not if a principal purpose for obtaining such license, authorization, or regulation was to qualify the issuer as a regulated insurance company; and

− Engaged in regular issuances of (or subject to ongoing liability with respect to) insurance, reinsurance, or annuity contracts with persons that are not treated as related persons.

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Anti-Abuse Rule: Treas. Reg. Section 1.385-

• If an EG member enters into a transaction with a principal purpose of avoiding the purposes

3(b)(4)

of Treas. Reg. section 1.385-3 or -3T, any interest issued or held by that member or another EG member may be treated as stock.

• A non-exhaustive list of interests that could be subject to such recharacterization includes:

A i h i C d b i l di i 483• An interest that is not a Covered Debt Instrument, including a section 483 contract (what does it mean for a contractual earnout to be treated as stock?);

• A Covered Debt Instrument issued to a person that is not a member of the issuer’s EG, if the Covered Debt Instrument is later acquired by a member of the issuer’s EG orif the Covered Debt Instrument is later acquired by a member of the issuer s EG or such person later becomes a member of the issuer’s EG;

• A Covered Debt Instrument issued to an entity that is not taxable as a corporation for U.S. federal tax purposes;

• A Covered Debt Instrument issued in connection with a reorganization or similar transaction; or

• A Covered Debt Instrument issued as part of a plan or series of transactions to expand the applicability of the transition rules.

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Anti-Abuse Rule: Treas. Reg. Section 1.385-

• In addition to the foregoing, a Covered Debt Instrument is treated as stock if the funded member or any

3(b)(4) (cont’d)

member of its EG engages in a transaction with a principal purpose of avoiding the purposes of Treas. Reg. section 1.385-3 or -3T.

• Examples include:

− A member of the issuer’s EG is substituted as a new obligor or added as a co obligor on an existingA member of the issuer s EG is substituted as a new obligor or added as a co-obligor on an existing debt instrument;

− A Covered Debt Instrument is transferred in connection with a reorganization or similar transaction;

− A Covered Debt Instrument funds a distribution or acquisition where the distribution or acquisition is made by a member other than the funded member and the funded member acquires the assets of the other member in a transaction that does not make the other member a predecessor; or

− Members of a consolidated group engage in transactions as part of a plan or a series of transactions through the use of the consolidated group rules set forth in Treas. Reg. section 1.385-4T, including g g p g gthrough the use of the departing member rules.

• The Proposed Regulations contained an anti-abuse rule that applied to a principal purpose of avoiding the “application” of the regulations; the Final Regulations use “purpose” instead. What is the substantive difference, and what is the “purpose” of these regulations?difference, and what is the purpose of these regulations?

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Anti-Abuse Rule Example

FactsFacts

1) In Year 1, USS1 distributes a $100 note to FP (“USS1 Note A”).

2) In Year 1, with a principal purpose of avoiding the purposes of Treas. Reg. section 1.385-3, FP sells FP


USS1 Note A to a bank for $100 and lends $100 to USS1 in exchange for another USS1 note (“USS 1 Note B”).

Analysis

• USS1 Note A is recharacterized as stock from


1) Distribution of USS1 Note A

USS1 Note A is recharacterized as stock from issuance under the general rule. When USS1 Note A is sold to the bank, it is deemed exchanged for debt.

• USS1 Note B would not be treated as stock under the funding rule because there has not been a Prohibited Transaction

USS1Transaction.

• Because the transactions occurring in step 2 had a principal purpose of avoiding the purposes of Treas. Reg. section 1.385-3, USS1 Note B is treated as stock. See Treas. Reg. section 1.385-3(h)(3) Ex. 11.

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The “No Affirmative Use Rule”

• The Proposed Regulations contained a “No Affirmative Use” rule providing that they did not apply to the extent a person entered into a transaction that otherwise would be subject to theentered into a transaction that otherwise would be subject to the transaction rules with a principal purpose of reducing the federal tax liability of any member of the EG that included the y yissuer and holder of the debt instrument.

• The Final Regulations reserve on a No Affirmative Use rule. What does this mean for taxpayers?

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Operating Rules—Timing• In general, when a Covered Debt Instrument is recharacterized as stock, it is treated as

k f h d f istock from the date of issuance.

• However, if a Covered Debt Instrument is treated as funding a Prohibited Transaction occurring after the instrument is issued, the Covered Debt Instrument is deemed to be exchanged for stock on the date of the Prohibited Transactionexchanged for stock on the date of the Prohibited Transaction.

• If a Covered Debt Instrument is treated as stock due to the predecessor/successor rules, it is deemed exchanged for stock on the latest of (i) the date of issuance; (ii) the date of the Prohibited Transaction; or (iii) the completion of the transactionthe date of the Prohibited Transaction; or (iii) the completion of the transaction creating the predecessor or successor.

• Where a Covered Debt Instrument is treated as stock due to a retesting, it is deemed exchanged for stock on the latest of (i) the date of issuance; (ii) the date of the g ( ) ; ( )Prohibited Transaction; or (iii) the date of retesting.

• The Proposed Regulations contained certain situations in which a debt instrument would be recharacterized from the date of issuance as a result of a later Prohibited Transaction,

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resulting in unintended consequences.

Timing ExampleFacts

1) O J 1 Y 1 FS1 l d $100 USS1 fFP

2) USS1 stock for FS2 stock

1) On January 1, Year 1, FS1 lends $100 to USS1 for a USS1 note (“USS1 Note”).

2) On July 1, Year 1, FP transfers all of the USS1 stock to FS2 in exchange for FS2 stock.

3) On December 1, Year 1, USS1 distributes $100 to

USS1 FS1 USS2


3) O ece be , e , USS d s bu es $ 00 oFS2.

Analysis

• USS1 Note is recharacterized as stock under the funding rule.

• Under the Proposed Regulations, USS1 Note would be recharacterized as stock as of issuance because the Prohibited Transaction (the distribution of $100) occurred in the same taxable year as the issuance of the note. This would prevent step 2 from qualifying

i 368( )(1)(B) i iFS2

80% 20%

3) $100 distribution

as a section 368(a)(1)(B) reorganization.

• Under the Final Regulations, USS1 Note is not recharacterized until the date of the Prohibited Transaction. Could the recharacterization still cause step 2 to fail reorganization treatment under step USS1

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transaction principles?

Operating Rules—Retesting• When an instrument is recharacterized as stock, and the holder andWhen an instrument is recharacterized as stock, and the holder and

issuer subsequently cease to be members of the same EG (including if the instrument is transferred outside the EG), the instrument ceases to be treated as stock.

• Immediately before the transaction causing the holder and issuer to cease to be members of the same EG, the issuer is deemed to issue a new Covered Debt Instrument to the holder in exchange for the deemednew Covered Debt Instrument to the holder in exchange for the deemed stock.

• At the same time, all other Covered Debt Instruments are retested under the funding rule.

• What happens if the issuer is the target of an outbound reorganization? Does that have the same effect as leaving the EG?

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Does that have the same effect as leaving the EG?

Retesting ExampleFacts1) In Year 1, FP lends $300 to USS1 for a USS1

note (“USS1 Note A”).2) In Year 2, USS1 distributes $300 cash to FP.3) In Year 3 FP lends another $300 to USS1 for

FP


4) USS1 Note A for cash

3) In Year 3, FP lends another $300 to USS1 for another USS 1 note (“USS1 Note B”).

4) In Year 4, FP sells USS 1 Note 1 to a bank for cash.

Analysis


2) $300 Distribution

Analysis• Under the ordering and non-duplication rules,

the distribution in Year 2 causes USS1 Note A to be treated as stock prior to the sale to the bank in Year 4.USS1 bank in Year 4.

• When USS1 Note A is sold to the bank in Year 4, USS1 Note B is re-tested and treated as stock because it is now funded by the Year 2 distribution. What would be the result if

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USS1 Note B was sold in Year 6?Assumption: No exceptions to the general or funding rule are applicable

Additional Example—Pre-Sale Restructuring

Facts

1) An unrelated third party wishes to acquire the stock of USS1, but it does not wish to acquire DS1. USS1 owes a preexisting $50 USS1 Note to FP. To extricate DS1 from USS1, FP engages in the following transactions:

2) FP forms US Newco and capitalizes it with cash.FP

4) USS1 distributes US Newco Note to FP in retirement of USS1 Note

2) Formation and capitalization of 3) US Newco acquires all of the stock of DS1 from USS1 in

exchange for $50 cash and a $50 US Newco Note.

4) USS1 retires the preexisting USS1 Note with US Newco Note.

5) FP sells USS1 to the unrelated party.

AnalysisUS NewcoUSS1

3) DS1 stock for $50 d $50 US N

Preexisting $50 USS1Note

capitalization of US Newco

Analysis

• Under the general rule, the US Newco Note is treated as stock because it is issued in exchange for EG Stock.

• The subsidiary stock acquisition exception (discussed below) does not apply because US Newco does not have control USS1after step 2, using section 958(a) attribution.DS1

and $50 US NewcoNote

DS2 DS1 p g ( )

• Why is USS Newco Note treated as stock even though it does nothing more than preserve the status quo and is not “new” debt in an economic sense?

• Why does the result differ if US Newco acquires all of the DS1assets (e.g., DS1 is a DRE) from USS1 instead of DS1 stock?

DS1 DS2 DS1

Value = $100

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Additional Example—F Reorganization

Facts

1) USS1 forms USS2, then USS1 merges with and into USS2. In the merger, FP surrenders its USS1 stock for USS2 stock and a USS2 note (“USS2Note”) in a transaction qualifying as a section 368(a)(1)(F) reorganization.

Analysis

• Under Treas. Reg. section 1.368-2(m)(3)(iii), a transaction may be treated as i i h h h ld f k i h f i

FP

an F reorganization even though a holder of stock in the transferor receives “money or other property” from the transferor or the resulting corporation. Such distribution is treated as an unrelated transaction.

• A commentator asked whether Treas. Reg. section 1.368-3(m)(3)(iii) created a circularity—if the issuance of the USS2 Note is treated as a separate distribution under Treas. Reg. section 1.368-2(m)(3)(iii), such note USS1 1) FP surrenders its

USS1 stock in p g ( )( )( ),would be recharacterized as USS2 stock under the general rule, and would then arguably be treated as part of the reorganization, thereby turning off Treas. Reg. section 1.368-2(m)(3)(iii), which would in turn prevent the general rule from applying.

• The preamble to the Final Regulations provides that the issuance of USS2Note is subject to Treas Reg section 1 368 2(m)(3)(iii) such that USS2

1) Merger

USS1 stock in exchange for USS2stock and USS2Note

Note is subject to Treas. Reg. section 1.368-2(m)(3)(iii), such that USS2Note is treated as stock under the general rule. Such treatment does not then retroactively prevent Treas. Reg. section 1.368-2(m)(3)(iii) from applying. See Preamble at 317-18.

• Is this result intended to be provided for by the principles of Treas. Reg. section 1.385-3(b)(3)(vi)? That provision only applies to the funding rule,

USS2

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not the general rule.

Proposed Regulations—Effective Date and Transition Rules

• Proposed Effective Date: The Proposed Regulations were to be effective on the date they were published.

• Grandfather Provisions:

• Under the Proposed Regulations, the transaction rules would have applied to any debt instrument issued on or after April 4 2016 and to any debt instrument treated as issued before April 4 2016 asissued on or after April 4, 2016, and to any debt instrument treated as issued before April 4, 2016, as a result of a check-the-box election that was filed on or after April 4, 2016.

• An otherwise Prohibited Transaction (for example, a distribution by a funded member) would not have been taken into account for purposes of the per se rule if the Prohibited Transaction occurred before April 4 2016 (b t not if it as treated as occ rring before April 4 2016 as a res lt of abefore April 4, 2016 (but not if it was treated as occurring before April 4, 2016 as a result of a check-the-box election that was filed on or after April 4, 2016).

• Transition Rule: If the transaction rules would have treated a debt instrument as stock prior to the finalization date, the debt instrument would have been treated as debt for 90 days after the finalization d if h d b i h ld b EG b h 90 h d f h fi li i d h d bdate; if the debt instrument was held by an EG member on the 90th day after the finalization date, the debt instrument would have been deemed exchanged for stock on such date.

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Final Regulations—Effective Date and Transition Rules• General Effective Date: The Final Regulations generally are effective on the date they are published (the

“Publication Date”) for taxable years that end on or after the date that is 90 days after they are published (the “Transition Date”).

• Grandfather Provisions:

• The transaction rules only apply to a debt instrument issued on or after April 5 2016 even if the• The transaction rules only apply to a debt instrument issued on or after April 5, 2016, even if the instrument is deemed issued before April 5, 2016 by reason of an entity classification election filed after April 4, 2016.

• An otherwise Prohibited Transaction (for example, a distribution by a funded member) will not be t k i t t f f th l if th P hibit d T ti d b f A iltaken into account for purposes of the per se rule if the Prohibited Transaction occurred before April 5, 2016, even if it is deemed to occur issued before April 5, 2016, by reason of an entity classification election filed after April 4, 2016.

• Transition Rule: If the transaction rules would have treated a Covered Debt Instrument as stock prior to the Transition Date (including in taxable years ending before the Transition Date), the Covered Debt Instrument is treated as debt through the Transition Date; if the instrument is held by an EG member immediately after the Transition Date, the instrument will be deemed exchanged for stock on such date.

• Similar rules are provided for the partnership-related provisions in Treas. Reg. section 1.385-3T.

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Effective Date and Transition Rules (cont’d)• Transition Funding Rule:

• If a Covered Debt Instrument would be recharacterized as stock between April 5, 2016, and the Transition Date but is not recharacterized by reason of the effective date and transition rules, all payments made with respect to such instrument (other than stated interest) after the instrument would have been recharacterized as stock are treated as distributions for purposed of applying the p p pp y gfunding rule.

• This applies to all principal payments, including refinancings.

• This applies even if the issuer and holder cease to be members of the same EG during the transition i d ( bj t t th t ddl l )period (subject to the straddle rules).

• Question: What if the issuer and holder cease to be members of the same EG after April 4, 2016, but before the Publication Date?

• If a Covered Debt Instrument would be recharacterized as stock between April 5, 2016, and the pTransition Date but is not recharacterized by reason of the effective date and transition rules, the issuance of the instrument may be treated as a distribution or acquisition for purposes of the funding rule unless the issuer and holder are members of the same EG immediately after the Transition Date. This supersedes the general non-duplication rule.

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Effective Date and Transition Rules—ExampleFactsFacts• FP wholly owns USS1, and both corporations use a calendar year.• On June 1, 2016, USS1 distributes a $100x note to FP (“Note 1”).• On January 1, 2017, USS1 distributes a $200x note to FP (“Note 2”).• On January 2, 2017, USS1 repays Note 1 in full.• FP and USS1 remain EG members past the Transition Date.Discussion• The Final Reg lations generall are not applicable to USS1 and FP ntil 2017• The Final Regulations generally are not applicable to USS1 and FP until 2017.• Treas. Reg. section 1.385-3 does not apply to Note 1 because it is issued in a previous taxable year.• Treas. Reg. section 1.385-3 applies to Note 2 because it is issued in 2017, but Note 2 is not

recharacterized as stock until immediately after the Transition Date.• The repayment of Note 1 is a distribution for purposes of the funding rule because Note 1 is a Covered

Debt Instrument that would have been recharacterized as stock in the absence of the effective date and transition rule provisions of the Final Regulations.

• The issuance of Note 1 will not be treated as a distribution or acquisition for purposes of the funding rule.

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• The no affirmative use rule;

Th li i f h l f i i• The application of these rules to foreign issuers;

• The application of these rules to U.S. branches of foreign issuers in the absence of more comprehensive guidance with respect to foreign issuers; and

• How the exceptions of Treas. Reg. section 1.385-3 would apply to brother-sister groups with non-corporate parents.

• If future guidance is released addressing these issues, it will not apply to interests issued before the date of such guidance.

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Temporary Regulations• Some of the significant new provisions are included in temporary, rather than

final, regulations, including:

• The ordinary course, 270 day and related exceptions;

• Rules relating to cash pools;g p ;

• Rules relating to DREs and Controlled Partnerships; and

• Rules relating to consolidated groups.

Q i• Questions:

• Why were these provisions separately promulgated as temporary regulations?

• What are the consequences to taxpayers if these temporary regulations expire before they are finalized?

• Does the Government anticipate significant changes to the temporary

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regulations when they are issued in final form?

Worthless Stock Loss DeductionsWorthless Stock Loss Deductions

Worthless Stock Losses

Background – Basic Rule:

• A taxpayer is generally permitted to deduct a stock loss equal to its tax basis in the stock in the year such stock becomes completely worthless under § 165.

– The loss must be (a) evidenced by a closed and completed transaction, (b) fixed by id tifi bl t d ( ) t ll t i d d i th t bl T R §identifiable events, and (c) actually sustained during the taxable year. Treas. Reg. §1.165-1(b).

– Whether and when stock becomes “worthless” is a facts-and-circumstances determination. “Worthless” stock has neither liquidating value nor potential future value.

• Under § 165(g)(3), a worthless stock loss will generally be characterized as ordinary rather than capital if:

Th US t ti di tl t l t 80 t f th ti d l– The US parent corporation owns directly at least 80 percent of the voting power and value of the loss subsidiary; and

– At least 90 percent of the loss subsidiary’s aggregate gross receipts for all taxable years must be from sources other than royalties, rents, dividends, interest, annuities and gains from sales or exchanges of stocks and securities.

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Worthless Stock LossesOpen Issues:

Hi t i G R i t• Historic Gross Receipts– How far back must gross receipts be tested?– What if stock previously acquired from a third party?– When does a successor/acquiring corporation succeed to the gross receipts history of a target loss

corporation in a § 381 transaction ?

• Look through for Gross ReceiptsGuidance requested as to whether in what circumstances and how the look through approach works– Guidance requested as to whether, in what circumstances, and how the look-through approach works for intercompany transactions. A look-through approach has been applied by the IRS in certain PLRs (without comprehensive explanation) for purposes of the gross receipts test.

• Applicability of § 165(g)(3) to S corporations– If stock of an S corporation becomes wholly worthless, is the S corporation entitled to an ordinary

loss deduction under § 165(g)(3)?– In PLR 201552026, an S Corporation’s attempt to convert a worthless stock loss in its Qsub from

capital to ordinary by terminating its S corporation status failed to qualify under § 165(g)(3).– According to a government spokesperson at the May ABA Meeting in Washington DC, guidance on

these issues is imminent.127

Worthless Stock Losses

Practical Considerations:

• In what year does stock become worthless? Three approaches:1. Identifiable Event (e.g., file for bankruptcy, shutter the business, liquidate the subsidiary)2. A deemed liquidation the result of a check the box election. See Rev. Rul. 2003-125.3. Irreversible deterioration over the course of the relevant tax year

• Burden on the taxpayer to establish and document:1 P t ti ’ b i i th l b idi ’ t k1. Parent corporation’s basis in the loss subsidiary’s stock2. Worthlessness of the loss subsidiary 3. Timing of the worthlessness 4. Composition of historical gross receipts

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Recent Guidance in Income Tax Accounting

Timing of Deductions – the “All Events” Testg

Background – Key RulesBackground Key Rules

As relevant, accrual method taxpayers can generally deduct expenses before they are paid as long as “all events have occurred which determine the fact of liability and the p g yamount of such liability can be determined with reasonable accuracy.” § 461(h)(4).

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Giant Eagle Inc. v. Commissioner, 822 F.3d 666 (3rd Cir. 2016)

• Giant Eagle, an operator of retail supermarkets, pharmacies and gas stations, rewarded customers with “fuelperks!” when they purchased qualifying goods or services. “Fuelperks!” were then redeemable for reductions in the price of future purchases of fuel.

• Giant Eagle deducted its “fuelperks!” liabilities in the year awarded.

• The IRS disallowed the deduction based on the definition of a “fixed liability” established in• The IRS disallowed the deduction based on the definition of a fixed liability established in United States v. General Dynamics Corp., 481 U.S. 239 (1987).

– In General Dynamics, the Supreme Court determined that an accrual-basis taxpayer could not deduct liabilities stemming from its self-insured medical plan prior to the submission of a claim form by the employee. The Court viewed the act of submitting a claim form a condition precedent – therefore the accrual did not satisfy the “fixed” prong of the test since no

i b ld b d if h l f il d b i l ireimbursement would ever be due if the employee failed to submit a claim.

• The Tax Court sided with the IRS, ruling that Giant Eagle’s liability was not fixed because the right to redeem the rewards was contingent on the customer using a ‘fuelperks!’ card to make an

t l f l hactual fuel purchase.

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Giant Eagle Inc. v. Commissioner

The Third Circuit reversed, holding that the rewards were fixed when earned by the customer because it had a valid, unilateral contract with Giant Eagle. Under the relevant state contract law, such a contract legally obligated Giant Eagle to provide the fuel price reduction (even though the

t t lti t l d d k )exact amount ultimately redeemed was unknown).

Practical Considerations:• Depending on the circumstances, Giant Eagle may potentially apply more broadly. Taxpayers epe d g o e c cu s a ces, Giant agle ay po e a y app y o e b oad y. a paye s

with loyalty reward programs, such as frequent flyer miles, credit card points, or other rebate accruals, such as Medicaid rebates or merchandise coupons, may be able to benefit from Giant Eagle.

• A key factor in the Third Circuit’s decision was Pennsylvania law The court emphasized thatA key factor in the Third Circuit s decision was Pennsylvania law. The court emphasized that applicable contract law meant the liability would have to be paid. Taxpayers seeking to rely on Giant Eagle should thus consider whether applicable local law establishes a similar legal obligation for the taxpayer to pay/perform.

• BUT The IRS has publicly stated that it will not follow this judicial precedent so taxpayers• BUT – The IRS has publicly stated that it will not follow this judicial precedent, so taxpayers outside the Third Circuit must proceed with caution. See AOD 2016-03.

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Deductibility of Fines and Penalties under §162(f)y § ( )

Background – Key Rules

In general, a taxpayer cannot take a deduction under § 162 for fines and penalties paid for the violation of any law to a US or foreign government, including any political subdivision, corporation or other entity serving as an agency or instrumentality thereof. , p y g g y yTreas. Reg. § 1.162-21(a).

Compensatory damages and other non-punitive amounts paid to a government generally are not considered a “fine or penalty” for purposes of this rule.

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Recent Guidance

CCA 201623006• In this CCA, the IRS concluded that the Financial Industry Regulatory Authority (FINRA) is

an agency or instrumentality of the U.S. government for purposes of § 162(f), so fines issued by FINRA are not deductible.

• FINRA is a private, nonprofit Delaware corporation that is not part of the government. It is an independent self-regulatory organization for the securities industry although its existence wasindependent, self regulatory organization for the securities industry, although its existence was authorized by the Securities Exchange Act.

– Could this ruling be extended to other self-regulating industry bodies? E.g., NAR, AMA, AICPA?

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Recent Guidance: CCA 201619008

• In this CCA, the IRS concluded that an amount paid as civil disgorgement t th SEC f i l ti th F i C t P ti A t (FCPA)to the SEC for violating the Foreign Corrupt Practices Act (FCPA) was primarily punitive (rather than compensatory or remedial) and was therefore not deductible by reason of § 162(f).

– Whether an amount paid is primarily punitive or compensatory/remedial in nature is a fact-specific determination

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CCA 201619008Background

• Taxpayer alleged to have violated “books and records” and “internalbooks and records and internal control” provisions of FCPA.

• Taxpayer and SEC entered into a Consent Agreement pursuant to whichConsent Agreement, pursuant to which the Taxpayer agreed to pay a disgorgement amount representing profits gained as a result of alleged violations.

• Taxpayer paid other amounts to DOJ that were conceded to be nondeductible penalties.p

• No allegation of violation of “anti-bribery” provision of FCPA, only books and records and internal

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controls

What Is Disgorgement?The Common Law Definition

“[T]he unjust enrichment of a conscious wrongdoer, or of a defaulting fiduciary without regard to notice or fault, is the net profit attributable to the underlying wrong. The object of restitution in such cases is to eliminate profit from wrongdoing while avoiding, so far as possible, the imposition of a penalty. Restitution remedies that pursue this object are often called ‘disgorgement’ or ‘accounting.’”

Restatement (Third) of Restitution and Unjust Enrichment

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What Is Disgorgement?Courts’ View of the SEC’s Disgorgement Power

“Disgorgement just leaves the “[D]isgorgement [has a] remedialDisgorgement just leaves the wrongdoer in the position he would have occupied had there been no misconduct.” Kokesh (C.A.10 2016) “A criminal fine is punitive,” whereas

“disgorgement is restitutionary.” Blackwell (S.D. Ohio 2007)

[D]isgorgement [has a] remedial purpose—disgorgement is imposed not to punish, but to ensure illegal actions do not yield unwarranted enrichment even to innocent parties..” Contorinis (C.A.2 2014)

A “disgorgement order is not, in fact, a fine levied against the petitioners as punishment for their conduct Rather it is the

“[D]isgorgement restores the status quo ante by depriving violators of ill-gotten profits.”

conduct. Rather it is the means by which the petitioners are required to remedy the unjust enrichment.” Hateley(C.A.9 1993)

Zacharias (C.A.D.C. 2009)

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Advance PaymentsyBackground – Key Rules

Under the general rule, income is includible in gross income for an accrual method taxpayer when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. Treas. Reg. § 1.451-1(a).

Deferral is permitted for certain advance payments attributable to long-term contracts and the sale of goods, as well as “integral” services related to the provision of these core goods or activities. Treas. Reg. § 1.451-5.• Qualifying advance payments must generally be included in income in the year in which• Qualifying advance payments must generally be included in income in the year in which

properly accruable under the taxpayer's method of accounting for tax purposes, as long as the advance payments are included no later than the year in which they are included for financial reporting purposes. If t i t f th i i f d d i t l i th• If a taxpayer receives an amount for the provision of goods and non-integral services, the payment is treated as an advance payment only to the extent allocable to the obligation to provide goods.

– A 5% de minimis rule applies to amounts that aren't allocable.

R P 2004 34 l i li i d d f l h f i f d• Rev. Proc. 2004-34 also permits limited deferral to the next tax year for certain types of advance payments received, including for services.

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Advance Paymentsy

TAM 201610017

• In TAM 201610017, the taxpayer, a retailer that sold goods as well as related delivery, installation and repair services, sought to apply the deferral method of Treas. Reg. § 1.451-5 to amounts received for gift cards sold to customers. The cards did not expire and were redeemable for any of its goods and (integral) services, as well as similar (non-integral) y g ( g ) , ( g )services it provided with respect to other companies’ merchandise.

• The IRS addressed whether all or a portion of amounts received for the gift cards, which were redeemable for both merchandise and integral and non integral services constituted advanceredeemable for both merchandise and integral and non-integral services, constituted advance payments eligible for deferral under Treas. Reg. § 1.451-5.

• The IRS concluded that gift cards that can be redeemed for goods as well as integral and non-integral services are eligible for deferral but the amounts received must be allocated by treating all of the taxpayer’s outstanding gift cards at the end of the tax year of their sale as a single agreement and estimating how much is allocable to the eligible and ineligible categories of income. By applying this approach, the taxpayer can defer amounts received for its gift cards to the extent it can appropriately estimate of the amounts eligible for deferral.

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Background of Relevant Section 355 Provisions

Section 355 Requirements

• Statutory Requirements

q

Statutory Requirements− Control Immediately Before− Distribution of Stock and Securities Constituting Control

Not a Device for Distribution of E&P− Not a Device for Distribution of E&P− Distributing & Controlled Engaged in an Active Trade or Business

• Section 355(g)• Section 355(a) Non-statutory Requirements

− Business Purpose− Continuity of Shareholder Interest− Continuity of Business Enterprise

• Special Corporate-Level Requirements− Section 355(d) and (e)Section 355(d) and (e)

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The No Device RequirementThe No Device Requirement

No Device RequirementNo Device Requirement

• The distribution cannot be used principally as a device for the distribution of the earnings and profits g p(“E&P”) of either D or C.

• Seeks to prohibit bail-out of a corporation’s E&P at capital gains rates.

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Device – The Concern

30 b50 b 20 b, 40 v

30 b, 60 v

50 b

355A

A

$4060 v$40 E&PD $40 E&P

40

D

D C

Distribution of C IF 355 & sale of C

40 vC

Distribution of C$40 dividend or 355? $20 cap. gains

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Relevance to a “Unified Rate” Regimeg

• When capital gains rates and qualified dividend rates are the same, what is h l if f h d i i ?the relevance, if any, of the no device requirement?– What if D shareholder(s) have no basis in their D stock prior to spin

off?– What if D shareholder(s) are eligible for a 0% withholding rate under

an applicable income tax treaty?

146

Device: Facts & Circumstances Analysisy

• Device factors (Treas. Reg. section 1.355-2(d)(2))− Pro-rata distribution− Sale or exchange of D or C after distribution

- A sale or exchange of D or C stock pursuant to an arrangement negotiated or agreed upon prior to the distribution is substantial evidence of device

− D or C has excessive non-business assets

• Non-Device factors (Treas. Reg. section 1.355-2(d)(3))− Corporate business purpose− D is publicly traded and no 5% shareholderp y− All distributee corporations entitled to DRD

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Treas. Reg. Section 1.355-2(d)(5)(iv)Section 302(a) Transactions( )

• Treas. Reg. Section 1.355-2(d)(5)(iv)

– A distribution is ordinarily considered not to have been used principally as a device if, in the absence of section 355, with respect to each shareholder distributee, the distribution would be a redemption to which section 302(a) applied.

– Treas. Reg. section 1.355-2(d)(5)(i) provides that such distributions are ordinarily considered not to have been used principally as a device, notwithstanding the presence of any of the device factors described in Treas. Reg. section 1.355-2(d)(2).

Treas Reg section 1 355 2(d)(5)(i) “ordinarily” protection is not available if the same shareholder(s)– Treas. Reg. section 1.355-2(d)(5)(i) ordinarily protection is not available if the same shareholder(s) receive more than one C in a split off and then one or more C is retained while one or more C is sold (the “Exception”). See also Treas. Reg. section 1.355-2(d)(5)(v), Ex. 2.

• Exception presumably concerned with economically similar transaction where D splits off CException presumably concerned with economically similar transaction where D splits off C where C has 2 or more businesses and then C contributes a business to C1 and spins off C1 pro rata to the shareholders split off from D.

• What does “ordinarily” mean? Is the exception to such language limited to the Exception? IsWhat does ordinarily mean? Is the exception to such language limited to the Exception? Is the allocation of E&P under Treas. Reg. section 1.312-10 evidence of device because it potentially enables future distributions to result in a smaller dividend?

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Device (Cont’d): Nature & Use of Assets Treas. Reg. Section 1.355-2(d)(2)(iv)g ( )( )( )

• General Rule– The determination of whether a transaction was used principally as a device

will take into account the nature, kind, amount, and use of the assets of D and C (and corporations controlled by them) immediately after the transaction.

• Non Qualifying Assets• Non-Qualifying Assets– The existence of assets that are not used in a trade or business that satisfies the

ATB requirement (“Non-Qualifying Assets”) is evidence of device. – Examples include cash and other liquid assets that are not related to theExamples include cash and other liquid assets that are not related to the

reasonable needs of the ATB. • The higher the ratio for each corporation of the value of Non-Qualifying

Assets not used to the value of ATB-qualifying assets, the more evidence ofAssets not used to the value of ATB qualifying assets, the more evidence of device.

• In a split off, liquid assets used to equalize values ordinarily is not evidence of device.of device.

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Device (Cont’d): Treas. Reg. Section 1.355-2(d)(4), Ex. 4g ( )( ),

• Background: Corporation X is engaged in a regulated business in St t M d ll f th t k f ti Y hi h i tState M and owns all of the stock of corporation Y, which is not engaged in a regulated business in State M. State M has recently amended its laws to provide that affiliated corporations operating in M may not conduct both regulated and unregulated businessesM may not conduct both regulated and unregulated businesses.

• X purchases operating assets unrelated to the Y business and transfers them to Y. X then distributes the Y stock pro rata among X’s shareholdersX s shareholders.

• As a result of the transfer of the recently acquired operating assets, the ratio of the value of its Non-Qualifying Assets to the value of its ATB-qualifying assets is substantially greater for Y than for XATB-qualifying assets is substantially greater for Y than for X.

• There is no other evidence of device or evidence of nondevice. • Conclusion: The transaction is considered to have been used

principally as a deviceprincipally as a device.

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Nature & Use of Assets: Related Function Treas. Reg. Section 1.355-2(d)(2)(iv)(C)g ( )( )( )( )

• There is evidence of device if the D (or C) business is:– A “secondary business” that continues as such for a significant period

after the spinoff, and – Can be sold without adversely affecting the business of C (or D) y g ( )

• A secondary business is a D (or C) business that’s principal function is to serve the C (or D) business.

• The activities of the secondary business may consist of providing property or performing services.

151

Related Function Example Treas. Reg. Sections 1.355-2(d)(2)(iv)(C), -3(c) (Ex. 11)g ( )( )( )( ), ( ) ( )

• Background: For the past eight years, corporation X has been engaged in h f d l f l d l d X ll f h kthe manufacture and sale of steel and steel products. X owns all of the stock

of corporation Y, which, for the past six years, has owned and operated a coal mine for the sole purpose of supplying X’s coal requirements in the manufacture of steelmanufacture of steel.

• Transaction: X distributes the stock of Y to X’s shareholders where X and Y each satisfy the ATB requirement.Th l i ’ i i l f i f l i X’ l i• The coal mine’s principal function of supplying X’s coal requirements continued after separation and the coal mine could be sold without adversely affecting X’s steel business. C l i E id f d i i t• Conclusion: Evidence of device exists.

152

Relevance of Business Purpose to No Device Requirement: Treas. Reg. Section 1.355-2(d)(3)(ii)q g ( )( )( )

• The corporate business purpose for the transaction is evidence of d inondevice.

• The stronger the evidence of device, the stronger the corporate business purpose required to satisfy the no device requirement.

• The transfer or retention of Non-Qualifying Assets can be outweighed by the existence of a corporate business purpose for such transfers or retentions.

• Strength of a corporate business purpose will be based on all of facts and circumstances, including, but not limited to, the following factors:– The importance of achieving the purpose to the success of the business;– The extent to which the transaction is prompted by a person not having a

proprietary interest in D or C, or by other outside factors beyond the control of the D; andThe immediac of the conditions prompting the transaction– The immediacy of the conditions prompting the transaction.

153

Section 355(g)Section 355(g)

Section 355(g)(g)

• Section 355 will not apply if:

(A) Immediately after the transaction, either D or C is a Disqualified Investment Corporation (“DIC”), and

(B) Immediately after the transaction, any person owns a 50 percent (vote or value, applying section 318 attribution) or greater interest in any DIC, but only if such person did not hold such an interest in such corporation immediately before the transaction.

• When describing “current law,” the House Report briefly discusses the device requirement limiting its discussion to describe the section 302(a) ordinarily no device exceptiondevice exception.

155

Disqualified Investment Corporation Definitionq p

• D or C is a DIC if 2/3 or more of the FMV of all of itsD or C is a DIC if 2/3 or more of the FMV of all of its assets constitutes investment assets.

• “Investment Assets” include:

− Cash, stock or securities, certain partnership interests, debt, options, forward or futures contract, notional principal contract, derivative, foreign c rrenc or an similar assetforeign currency, or any similar asset.

− Look-through rule when ownership of at least 20% of the vote and value in lower-tier corporate subsidiaries.

i f i d i fi i l d b i i− Exception for certain assets used in financial trade or business, certain mark-to-market assets.

156

Proposed No Device RegulationsProposed No-Device Regulations

The Proposed Regulationsp gThe Proposed No-Device Regulations include several new provisions, including the following:• The “nature and use of assets” factor of the No Device Requirement

now distinguishes between Business and Nonbusiness Assets (each as defined below) rather than active trade or business (“ATB”) and non-ATB assets.

• Guidance is provided regarding the determination of when the presence of Nonbusiness Assets or a difference between the ratios of the Business Assets to Nonbusiness Assets of Distributing and Controlled (“D” and “C ” respectively) constitutes evidence of deviceControlled ( D and C, respectively) constitutes evidence of device.

• A per se device rule is provided for certain situations involving large quantities of Nonbusiness Assets and a large difference between the ratios of the Business Assets to Nonbusiness Assets of D and C.A b i h l h i f i A• A business purpose that relates to the separation of Business Assets from Nonbusiness Assets may no longer be evidence of nondevice.

• An anti-abuse rule and various operating rules are included (discussed below after the slides on the “Small” ATB Exception).p )

158

New Definitions

The Proposed Regulations add the following defined terms:• Business. “Business” generally means the active conduct of a trade or business for

Section 355(b) purposes without regard to certain requirements, such as the five-year active conduct requirement and the collection-of-income requirement.

• B siness Assets “B i A t ” f ti it t sed i• Business Assets. “Business Assets” of a corporation are its gross assets used in one or more Businesses.

– Cash and Cash Equivalents. Strict test for characterizing cash and cash equivalents as “Business Assets.” See discussion below.

• Nonbusiness Assets. “Nonbusiness Assets” of a corporation are its gross assets other than Business Assets.

• Total Assets. “Total Assets” of a corporation are its Business Assets and its Nonbusiness Assets, collectively.

• Nonbusiness Asset Percentage. The “Nonbusiness Asset Percentage” of a corporation is the percentage determined by dividing the fair market value (“FMV”) of its Nonbusiness Assets by the FMV of its Total Assetsof its Nonbusiness Assets by the FMV of its Total Assets.

159

Evidence of Device Presence of Nonbusiness Assets & Proportionality

Presence of Nonbusiness Assets and their relative proportions can constitute evidence of device See Prop Treas Reg section 1 355-2(d)(2)(C)

p y

of device. See Prop. Treas. Reg. section 1.355-2(d)(2)(C).• Magnitude of Nonbusiness Assets

– Ownership of Nonbusiness Assets by D or C is evidence of device.– The strength of the evidence will be based on all the facts and circumstances, including the Nonbusiness Asset

Percentage for each corporation. g p– The larger the Nonbusiness Asset Percentage of either corporation, the stronger is the evidence of device. – Favorable Presumption: Ownership of Nonbusiness Assets ordinarily is not evidence of device if the

Nonbusiness Asset Percentage of each of D and C is less than 20 percent.• Proportionality of Nonbusiness Asset Percentages

A diff b t th N b i A t P t f D d th N b i A t P t f C– A difference between the Nonbusiness Asset Percentage of D and the Nonbusiness Asset Percentage of C is evidence of device, and the larger the difference, the stronger is the evidence of device.

– Favorable Presumption: Such a difference ordinarily is not itself evidence of device (but may be considered in determining the presence or the strength of other device factors) if—

• The difference is less than 10 percentage points; orE ti f lit ff t li l• Exception for split-off to equalize values.

Corporate Business Purpose: Evidence of device presented by ownership of Nonbusiness Assets, or the difference between the Nonbusiness Asset Percentages for D and C, can be outweighed by a corporate business purpose for the ownership or the diff S P T R ti 1 355 2(d)(3)(ii)difference. See Prop. Treas. Reg. section 1.355-2(d)(3)(ii).

160

Addition of “Per Se” Device TestProp. Treas. Reg. Section 1.355-2(d)(5)p g ( )( )

• The Proposed Regulations add a “per se” test (the “Per Se Test”), which provides that a distribution is considered to have been used principally as aprovides that a distribution is considered to have been used principally as a device, notwithstanding the presence of nondevice factors, where 2 requirements are met:

– the Nonbusiness Asset Percentage of either D or C is 66 ⅔ percent or more; and– a specified level of disproportionality exists between D’s and C’s Nonbusiness Asset

Percentages as follows: • Nonbusiness Assets between 66 ⅔ percent and 80 percent. Both (1) the Nonbusiness Asset

Percentage of either D or C is greater than or equal to 66 ⅔ percent and less than 80 percent and (2) th N b i A t P t f th th ti i l th 30 t(2) the Nonbusiness Asset Percentage of the other corporation is less than 30 percent;

• Nonbusiness Assets between 80 percent and 90 percent. Both (1) the Nonbusiness Asset Percentage of either D or C is greater than or equal to 80 percent and less than 90 percent and (2) the Nonbusiness Asset Percentage of the other corporation is less than 40 percent; or

• Nonbusiness Assets 90 percent or Above. Both (1) the Nonbusiness Asset Percentage of either D or C is greater than or equal to 90 percent and (2) the Nonbusiness Asset Percentage of the other corporation is less than 50 percent.

• Significant departure from the existing facts-and-circumstances model of the current Regulations (particularly given the strict definition of “Business g (p y gAssets”).

161

Exceptions to the Per Se Test

• Exceptions to the Per Se Test exist for two categories of transactions:Di id d R i d D d ti Di t ib ti t ti th t if S ti– Dividends Received Deduction. Distributions to corporations that, if Section 355 did not apply, would result in an 80-percent or 100-percent DRD.

– Certain Presumptively Good Transactions. As provided above, certain distributions are “ordinarily” not considered to have been used principally as a device.

• Absence of earnings and profits (“E&P”)• Capital gain treatment in the absence of Section 355 with respect to each distributee

• Compare the 80 percent DRD exception to transactions that do not fully• Compare the 80-percent DRD exception to transactions that do not fully meet the test for presumptively good transactions:– The 80-percent DRD exception allows for the potential to convert 20 percent of

the value of C stock into capital gain (including the potential basis recovery on a subsequent stock sale), yet the exception applies.

– In contrast, if 20 percent of the distributee shareholders in a split-off would not have received capital gain treatment, the exception does not apply.

• Question: Should the exception be expanded to include any distribution which inQuestion: Should the exception be expanded to include any distribution which, in the absence of Section 355, would result in dividend income with respect to 20 percent or less of the distributed shares?

162

Per Se Device TestExamples

“Per Se” Device Not “Per Se” Device

p

Shareholders

Facts-and-Circumstances Test Applies

Shareholders

D C D C

Nonbusiness Asset Percentage




163

Percentage of 85%

Percentage of 35%

Percentage of 75%

Percentage of 35%

Treatment of Cash and Liquid Assets in Device Analysis

Device AnalysisTreatment of Cash and Cash Equivalents (“Per Se” Test)q ( )

• Working Capital. Business Assets include cash and cash equivalents held as a bl t f ki it l f B ireasonable amount of working capital for one or more Businesses.

• Required for Exigencies. Business Assets “include” assets required (by binding commitment or legal requirement) to be held to provide for (1) exigencies related to a Business or (2) regulatory purposes with respect to a Business.related to a Business or (2) regulatory purposes with respect to a Business.

– Does the use of “include” suggest that an asset in certain situations may constitute a Business Asset even if its holding is not a “requirement”? But see Prop. Reg. Example 4.Wh t b t t t i d b l t b h ld f l t b t– What about an asset not required by law to be held for regulatory purposes, but nonetheless is held for the purpose of maintaining a constructive relationship with regulators?

• Securing Financial Obligations. Business Assets “include:”– assets that the holder is required (by binding commitment or legal requirement) to hold

to secure or otherwise provide for a financial obligation reasonably expected to arisefrom a Business; and

– assets held to implement a binding commitment to expend funds to expand or improve aassets held to implement a binding commitment to expend funds to expand or improve a Business.

165

Division of Nonbusiness Assets – DeviceProp. Reg. Example 2: Disproportionate Division of Nonbusiness Assets

SHs SHs SHsPro RataDistribution

D$195

D$195$45 C

$45D

$150

Rest.C Value: $100

Val e:

Rest.C

Value: Value:

Rest.Rest.

Value:

Facts:$ $

Rest. Value: $105 Rest. Value:

$105Value: $100

Value: $105

• D operates a restaurant with a value of $100, and C operates a restaurant with a value of $105. D also has $195 cash, which D holds as a Nonbusiness Asset.

• C will lose its franchise if it remains a subsidiary of D. The franchise is about to expire. • D will be forced to relocate within 24 months and, while D has not made any plans, it is weighing its

option to purchase a building for the relocation

166

option to purchase a building for the relocation. • D contributes $45 to C, which C will retain, and distributes the stock of C pro rata among D’s

shareholders.

Division of Nonbusiness Assets – Device Prop. Reg. Example 2: Disproportionate Division of Nonbusiness Assets (cont’d)

Analysis:• The Nonbusiness Asset Percentage for each of D and C exceeds 20 percent and is

evidence of device.– Nonbusiness Asset Percentage of D = 60 percent ($150/$250).

N b i A P f C 30 ($45/$150)– Nonbusiness Asset Percentage of C = 30 percent ($45/$150). • The difference between D’s Nonbusiness Asset Percentage and C’s Nonbusiness

Asset Percentage exceeds 10 percentage points (it is 30 percentage points), which is also evidence of devicealso evidence of device.

• The corporate business purpose for the distribution is evidence of nondevice. – However, no corporate business purpose exists for the difference of

Nonbusiness Asset Percentages because the purchase that is being considered is No bus ess sse e ce ges bec use e pu c se s be g co s de ed s“not required by any exigency.”

• The fact that the distribution is pro rata is also evidence of device.• Conclusion: Device.

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Division of Nonbusiness Assets – NondeviceProp. Reg. Example 4: Disproportionate Division of Nonbusiness Assets

SHs SHs SHsPro RataDistribution

D$195

D$195$45 C

$45D

$150

Rest.C Value: $100

Val e:

Rest.C

Value: Value:

Rest.Rest.

Value:

Facts: Analysis:

Rest. Value: $105 Rest. Value:

$105Value: $100

Value: $105

The facts are the same as in Prop. Reg. Example 2, except that: • The lease for the State M location will expire in 6

months instead of 24 months; and • D will use $80 of the $150 cash it retains to purchase a

nearby building for the relocation.

• Nonbusiness Asset Percentage of each of D and C exceeds the 20-percent presumption threshold and is evidence of device (60 percent for D; 30 percent for C).

• The difference between Nonbusiness Asset Percentages (60 percent versus 30 percent) is also evidence of device.

• D’s corporate business purpose for a significant part of the

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See Prop. Treas. Reg. section 1.355-2(d)(4), Ex. 4• D s corporate business purpose for a significant part of the

difference of Nonbusiness Asset Percentages is evidence of nondevice because D’s committed use of such Nonbusiness Asset is “required by business exigencies.”

• Conclusion: No device.

Division of Nonbusiness Assets – Nondevice Prop. Reg. Example 4: Disproportionate Division of Nonbusiness Assets (cont’d)

• Unaccounted-for cash; Emphasis on Proportionality. No device, even though D d C h h t d i t d f ti l t b i thand C have cash not designated for any particular corporate business purpose, the

amount of which is equal to 28 percent, and 30 percent, of their respective assets. • Required by Business Exigency. Prop. Reg. Examples 2 and 4 indicate that the

facts-and-circumstance analysis for cash employs a “required by a businessfacts and circumstance analysis for cash employs a required by a business exigency” standard (although not a binding commitment or legal requirement like the Per Se Test).

– Consideration of use of cash within 12 months is insufficient (See Prop. Reg. Example 2), but certainty of use of cash within 6 months is sufficient (See Prop Reg Example 4)of cash within 6 months is sufficient (See Prop. Reg. Example 4).

– Probability of Use of Cash. How certain does the use of cash have to be to meet the standard? Is a “reasonable expectation” enough? What about a “significant possibility”? If so, a clarification would be desirable.

– Timing Standard. Consider the importance of the reference to “6 months” in light of past guidance suggesting a 12-month period.

• See Rev. Proc. 96-30 (Appendix A), which enumerates a number of business purposes generally based on a 12-month period.

• Are the Proposed Regulations intended to impact routine corporate finance d i i ?decisions?

169

Impact on Routine Corporate Finance Decisions

Impact of DisproportionalityHypothetical 1: Influence on Routine Corporate Finance Policy

Facts:Consider the same facts as Prop. Reg. Example 2, except that:

SHsPro RataDistributionStep 1

• D has a reasonable expectation to use such cash in its Restaurant business within 18 months, and D’s management would keep D’s cash at D to avoid the potential for future overleveraging or a dilutive public offering.

• C has no use for additional cash and is expected to

$100

D$195

BusCpgenerate excess cash in the future.

• The Proposed Regulations create uncertainty as to whether such reasonable expectation is sufficient.

Questions:• Overarching Issue: Must D reduce its cash to

Bus.

Bus.C

Value: $105

Value: $100

$45qualify under Section 355 and risk becoming overleveraged later?

• Option 1: D pays a cash dividend to its shareholders, which clearly would eliminate the issue.

• Option 2: As depicted to the right, could D contribute a proportionate amount of cash to C even though C has

SHs$45

Step 2

a proportionate amount of cash to C even though C has no use for the cash (preferable to Option 1 but also undesirable)? This approach will cure disproportionality but significant Nonbusiness Assets will remain. See Prop. Reg. Example 4.

• Anti-Abuse Rule: Consider the need for a tax sharing agreement to force C to keep this cash for hich it has Value: B

C$100

D$95

B Value:

171

agreement to force C to keep this cash for which it has no use.

– Note: The Anti-Abuse Rule may prohibit a post-spin-off distribution by C.

Value: $100

Bus.Bus. Value: $105

Hypothetical 2: Anti-Abuse Rule & Business Judgmentg

SHsSHsCBank

C D CashUse

D$195

Bank1

2$195 $195

$195

V l

Bus. Bus.

V lBus.

Bus.C

Value: $105

Value: $100

$195

Value: $100

Value: $105

$105

Facts: Questions:Consider the same facts as Hypothetical 1, except that: • D has preexisting debt to Bank 1 which it repays. • D makes the repayment with the understanding that it

may have to borrow in the future to finance its anticipated (but not firm) expansion plans.

• If D borrows in the future pursuant to its reasonable expectation existing at the time of repayment, would the Anti-Abuse Rule (discussed below) apply on the theory that the repayment was “transitory”?

• Would it matter if the “old and cold” and new borrowings i d t t t th l ?

172

were carried out pursuant to the same revolver?• If the Anti-Abuse Rule is inapplicable, why should D have

to incur expenses associated with debt repayment and new borrowings?

Business Purpose as a Nondevice Factor

New Corporate Business Purpose Limitation

A corporate business purpose that relates to a separation of Nonbusiness Assets from one or more Businesses or Business Assets is not evidence of nondevicefrom one or more Businesses or Business Assets is not evidence of nondeviceunless the corporate business purpose involves an exigency requiring an investment or other use of the Nonbusiness Assets in one or more Businesses of D or C, or both.• No other corporate business purpose can offset such a device factor notwithstanding

how significant the corporate-level benefits may be for D or C (and notwithstanding the absence of any shareholder-level purpose).

• The fact that the corporate business purpose completely and compellingly explains the Nonbusiness Assets is not otherwise taken into account.

• The significance of the corporate-level benefits to the ATB is not taken into accountaccount.

Prop. Treas. Reg. section 1.355-2(d)(3)(ii)

174

New Corporate Business Purpose Nondevice LimitationHypothetical 3: Required Disposal of Nonbusiness Asset

Public PublicPublicPro RataDistribution

D30%

DCDX Stock;B i B

Bus.A

Bus.BX

30%

Bus.AX

30%Bus.AC

Business B

Bus.B

Bus.B X

30%

Facts:• D is a widely held corporation that conducts Business A and Business B, and also owns 30 percent of the

stock of X; each of Business A and Business B has a FMV approximating the value of the X stock that D owns.

• Pursuant to an anti trust order D must either dispose of its X stock or significantly curtail its operations of

175

• Pursuant to an anti-trust order, D must either dispose of its X stock or significantly curtail its operations of Business A.

• To comply with this anti-trust order, D contributes Business B and its X stock to C and distributes the C stock pro rata to its shareholders.

New Corporate Business Purpose Nondevice Limitation Hypothetical 3: Required Disposal of Nonbusiness Asset (cont’d)

Analysis:Th ti t t d d d th t th i ld lt t D’ ATB t b• The anti-trust order, and damage that otherwise would result to D’s ATB, cannot be taken into account as evidence of nondevice to offset the Nonbusiness Asset device factor, even though the corporate business purpose is compelling and completely explains the existence of the device factor.

Questions:• The substantial business purpose relating to the impending substantial damage to

Business A meaningfully distinguishes this fact pattern from a Gregory-type fact pattern referenced in the Proposed Regulations’ preamble. Why should the purpose p e e e e ced e oposed egu o s p e b e. W y s ou d e pu poseno longer be relevant to the device analysis, as it otherwise would be under the facts-and-circumstance analysis of the current Regulations?

• Publicly Traded/ No Five-Percent Shareholder Nondevice Factor. Can the publicly traded nondevice factor outweigh this evidence of device where no corporatepublicly traded nondevice factor outweigh this evidence of device where no corporate business purpose for the distribution is to facilitate sales by any shareholders?

– The fact that the shareholders readily could sell their stock of C or D on the public market regardless of any disproportionality in Nonbusiness Assets is supportive of a conclusion that the purpose for the disproportionality is something other than to facilitateconclusion that the purpose for the disproportionality is something other than to facilitate sales.

176

New Corporate Business Purpose Nondevice Limitation Hypothetical 4: Incremental Benefit Creating Device Uncertainty

Scenario 1: Regulatory-Motivated Spin-Off

SHsPro RataDistribution

Scenario 2: Incremental Regulatory Benefit

SHsPro RataDistribution

D

Distribution

D

Distribution

Bus

Bus.MC

Value: $1 000XValue:

30%

Bus.

Bus.M C

Value: $1 000 X

15%15%

F t F t

Bus.N

Value: $1,000

$1,000XValue: $1,000

Bus.N

Value: $1,000

$1,000 XValue: $1,000

Facts:• D has three groups of assets: Business M and Business N,

each of which comprises Business Assets worth $1,000, and 30 percent of the stock of X, a Nonbusiness Asset which has a value of $1,000.

• D proposes to separate Business N from Business M solely

Facts:• Same as Scenario 1, except that a complete separation of the

stock of X from Business M will result in an incremental $100 regulatory benefit to Business M.

• D’s sole motivations for the spin-off of Business N and the X stock are (1) the same $50 risk-reduction benefit in

177

to achieve a $50 regulatory benefit for Business M. In addition to contributing Business N to C, D also contributes half of its X stock to C so as to allocate its Nonbusiness Assets on a pro-rata basis.

• No device.

Scenario 1, and (2) a $100 regulatory benefit to Business M resulting from the total separation of X.

• Device, notwithstanding an even stronger business purpose?• Must D sell or separately distribute the X stock?

Other Operating RulesOther Operating Rules

Ownership Interests in Partnerships & Subsidiaries

• Interest in Partnerships. See Prop. Treas. Reg. section 1.355-2(d)(2)(iv)(D)(6)– General Rule: A partnership interest generally is considered a Nonbusiness Asset– General Rule: A partnership interest generally is considered a Nonbusiness Asset. – Exception: If a D or C is considered to be engaged in the Business conducted by a partnership using ATB criteria, the

FMV of the partnership interest would be allocated between Business Assets and Nonbusiness Assets in the same proportion as the proportion of the FMVs of the partnership’s Business Assets and Nonbusiness Assets.

• Stock in Corporations. See Prop. Treas. Reg. section 1.355-2(d)(2)(iv)(D)(7)– General Rule: Stock in a corporation, other than a member of the DSAG or the CSAG, generally is a Nonbusiness

Asset.– Exception: If a Member of a 50-Percent-Owned Group with respect to D or C owns stock in another Member of such

50-Percent-Owned Group (other than a member of the DSAG or the CSAG, respectively), the FMV of such stock would be allocated between Business Assets and Nonbusiness Assets in the same proportion as the proportion of the FMVs of the issuing corporation’s Business Assets and Nonbusiness Assets.

– Computation made with respect to lower-tier members before the computations with respect to higher-tier members.– 50-Percent-Owned Group, Member of a 50-Percent-Owned Group.

• “50-Percent-Owned Group” has the same meaning as SAG, except that “50-percent” is substituted for “80-percent” each place it appears in Section 1504(a)(2), for purposes of Section 355(b)(3)(B). p p pp ( )( ), p p ( )( )( )

• A Member of a 50-Percent-Owned Group is a corporation that would be a member of a DSAG or a CSAG, with the substitution provided in this Prop. Treas. Reg. section 1.355-2(d)(2)(iv)(B)(7).

• Proper Adjustments made for Obligations between Entities • Divergence from Section 355(g) Model.g (g)

– 50-percent threshold for corporations versus 20-percent threshold provided in Section 355(g).– Proposed Regulations are based on “net value” rather than “gross value.”

179

SAG & FMV Concepts

• Separate Affiliated Group. Members of the DSAG are treated as a single corporation and members of a– Members of the DSAG are treated as a single corporation, and members of a CSAG are treated as a single corporation.

– References to D include all members of the DSAG.– References to C include all members of the CSAG– References to C include all members of the CSAG.

• Fair Market Value. The FMV of an asset is determined under general U.S. federal income tax principles.– The FMV is reduced (but not below the adjusted basis of the asset) by the

amount of any liability that is described in Section 357(c)(3) and relates to the asset (or to a Business with which the asset is associated).

• What is the reason for this reduction?• What is the reason for this reduction?– Any other liability is disregarded for purposes of determining the FMV of an

asset.

See generally Prop. Treas. Reg. section 1.355-2(d)(2)(iv)(D)(2) & (5)180

Nonbusiness Asset PercentageProp. Reg. Example 5: Illustration of Look-Through Rules

Determination of SAG• S1 is a member of the C 50-Percent-Owned Group because C

owns at least 50% of the stock of S1S3 i b f th C 50 P t O d G b S1

C’s Nonbusiness Asset Percentage is 3.6%

• S3 is a member of the C 50-Percent-Owned Group because S1owns at least 50% of the stock of S3

• S2 is not a member of the C 50-Percent-Owned Group

Nonbusiness Asset Percentage of S3• S3’s Nonb siness Asset Percentage is 33⅓% ($1 500 50%

C$10,000 Business Assets$5,000 Nonbusiness Assets$880 Stock of Subsidiary$3,500 Liabilities

• S3’s Nonbusiness Asset Percentage is 33⅓% ($1,500 Nonbusiness Assets / $4,500 Total Assets)

Nonbusiness Asset Percentage of S1• S1’s stock in S2 worth $160 is a Nonbusiness Asset• S1’s stock in S3 worth $600 is divided in proportion to S3’s

50%

S1$1,000 Business Assets$500 Nonbusiness Assets$760 Stock of Subsidiaries$500 Liabilities• S1 s stock in S3 worth $600 is divided in proportion to S3 s

Nonbusiness Asset Percentage of 33⅓% ($400 Business Assets and $200 Nonbusiness Assets)

• S1 has $1,400 of Business Assets and $860 of NonbusinessAssets

• S1’s Nonbusiness Asset Percentage is 38.05% ($860 S2 S3

40% 60%

$

g (Nonbusiness Assets / $2,260 Total Assets)

Nonbusiness Asset Percentage of C• C’s stock in S1 worth $880 is divided in proportion to S1’s

Nonbusiness Asset Percentage of 38.05% ($545 Business A d $335 N b i A )

$3,000 Business Assets$1,500 Nonbusiness Assets$3,500 Liabilities

$500 Business Assets$100 Nonbusiness Assets$200 Liabilities

181

Assets and $335 Nonbusiness Assets)• C has $10,545 of Business Assets and $5,335 of Nonbusiness

Assets• C’s Nonbusiness Asset Percentage is 33.6% ($5,335

Nonbusiness Assets / $15,880 Total Assets)

Nonbusiness Asset PercentageProp. Reg. Example 7: Illustration of Look-Through Rules

Facts• D borrows $500 from P in exchange for a note (the “D Note”)• The D Note is a Nonbusiness Asset in the hands of P

D’s Nonbusiness Asset Percentage is 70%

• D invested the proceeds of the D Note in Nonbusiness Assets

Application of Partnership Look-Through• D’s interest in P is treated as a Nonbusiness Asset in

proportion to P’s Nonbusiness Asset percentageb i i ($

D$1,000 Business Assets$2,500 Nonbusiness Assets

• P’s Nonbusiness Asset Percentage is 75% ($1,350 Nonbusiness Assets / $1,800 Total Assets)

Nonbusiness Asset Percentage of D• D’s 40% interest in P worth $400 is divided in proportion to

P’s Nonbusiness Asset Percentage of 75% ($100 Business

40%

D

$450 B i A

$400 Partnership Interest$500 Liability to P$500

D Note

P s Nonbusiness Asset Percentage of 75% ($100 Business Assets and $300 Nonbusiness Assets)

• Because there is an obligation between D and P, “appropriate adjustments” must be made to avoid double inclusion of assets under Prop. Treas. Reg. section 1.355-2(d)(2)(iv)(D)(8)– Because D has a 40% interest in P, D is treated as having

$450 Business Assets$1,350 Nonbusiness Assets(including $500 D Note)$800 Liabilities

P

, gborrowed $200 (40% of $500) from itself

– D’s Nonbusiness Assets must be decreased by $200• D’s Nonbusiness Asset Percentage is 70% ($2,600

Nonbusiness Assets / $3,700 Total Assets)

182

Would the “appropriate adjustment” be the same if D had invested the proceeds of the D Note in Business Assets?

Multiple Controlled Corporations

• General Rule: If a transaction involves distributions by D of the stock of more than one C, the general asset test and the Per Se Test will apply to all such Cs.

• To the extent any rule would require a comparison between• To the extent any rule would require a comparison between characteristics of D and C, there would have to be a comparison between D and each C and between each C and each other C.

• If any comparison under the general asset test or the Per Se Test would result in a determination that a distribution is a device, then all distributions involved in the transaction would be considered aall distributions involved in the transaction would be considered a device.

See generally Prop. Treas. Reg. section 1.355-2(d)(2)(iv)(D)(1)

183

Timing Rules

• Time to Identify Assets and Determine Character of Assets. – Identification of D’s and C’s relevant assets, and determination of such assets’ character

as Business Assets or Nonbusiness Assets, are made immediately after the distribution.– Thus, D’s assets do not include any asset, including stock of C, that is distributed in the

transaction.• Time to Determine FMV of Assets.

D and C each must determine the FMV of its assets as of one of the following dates:– D and C each must determine the FMV of its assets as of one of the following dates:a) immediately before the distribution;b) on any date within the 60-day period before the distribution;c) on the date of an agreement with respect to the distribution that was binding on D on such date and at

all times thereafter; ord) on the date of a public announcement or filing with the SEC with respect to the distributiond) on the date of a public announcement or filing with the SEC with respect to the distribution.

– What constitutes a “binding agreement” for purposes of alternative (c)?• What is the impact of modifications or amendments to the agreement?• Has the Government considered applying the rules of Treas. Reg. section 1.368-2(e)(2)(ii) (relating to

the signing date rule)?Consistenc : D and C m st determine FMV consistentl ith each other and as of the– Consistency: D and C must determine FMV consistently with each other and as of the same date.

• If consistency is not met, FMV of assets will be determined immediately before the distribution for all purposes of such provisions, unless the Commissioner determines that the use of such date is inconsistent with the purposes of Section 355 and the Regulations thereunder.

• What would be an example of the use of a date that is inconsistent with the purposes Section 355 andWhat would be an example of the use of a date that is inconsistent with the purposes Section 355 and the regulations thereunder?

See generally Prop. Treas. Reg. section 1.355-2(d)(2)(iv)(D)(3) & (4)184

The Active Trade or Business Requirement

Active Trade or Business Requirementq

(1) D and C must each be engaged in an active trade or business (“ATB”) immediately after the distributionafter the distribution.

(2) Both D and C’s business must have been actively conducted throughout the 5-year period ending on the date of the distribution.

(3) Neither D nor C’s business (nor control of a corporation conducting such business) can have been acquired in a taxable transaction within 5-years of the distribution.

Section 355(b), Treas. Reg. section 1.355-3, Prop. Treas. Reg. section 1.355-3.

Note: The ATB test was inserted in order to prevent the tax free separation of an i ti ti i t ti d i ti titi S R t N 1622 83d Cexisting corporation into active and inactive entities. S. Rept. No. 1622, 83d Cong.,

2d Sess. 51 (1954).

186

Section 355(b)(3): ATB Tested Through “Separate Affiliated Group”p p Starting in 2006, all members of a corporation’s “separate affiliated group”

(i.e., the affiliated group that would be determined under section 1504(a) if such corporation were the common parent and section 1504(b) did not apply)such corporation were the common parent and section 1504(b) did not apply)—determined immediately after the distribution—generally are treated as a single corporation for purposes of the ATB requirement.

C b li d “th t it i i t t i lif l i f t Congress believed “that it is appropriate to simplify planning for corporate groups that use a holding company structure to engage in distributions that qualify for tax-free treatment under section 355.” (H. Rep. No. 109-304).

A stock acquisition that results in a corporation joining a SAG is treated as an acquisition by the SAG of the assets of that corporation.

Note that the SAG rules use a different definition of control (i.e., 80% ( ,vote/value) from section 355’s “control” requirement (i.e., 80% vote and 80% of each non-voting class).

Under regulations proposed in 2007 certain tax-free transactions would be Under regulations proposed in 2007, certain tax free transactions would be treated as taxable (and certain taxable transactions as tax-free) for purposes of the SAG rules.

187

Size of D’s and C’s ATB Relative to Other Assets• Section 355(b) and Treas. Reg. section 1.355-3(b)

• No specific reference to absolute or relative size of the ATB.

• Rev. Rul. 73-44• D owns three lines of business: (1) ATB-qualifying assets (“Biz1”), (2) active business

assets, owned by C, that do not satisfy the ATB requirement because they were recently acquired in a transaction in which gain was recognized (“Biz2”) and (3) ATB-qualifyingacquired in a transaction in which gain was recognized ( Biz2 ) and (3) ATB qualifying assets (“Biz3”).

• D transfers Biz3 to C; after the transfer, Biz3 represents represents a “substantial portion” but less than 50% of the value of C’s total assets.“Th i i t i ti 355(b) th t ifi t f th• “There is no requirement in section 355(b) that a specific percentage of the corporation’s assets be devoted to the active conduct of a trade or business. In the instant case, therefore, it is not controlling for purposes of the [ATB] requirement that the active business assets of [C] represent less than half of the value of [C] immediately ft th di t ib ti ”after the distribution.”

• “The fact that . . . investment assets were not involved, and that the transaction was compelled by valid business purposes are indicative of the absence of device.”

• “[T]he assets included in [C] represent operating businesses, and not assets that could be [ ] [ ] p p gused to facilitate the distribution of [D’s or C’s E&P].”

188

General Counsel Memoranda Relating to Size of Active Trade or Businessof Active Trade or Business• GCM 34238 (underlies Rev. Rul. 73-44; ATB requirement satisfied where C’s only qualifying ATB assets represented approximately 5% of the net book value of its

C’ h ll i )assets; C’s other assets generally were not investment-type assets).

• GCM 31959 (ATB requirement satisfied where C’s ATB assets were “only a small percentage” of C’s total assets; C’s other assets consisted of stock in wholly owned p g ; ysubsidiaries which held ATB assets).

• GCM 31799 (ATB requirement satisfied where ATB assets represented less than 2% f ti ’ t b t 65% f it t i t d f t k i h ll d2% of corporation’s assets, but 65% of its assets consisted of stock in wholly owned subsidiaries which held ATB assets and the remainder consisted of either internal JV interests or interests in corporations shared with outside investors which also held ATB assets).)

• GCM 36069 (ATB requirement satisfied where only 16% of C’s assets were ATB-qualifying assets; C’s other assets consisted of wholly owned subsidiary stock which only held real estate solely used by C and a small amount of cash)which only held real estate solely used by C, and a small amount of cash).

189

Proposed “Small” Active Trade or Business Regulations

Relatively Small ATBsy• The Preamble explains that adopting a minimum size requirement (the

“MSR”) for ATBs is both appropriate and consistent with priorMSR ) for ATBs is both appropriate and consistent with prior guidance.

• According to the Preamble:– Permitting section 355(b) to be satisfied with an ATB that is economicallyPermitting section 355(b) to be satisfied with an ATB that is economically

insignificant in relation to the other assets of D or C is not consistent with the congressional purpose of section 355 because it would permit the separation of inactive assets from a business, rather than the separation of different businesses.

– Recent changes to section 355 particularly the SAG rules make compliance with– Recent changes to section 355, particularly the SAG rules, make compliance with the MSR simpler than it would have been prior to those changes.

– Rev. Rul. 73-44 is not inconsistent with the MSR as the ruling concludes there is no requirement that a specific percentage of a corporation’s assets be devoted to th ATB t th t i ll i i ifi t ATB ti fi ti 355(b)the ATB not that an economically insignificant ATB satisfies section 355(b).

• However, the statement in Rev. Rul. 73-44 regarding a minimum percentage will be modified to take into account the MSR.

191

Minimum Size Requirement for ATBq• In order to satisfy the MSR, the percentages of D’s and C’s gross

assets that are used in 1 or more ATBs (“ATB Assets”) must both be at ( )least 5%. Prop. Treas. § 1.355-9(a)(3), (b).

• This test requires the ATB to satisfy all of the requirements for ATBs, including the 5-year requirement. Prop. Treas. § 1.355-9(a)(2), (4).

• Assets used in a Business that is not an ATB are not ATB Assets, even though they are Business Assets for the nature and use of assets factor of the No Device Requirement.

• ATB Assets include:• ATB Assets include:– Reasonable working capital for 1 or more ATBs;– Assets that are required to be held to provide for exigencies related to the

ATB;;– Assets that are required to be held to secure or otherwise provide for a

financial obligation reasonably expected to arise from an ATB; and– Assets held to implement a binding commitment to expend funds to

expand or improve an ATB Prop Treas § 1 355 9(a)(3)expand or improve an ATB. Prop. Treas. § 1.355-9(a)(3).

192

Minimum Size Requirement Operating Rulesq p g• All members of the CSAG and all members of the DSAG are treated

as single corporations.– The 50-Percent Member rule from the proposed No Device Requirement

modifications does not apply because an ATB of such 50-Percent Member would not be attributed to D or C under the current SAG rules.

– See Prop. Treas. § 1.355-9(c)(1).

• Partnership interests owned by D or C:– The fair market value of an interest in an ATB Partnership will be

allocated between ATB Assets and other assets in proportion to the percentage of ATB Assets held by the ATB Partnership.N h hi i ATB A– No other partnership interests are ATB Assets.

– See Prop. Treas. § 1.355-9(c)(3).

193

Rules Relating to both the Proposed No Device and “Small” Active TradeNo Device and Small Active Trade

or Business Regulations

Anti-Abuse Rules

• A transaction or series of transactions undertaken with a principal purpose of affecting the Nonbusiness Assetprincipal purpose of affecting the Nonbusiness Asset Percentage of any corporation will not be given effect for purposes of the device factors described above.

• Similarly, a transaction or series of transactions undertaken with a principal purpose of affecting the percentage of anywith a principal purpose of affecting the percentage of any corporation’s assets that are used in an ATB will not be given effect for purposes of the MSR.

195

Anti-Abuse Rules (cont’d)( )• For these purposes, a transaction or series of transactions includes:

– A change in the form of ownership of an asset;A change in the form of ownership of an asset;– An issuance, assumption, or repayment of indebtedness or other obligations; and– An issuance or redemption of stock.

• These anti-abuse rules do not apply to pp y– A non-transitory transfer of assets between D and C; or– A non-transitory acquisition or disposition of assets from or to a person the

ownership of whose stock would not be attributed to D or C under section 318(a) (but excluding the option attribution rules of section 318(a)(4))(but excluding the option attribution rules of section 318(a)(4)).

• Is the term “person” in the anti-abuse rule limited to sellers or buyers of assets that are attributed to D or C through corporate attribution?

– For example does the related party carve out to the exception apply where A owns– For example, does the related party carve out to the exception apply where A owns 100% of D and 99% of a partnership and the partnership non-transitorily transfers assets to C prior to the distribution of C?

– What if the partnership is wholly owned by members of the DSAG?– Does the anti-abuse rule effectively turn off the treatment permitted under Notice

2007-60?196

Small ATB Anti-Abuse Rule – Examplep

Third PartyStep D

Business A Assets

Step 1

D

$4x Cash

Business A, Business B, and $5x Cash*Step

2

Business A (5 years)

FMV=$1x

Business C (5 years)

FMV=$50x

Business A FMV=$4x

C

Business B (2 years)

FMV=$40x $9x Cash

• Without Step 1, C’s ATB Assets would be less than 5% of its total assets.p , %• By purchasing additional Business A assets from a third party as an expansion of D’s

historically owned Business A, D causes C’s ATB Assets to be in excess of 5% under the expansion doctrine.

• Anti abuse rule does not appear to apply because D acquires assets from a third party

197

• Anti-abuse rule does not appear to apply because D acquires assets from a third party that C has no intent to dispose of.

* C has no plan or intent to dispose of the Business A Assets acquired in Step 1.

Valuation Dates• D and C can elect to use one of the following dates for purposes of

determining the fair market value of their assets:– Immediately before the distribution;– Any date within the 60-day period before the distribution;– The date of the binding distribution agreement; or

h d f bli S C fili i h h di ib i– The date of a public announcement or SEC filing with respect to the distribution.

• D and C both must consistently use the same date for purposes of the Nonbusiness Asset calculations and the MSR.

• A failure of D and/or C to consistently use the same date will cause the relevant valuation date to be immediately before the distribution, unless the IRS determines that the use of such date is inconsistent with the purposes of section 355 and the regulations thereunder.

198

Evolution of IRS Ruling PolicyEvolution of IRS Ruling Policy

Evolution of IRS Section 355 Ruling Policy • Prior to Rev. Proc. 2003-48, private letter rulings addressing section 355 generally

ruled on whether the transaction qualified in full, with few caveats.

g y

– Rev. Proc. 96-30 (and Rev. Proc. 86-41 before it) set forth in a checklist questionnaire the information that had to be included in requests for rulings under section 355.

– However, under Rev. Proc. 96-43, for purposes of ATB requirement, the IRS required thatHowever, under Rev. Proc. 96 43, for purposes of ATB requirement, the IRS required that the gross assets of the trades or businesses relied on to satisfy ATB requirement must have a FMV that is at least 5% of the total FMV of the gross assets of the corporation conducting the trades or businesses. See Section 4.01(30) of Rev. Proc. 2003-3, 2003-1 C.B. 113.

• IRS may rule that the trades or businesses satisfy the ATB requirement if it can be established that, based upon all relevant facts and circumstances, the trades or businesses are not de minimis compared with the other assets or activities of the corporation and its subsidiaries.

• Was the reason behind the IRS’s willingness to rule when the ATB represented less than 5% related to IRS sympathy to structuring issues related to former section 355(b)(2)(A) which required that D or C, as the case may be, be engaged directly in an ATB or that “substantially all of [such corporation’s] assets consist of stock andATB or that substantially all of [such corporation s] assets consist of stock and securities of a corporation controlled by [such corporation]”?

– IRS willing to issue rulings on device and business purpose, among other requirements. 200

Evolution of IRS Section 355 Ruling Policy

• In Rev. Proc. 2003-48, the IRS instituted a pilot program (which it subsequently adopted on a more permanent basis) under which it would no

g y

q y p p )longer rule on business purpose, device, or section 355(e) “plan” issues.

– Section 4.07 of Rev. Proc. 2003-48 deleted the 5% ATB threshold by deleting section 4 01(30)section 4.01(30).

– Though unwilling to rule on a “plan” issue, the IRS would still entertain requests for rulings on related “significant issues” under section 355(e).

– The IRS justified the change in part by an intent to dedicate its resources to increasing the amount of published guidance under section 355.

Th IRS l d i R P 2003 48 h i ld d li f– The IRS also announced in Rev. Proc. 2003-48 that it would decline a request for a supplemental letter ruling unless the request presented a “significant issue.”

201


• Ordinarily, the IRS will not issue a letter ruling on only part of an integrated transaction

g y

integrated transaction.

• In Rev. Proc. 2009-25, however, the IRS instituted an optional pilot program (subsequently made more permanent and exclusive in 2013) for rulings solely under the jurisdiction of the Associate Chief Counsel (Corporate) on “significant issues” involving the tax consequences or characterization of part of a transaction that occurs in the context of a section 355 distribution.section 355 distribution.

• The IRS also announced in Rev. Proc. 2009-25 that it would generally rule on non-plan section 355(e) issues, including the effect of redemptions, if

d li ld lt i th b i i iti f 50%an adverse ruling would result in there being an acquisition of a 50% or greater interest as part of a plan including the spin-off.

202


• Rev. Proc. 2009-25 defined “significant issue” as an issue of l h h f ll i

g y

law that met the following tests:

(1) the issue is not clearly and adequately addressed by a statute, l ti d i i f t t t t th th it bli h dregulation, decision of a court, tax treaty, or other authority published

in the Internal Revenue Bulletin;

(2) the resolution of the issue is not essentially free from doubt (i e(2) the resolution of the issue is not essentially free from doubt (i.e., taxpayer’s counsel is unable to render a “will” opinion on the issue because of concern over a legal issue); and

(3) the issue is legally significant and germane to determining the major tax consequences of the transaction.

203

Evolution of IRS Section 355 Ruling Policy • In Rev. Proc. 2013-3, the IRS announced that three new areas were under

study, and that it would not rule on them until publishing a revenue ruling revenue procedure regulations or other authority

g y

ruling, revenue procedure, regulations or other authority.

• These three new areas may be summarized as follows:

(1) recapitalizations into control;

(2) debt issued in anticipation of a spin-off; and

(3) “north-south” transactions.

• In Rev. Proc. 2013-32, the rulings program for transactions under ti 332 351 355 368 d/ 1036 b t ti ll t b ksections 332, 351, 355, 368 and/or 1036 was substantially cut back.

Under the program, which is currently in effect, the IRS will only rule on issues that are “significant.”

– “Significant” is defined as an issue that is not essentially free from doubt and that is germane to the tax consequences of the transaction.

204

Rev. Proc. 2015-43 & Notice 2015-59

• IRS released Rev. Proc, 2015-43 and Notice 2015-59 (the “notice”) onIRS released Rev. Proc, 2015 43 and Notice 2015 59 (the notice ) on September 14, 2015.

• Rev. Proc. 2015-43 provided policies under section 355 and related provisions for spin-offs involving relatively small ATBs.

• The notice stated that Rev. Proc. 2015-43 does not distinguish between pro rata and non-pro rata distributions.

• Rev. Proc. 2015-43 provided that the IRS will not issue a ruling on “any i l ti t th lifi ti d ti 355 d l t d i i ”issue relating to the qualification under section 355 and related provisions” if one of the three no-rule policies applies.

205

Rev. Proc. 2015-43 & Notice 2015-59

• The notice identified four circumstances in which qualification of a distribution under section 355 was under study:y

1. Ownership by D or C of a small amount of ATB Assets in relation to all of its assets.

2. Ownership by D or C of investment assets having substantial value in relation to (a) the value of all of such corporation’s assets, and (b) the value of the assets of the trade(s) or business(es) relied upon to meet the ATB ( ) ( ) prequirement.

3. A significant difference between D’s ratio of investment assets to assets th th i t t t d h ti f Cother than investment assets and such ratio of C.

4. An election by D or C (but not both) to be a RIC or a REIT.

206

Relevance of General Utilities Repeal to Device and ATB Requirementsq• Treasury and the IRS referenced sections 337(d) and 355 when discussing the four circumstances under study.

• Section 337(d) provides:

• The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of the amendmentsmade by subtitle D of title VI of the Tax Reform Act of 1986, including—(1) regulations to ensure that such purposes may not be circumvented through the use of any provision of law or regulations (including the consolidated return regulations and part III of this subchapter) or through the use of a regulated investment company, real estate investment trust, or tax-exempt entity, and (2) regulations providing for appropriate coordination of the provisions of this section with the provisions of this title relating to taxation of foreign corporations and their shareholdersrelating to taxation of foreign corporations and their shareholders.

• The preamble to the 1989 final device regulations provided that “[the IRS] is developing regulations under section 337(d) of the Code that will relate to the distribution of stock, or stock and securities, of a controlled corporation. New section 1.355-6 is reserved for this purpose.”

• In March, 1989, Treasury indicated that it would be exercising its authority under section 337(d) to prevent the use of “subsidiary-tracking” stock to sell a business without triggering a General Utilities tax. The scheme, as explained by Treasury, was the purchase by X of D stock tracking C eventually followed by a split off of C to X.

• In 1990, Congress enacted section 355(d), effectively shutting down the transaction described immediately above.

• In 1992, Treasury closed the regulatory project reserved for under Treas. Reg. section 1.355-6 without the promulgation of regulations.

• Rev. Rul. 2003-110 (holding that “[i]n determining whether a distribution of the stock of a controlled corporation satisfies the [business purpose requirement] that the distribution be motivated, in whole or substantial part, by one or more corporate

207

[ p p q ] , p , y pbusiness purposes, the fact that [section] 355 permits [D] to distribute the stock of [C] without recognition of gain does not present a potential for the avoidance of Federal taxes under [Treas. Reg. section] 1.355-2(b).”).

General Utilities Related ConcernsGeneral Utilities-Related Concerns

General Utilities Repealp

• The Preamble provides that Treasury and the IRS remain concerned that taxpayers may interpret the regulations under section 337(d) andthat taxpayers may interpret the regulations under section 337(d) and section 355 in a manner inconsistent with General Utilities repeal.

Th f T d th IRS ti t t d h th itti• Therefore, Treasury and the IRS continue to study whether permitting tax-free separations of large amounts of Nonbusiness Assets from Business Assets, especially when the gain in the Nonbusiness Assets is expected to be eliminated is consistent with General Utilities repeal inexpected to be eliminated, is consistent with General Utilities repeal in all circumstances.

T t t t ti l dditi l id d• Treasury requests comments on potential additional guidance under section 337(d) addressing such transactions.

209

Recapitalizations into Section 368(c) ControlSection 368(c) Control

Section 355 Control Requirementq

• For a spin-off to be tax-free, D must: – Control C (within the meaning of section 368(c)) immediately before

the distribution; and ;– Distribute control of C.Sections 355(a)(1)(A); 355(a)(1)(D).

• Under section 368(c), “control” means ownership of:– Stock possessing 80% of the vote; and– 80% of each class of non-voting stock.80% of each class of non voting stock.Rev. Rul. 59-259.

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Background – Control Requirementg q• In a section 355 transaction, Distributing must own and distribute “control” of the controlled

corporation within the meaning of section 368(c) (i.e., Controlled stock with at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent g p pof the total number of shares of each class of nonvoting stock).

• In Rev. Rul. 69-407, 1969-2 C.B. 50, the IRS ruled that a corporation could recapitalize to alter its capital structure in order to facilitate the acquisition of control by a shareholder prior to a section 355 distributionsection 355 distribution.

– In the ruling, the IRS indicated that this type of recapitalization should be respected if it results in a “permanent realignment of voting control.”

– See also Rev. Rul. 56-117, 1956-1 C.B. 180 (permitting a recapitalization to obtain control f f i 355 i ff) f R R l 63 260 1963 2 C B 147 (fi di hfor purposes of a section 355 spin-off); cf. Rev. Rul. 63-260, 1963-2 C.B. 147 (finding that section 355 did not apply because control was obtained in a “transitory and illusory sense”).

• Consistent with Rev. Rul. 69-407, the IRS has issued numerous PLRs under which the creation of a high-vote / low-vote structure to ensure control is respected.

– More recently, the IRS had gone one step further by issuing rulings that allow post-distribution recapitalizations to unwind a high-vote / low-vote structure that was put in place to facilitate a section 355 distribution.

– These rulings generally permitted the unwinding if the subsequent recapitalization did notThese rulings generally permitted the unwinding if the subsequent recapitalization did not occur pursuant to a binding commitment entered into before the section 355 distribution and was dependent on intervening events.

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Rev. Rul. 69-407

D X & Y

70% Vote 30% Vote

D X & Y

80% Vote 20% Vote70% Vote70% Value

Class B

30% Vote30% Value

C

Class A

80% Vote70% Value

20% Vote30% Value

CCommon Common

C

• In Rev. Rul. 69-407, C recapped the stock owned by D and X and Y so that D had 80% of the vote. The recapitalization did not change the proportional interests of D, X, and Y in C, but only altered the proportionate voting rights of the parties.

• The ruling concludes that respecting D as controlling C as a result of the recapitalization is appropriate because the recapitalization “resulted in a permanent realignment of voting control.”p p g f g

• See also Rev. Rul. 56-117, 1956-1 C.B. 180 (permitting a recapitalization to obtain control for purposes of a section 355 spin-off); cf. Rev. Rul. 63-260, 1963-2 C.B. 147 (finding that section 355 did not apply because control was obtained in a “transitory and illusory sense”).

213

IPO Carve-Outs

P Public

P Public

P S Public P S

Public

60% 40% 85% 15%

S S

214

Section 355: Recaps Into and Out of Controlp

D t f D t f D t S l t lDate of Ruling/Spin

Date of SupplementalRuling Request

Date SupplementalRuling Published

Supplemental Ruling Number

3/25/99 6/28/01 9/28/01 200139011

6/2/99 10/8/03 1/16/04 200403041

8/30/02 8/19/03 11/21/03 200347013

215

Section 355: Recaps Into and Out of Controlp

• Rev Proc 2003 48 stated CC:Corp would not issue supplemental rulings on spin offs due• Rev. Proc. 2003-48 stated CC:Corp. would not issue supplemental rulings on spin-offs due to change of circumstances (did not apply to 3 rulings cited above, because sought before effective date).

– What is scope of “change of circumstances”?A d 2005 CC C t d i i t ti f l t d d l t– Around 2005 CC:Corp stopped requiring representations of no plan to undo dual vote structure.

• In 2008 Wessel, Pari and D’Avino added to their treatise: – “The authors understand that the Service will rule favorably if, following the distribution,

th t t th t th b d f di t f t ll d ill id h th tthe taxpayer expects that the board of directors of controlled will consider whether to unwind the dual class structure as long as it is subject to an independent shareholder vote.” p. 417

• PLR 200837027 stated that “in connection with the resolutions to be submitted to the Controlled shareholders at the next regularly scheduled annual shareholders’ meeting ofControlled shareholders at the next regularly scheduled annual shareholders meeting of Controlled or at a special shareholders’ meeting of Controlled,” shareholders could vote to approve a resolution to undo a recapitalization into control consummated in connection with the spin-off addressed by the ruling. Later rulings involving recaps into control included similar language in representations.

216

PLR 201007050Recap into Control for Spin-off Followed by Unwindp p y

D1 distributes Class B

D2 Shares of Class A stock are issued to D2

for assets (not clear

D1 distributes Class B stock of C to D2

(“Internal Spin-off”)

P bli

24

D1Shares of Class A stock are issued to h bli i IPO

from ruling if steps 1-2 are part of same plan

as step 4)

Public

3C 1

the public in an IPO;D2 then buys 10%

from publicC is recapped to create

Class A & B stock; D1 is issued Class B stock

Step 5: D2 offers to exchange its Class A stock in C for D2 stock owned by the D2 shareholders (“Exchange Offer”

3

Step 5: D2 offers to exchange its Class A stock in C for D2 stock owned by the D2 shareholders ( Exchange Offer resulting in an “External Split-off” to the D2 shareholders). Offer provides that, if the conditions to the Exchange Offer are met, then D2 will convert the Class B stock received in the Internal Spin-off to Class A stock (the “Unwind”) prior to consummation of the Exchange Offer/External Split-off.

Step 6: Conditions are met, and Unwind and External Split-off are consummated.

Step 7: D2 contributes assets to D1 (North-South issue). Rep: Internal Spin-off not conditional on contribution.

217

PLR 201007050 (cont’d)( )

Th IRS l d “ h U i d ill h I l S i ff f il• The IRS concludes: “the Unwind will not cause the Internal Spin-off to fail to satisfy the control immediately before requirement of section 355(a)(1)(A).” Cf. Rev. Rul. 98-27.

• The taxpayer represented that immediately after the Internal Spin-off, there would be “no legally binding obligation to change the capital structure or the Charter of Controlled” and “no legally binding obligation to proceed with the remainder of the Proposed Transaction.”– Compare to prior PLRs requiring no plan or intention.

• Consummation of the Exchange Offer/External Split-off was conditioned upon a minimum level of participation in the Exchange Offer.– The exchange ratio for the Exchange Offer was set at a level intended to encourage the

D2 shareholders to tender their D2 stockD2 shareholders to tender their D2 stock.

• Does “economic substance” under section 7701(o) affect the analysis? (Is tax benefit “clearly consistent” with the statute and policies?)

218

Taxpayer Reform Act of 1997p y

• Added section 355(e) and section 368(a)(2)(H) to the Code• Added section 355(e) and section 368(a)(2)(H) to the Code.• In general, these provisions turned off the application of the step transaction

doctrine with respect to transactions following spin-offs for purposes of determining whether a distribution qualifies under section 355determining whether a distribution qualifies under section 355.

– Section 368(a)(2)(H)(ii) provides that, in the case of a transaction with respect to which the requirements of section 355 (or so much of section 356 as relates to section 355) are met, the fact that the shareholders of the distributing corporation dispose of part or all of the distributed stock, or the fact that the corporation whose stock was distributed issues , padditional stock, shall not be taken into account.

– Section 355(e) generally imposes a corporate level (but not shareholder level tax) if, pursuant to a plan, one or more persons acquire directly or indirectly stock representing a 50-percent or greater interest in D or C.

• Rev. Rul. 98-27 revoked Rev. Rul. 96-30 and acknowledged that step transaction principles no longer applied with respect to transactions engaged in by D or C following a spin-off.

219

Taxpayer Reform Act of 1997p y

• Rev. Rul. 2003-79 turned off the step transaction doctrine with respect to “born to die” transactions and quoted the following legislative history to section 355(e) and section 368(a)(2)(H):

The . . . bill does not change the present-law requirement under section 355 that theThe . . . bill does not change the present law requirement under section 355 that the distributing corporation must distribute 80 percent of the voting power and 80 percent of each other class of stock of the controlled corporation. It is expected that this requirement will be applied by the Internal Revenue Service taking account of the provisions of the proposal regarding plans that permit certain types of planned restructuring of the distributing corporation following the distribution, and to treat similar restructurings of the controlled corporation in a similar manner. Thus, the 80-percent control requirement is expected to be administered in a manner that would prevent the tax-free spin-off of a less-than-80-percent controlled subsidiary, but would not generally impose additional

t i ti t di t ib ti t t i f th t ll d ti if hrestrictions on post-distribution restructurings of the controlled corporation if such restrictions would not apply to the distributing corporation.

H.R. Rep. No. 105-220, at 529-30 (1997); 1997-4 C.B. 1457, at 1999-2000.

220

Rev. Proc. 2013-3 No Rule

• Rev. Proc. 2013-13 provided that, until the IRS resolves the issue, it will no longer rule on:– Whether a corporation is a “controlled corporation” within the meaning of

section 355(a)(1)(A) if, in anticipation of a distribution of the stock of the corporation, a distributing corporation acquires putative control of the controlled corporation (directly or through one or more corporations) in any transaction (including a recapitalization) in which stock or securities were exchanged for stock having a greater voting power than the stock or securities relinquished in the exchange, or if, in anticipation of a distribution of the stock of the putative controlled corporation, such corporation issues stock to another person having different voting power per share than the p g g p pstock held by the distributing corporation.

221

Revenue Procedure 2016 40Revenue Procedure 2016-40

Rev. Proc. 2016-40

• Rev. Proc. 2016-40 provides two safe harbors that generally may apply where a recapitalization into Controlgenerally may apply where a recapitalization into Control is followed by an “unwind” of the rearranged capital structure.

• Rev. Proc. 2016-40 also removes recapitalizations into Control from the No Rule listControl from the No Rule list.– However, the IRS may decline to issue a letter ruling addressing

an acquisition of Control where appropriate in the interest of d t d i i t ti th d h t d bsound tax administration or on other grounds when warranted by

the facts and circumstances of a particular case.

223

Applicability of Rev. Proc. 2016-40pp y• Rev. Proc. 2016-40 applies to a distribution if:

– D does not own stock constituting Control of C,g ,– C issues shares of one or more classes of stock to D and/or to other

shareholders of C (the “Issuance”), as a result of which D owns stock constituting Control of C,

– D subsequently distributes its C stock in a section 355 transaction andD subsequently distributes its C stock in a section 355 transaction, and– C subsequently engages in a transaction that unwinds the Issuance (an

“Unwind”).

A U i d i i h• An Unwind is a transaction that– Substantially restores C’s shareholders to the relative interests they

would have held in C (or its successor) had the Issuance not occurred and/or

– Substantially restores the voting rights and value of the classes of C’s stock that were present prior to the Issuance.

224

Rev. Proc. 2016-40 Safe Harbors• If a distribution subject to Rev. Proc. 2016-40 falls within one

of the safe harbors, the IRS will not assert that the Issuance o e s e bo s, e S w o sse e ssu celacks substance (and that therefore D lacks Control of C immediately before the distribution).

• These safe harbors only apply for purposes of determining whether an acquisition of Control has substance for purposes of the Control Requirement, and not for any other purposes.q , y p p

• If a transaction falls outside the safe harbors, Rev. Proc. 2016-40 has no effect and the determination of whether an acquisition40 has no effect and the determination of whether an acquisition of Control has substance, and is therefore respected, is determined under general federal tax principles.

225

24-Month Safe Harbor

• The 24-month safe harbor is satisfied if:– No action is taken, including the adoption of a plan or policy,– At any time prior to 24 months after the distribution, – By C’s board of directors or management, or any of C’s controlling

shareholdersshareholders,– That would, if implemented, actually or effectively result in an

Unwind.

• What if the SEC disclosures at the time of the spin state that, 24 months after the distribution, there will be an independent vote of the shareholders regarding whether or not to implement an Unwind?

226

Unanticipated Third Party Transaction Safe Harborp y

• The unanticipated third party transaction safe harbor is satisfied if C engages in a transaction with one or more persons that results in an Unwind, regardless of whether the transaction takes place within 24 months after the distribution, provided that:

– There is no agreement, understanding, arrangement, substantial negotiations, or discussions concerning the transaction or a similar transaction at any time during the 24 months prior to the distribution, and

– No more than 20% of the interest in the other party (by vote or value) is owned by the same persons that own more than 20% of the stock of C.

• The terms “substantial negotiations ” “discussions” and “similar transaction” used• The terms “substantial negotiations,” “discussions” and “similar transaction” used above are within the meanings of Treas. Reg. sections 1.355-7(h)(1), (6), and (12)-(13), respectively.

• The determination of 20% ownership of C and the other party applies the constructive ownership rules of section 318(a) as modified by section 304(c)(3), except that for purposes of applying section 318(a)(3)(A) and (B), the principles of section 304(c)(3)(B)(ii) apply without regard to section 304(c)(3)(B)(ii)(I).

227

Business PurposeRequirement

Business Purpose Requirementp q

Gregory v. Helvering“The whole undertaking, though conducted according tothe terms of the [statute] was in fact an elaborate andthe terms of the [statute], was in fact an elaborate anddevious form of conveyance masquerading as a corporatereorganization.”

229

Business Purpose RequirementTreas. Reg. section 1.355-2(b)g ( )

• Corporate business purpose – The distribution must be carried out for one or more corporate business purposes. The transaction must be motivated, in whole or substantial part, by such corporate purposes.

• Exigency – Provide nonrecognition only to distributions incident to readjustments of corporate structure required by business exigency.

Oth th f d l i t id M t b l d b t ti l f d l t• Other than federal income tax avoidance – Must be a real and substantial non-federal tax purpose germane to the business of D, C or D’s affiliated group.

• No impractical or unduly expensive nontaxable alternative.

• Rev. Proc. 96-30 contains a non-exhaustive list of IRS-approved corporate business purposes, though the IRS stopped issuing private letter rulings on the business purpose requirement in 2003.

– Business purposes described in Rev. Proc. 96-30 include enhancing the fit and focus of each business, providing an equity interest in a particular business to a key employee, facilitating a borrowing or stock offering, facilitating an acquisition by D or C (or of D), producing cost savings, and eliminating competition with customers or suppliers.

• Does there need to be an independent, corporate business purpose for contributing the relied upon ATB to C (or holding back the relied upon ATB in D)?

230

Revenue Procedure 2016 45Revenue Procedure 2016-45

Revenue Procedure 2016-45Revenue Procedure 2016 45

• As noted above since Rev Proc 2003 48 the Service has declined to rule on both the business• As noted above, since Rev. Proc. 2003-48 the Service has declined to rule on both the business purpose requirement under § 355(b) and Treas. Reg. § 1.355-2(b) and the device prohibition in §355(a)(1)(B) and § 1.355-2(d).

• Revenue Procedure 2016-45 removes these two no rules.– “The Service has determined there are a number of unresolved legal issues under § 1.355-2(b) pertaining to

the corporate business purpose requirement and under § 355(a)(1)(B) and § 1 355-2(d) pertaining to devicethe corporate business purpose requirement and under § 355(a)(1)(B) and § 1.355-2(d) pertaining to device that can be germane to determining the tax consequences of a distribution. The Service has also determined that it is appropriate and in the interest of sound tax administration to provide guidance to taxpayers on significant issues (as defined in section 3.01(50) of Rev. Proc. 2016-3) in these two areas.”

– “Accordingly, the Service will issue a letter ruling with respect to a significant issue under § 1.355-2(b) pertaining to the corporate business purpose requirement, and a significant issue under § 355(a)(1)(B) and §1 355 2(d) pertaining to device provided that the issue is a legal issue and is not inherently factual in nature1.355-2(d) pertaining to device, provided that the issue is a legal issue and is not inherently factual in nature. However, as with other requests for letter rulings, the Service may decline to issue a letter ruling addressing these significant issues when appropriate in the interest of sound tax administration or on other grounds when warranted by the facts or circumstances of a particular case. See section 6 of Rev. Proc. 2016-1 and section 3.02(10) of Rev. Proc. 2016-3.”

• Note that rulings in these two areas are still subject to the “significant issue” requirement.• The revenue procedure quotes Rev. Proc. 2016-3 and defines a “significant issue” as “an issue of law

the resolution of which is not essentially free from doubt and that is germane to determining the tax consequences of the transaction.”

• The issue also must be “a legal issue” and not “inherently factual in nature.”

232

Revenue Procedure 2016-45Revenue Procedure 2016 45

• How broadly will the Service interpretHow broadly will the Service interpret “significant legal issue” in the context of business purpose and device?

• Rev. Proc. 96-30 included what information was generally required to be shown to establish certain id tifi d b iidentified business purposes. – Will the Service require similar factual information to

issue a ruling on a significant legal issue related to oneissue a ruling on a significant legal issue related to one of the business purposes identified in Rev. Proc. 96-30? Or will the Service rule without that information because it is “inherently factual” in nature?because it is inherently factual in nature?

233

Recent Developments in Corporate Tax - Jones Day Slide Presentation.pdf · Recent Developments in Corporate Tax Scott M. Levine Jones Day Washington D.C. Lori A. Hellkamp Jones Day

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