A North-South spinoff is a section 355 distribution that is accompanied by a contribution of property from the shareholder to the Distributing corporation. The IRS has consistently ruled in recent years that the contribution will not be integrated with the spinoff. Taxpayers like this result because integrating the contribution with the spinoff could generate tax liabilities: the shareholder and Distributing might be found to have exchanged property in a taxable exchange. Given the state of play allowed by the IRS, the more interesting question is why so many shareholders evidently want to make such contributions incident to spinoffs.
LTR 201202007. This is the most recent of the North-South spinoff rulings. D2, a domestic public company, held domestic and foreign subsidiaries, including a large stake owned by foreign D in a foreign public company. At the end of several steps including first an internal spinoff and then an external spinoff: (1) D2’s public shareholders will own the stock of a new domestic public holding company that holds stock of the foreign public company, (2) all of D2’s directly owned foreign subs will have been relocated under D1, and (3) D2 will have received cash from the IPO carried out by the new domestic public holding company, which cash D2 will use to pay its debts.
From a business point of view, it appears that indirectly monetizing its interest in the foreign public company was a large part of D2’s purposes. But that is not an appropriate business purpose to support a tax free spinoff, so D2 had to construct another story for the IRS. From a business point of view, it also appears that consolidating all of its foreign subsidiaries under one foreign holding company, D1, was a large part of D2’s purposes. But that, too, could not be the stated business purpose for the two spins because the contribution of the other foreign subs to D1 was the “south” part of the North-South transaction and depended on being separate from the spinoff by D1 (the internal spinoff).
Therefore, D2 wanted to just contribute its other foreign subsidiaries to D1 in exchange for D1 stock, not in exchange for the stock of the foreign public company ultimately spunoff to D2’s shareholders in the external spin.
Recall that D1 is the Distributing corporation in the internal spin of the foreign public company that precedes the external spin of the new domestic public holding company. Thus taxpayer needed a ruling to insure that D2’s contribution of the other foreign subs to D1 was in exchange for the D1 stock nominally issued and not in exchange for the stock of the foreign public company. The IRS obliged.
Representation Required. The taxpayer made this representation with respect to the contribution of the foreign subsidiaries (called the “Transfer”): “There is no regulatory, legal, contractual or economic compulsion or requirement that the Transfer be made as a condition of the distribution by Distributing 1 of either: (i) the distribution of Controlled 1 stock in the Internal Distribution or (ii) the assets distributed by Distributing 1 to Distributing 2 in step (2) of proposed transactions.”
The last part of the representation refers to a second event that the taxpayer wanted to be separate from the internal spinoff, but did not seek a ruling on: an asset distribution from D1 to D2, which taxpayer intended to report as a section 301 distribution.
As to the Transfer, the key part of the representation is the lack of economic compulsion. It would be rare for the taxpayer to have been under any regulatory or legal duty to “pay” for D1’s spinoff with an exchange of other property. Perhaps some foreign laws do not permit a spinoff but rather would require a split off (that is, exchange of some stock of D1 for the spun off subsidiary), but rarely would a distribution by a foreign corporation be conditioned on a contribution of other property unless the distribution would have rendered D1 insolvent in violation of some foreign country law. It also is possible that a spin would violate a contractual debt covenant, and so that is likely what the reference to no “contractual compulsion” means.
Even though the internal spinoff might not have rendered D1 insolvent, it might have made D1 not an economically useful company, which was in need of more assets. In such a case the taxpayer presumably can make the representation that there was no economic compulsion that the Transfer be made. If so, the threshold for making the representation is pretty low.
Note that the case discussed here does not involve an exchange between Distributing and Controlled. That sort of exchange raises analogous though different issues because there likely will be an overlapping D reorganization occurring.
What Was Going On? It is highly likely that the Transfer was simply a case of the taxpayer killing two birds with one stone – actually three birds. First it monetized its interest in the foreign public company, second it paid down its debts, and third it consolidated its foreign subsidiaries in one foreign group. The latter step is almost always desirable because it can permit movement of foreign earnings around in the foreign group without first having to repatriate the earnings and pay U.S. tax for the privilege of retransferring those earnings to another foreign subsidiary.
None of these aims amount to the requisite business purposes for a tax free spinoff. That is why taxpayer had to also represent that the substantial business purpose was “fit and focus,” an all-purpose get out of jail free card for tax free treatment of spinoffs.
Note that the representation required by the IRS was NOT that the taxpayer would have carried out the spinoffs, or made the Transfer, anyway, without the other step. Indeed it appears that a taxpayer can make the “no compulsion” representation even though the Transfer was a deal breaker for doing the spinoffs. All the IRS requires is that taxpayer did not have to make the Transfer, but merely wanted to. That means that the representation required here is significantly less onerous than the “would have done it anyway” representation that serves to grease the wheels of many other bumps along the road to a spinoff ruling.
Turning to the question raised at the top of this article, why do so many taxpayers want to do a transaction that seems to replace value distributed to them by the Distributing corporation in a spinoff, but the taxpayers deny that is what is going on? On the surface, relatively benign reasons appear, like the inferred reason for the Transfer here: we just happened to want to consolidate our other foreign subs under Distributing. In light of the IRS’ continuing to make these rulings it does not appear that the IRS is suspicious of such representations.
Take Away: The takeaway from this and earlier similar rulings (LTRs 20061106, 200411021, 2002215031, 9708012, 201033007, 201149012) is that form controls the separation of the south part from the north part of a spinoff, so long as that taxpayer does not have to admit that “the devil made me do it.” However, it is likely that most taxpayers engage in a North-South transaction only after receiving a letter ruling.
