In the current economy, as today’s tax system struggles to strike the right balance between tax-free treatment for corporate transactions and the potential for taxpayer abuse, further changes to the tax code loom ominously on the horizon as the qualified dividend income rules, first passed by Congress in 2003 and extended by President Bush in 2006, are set to expire at the end of 2010. Presently, qualified dividend income is taxed at the lower tax rate embodied in capital gains, but if the law does expire at the end of 2010, qualified dividend income will no longer exist and dividend income will be taxed at the higher tax rate applied to ordinary income.
A divorce between qualified dividend income and preferential capital gains rates would effectively continue the largely implicit trend inherited from the late 20th century of increasingly burdening corporate transactions involving the distribution of appreciated property under subchapter C of the Internal Revenue Code with a lucid labyrinth of restrictions, but at the same time it would make section 355 of the tax code that much more important to practitioners by virtue of the splintered tax-free benefits it provides at both the corporate and shareholder levels. A dinosaur in a time warp of sorts, section 355 is the yellow brick road when a corporation wants to divide its existing businesses into more than one corporation without incurring tax, and what makes it so remarkable is that since 1986 it has been the only game in town.
However, in recent years, concerned with the potential for tax abuse, Congress has specifically targeted section 355 and has narrowed the circumstances of its application by poaching its power in a series of patchwork limitations. One such limitation is set forth in section 355(g). This statute is interesting because it was the regulatory response to the so-called “cash-rich split-offs” that plagued the better part of this decade. As a result of the enactment of section 355(g), a transaction is currently fully taxable at both the corporate and shareholder levels if it fails to meet its requirements.
As we wait for the decision on the expiring qualified dividend income at the end of the year, understanding section 355, as well as the inherent limitations in section 355(g), will become ever more important for practitioners. Accordingly, this article addresses section 355 within the context of a case study involving the tax-free Janus Capital and DST Systems, Inc. cash-rich split-off that was entered into in 2003 and the subsequent limitations imposed by the addition of section 355(g) that would currently make it fully taxable.
I. The Transaction between Janus Capital and DST Systems, Inc.
A. A Brief Description
On August 25, 2003, Janus Capital (“Janus”) transferred 32.3 million shares of DST Systems, Inc. (“DST”) stock to DST in exchange for 100% of the common stock of the wholly owned DST printing and graphics design subsidiary Output Solutions.[i] Seeking to avoid capital gains tax under 302 on the proceeds of the exchange, the parties structured the transaction as a so-called “cash-rich split-off” under section 355 of the Internal Revenue Code.[ii] Under the terms of the deal, DST contributed cash to Output Solutions ranging from approximately $854 million to $999 million.[iii] Bundled together with the printing and graphics design business assets, the total value of the deal was nearly $1.2 billion with the cash component between 88.13% and 89.68%.[iv] In the end, in what was a transaction described by many as essentially a taxable sale of stock, Janus wound up with tax-free cash as well as the Output Solutions’ commercial printing and graphics design business assets while DST reduced its shares outstanding by more than twenty-five percent.[v]
B. An Overview of Cash-Rich Split-Offs
Section 355 has three basic qualifying transactions: spin-offs, split-offs and split-ups.[vi] A split-off resembles a redemption that would generally be governed by the provisions of section 302 without the application of section 355.[vii]
Generally, in a cash-rich split-off, the parent corporation (“parent”) stuffs its subsidiary with large amounts of cash and other liquid assets, which usually is substantial in comparison to the value of the active trade or business assets the subsidiary holds, and then transfers all of the stock of the subsidiary to a shareholder of the parent in a redemption of the shareholder’s interest in the parent that qualifies for tax-free treatment at both the corporate and shareholder level under section 355.[viii]
The tax consequences for these kinds of transactions are significant considering it is the result of an exchange wherein a parent transfers appreciated property in a tax-free distribution consisting of a large percentage of cash assets to a shareholder while at the same time a shareholder is able to bail out substantial investment assets tax-free from the corporate solution.[ix] Though the bailout of corporate earnings and profits by a shareholder, which allows for capital gains treatment and basis recovery, generally, is less of a current concern with qualified dividend income at preferential capital gains rates (unless at the end of 2010 the qualified dividend income rules expire), the potential for tax abuse is still a significant concern involving the use of section 355 to avoid corporate level tax on distributions of appreciated property.[x]
II. Tax Treatment of a Cash-Rich Split-Off Under Section 355
A. Background of section 355
Prior to section 355, the General Utilities doctrine, which was codified in section 311(a)(2) in 1954, provided that a corporation generally did not recognize a gain or loss on the distribution of appreciated property to its shareholders.[xi] In the Tax Reform Act of 1986, the General Utilities doctrine was repealed and in its place Congress enacted section 311(b), which requires a corporation to recognize a gain whenever the fair market value of the property distributed exceeds its adjusted basis.[xii] Thus, the Code currently reflects the congressional intent that corporate distributions of appreciated property should be subject to a corporate level tax.[xiii] However, despite the narrowing circumstances in which a corporation may distribute appreciated property to a shareholder without incurring a corporate level tax, one of the last remaining exceptions to the impact of the repeal of the General Utilities doctrine applies to transactions that meet the requirements of section 355.[xiv]
B. Analysis of the Janus Transaction in a pre-section 355(g) World
Section 355 applies to transactions that satisfy each of the following statutory and non-statutory requirements.[xv] First, the distributing corporation must distribute solely stock or securities of a corporation which it controls immediately before the distribution.[xvi] Under 368(c), control is defined as holding 80 percent of voting stock and 80 percent of all other classes of stock in the corporation.[xvii] Here, the facts of the transaction state that Output Solutions owns, immediately before the distribution, DST as a wholly owned subsidiary. This clearly is “control” within the meaning of 368(c), thus satisfying the control requirement.
Next, the distribution requirement will be met if the parent either (i) distributes all of its stock and securities in the subsidiary, or (ii) distributes an amount of stock in the controlled corporation constituting control under section 368(c).[xviii] Here, DST distributed all of its stock interest in Output Solutions to Janus in exchange for most of Janus’ interest in DST.
The active trade or business requirement is met if, immediately after the transaction, the distributing corporation and controlled corporation each are engaged in an active trade or business that (i) has actively conducted the trade or business for at least five years ending on the distribution date, (ii) was not acquired in a taxable transaction within five years of the distribution date, and (iii) was not conducted by another corporation the control of which was acquired during that five year period in a taxable transaction.[xix] The determination of whether a business is actively conducted requires analysis of the facts and circumstances.[xx] Although, there is no requirement specified in section 355 regarding how much of a controlled corporation’s assets must be attributed to an active trade or business, the IRS has provided that five percent or more of the net book value of assets should satisfy the requirement.[xxi] In addition, the regulations denote that transactions must satisfy a continuity of business enterprise requirement under section 355, though it largely overlaps the active trade and business requirement.[xxii]
The facts of the transaction clearly establish that the active trade or business requirement, as well as the continuity of business enterprise requirement, are met. Here, both DST and Output Solutions were, immediately after the transaction, engaged in the active conduct of a trade or business; DST remained engaged in its information processing and business software business while Output Solutions, renamed “JCG Partners,” continued its commercial printing and graphics design business behind an additional $15 million investment flushed into the business from Janus.[xxiii]
Next, the split-off must be motivated by one or more corporate business purposes.[xxiv] It was the landmark case of Gregory v. Helvering in which the U.S. Supreme Court first established a corporate “business purpose” requirement for tax-free reorganizations.[xxv] The regulations provide that the business purpose requirement will be satisfied if there is “a real and substantial non-Federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group…to which the distributing corporation belongs.”[xxvi]
Here, DST listed several business purposes for the transaction.[xxvii] The reasons given included improvement of competitive position in the mutual fund industry, access to bank credit and lack of desired fit of the Output Solutions business with DST’s “core output business.”[xxviii] Under Rev. Proc. 96-30, Appendix A, all of the business purposes cited by DST have been acceptable business purposes in the past.[xxix] Thus, assuming one of the reasons cited by DST for the transaction is determined to be an acceptable business purpose, the business purpose requirement would be satisfied.
Next, section 355 requires that the transaction was “not used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both.” [xxx] In addition, under the regulations the determination whether a spin-off constitutes a device requires a facts and circumstance analysis.[xxxi] The factors that suggest a device are (1) pro rata distributions, (2) subsequent sales or exchanges of distributing or controlled stock, and (3) if either the distributing or controlled corporation has substantial assets including cash and other liquid assets not related to the active business.[xxxii]
The factors that suggest there is not a device are: (1) corporate business purpose; (2) distributing corporation is publicly traded and widely held with no 5% shareholders; and (3) distribution to domestic corporate shareholders meeting the requirements for the 80% or 100% dividends received deduction.[xxxiii]
Here, Output Solutions consisted of nearly 89% cash assets not related to the commercial printing and graphics design. Under a facts and circumstances test, this tends to provide evidence of a device to distribute earnings and profits. However, the presence of a strong business purpose helps “prevent the determination that the transaction was used principally as a device.”[xxxiv] In this transaction, the business purposes described above including fit and focus, financing purposes and competition issues suggest that the distribution is not a mere device. In addition, the non-device factor involving the distribution to domestic shareholders eligible for the dividends received deduction under section 243 would further suggest the absence of a device.[xxxv] The regulations further provide that an exchange “ordinarily is not considered a ‘device’ to avoid dividend tax if the distribution would have been treated by the shareholder as a redemption that was a sale or exchange of its stock, rather than a dividend, if section 355 had not applied.”[xxxvi]
In this transaction, Janus’ reduction in ownership would have met the requirements of a substantially disproportionate redemption of stock under section 302(b)(2) since Janus owned less that 50% of DST after the redemption and would have reduced its ownership interest in DST to less that 80% of what it was prior to the transaction. Thus, it would have qualified for sale or exchange treatment. Therefore, the transaction does not appear to be a mere device.[xxxvii]
Assuming the other requirements such as continuity of proprietary interest, section 355(d) and 355(e) do not present problematic issues, section 355 would apply to the transaction.[xxxviii] Thus, under the law in effect at the time the transaction was entered into in 2003, Janus would have been entitled to non-recognition treatment under section 355(a) while DST would have been entitled to non-recognition under section 355(c).
III. Regulatory Response: Section 355(g)
A. Background of section 355(g)
In response to the techniques employed in cash-rich split-offs, Congress passed the Tax Increase Prevention and Reconciliation Act of 2005 (“TIPRA”), which added section 355(g) to the Internal Revenue Code.[xxxix] In effect, section 355(g) was enacted to prevent taxpayers attempting to avoid the repeal of the General Utilities doctrine from qualifying for section 355 tax-free treatment by reducing the acceptable component of cash and other investment assets in certain distributions made by corporations that hold a substantial amount of investment assets relative to the amount of active trade or business assets.[xl]
B. Overview of section 355(g) Requirements
Section 355(g) provides that section 355 will not apply to a distribution if (i) either the distributing corporation or controlled corporation is a “disqualified investment corporation” immediately after the transaction, and (ii) any person holds a 50-percent or greater interest (by vote or value) in any disqualified investment corporation immediately after the transaction, but only if such person did not hold such interest immediately before the transaction.[xli]
A corporation is a “disqualified investment corporation” if the fair market value of its “investment assets” is at least two-thirds or more of the fair market value of its assets.[xlii] Under section 355(g)(2)(B), the term “investment assets” generally includes (i) cash, (ii) stock or securities, (iii) partnership interests, (iv) any debt instrument or other evidence of indebtedness, (v) any option, forward or future contract, notional principal contract, or derivative, (vi) foreign currency, or (vii) any similar asset.[xliii]
C. Analysis of the Janus Transaction Under 355(g)
Consider the new tax consequences to the Janus and DST transaction with the imposition of 355(g). Output Solutions would be a disqualified investment corporation under 355(g) because the fair market value of its investment assets consists of nearly 89% of the fair market value of all its assets, which is well above the two-thirds threshold. Thus, section 355 would not apply to the split-off.[xliv]
Moreover, because Janus held at least a 50-percent interest in Output Solutions immediately after the exchange, but did not hold such an interest immediately before the exchange, it would also violate the 50-percent or greater interest rule in a disqualified investment corporation.[xlv] Therefore, under current law, the split-off would be fully taxable both on the corporate level under section 311(b) and shareholder level under section 302.[xlvi]
IV. Critique of 355(g)
Since the modification of section 355 with TIPRA in 2005, several interpretive issues have been raised regarding section 355(g) including the scope of the investment asset definition and the interaction between section 355(g) and the device requirement of section 355.[xlvii]
Section 355(g) requires a corporation to measure its “investment assets” when assessing the fair market value of all of its assets.[xlviii] Within this context, there has been criticism regarding the scope of the investment asset definition because it appears that the measurement of a disqualified investment corporation is based upon the gross value of the investment assets while liabilities are disregarded.[xlix] In response to this uncertainty, critics have recommended that section 355(g) exclude accounts receivable from the definition of investment assets to the extent they are offset by accounts payable.[l] Moreover, there have been suggestions that the government verify that investment assets the distributing corporation will transfer to creditors or shareholders as part of the plan of distribution will not be taken into account for purposes of section 355(g).[li] Furthermore, critics suggest that non-investment assets acquired with investment assets should not be treated as investment assets as long as the non-investment assets are related to the business that such corporation conducts.[lii] An additional criticism levied against the scope of the definition of investment assets in section 355(g) is in reference to the eighth entry in the enumerated list which states “Any similar asset.”[liii] There is no suggestion in the code, absent a provided exception, of how an asset is similar or not similar to the enumerated investment assets based on the language of the statute.[liv]
Another issue critics have identified as seemingly unclear is the interaction of section 355(g) with the device requirement of section 355.[lv] As a result of their similar inquiries, critics have asked for the government to confirm that a transaction that does not trigger section 355(g) due to an acceptable investment assets component would not also be susceptible to a contention that the same acceptable investment assets component suggests presence of a device for the distribution of earnings and profits.[lvi]
In the end, despite these concerns, section 355(g) chugs along and in today’s economy, the next Janus-like transaction will have to take notice. But even without a perfected roadmap and an accrued back lot of transactional history fitting neatly enough under section 355(g) to appease the peculiarities of all future individual transactions, perhaps some certainty is gained by practitioners regarding the standpoint of the IRS. In the uncertain and ever evolving world of section 355 following the repeal of General Utilities, the narrowing pathway to tax-free bliss perhaps will dote upon this somewhat measured certainty, even if begrudgingly and acceptingly alike. Perhaps.
[i] See Janus Capital Group, Inc. Form 8-K (SEC File #001-15253) (filed 8/26/03).
[ii]See Robert S. Bernstein, “Janus Capital Group’s Cash Rich Split-Off,” Corporate Taxation, (November-December 2003) at 39.
[iii] Id. at 39.
[iv] Id. at 39.
[v] Id. at 39; see also Yuka Hayashi, “Janus-DST Deal Plan Draws Mixed Reactions From Analysts,” Dow Jones Newswire (August 31, 2003).
[vi] Ginsburg & Levin, Mergers, Acquisitions and Buyouts at 10-5 (January 2008).
[vii] Id. at 10-5.
[viii] Id. at 10-5, 10-6; See Bernstein at 39.
[ix] See I.R.C. 355; see also Ginsburg & Levin at 10-5, 10-6; see also Bernstein at 39.
[x] I.R.C. 355; See I.R.C. 1(h)(11)(A); see also I.R.C. 1(h)(3)(B), (11); see also I.R.C. 311.
[xi] General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935).
[xii] I.R.C. 311(b); See Ginsburg & Levin at 22.
[xiii] I.R.C. 311(b).
[xiv] I.R.C. 355; See Ginsburg & Levin at 23.
[xv] I.R.C. 355; See Treas. Reg. 1.355-2(b)(2); see also Treas. Reg. 1.355-2(c); see also Treas. Reg. 1.355-1(b).
[xvi] I.R.C. 355(a)(1)(A)(i), (ii).
[xvii] I.R.C. 368(c).
[xviii] I.R.C. 355(a)(1)(D)(i), (ii) (If the distributing corporation retains stock in the controlled corporation, it must establish that its retention of the stock was not principally to avoid taxes); See Treas. Reg. 1.355-2(e).
[xix] I.R.C. 355(b)(2)(B), (C), (D); See Rev. Rul. 2002-49, 2002-2 C.B. 288; see also I.R.C. 355(b)(2)(D)(i), (ii); see also Treas. Reg. 1.355-3(a)(i), (ii).
[xx] See Treas. Reg. 1.355-3(b)(2)(ii), (iii).
[xxi] I.R.C. 355. see also Bernstein at 40.
[xxii] Treas. Reg. 1.355-1(b).
[xxiii] See Bernstein at 39.
[xxiv] See Treas. Reg. 1.3552(b)(1).
[xxv] 293 U.S. 465 (1935); See Treas. Reg. 1.355-2(b)(2); see aslo Rev. Proc. 2003-48, sec. 4.01(1), 2003-29 I.R.B. 86, 88 (the IRS will not issue advance rulings on whether a section 355 transaction has a business purpose).
[xxvi] Treas. Reg. 1.355-2(b)(2).
[xxvii] See Bernstein at 40.
[xxviii] Id. at 40; See DST Systems, Inc. Form 8-K (SEC File #001-14036) (filed 8/26/03).
[xxix] Id. at 40; See Rev. Proc. 96-30, 1996-2 CB 300, Appendix A.
[xxx] I.R.C. 355(a)(1)(B); See Rev. Rul. 77-377, 1977-2C.b. 111, 111 (“the purpose of the device restriction of section 355(a)(1)(B) of the Code is to prevent the use of section 355 to avoid the dividend provisions of the Code.”).
[xxxi] Treas. Reg. 1.355-2(d)(1).
[xxxii] See Treas. Reg. 1.355-2(d)(2)(ii)-(iv).
[xxxiii] See I.R.C. 243; see also Treas. Reg. 1.355-2(d)(3)(ii)-(iv).
[xxxiv] See Treas. Reg. 1.355-2(d)(3)(ii).
[xxxv] See I.R.C. 243.
[xxxvi] H.R. REP. 109-455, 109th Cong. 2d Sess. 67, 69 (2006) (Conference Report); See Treas. Reg. 1.355-2(d)(5)(iv); see also Rev. Rul. 71-383, 1971-2 C.B. 180.
[xxxvii] See H.R. REP. 109-455, 109th Cong. 2d Sess. 67, 69 (2006) (Conference Report); see also Treas. Reg. 1.355-2(d)(5)(iii), (iv) (a distribution that results in capital gain treatment under section 302 to the shareholder such as a redemption that terminates shareholder’s interest is ordinarily not considered a device).
[xxxviii] I.R.C. 355; See Bernstein at 40.
[xxxix] See NYSBA 355(g) Report; see also Joint Committee on Taxation, Description of Revenue Provisions Contained in the President’s Fiscal Year 2007 Budget Proposal (JCS-1-06), March 2006 (identified various cash-rich split-off transactions including the Janus and DST exchange).
[xl] I.R.C. 355(g)(1)(A),(B).
[xli] I.R.C. 355(g)(1)(A), (B); See I.R.C. 355(g)(3) (50% or greater interest derives its meaning from section 355(d)).
[xlii] I.R.C. 355(g)(2)(A)(i).
[xliii] See I.R.C. 355(g)(2)(B)(ii) (exclude assets that are actively used in a lending, finance, banking, or insurance business, substantially all of the income of which is derived from unrelated parties (within the meaning of sections 267(b) or 707(b)(1)).
[xliv] I.R.C. 355(g)(2)(A)(i).
[xlv] See 355(d) (interest possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or at least 50 percent of the total value of shares of all classes of stock).
[xlvi] See I.R.C. 302(b)(1)-(4) (distribution that results in capital gain treatment to the shareholder such as a redemption that terminates shareholder’s interest); see also Treas. Reg. 1.355-2(d)(5)(iii), (iv) (redemption is ordinarily not considered a device).
[xlvii] See NYSBA 355(g) Report.
[xlix] See NYSBA 355(g) Report.
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