IRS Updates Ruling Policy on Corporate Business Purpose and Device Requirements under Section 355
The U.S. Internal Revenue Service (“IRS”) released Revenue Procedure 2016-45 (the “Revenue Procedure”) on August 26, 2016, permitting taxpayers once again to seek private letter rulings on issues of “corporate business purpose” and “device” under Section 355 of the U.S. Internal Revenue Code of 1986, as amended (dealing with tax-free spin-offs and related transactions). The corporate business purpose and device requirements under Section 355 have long been matters on which the IRS has preemptively declined to issue letter rulings or determination letters (these are commonly referred to as “no-rule” areas, the full list of which is reissued annually; see, e.g., Rev. Proc. 2016-3). The Revenue Procedure states that the IRS has determined that there are a number of unresolved legal issues relating to the corporate business purpose and device requirements that may be germane to determining the tax consequences of a transaction. As a result, the IRS will consider ruling requests, dated on or after August 26, 2016, related to the corporate business purpose and device requirements, subject to the overall standard requiring that the request present a “significant issue” and the general latitude of the IRS not to rule if, in their view, the facts and circumstances so warrant.
By removing these issues from the no-rule list, the IRS offers corporations considering a tax-free spin-off the possibility of significantly greater comfort on the U.S. federal income tax treatment of the transaction. The change in position may also reflect recognition by the IRS that while existing published and non-published guidance on corporate business purpose and device addresses many open issues in respect of these requirements of Section 355, significant issues remain that may merit seeking an IRS determination before a transaction proceeds.
The removal of corporate business purpose and device from the no-rule list follows on the heels of the July issuance of proposed regulations under Section 355 addressing the “device” and “active trade or business” requirements of Section 355. Notably, the Revenue Procedure does not specifically discuss whether questions about the application or interpretation of the new proposed regulations relating to device are amenable to ruling requests (indeed, the Revenue Procedure does not mention these proposed regulations at all). Click here for our client alert on the proposed regulations on “device” and “active trade or business”.
A brief background on private letter rulings and no-rule areas under Section 355 follows.
Background on Private Letter Rulings.
Generally, a taxpayer seeking a private letter ruling must pose specific questions on which the IRS is asked to rule. The usual standard is that the questions presented must involve significant unresolved legal issues – that is, legal (and not factual) issues for which the Internal Revenue Code, the Treasury Regulations and other published guidance do not settle the issue. Rulings on settled issues are commonly referred to as comfort rulings, and the IRS normally declines to provide comfort rulings to taxpayers. The IRS’s annual list of no-rule areas (and a second list of areas on which the IRS will not “ordinarily” rule) announces those areas that the IRS believes are either inherently factual in nature or for some other reason are not amenable to a ruling. As a practical matter, a taxpayer desiring comfort on a no-rule matter must seek an opinion of counsel instead. Although not without precedent, it is relatively uncommon for the IRS to remove a particular issue from the list of no-rule matters, and so the Revenue Procedure is notable on that basis alone.
No-rule areas under Section 355.
The IRS no-rule list for 2016, consistent with prior years, announced both a general limitation on private letter rulings on matters relating to various tax-free corporate transactions, including spin-offs, and specific no-rule areas relating to spin-offs. The general limitation is that the IRS only rules on “significant issues” involving these tax-free corporate transactions – meaning issues of law not “essentially free from doubt” and germane to determining the tax consequences of the transaction. The specific no-rule and “ordinarily” no-rule areas for Section 355 included:
the “corporate business purpose” requirement set forth in Treasury Regulations Section 1.355-2(b), which generally requires that a transaction intended to qualify as tax-free under Section 355 must have a corporate business purpose;
the “device” requirement set forth in Section 355(a)(1)(B), which generally requires that a transaction intended to qualify as tax-free under Section 355 not be principally a device for distributing the earnings and profits of the distributing corporation;
except for certain specific situations, whether a “plan” exists under Section 355(e), which generally requires gain recognition in connection with transactions where there is a plan to acquire 50%-or-greater control in either the distributing or controlled corporation (so-called Morris Trust transactions);
ordinarily, whether the “five year active business” requirement of Section 355(b) is met when cash (or other liquid or inactive assets) is transferred to the controlled corporation in a transaction intended to qualify as tax-free under Sections 351(a) or 368(a)(1)(D);
ordinarily, any issue relating to certain “conversion transactions” under Treasury Regulations Section 1.337-1(d) if property owned by any distributing corporation or any controlled corporation becomes the property of a regulated investment company (RIC) or a real estate investment trust (REIT) in a conversion transaction;
ordinarily, except for certain specific situations, whether the “active trade or business” requirement of Section 355(b) is met where the gross fair market value of the assets of the trades or businesses on which the distributing corporation or the controlled corporation relies to satisfy the active trade or business requirement is less than 5% of the gross fair market value of the assets of such corporation; and
ordinarily, any “non-plan” issue under Section 355(e), except for certain specific situations where an adverse ruling on a non-plan issue would result in the existence of a plan under Section 355(e).
The Revenue Procedure announced that, subject to the significant issue standard applicable to tax-free corporate transactions generally, the IRS will accept requests for rulings (dated on or after August 26, 2016) on the “corporate business purpose” and “device” requirements. The other areas noted above (“plan” and “non-plan” under Section 355, “five-year active business,” “conversion transactions,” and “active trade or business”) remain on the no-rule / ordinarily no-rule list.