On July 14, 2016, the IRS issued proposed regulations (REG-134016-15) that would modify the device prohibition under Section 355(a)(1)(B) (Device Prohibition) and the active trade or business requirement of Section 355(b) (ATB Requirement). Previously, in Revenue Procedure 2015-43, 2015-40 I.R.B 467, and Notice 2015-59, 2015-40 I.R.B. 459, the IRS expressed concern that a spinoff involving a relatively small active trade or business and a large proportion of "investment assets" could present evidence of a device for the distribution of E&P, lack an adequate business purpose, or be used as a means of improperly circumventing General Utilities repeal (i.e., the general principle that a corporation should recognize gain on the distribution of appreciated assets to its shareholders).

Modifications to device prohibition

The proposed regulations would modify the corporate business purpose nondevice factor in Reg. Section 1.355-2(d)(3)(ii) and the nature and use of the assets device factor in Reg. Section 1.355-2(d)(2)(iv). Additionally, the proposed regulations introduce a new minimum threshold beyond which a transaction will be considered a device (Per Se Device Rule).

Rather than focusing on "investment assets" as utilized in Revenue Procedure 2015-43 and Notice 2015-59, the proposed regulations focus on "Business Assets" and "Nonbusiness Assets." Generally, Business Assets are gross assets used in an active trade or business without regard to the five-year requirement of Section 355(b), and Nonbusiness Assets are gross assets that are not Business Assets. Business Assets include cash and cash equivalents held as a reasonable amount of working capital, assets required to be held for exigencies, regulatory purposes, or to secure a financial obligation related to a business, and assets held to implement a binding commitment to expend funds or expand or improve a business.

The proposed regulations would modify the corporate business purpose nondevice factor in Reg. Section 1.355-2(d)(3)(ii) by providing that a corporate business purpose that relates to a separation of Nonbusiness Assets from one or more businesses or from Business Assets would not be evidence of nondevice, unless the business purpose involves an exigency that requires an investment or other use of the Nonbusiness Assets in a business.

The proposed regulations would also modify the nature and use of the assets device factor in Reg. Section 1.355-2(d)(2)(iv) by providing thresholds for determining when: (i) the ownership of Nonbusiness Assets by a distributing corporation (Distributing) or a controlled corporation (Controlled) or (ii) a difference between ratios of ownership of Nonbusiness Assets between Distributing and Controlled, will be considered evidence of a device. When: (i) each of Distributing's and Controlled's "Nonbusiness Asset Percentage" (i.e., a corporation's Nonbusiness Assets divided by its total assets) is less than 20%; or (ii) the difference in the Nonbusiness Asset Percentage of Distributing and Controlled is less than 10% (or a larger difference that is attributable to the need to equalize values in a split-off), such ownership or allocation of Nonbusiness Assets under a distribution will not ordinarily be considered evidence of a device.

Further, the Per Se Device Rule provides that if: (i) Distributing or Controlled has a Nonbusiness Asset Percentage of 66 2/3% or more and (ii) the difference between the Nonbusiness Asset Percentage of Distributing and Controlled is within one of three specified ranges (generally, when the Nonbusiness Asset Percentage of the corporation satisfying the first condition is roughly twice that of the other corporation), the distribution will be considered a device notwithstanding the presence of any other nondevice factors (i.e., the distribution will not qualify under Section 355).

The Per Se Device Rule does not apply when: (i) the distribution is to a domestic corporation that would, in the absence of Section 355, be entitled to an 80%-or-more dividends received deduction, (ii) the distribution would be described in Section 302(a) (or Section 303) in the absence of Section 355 (i.e., a split-off to an unrelated shareholder), or (iii) Distributing has no E&P as described in the existing device regulations.

In determining the amount of Business Assets and Nonbusiness Assets, the proposed regulations would allow corporations to look through: (i) partnerships whose business would be attributed to that corporation under the current rules of Section 355(b); and (ii) a corporate member of a "50-Percent-Owned-Group" (generally, a member of that corporation's separate affiliated group, but with a 50%, rather than 80%, ownership threshold).

New 5% minimum threshold for ATB requirement

Prop. Reg. Section 1.355-9 establishes a new 5% minimum threshold with respect to the ATB requirement. To satisfy the ATB requirement, the "Five-Year-Active-Business Asset Percentage" (i.e., the percentage determined by dividing the fair market value of a corporation's "Five-Year-Active-Business Assets" by the fair market value of its Total Assets) of each of Controlled and Distributing (and their respective separate affiliated groups) must be at least 5%. This requirement adopts the partnership look-through rules of the modified device requirement, but does not permit corporations to look through a 50-Percent-Owned-Group.

Timing considerations, anti-abuse rule, and effective date

For purposes of the modified device requirements and the new 5% minimum threshold, the relevant assets are those held by Distributing and Controlled immediately after the distribution, and the character of these assets would also be determined at that time. The fair market value of assets, however, would be determined, at the election of the parties on a consistent basis, either: (i) immediately before the distribution, (ii) on a particular day within the 60-day period before the distribution, (iii) on the date of an agreement with respect to the distribution that was binding on Distributing as of the date of the agreement and at all times thereafter, or (iv) on the date of a public announcement or filing with the Securities and Exchange Commission with respect to the distribution.

The proposed regulations contain broad anti-abuse rules that would disregard the effect of a transaction or series of transactions undertaken with a principal purpose of affecting the Nonbusiness Asset Percentage or the Five-Year-Active-Business Asset Percentage of any corporation in order to avoid a violation of the rules established in the proposed regulations.

The proposed regulations will generally apply to transactions occurring on or after the date on which the regulations are finalized, with transition relief exceptions for distributions: (i) undertaken pursuant to an agreement, resolution, or other binding corporate action on or before publication of final regulations; (ii) described in a ruling request submitted to the IRS on or before July 15, 2016; or (iii) described in a public announcement or filing with the SEC on or before publication of final regulations.

Implications

If finalized, the proposed regulations will limit the circumstances in which a distribution involving a corporation owning a large proportion of nonbusiness assets can qualify for tax-free treatment and require increased scrutiny regarding the nature, valuation, and allocation of assets involved in a tax-free distribution.

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