On December 16, 2016, the Treasury Department issued temporary regulations (TD 9805) (81 Federal Register 91738) on the application of Section 355(e) to predecessors and successors of the distributing corporation (Distributing) and the controlled corporation (Controlled) in a Section 355 spin-off. The most important development in the temporary regulations is that they expand the reach of Section 355(e) by broadening the definition of a "Predecessor of Distributing," (POD) compared to the definition that was provided by the proposed regulations issued in 2004 (REG-145535-02) (2004 Proposed Regulations).

In addition to defining the terms "predecessor" and "successor," the temporary regulations limit the amount of gain recognized under Section 355(e) in the case of certain transactions involving PODs. The temporary regulations also prevent Section 355(f) from overriding the benefit of the gain limitation rule in the case of certain intra-group distributions, and provide some clarification regarding elections under Section 336(e) for gain recognized under Section 355(e).

Effective date

The temporary regulations generally apply to distributions occurring after January 18, 2017. However, under a transition rule, the temporary regulations do not generally apply to distributions:

A. Made pursuant to a binding agreement in effect on or before December 16, 2016 and at all times thereafter
B. Described in a PLR request submitted to the IRS on or before December 16, 2016
C. Described on or before December 16, 2016 in a public announcement or an SEC filing

The transition rule only applies if all related pre-distribution transactions that together effect a division of the assets of a POD (i.e., the steps relevant to the determination of POD status) are described in such agreement, PLR request, announcement — or SEC filing.

In addition, taxpayers and their affiliates are permitted to apply the temporary regulations to distributions occurring after November 22, 2004, provided the temporary regulations are applied consistently to all distributions occurring after November 22, 2004 that are pursuant to the same plan.

Section 355(e)

Section 355 generally provides nonrecognition treatment to Distributing and its shareholders for spin-offs of Controlled that meet numerous statutory and regulatory requirements. Section 355(e) denies such nonrecognition treatment if the spin-off is part of a plan pursuant to which one or more persons acquire a 50% or greater interest (i.e., stock) in Distributing or Controlled.

The main purpose of the temporary regulations is to identify the planned acquisition of corporations (i.e., predecessors and successors) whose stock should be taken into account under Section 355(e). As further described below, the temporary regulations treat planned acquisitions of a POD and planned acquisitions of successors of Distributing and Controlled in a manner similar to planned acquisitions of Distributing and Controlled. For example, for purposes of determining whether there has been a planned acquisition of 50% of the stock of Distributing under Section 355(e)(2)(A)(ii), a planned acquisition of the stock of a successor of Distributing is treated as though it were a planned acquisition of the stock of Distributing itself.

Predecessor of Distributing

In general, the temporary regulations treat a corporation as a POD if:

1. An asset or assets of the corporation are transferred directly or indirectly to Distributing as part of a plan involving a spin-off and the spin-off results in a separation of the corporation's assets between the corporation or Distributing and Controlled
2. Gain is not fully recognized on the assets that are transferred from the corporation to Distributing and then to Controlled as part of the plan

The formal definition of a POD, however, is relatively elaborate and contains numerous defined terms. Generally, Temporary Regulation Section 1.355-8T(b)(1) describes two sets of facts that must exist before and immediately after a spin-off in order for a corporation (a Potential Predecessor of Distributing) to constitute a POD. Thus, a Potential Predecessor of Distributing is a POD if the following requirements are met:

Pre-distribution requirements

As part of a plan:

1. Distributing directly or indirectly acquired some of the distributed Controlled stock in exchange for a direct or indirect interest in "Relevant Property."
2. Controlled directly or indirectly held the Relevant Property immediately before the distribution.
3. The gain on the Relevant Property transferred to Controlled was not recognized in full as part of a plan involving the spin-off.

In addition, the temporary regulations require that any Controlled stock distributed in the distribution reflects the basis of any "Separated Property."

Post-distribution requirement

1. Immediately after the distribution, direct or indirect ownership of Relevant Property has been divided between Controlled and Distributing or the Potential Predecessor.

For purposes of these requirements, "Relevant Property" is any property held directly or indirectly by the Potential Predecessor during the "Plan Period." The "Plan Period" generally is the period that (1) begins when any pre-distribution step is first agreed to, understood, arranged, or substantially negotiated and (2) ends immediately after the distribution. "Separated Property" is generally Relevant Property (or an indirect interest therein) that is exchanged by Distributing with Controlled in exchange for Controlled stock as part of a plan.

Treas. Reg. Section 1.355-8T(a)(3) summarizes the foregoing rules with this overview:

"A corporation generally will be a POD if as part of a Plan the distribution accomplishes a division of the assets that the corporation directly and indirectly held during the Plan Period; that division occurs through transfers, as part of a Plan, resulting in Controlled directly or indirectly holding some but not all of those assets immediately after the distribution; and all of the gain on that corporation's assets directly or indirectly held by Controlled is not recognized before the distribution."

Thus, the movement of the Potential Predecessor's asset to Distributing and Controlled must occur pursuant to a plan in order for a Potential Predecessor to be a POD. The preamble to the temporary regulations acknowledges the free-form nature of the POD definition, stating that "[n]o specific transactional form is required with regard to the transfer of assets to Controlled, although such transfers must be made as part of a plan."

Like the 2004 Proposed Regulations, the temporary regulations alternatively provide that a Potential Predecessor of Distributing that transfers Controlled stock to Distributing may be a POD even if none of the Potential Predecessor's assets are ultimately transferred to Controlled. Like the general definition of a POD, the alternative definition requires that there be a division of the Potential Predecessor's assets in the overall transaction. Generally, under the alternative definition, the Potential Predecessor's assets are divided as a result of the spin-off so long as not all of its assets are transferred to Controlled.

In keeping with the relative breadth of the POD definition, the temporary regulations treat a successor of a Potential Predecessor of Distributing as a Potential Predecessor of Distributing and a Predecessor of a POD as a POD.

Application of the Section 355(e) plan rules

As noted, the general and the alternative definitions of a POD require that the steps that are relevant to the determination of POD status occur pursuant to a plan. The temporary regulations define the term "plan" for this purpose by reference to the definition in Treas. Reg. Section 1.355-7, subject to certain modifications. In applying Treas. Reg. Section 1.355-7, however, references to a "distribution" in that regulation include the related pre-distribution steps that together effect a division of the assets of a POD. In addition, the temporary regulations provide that in determining whether an acquisition of a POD is part of a plan, only an agreement, understanding, arrangement or substantial negotiations (AUASN) engaged in by Distributing, Controlled, their controlling shareholders, or persons acting with their permission, are taken into account. An AUASN conducted by the POD itself (or its representatives) would only be taken into account to the extent that it were acting on behalf of Distributing or Controlled (e.g., as a controlling shareholder).

Separate register of planned acquisitions for a POD and gain recognition limitations

The preamble to the temporary regulations characterizes the tax-free separation of the POD's assets that occurs in the Section 355 transaction as a mini-spin-off or "synthetic spin-off" by the POD. Accordingly, the temporary regulations effectively require the maintenance of a separate register of planned acquisitions of a POD so that Section 355(e) may be applied to Distributing's synthetic spin-off of the POD's assets in the Section 355 distribution of Controlled.

In addition, the temporary regulations provide a limitation on Distributing's Section 355(e) gain recognition if there are planned acquisitions of 50% of the stock of a POD but not of Distributing or Controlled. In such a case, the temporary regulations limit Distributing's gain recognition to the lesser of:

1. The full amount described in Section 355(c)(2) or 361(c)(2), as applicable
2. The amount that would be recognized in a hypothetical transaction in which Distributing transferred all the Separated Property that Distributing received from the POD to a newly formed corporation in exchange solely for stock of such corporation in a reorganization under Section 368(a)(1)(D) and then distributed the stock of the hypothetical corporation to the shareholders of Distributing in a transaction to which Section 355(e) applied

More limited gain recognition relief is provided for situations in which there is a planned 50% acquisition of Distributing but not of the POD. However, such relief is only available where the 50% acquisition of Distributing occurs in a Section 381 transaction in which Distributing acquires the assets of a POD. Moreover, the temporary regulations might allow for scenarios in which the direction of a merger between a putative POD and a smaller Distributing will determine the amount of gain recognized in the distribution, even though the assets distributed and the shift in stock ownership between the two corporations are identical.

As noted above, because the applicable gain recognition rule can vary depending on whether there is a planned 50% acquisition of a POD or Distributing, the temporary regulations effectively require separate tracking of stock acquisitions of PODs as well as of Distributing itself. The separate tracking of acquisitions of the POD continues even after the POD is acquired in a Section 381 transaction by another corporation, including Distributing. If Distributing is a Section 381 successor to a POD, then planned acquisitions of Distributing stock after the Section 381 transaction are taken into account as acquisitions of both the POD and Distributing, in their respective, separate registers.

Section 355(f)

Section 355(f) provides that Section 355 does not apply to the distribution of stock from one member of an affiliated group to another if the distribution is part of a plan described in Section 355(e)(2)(A)(ii) determined after the application of Section 355(e). Absent the temporary regulations, if an intra-group spin by D1 of C1 to D2 (all members of the same affiliated group) is followed by a spin of C1 by D2 outside of the group and, if the intra-group spin is part of a plan involving a 50% acquisition of a POD1 (but not of D1 itself or C1), then Section 355(f), by turning off Section 355 with respect to the intra-group spin, would prevent the gain limitation rule from applying to the intra-group spin of C1. The temporary regulations allow taxpayers to apply the gain limitation rule to D1's spin of C1 or alternatively to apply Section 355(f) to such distribution, assuming that Section 355(f) is then consistently applied to distributions within the group that are part of the same plan.

Predecessor of Controlled

Like the 2004 Proposed Regulations under Section 355(e), the temporary regulations generally do not identify a predecessor of Controlled as an entity whose acquisitions must be tracked in applying Section 355(e)(2)(A)(ii) to acquisitions of Controlled stock (i.e., in ascertaining whether there has been a planned acquisition of 50% of Controlled stock). Instead, the temporary regulations employ a predecessor of Controlled concept solely for purposes of applying Section 355(e)(2)(C). Section 355(e)(2)(C) provides that if, immediately after the completion of acquisitions that would otherwise be part of a plan under Section 355(e), Distributing and Controlled are members of a single affiliated group under Section 1504(a) without regard to Section 1504(b), then such acquisitions are not part of a plan under Section 355(e)(2)(A)(ii). Under the temporary regulations, the fact that a predecessor of Controlled is no longer in existence does not prevent Section 355(e)(2)(C) from providing relief.

Successors

The temporary regulations treat corporations that acquire the assets of Distributing or Controlled after the distribution in a Section 381(a) transaction as a successor of Distributing or Controlled, respectively. The regulations allow for multiple successors, in the event of successive Section 381 transactions. With respect to asset transfers by Distributing or Controlled to joint ventures, the preamble to the temporary regulations states that "[a]lthough the Treasury Department and the IRS continue to study this issue, the temporary regulations treat as a Successor for Section 355(e) purposes only a transferee to which Distributing or Controlled transferred its assets in a Section 381 transaction after a distribution."

Section 336(e)

The temporary regulations clarify that Distributing generally is not eligible to make a Section 336(e) election with respect to a distribution to which the temporary regulations apply unless, absent the election, Distributing would be required to recognize the Statutory Recognition Amount in the distribution under Treas. Reg. Section 1.355-8T(e)(2), (3) and (4). The temporary regulations define the Statutory Recognition Amount as the amount of gain recognized under Section 355(c)(2) or Section 361(c)(2), as applicable.

Implications

The new definition of a POD has not previously been subject to notice and comment and will become applicable to distributions occurring after January 18, 2017, subject to a grandfather rule. Close scrutiny of the temporary regulations is necessary to determine the exact scope of the definition. The regulations themselves offer an example in which an unrelated corporation transfers property to Distributing in exchange for 10% of Distributing's stock as part of a larger Section 351 transaction. Because such property is then transferred by Distributing to Controlled (which is spun off) as part of the same plan, the new 10% shareholder is treated as a POD. Another example in the temporary regulations treats, as a POD, a corporation that owns stock of a second corporation that merges into Controlled in a forward triangular reorganization described in Section 368(a)(1)(A) and Section 368(a)(2)(D) in exchange for stock of Distributing, where Distributing wholly owns Controlled. It also should be noted that because a POD may remain in existence indefinitely, and because the plan period does not end until immediately after the spin-off, heightened vigilance regarding the movement of assets into and out of the POD (and ultimately to Controlled) is necessary.

Regarding the application of the plan rules of Treas. Reg. Section 1.355-7 to acquisitions of PODs, the temporary regulations provide general principles regarding the application of the plan rules to POD acquisitions. However, questions are bound to arise. For example, if the plan to acquire stock of a Potential Predecessor of Distributing relates only to the separation of one asset of such corporation but instead a different asset of such corporation is separated, is the POD definition satisfied? A similar question is presented by the gain limitation rules for planned 50% acquisitions of a POD. The gain is limited to the built-in gain in Separated Property, but the definition of Separated Property appears to include only the property of the POD that is separated as part of a plan, rather than all of the property of the POD that is ultimately transferred to Controlled.

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