The IRS has issued guidance addressing certain "North-South" transactions occurring in connection with spin-off transactions.

Revenue Ruling 2017-09 addresses two scenarios. In Situation 1, the IRS considers whether a "southbound" property transfer to a distributing corporation (D) by D's sole shareholder (P) should be respected as separate from the subsequent "northbound" transfer by D of the stock of its controlled subsidiary (C) to P, or whether the two transfers should be treated as having been made in exchange for each other for federal income tax purposes. In Situation 2, the IRS similarly addresses whether to integrate a northbound property transfer by C to D with a subsequent southbound property transfer by D to C that is described in Section 368(a)(1)(D) and which is followed by a Section 355 distribution of the C stock.

Situation 1

Facts

P owns all of the stock of D; D, in turn, owns all of the stock of C. The value of the C stock is $100. To satisfy the active business requirement of Section 355, D will rely on Business A, which has been conducted directly by P for more than five years. Thus, on Date 1, P transferred the Business A assets to D in exchange for additional shares of D stock. The transferred Business A assets had a value of $25. On Date 2, as part of the same overall plan, D transferred all of the stock of C to P.

At issue is whether P's transfer of the Business A assets to D and D's transfer of C stock to P should be respected as separate steps. If the steps are respected as separate, P would be treated as having transferred the Business A assets to D on Date 1 in an exchange to which Section 351 applies, and D would be treated as having distributed the stock of C to P on Date 2 in a distribution to which Section 355 applies. However, if the steps are integrated, D would be treated as transferring the C stock in exchange for the assets contributed by P, to the extent of the value of those assets. Thus, P and D would each recognize gain or loss under Section 1001 on the exchange of the Business A assets for 25% of the C stock. Moreover, as to the remaining 75% of the C stock, because D would not be treated as distributing stock constituting Section 368(c) control, the distribution would not satisfy the requirements of Section 355. Accordingly, D would recognize gain (but not loss) on the distribution of 75% of the C stock under Section 311(b), and Section 301 would apply to P's receipt of such stock.

Revenue Ruling 2017-09 states that in determining whether steps of a transaction should be integrated:

"[t]he tax treatment of a transaction generally follows the taxpayer's chosen form unless: (1) there is a compelling alternative policy; (2) the effect of all or part of the steps of the transaction is to avoid a particular result intended by otherwise-applicable Code provisions; or (3) the effect of all or part of the steps of the transaction is inconsistent with the underlying intent of the applicable Code provisions."

With respect to Situation 1, the relevant code provisions are Section 355(b)(2)(C) and (D) and Section 351. Section 355(b)(2)(C) and (D) generally allow a taxpayer to satisfy the active business requirement of Section 355 with a five-year old active business acquired within the five-year period preceding the spin-off, provided the acquisition occurred in a transaction in which no gain or loss was recognized. The ruling states that "[t]hese provisions ensure that transfers of assets in transactions eligible for nonrecognition treatment … will not adversely impact an otherwise qualifying [Section] 355 distribution." Thus, the ruling states that the "transfer of property permitted to be received by D in a nonrecognition transaction has independent significance when undertaken in contemplation of" a spin-off by D and concludes that the contribution "is respected as a separate transaction, regardless of whether the purpose of the transfer is to qualify the distribution under [Section] 355(b)(2)(C)."

The ruling goes on to say that the transfer by P is the type of transaction to which Section 351 is intended to apply, and the transaction as a whole does not indicate that P's transfer should be recharacterized: each step provides for continued ownership in modified corporate form; the steps do not resemble a sale; and no ownership interests are liquidated or otherwise redeemed. Thus, because the effect of the two steps is consistent with the policies underlying Sections 351 and 355, the steps should be respected as separate. Section 351 should apply to P's contribution on Date 1, and Section 355 should apply to D's distribution on Date 2.

Importantly, the ruling also notes that the steps would be similarly respected if, instead of acquiring an active business from P, D acquired an active business from a subsidiary of P in a cross-chain reorganization under Section 368(a)(1).

Situation 2

Facts

P owns all of the stock of D; D, in turn, owns all of the stock of C. On Date 1, C transferred $15 cash and property with a value of $10 to D. On Date 2, D transferred property with a value of $100 and an adjusted basis of $20 to C. Thereafter, D distributed all of the stock of C to P. The Date 1 transfer by C was made in pursuance of the plan of reorganization.

At issue is whether the transfer by C on Date 1 is governed by Section 301 or by Section 361(b). This, in turn, depends on whether the transfer by C and the transfer by D should be respected as separate, or integrated. If respected, Section 301 would apply to D's receipt of property from C on Date 1, and under Section 361(a) no gain or loss would be recognized as a result of D's transfer or contribution of property to C on Date 2. If integrated, the money and other property transferred to D would constitute boot in the reorganization. Under Section 361(b)(1)(B), D would recognize gain on its Date 2 transfer to C to the extent of such boot, provided D does not "purge" the boot through a distribution to P or (subject to the basis limitation in Section 361(b)(3)) a transfer to D's creditors.

The ruling provides that because the Date 1 transfer by C was made in pursuance of a plan of reorganization, Section 361 treats the transfer as having been made in exchange for the property transferred by D to C on Date 2.

Revocation of the No-Rule Policy with respect to North-South Transactions

Finally, Revenue Ruling 2017-09 modifies Revenue Procedure 2017-3 by deleting Section 5.02, thus revoking the IRS's no-rule policy with respect to the steps in a north-south transaction.

Implications

Situation 1 of Revenue Ruling 2017-09 provides welcome relief to corporations engaging in internal spin-offs. Note, however, that the ruling does not expressly address a fact pattern in which the value of the southbound property transferred by P to D has a value that is worth 20% or less of the value of the C stock (where C has only one class of stock and 100% of the C stock is distributed).

Corporations engaging in restructurings involving spin-offs will be interested in considering the interplay between Revenue Ruling 2017-09 and Revenue Ruling 70-18, in which D and a target corporation, both of which own C stock, are themselves commonly, wholly owned. The target corporation merges into D and then D distributes 100% of the C stock to the shareholder in a distribution that Revenue Ruling 70-18 respects as separate from the merger. Of similar interest is Revenue Ruling 57-114, in which D and a target corporation are each 50% owned by the same individual. In that ruling, the Service declined to respect the separateness of (i) D's issuance of D stock in the tax-free acquisition of the target corporation's assets from (ii) a split-off by D of an historic subsidiary to such individual in exchange for all of the individual's D stock, including the D stock received by the individual in the acquisition.

Situation 2 might be viewed as an overly broad application of step-transaction principles, because it treats as boot any distribution that is in pursuance of the plan of reorganization. Thus, it seems appropriate to limit the Situation 2 conclusion to similar facts and not extrapolate a more broadly applicable rule regarding the treatment of property issued in connection with other reorganization fact patterns. See, e.g., Reg. Section 1.301-1(l) and Revenue Rulings 71-266 and 69-443.

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