Revised Temp. Regs. May Ease Anti-Morris Trust Rule Effects

The IRS issued revised Temp. Regs. Sec. 1.355-7T, effective for distributions after April 26, 2002. However, taxpayers can apply it in whole (but not in part) to distributions occurring after April 16, 1997, and on or before April 26, 2002. Temp. Regs. Sec. 1.355-7T uses the 2001 proposed regulations in many important ways.

Background

Congress enacted Sec. 355(e) in 1997 to ensure that a distributing corporation would recognize gain when new shareholders acquired control of a distributing or controlled corporation in connection with an otherwise tax-free spin-off. Sec. 355(e) would require the distributing corporation to recognize gain on the distribution of a controlled corporation if pursuant to a plan or series of related transactions, one or more persons acquire a 50% or greater interest in either the distributing or the controlled corporation.

Prior to Sec. 355(e), a distributing corporation could have an ownership change in connection with a Sec. 355 distribution by combining the distribution with a tax-free reorganization, thereby avoiding the limits on tax-free Sec. 355 distributions. This type of transaction is referred to as a "Morris Trust transaction," after Mary Arch W. Morris Trust, 367 F2d 794 (4th Cir. 1966).

In August 2001, the Service issued temporary regulations, almost identical to previously issued proposed regulations that defined a plan or a series of related transactions for purposes of the anti-Morris Trust statutory provision. The regulations contained a number of safe harbors that planners could use to avoid triggering gain recognition under Sec. 355(e).

The Facts-and-Circumstances Test

The prior regulations identified a number of facts and circumstances that tend to establish whether a distribution and a subsequent acquisition are part of a plan. For an acquisition following a distribution, both the distribution and acquisition would be part of a plan if the distributing and the controlled corporations (or any of their controlling shareholders) intended the acquisition (or a similar acquisition) to occur in connection with the distribution on the distribution date. Generally, the test emphasized whether bilateral discussions, agreements or arrangements about the acquisition occurred prior to the distribution.

Temp. Regs. Sec. 1.355-7T(b)(2) retains this understanding. Besides an acquisition involving a public offering, a distribution and a post-distribution acquisition would be part of a plan only if an agreement, understanding, arrangement or substantial negotiations about the acquisition (or a similar acquisition) existed at any time during a two-year period ending on the distribution date. In light of this, the revised temporary regulations delete the provision in the 2001 proposed regulations that a business purpose would exist if within six months after the distribution, an acquisition occurred, or an agreement, understanding, arrangement or substantial negotiations existed (the "reasonable certainty rule").

However, all facts and circumstances must be considered. For example, if a distribution was motivated by a corporate business purpose other than facilitating an acquisition (or a similar acquisition), and occurred at approximately the same time and in a similar form, regardless of whether the acquisition (or a similar acquisition) was effected, the taxpayer might be able to establish that the distribution and the acquisition were not part of a plan (Temp. Regs. Sec. 1.355-7T(b)(2)). This should make it easier to avoid taxation of a distribution using the general facts-and-circumstances test.

Similar Acquisition

The prior regulations also provided that an acquisition and an intended acquisition may be similar, even though the identity of the acquirer, the acquisition’s timing or the actual acquisition’s terms are different from the intended acquisition. Temp. Regs. Sec. 1.355-7T(h)(8) has a narrow definition of "similar acquisition." In general, an actual acquisition is similar to another potential acquisition if the actual acquisition resulted in a direct or indirect combination of all or a significant portion of the same business operations as the combination that would have been effected by such other potential acquisition. Thus, an actual acquisition might be similar to another acquisition, even if the timing or terms of the actual acquisition are different from those of the other acquisition (Temp. Regs. Sec. 1.355-7T(h)(8)). This reverses the conclusion of Example 7 in the prior regulations.

Substantial Negotiations

The revised temporary regulations provide a definition, absent from the prior regulations, of substantial negotiations. Substantial negotiations generally require discussions of significant economic terms. For example, in a reorganization, the exchange ratio between one or more officers, directors or controlling shareholders of a distributing or a controlled corporation (or another person or persons with the implicit or explicit permission of one or more officers, directors or controlling shareholders of the distributing corporation or a person who has the permission of the distributing corporation) may be significant (Temp. Regs. Sec. 1.355-7T(h)(1)(ii)). Thus, both the content of the discussions and the persons engaging in them have a bearing on whether negotiations are considered substantial.

Safe Harbors

Safe Harbors I and II of the prior regulations ensured that a distribution and later acquisition would not be treated as part of a plan if, among other conditions, the acquisition occurred more than six months after the distribution, and no agreement, understanding, arrangement or substantial negotiations existed within six months after the distribution. Thus, the safe harbors would not be available if an agreement, understanding, arrangement or substantial negotiations existed at any time prior to the distribution. Under the prior temporary regulations, some practitioners believed that if relevant parties engaged in substantial negotiations prior to the distribution, Safe Harbors I and II would still be available, as long as the negotiations terminated without an agreement prior to the distribution and did not resume until six months or a year after the distribution.

Under Temp. Regs. Sec. 1.355-7T (d)(1)(ii), an agreement, understanding, arrangement or substantial negotiations would make Safe Harbors I and II unavailable only if they occurred during the period beginning one year before the distribution and ending six months after.

Safe Harbor I of the prior regulations was only available if "[t]he distribution was motivated in whole or in substantial part by a corporate business purpose (within the meaning of 1.355-2(b)), other than a business purpose to facilitate an acquisition of the acquired corporation (Distributing or Controlled)." The revised temporary regulations provide that in testing whether an acquisition qualifies for the safe harbor, only acquisitive business purposes related to the acquired corporation would be relevant.

Safe Harbor II of the prior regulations was available only when (1) the amount of a distributing corporation’s or a controlled corporation’s stock (provided an acquisition business purpose exists) was not more than 33% of the distributing corporation or the controlled corporation and (2) not more than 20% of the acquired corporation was acquired within six months after the distribution. Put simply, the revised temporary regulations eliminate the quantitative restriction of the first prong and increase the percentage of the stock in the second prong to 25%.

Further, for purposes of the second-prong test, only stock acquired or the subject of an agreement, understanding, arrangement or substantial negotiations at some time during the period beginning one year before the distribution and ending six months after it, other than stock acquired in certain safe-harbor transactions, counted (Temp. Regs. Sec. 1.355-7T(d)(2)).

Subject to certain exceptions, Safe Harbor V of the prior regulations provided that an acquisition of stock of a distributing or a controlled corporation listed on an established exchange would not be part of a plan if it occurred pursuant to a transfer between shareholders of the distributing corporation or the controlled corporation, as long as neither is a 5% shareholder. Some commentators have suggested that the trading activities of shareholders who do not actively manage a corporation should not cause an acquisition and a distribution to be treated as part of a plan. The Service agreed; Temp. Regs. Sec. 1.355-7T(d)(5) extends the availability of the safe harbor to persons who are neither controlling shareholders nor 10% shareholders immediately before or after a transfer.

Finally, the Service added a new safe harbor, VII, which provides that an acquisition of stock of a distributing or controlled corporation by a qualified retirement plan is part of a plan that includes a distribution (Temp. Regs. Sec. 1.355-7T(d)(7)).

Conclusion

In general, the changes to the revised temporary regulations, particularly the safe harbors, are more favorable (and, thus, more valuable) for planning purposes than the prior temporary regulations.

From B. Todd Hetzer, CPA, Louisville, KY