The new anti-Morris trust and intragroup spin provisions

Mark J. Silverman

Introduction

Since the repeal of the General Utilities doctrine in 1986,(1)(*) one of the only ways in which corporations may distribute appreciated property to their shareholders without recognizing corporate-level gain is through the use of spin-off type transactions under section 355 of the Internal Revenue Code.(2) Often, corporations undertake such spinoffs to dispose of unwanted businesses in preparation for a tax-free acquisition by another corporation. For more than 30 years, these so-called Morris Trust transactions have been blessed as tax free under section 355,(3) provided the requirements of section 355 were met. Not anymore. The Taxpayer Relief Act of 1997 (hereinafter cited as "the 1997 Act")(4) added section 355(e) and (f), which severely limit these transactions.

This article analyzes sections 355(e) and 355(f) and other related changes that were made by the 1997 Act. Specifically, the article first describes the new provisions and their history; then it analyzes the language of the statute in the context of several examples and in light of the legislative history; and finally it provides recommendations to Congress and to the Department of the Treasury regarding what issues require additional guidance.

Description of the Statute and Its History

Following is a brief description of the new statutory language and the history of these provisions.

Description of Statutory Language

On August 5, 1997, President Clinton signed the 1997 Act. Section 1012 of the 1997 Act amends section 355 to place new restrictions on the acquisition and disposition of the stock of the distributing or controlled corporation. Section 1012 of the 1997 Act contains four basic provisions: (i) an anti-Morris Trust provision,(5) which is contained in new section 355(e); (ii) an intragroup distribution provision, which is contained in new section 355(f), (iii) a related provision contained in new section 358(g) authorizing the Treasury to issue basis adjustment regulations under section 358; and (iv) a modified control provision, which amends sections 351(c) and 368(a)(2)(H).

Section 355(e) - The Anti-Morris Trust Provision

Under new section 355(e), the anti-Morris Trust provision, a distributing corporation will recognize gain if one or more persons acquire, directly or indirectly, 50 percent or more of the stock (measured by vote or value) of the distributing or any controlled corporation as part of a plan or series of related transactions that was in place at the time of the distribution.(6) The distributing corporation recognizes gain equal to the "built-in" gain in the controlled corporation stock held by the distributing corporation.(7) No adjustment to the basis of the stock or assets of either corporation, however, is allowed by reason of the gain recognition.(8) The statute also creates a rebuttable presumption that any acquisition occurring two years before or after a section 355 distribution is part of such a plan.(9) For purposes of determining whether one or more persons has acquired a 50-percent interest, the section 318(a)(2) attribution rules generally apply (without regard to the 50-percent threshold of section 318(a)(2)(C)), and the aggregation rules of section 355(d)(7)(A) apply so that all related persons are treated as one person.(10) Moreover, except as provided in regulations, if a successor corporation in an A, C, or D reorganization acquires the assets of the distributing or any controlled corporation, the shareholders (immediately before the acquisition) of the successor corporation are treated as if they acquired stock in the corporation whose assets were acquired.(11) In short, section 355(e) essentially eliminates Morris Trust-type transactions and overturns more than 30 years of well-settled tax law.

The statute does, however, include several exceptions. For example, the following acquisitions are not taken into account for purposes of the anti-Morris Trust provision:(12)

* The acquisition of stock in the controlled corporation by the distributing corporation;

* The acquisition of stock in a controlled corporation by reason of holding stock in the distributing corporation;

* The acquisition of stock in any successor corporation of the distributing corporation or controlled corporation by reason of holding stock in such distributing or controlled corporation; and

* The acquisition of stock if the same shareholders own, directly or indirectly, 50 percent or more (measured by vote and value) of either the distributing or any controlled corporation before and after the acquisition.(13)

These exceptions apply only if the stock owned prior to the acquisition was not acquired as part of a plan to acquire a 50-percent or greater interest in either the distributing or controlled corporation.(14)

In addition, a plan (or series of related transactions) will not cause gain recognition under the new provision if, immediately after the completion of the plan or transaction, the distributing and controlled corporations are members of the same affiliated group.(15) The provision also does not apply to a distribution that would otherwise be subject to section 355(d), or a distribution pursuant to a title 11 or similar case.(16)

The anti-Morris Trust provision further authorizes Treasury to issue regulations necessary to carry out the purposes of the legislation, including regulations (i) providing rules where there is more than one controlled corporation, (ii) treating two or more distributions as one distribution, and (iii) providing rules similar to the substantial diminution of risk rules of section 355(d)(6) where appropriate for purposes of the legislation.(17) In addition, it extends the statute of limitations with respect to gain recognized under section 355(e), so that the statute does not expire until three years from the date the taxpayer notifies the Internal Revenue Service that the distribution occurred.(18)

For purposes of the anti-Morris Trust provision, any reference to a distributing or controlled corporation also refers to any predecessor or successor of the corporation.(19) Section 355(e) generally applies to distributions after April 16, 1997, unless certain transition rules apply.(20)

Section 355(f) -- Intragroup Distribution Provision

Under section 355(f), the intragroup distribution provision does not apply to any distribution of stock from one member of an affiliated group (whether or not the group files a consolidated return) to another member of such group, if the distribution is part of a plan or series of related transactions to which section 355(e) applies.(21) Section 1012(b)(2) of the 1997 Act also added section 358(g) to the Code, which authorizes Treasury to issue regulations to provide adjustments to the basis of group members' stock (whether or not section 355(e) applies) in order to reflect the proper treatment of intragroup distributions.(22) The intragroup distribution provision applies to distributions after April 16, 1997, unless certain transition rules apply.(23)

"Control Immediately After" Provision

Section 1012(c) of the 1997 Act relaxes the rule under sections 351 and 368(a)(1)(D) for determining control immediately after a section 355 transaction. Under the provision, shareholders receiving stock in a controlled corporation are treated as in control of the controlled corporation immediately after the distribution if they hold stock representing greater than a 50-percent interest by vote and value of such controlled corporation.(24) The former rule required 80 percent of the vote and 80 percent of each class of nonvoting stock as required by section 368(c). The statute does not, however, change the section 355 requirement that the distributing corporation distribute 80 percent of the voting power and 80 percent of each other class of stock of the controlled corporation in the transaction.(25) The change in the control test generally applies to transfers after August 5, 1997.(26)

History of the Statute

Administration's Budget Proposal

On February 6, 1997, the Clinton Administration, as part of its 1998 budget, proposed anti-Morris Trust legislation to be included in section 355(d).(27) The proposal would have required the distributing corporation (but not its shareholders) to recognize gain on the distribution of the stock of the controlled corporation, unless the direct and indirect shareholders of the distributing corporation, as a group, continued to own at least 50 percent of the total vote and value of both the distributing and controlled corporations at all times during the four-year period beginning two years before and ending two years after the distribution.(28)

In determining whether shareholders retain the requisite ownership of both corporations throughout the four-year period, acquisitions or dispositions of stock that are "unrelated" to the distribution would be disregarded. A transaction would be treated as unrelated if it were not "pursuant to a common plan or arrangement that includes the distribution."(29) For example, public trading of the stock in either the distributing or controlled corporation would be disregarded, even if the trading occurred in contemplation of the distribution.(30) Similarly, a hostile acquisition of the distributing or controlled corporation after the distribution would be disregarded -- but a friendly acquisition would generally be considered related to the distribution if it were pursuant to an arrangement negotiated (in whole or in part) prior to the distribution, even if it were subject to certain conditions (e.g., shareholder approval) at the time of the distribution.(31)

Archer/Roth/Moynihan Bill

On April 17, 1997, Representative Bill Archer, Chairman of the House Ways and Means Committee, introduced legislation in the House of Representatives(32) to restrict the use of section 355. Senator William Roth, Chairman of the Senate Finance Committee, and Senator Daniel Moynihan, Ranking Minority Member of the Senate Finance Committee, introduced identical legislation in the Senate on the same date.(33) Although the bill was similar to the President's budget proposal in that it would require recognition of corporate-level gain if either the distributing or controlled corporation were acquired, it differed in several important respects.

First, the proposal would have been added as a new subsection (e) to section 355, rather than as an addition to section 355(d).(34) Under proposed section 355(e), if a distribution were "part of a plan (or series of related transactions) pursuant to which a person acquires stock representing a 50-percent or greater interest in the distributing corporation or any controlled corporation (or any successor of either)," corporate-level gain would be recognized.(35) The import of the move from subsection (d) to subsection (e) was to make clear that an acquisition of the distributing or controlled corporation was not limited to "purchase" transactions as defined in section 355(d).(36) To coordinate the two subsections, the bill contained a provision that section 355(e) would not apply to any distribution to which section 355(d) applied.

Second, the bill did not limit corporate-level gain recognition to the distributing corporation. Rather, the bill provided that if the distributing corporation were acquired, gain would be recognized by the controlled corporation equal to the amount of gain that the distributing corporation would have recognized had it sold its assets for their fair market value immediately after the distribution. Conversely, if the controlled corporation were acquired, gain would be recognized by the distributing corporation equal to the amount of gain that the distributing corporation would have recognized had it sold the stock of the controlled corporation for its fair market value on the date of the distribution.(37)

Third, prohibited acquisitions were not limited to those occurring during the four-year period beginning two years before the distribution. Instead, if the distribution of the controlled corporation were part of a plan or series of related transactions pursuant to which a person acquired a 50-percent or greater interest in either the distributing or controlled corporation, gain would be recognized. There was, however, a rebuttable presumption that such an acquisition was pursuant to a plan or series of related transactions, if the acquisition occurred during the four-year period beginning two years before the distribution. Thus, although a plan was presumed to exist during the four-year period, a plan was not limited to the four-year period.

Fourth, a prohibited acquisition could occur with respect to the distributing or controlled corporation, or any successor thereof.

Fifth, the bill authorized Treasury to prescribe regulations necessary to carry out the purposes of the subsection, including regulations W providing for the application of section 355(e) where there is more than one controlled corporation, (ii) treating two or more distributions as one distribution, and (iii) providing for rules suspending the four-year period where stock is subject to a substantial diminution of risk.

Sixth, the bill extended the statute of limitations for the assessment of any deficiency attributable to gain recognized as a result of a prohibited acquisition to three years from the date the taxpayer notifies the IRS that the distribution occurred. Such a deficiency could be assessed within the three-year period, notwithstanding other provisions of law that would otherwise prevent assessment.

Finally, the bill added a new subsection (f) to section 355,(38) an extremely broad intragroup distribution provision, which did not appear in any form in the President's proposal. Subsection (f) provided that section 355, in its entirety, would not apply to the distribution of stock from one member of an affiliated group filing a consolidated return to another member of such group. The provision also required Treasury to issue regulations providing for proper adjustments for the treatment of such distributions, including adjustments to stock basis and earnings and profits.

The bill would apply to distributions made after April 16, 1997, unless certain transition rules applied.(39)

House Bill

On June 26, 1997, the House of Representatives passed a modified version of the Archer/Roth/Moynihan bill.(40) The House bill provided for a broader class of potential acquirers. The House bill's version of section 355(e) still provided for corporate-level gain recognition if a 50-percent or greater interest of either the distributing or controlled corporation is acquired pursuant to a plan or series of related transactions. Instead of the acquisition being by "a person" (as provided in the Archer/Roth/Moynihan bill), however, a prohibited acquisition could be made under the House bill by "1 or more persons ... directly or indirectly." The House bill also broadened the class of potential acquirees. The Archer/Roth/Moynihan bill provided that a prohibited acquisition could occur with respect to "the distributing corporation or any controlled corporation (or any successor)." The House bill, on the other hand, deleted the parenthetical reference to successor and added a new provision stating that "for purposes of this subsection, any reference to a controlled corporation or a distributing corporation shall include a reference to any predecessor or successor of such corporation."

In addition, the House bill added some new provisions. First, the House bill added a provision treating the acquisition of assets by a successor corporation in an A, C, or D reorganization (or any other transaction specified in Treasury regulations) as an acquisition of stock by the shareholders of such successor corporation. Although Chairman Archer's introductory statement to the Archer/Roth/Moynihan bill noted that "[i]t is anticipated that certain asset acquisitions would be treated as stock acquisitions,"(41) no such provision was included in that bill.

Second, although the House bill retained the exception for acquisitions of stock in any controlled corporation by reason of holding stock in the distributing corporation, it added three new exceptions for certain acquisitions, all of which appear in the final 1997 Act.

Third, the House bill modified the attribution rule for purposes of determining whether an acquisition has occurred. Rather than apply the entity attribution rules of section 318(a)(2) without regard to the 50-percent threshold in section 318(a)(2)(C), as in the Archer/Rath/Moynihan bill, the House bill applied section 355(d)(8)(A), which incorporates section 318(a)(2), but attributes stock owned by a corporation to its shareholder only if the shareholder owns 10 percent of the corporation.

Finally, the House bill added a provision amending the "control" requirement of sections 351 and 368(a)(1)(D) where the distributing corporation contributes appreciated assets to the controlled corporation in connection with the section 355 distribution. Under the proposal, the distributing corporation's shareholders need only hold more than 50 percent of the vote and value of the controlled corporation's stock following the distribution, as opposed to 80 percent of the vote and 80 percent of each class of nonvoting stock as currently required by section 368(c).(42)

Senate Bill

On June 27, 1997, the Senate approved a different version of the H.R. 2014 containing amendments to section 355. The Senate bill followed the House bill with respect to the anti-Morris Trust provision,(43) but it modified the intragroup distribution provision.(44) The Senate bill would make section 355 inapplicable to a distribution of stock within an affiliated group, regardless of whether the group files a consolidated return, but only if the distribution is part of a plan or series of related transactions that is described in section 355(e). In addition, similar to the House bill and the Archer/Roth/Moynihan bill, the Senate bill authorized Treasury to issue regulations providing for proper basis adjustments with respect to group members' stock. Unlike the House bill and the Archer/Roth/Moynihan bill, this authorization was not mandatory.

Taxpayer Relief Act of 1997

Section 1012 of the 1997 Act, as described above, essentially followed the Senate bill with certain modifications.

First, the 1997 Act modified the measurement and timing of gain recognition under section 355(e), so that regardless of whether the distributing or controlled corporation is acquired, gain is recognized by the distributing corporation immediately before the distribution, as measured by the appreciation in the stock of the controlled corporation.(45)

Second, the 1997 Act added a new exception for situations where the distributing and all controlled corporations are members of a single affiliated group immediately after the completion of the plan or transactions.(46) In addition, the 1997 Act modified the continuing control exception to provide that an acquisition does not require gain recognition if the same persons own more than 50 percent of the stock of the distributing corporation or any controlled corporation, directly or indirectly (rather than merely indirectly as in the House and Senate bills), before and after the acquisition.(47)

Third, the 1997 Act modified the attribution rule for purposes of determining whether an acquisition has occurred. The 1997 Act retained the application of the entity attribution rules of section 318(a)(2). However, rather than apply the 10-percent threshold of section 355(d)(8)(A) for purposes of attributing stock ownership from a corporation, as in the House and Senate bills, the 1997 Act provides that the corporate entity attribution rules of section 318(a)(2)(C) apply without regard to the 50-percent threshold.(48)

Finally, the 1997 Act clarified that section 355(f) applies with respect to an intragroup distribution only if section 355(e) in its entirety applies.(49)

Technical Corrections

The Tax Technical Corrections Act of 1997, which was marked up by the House Ways and Means Committee on October 9, 1997, is expected to address at least two of the provisions in section 355(e). The language of section 355(e)(3)(A) would be modified to clarify that the acquisitions described in subsections (i) through (iv) are not taken into account in determining whether there has been an acquisition of a 50-percent or greater interest in a corporation. Other transactions that are part of a plan or series of related transactions, however, could result in a prohibited acquisition.(50) In addition, the proposed Tax Technical Corrections Act changes the language of the continuing control exception of section 355(e)(3)(A).(51) Instead of providing that an acquisition does not require gain recognition "if shareholders owning directly or indirectly stock possessing" more than 50 percent of the vote and value "in the distributing or any controlled corporation before such acquisition own directly or indirectly stock possessing such vote and value in such distributing or controlled corporation after such acquisition," the exception would read, as follows:

(A) Except as provided in regulations, the following

acquisitions shall not be taken into account in

applying paragraph (2)(A)(ii):

(iv) The acquisition of stock in the distributing

corporation or any controlled

corporation to the extent that the percentage

of stock owned directly or indirectly

in such corporation by each person

owning stock in such corporation immediately

before the acquisition does not decrease.

Issues and Analysis

Purpose of Sections 355(e) and (f)

The legislative history of the 1997 Act points to several "abuses" at which sections 355(e) and (f) were aimed. First, section 355, which provides an exception to the repeal of the General Utilities doctrine, was intended to permit tax-free restructurings of several businesses among existing shareholders.(52) When new shareholders acquire some or all of either the distributing or controlled corporation, the transaction no longer looks like a mere restructuring, but rather like a sale of a business.(53) A few highly publicized transactions -- such as Viacom's spin-off of its cable company to TCI, General Motors' sale of Hughes Electronics to Raytheon, and Walt Disney's sale of its newspaper properties to Knight-Ridder -- contained features that caused the transaction to more closely resemble a sale. For example, one feature of such "disguised sale" transactions is that the corporation to be acquired borrows money or assumes a large amount of debt and distributes the proceeds of such debt to its shareholder or shareholders prior to a spin-off. Thus, upon the subsequent acquisition, the acquiring group inherits the debt of the acquired corporation, while the proceeds of such debt are retained by the "selling" group.(54) Another feature that has appeared in such transactions is a recapitalization of the interests of the old shareholders of the acquired corporation, converting their stock from common stock to nonvoting preferred stock or stock with voting rights that are disproportionate to the value of such stock, and the simultaneous issuance of voting common stock to the acquiring corporation.(55)

Congress's concern over "disguised sale" transactions is reminiscent of its reasons for enacting section 355(d) in 1990. Congress enacted section 355(d) in order to prevent so-called "mirror transactions."(56) The legislative history of section 355(d) states that Congress intended to prevent the avoidance of General Utilities repeal and the tax-free disposition of subsidiaries in transactions that resemble sales:

The provisions for tax-free divisive transactions

under section 355 were a limited exception to the

repeal of the General Utilities doctrine, intended

to permit historic shareholders to continue to carry

on their historic corporate businesses in separate

corporations. It is believed that the benefit of

tax-free treatment should not apply where the divisive

transaction, combined with a stock purchase

resulting in a change of ownership, in effect results

in the disposition of a significant part of the

historic shareholders' interests in one or more of

the divided corporations.(57)

Thus, the enactment of sections 355(e) and 355(f) can be seen as an attempt to complete what Congress had started when it enacted section 355(d). In fact, in the Administration's budgets for fiscal years 1997 and 1998, the Morris Trust repeal provision was included as an amendment to section 355(d).(58) It is important to note, however, that neither section 355(e) nor section 355(d) imposes a shareholder-level tax -- both sections impose only corporate-level taxes.

In addition, Congress was concerned that affiliated corporations could manipulate their outside bases through the use of tax-free intragroup distributions. For example, Congress was concerned that under the consolidated return regulations,(59) it is,possible to eliminate an excess loss account (ELA)(60) of a lower tier subsidiary, which creates the potential for the subsidiary to leave the group without recapture of the ELA, even though the group benefitted from the losses or distributions in excess of basis that lead to the existence of the ELA.(61) Moreover, Congress was concerned that the basis allocation rules of section 358(c) could result in inappropriate shifts of basis as a result of intragroup distributions. Section 358(c) currently requires that a shareholder's stock basis in its stock of the distributing corporation be allocated after a section 355 distribution between the stock of the distributing and controlled corporations in proportion to their relative fair market values. As explained in the 1997 Conference Report:

If a disproportionate amount of asset basis (as

compared to value) is in one of the companies

(including but not limited to a shift of value and basis

through a borrowing by one company and contribution of

the borrowed cash to the other), present law rules under

section 358(c) can produce an increase in stock basis

relative to asset basis in one corporation, and a

corresponding decrease in stock basis relative to asset

basis in the other company.(62)

Operation of Section 355(e)

Base Case

Section 355(e) applies if there is a section 355 distribution that is part of a plan pursuant to which a person or persons acquires, directly or indirectly, stock representing at least a 50-percent interest in the distributing corporation or any controlled corporation.

Example 1: A publicly traded corporation ("D") owns all

the stock of a controlled corporation ("C"). D has an

adjusted basis in its C stock of $100, and the fair market

value of its C stock is $150. In order to facilitate an

acquisition of D by a third corporation ("P"), D distributes

its C stock to its shareholders. Within two years, P

acquires all the stock of D in a section 368(a)(1)(B)

reorganization, with the shareholders of D receiving 40

percent of the stock of P in exchange for their D stock.

Under the facts of Example 1, D appears to recognize gain under section 355(e) in the amount of $50 (the amount of D's gain in its C stock), because the distribution of C was part of a plan under which P acquired a 50-percent or greater interest in D.(63)

The above example seems to be the type of transaction that Congress intended to tax. These simplified facts, however, do not address the numerous issues that arise in interpreting section 355(e). For example, what is a "plan?" What is a "related" transaction? What does "acquire" mean? What does the phrase "any controlled corporation" mean? These questions are not easily answered.

Distributions That Are "Part of a Plan"

a. What is a "Plan"?

Section 355(e) will only apply to a distribution that is part of a "plan" pursuant to which a person or persons acquire a 50-percent or greater interest in the distributing or any controlled corporation. A question thus arises concerning what constitutes a plan.(64) A senior staff member of the Joint Committee on Taxation recently stated that the legislative history intentionally omitted an explanation of what constitutes a plan.(65) The staff member further stated that whether a plan exists will "always be a matter of facts and circumstances."(66)

In discussing this issue, the staff member also noted that the legislative history does not include a statement exempting hostile takeovers, because it is difficult to determine when a hostile takeover becomes non-hostile.(67) A hostile takeover presents a peculiar problem in interpreting the meaning of the term "plan."(68) If a distributing corporation distributes a controlled corporation specifically to avoid a hostile takeover (a valid business purpose under Rev. Proc. 96-30),(69) but the distribution does not prevent such a takeover, the distributing corporation arguably can distribute the controlled corporation with no plan that another party would acquire 50 percent or more of the stock of the distributing or controlled corporation. In fact, its plan could be said to be the exact opposite -- to avoid such an acquisition. Factual difficulties arise, however, when trying to determine whether an acquisition is hostile or non-hostile. It remains to be seen how the IRS will interpret the term "plan" in the context of hostile takeovers.

b. Whose Plan is Relevant?

It must also be determined whose plan is relevant. Does the plan have to be the plan of the distributing or controlled corporation? Is the plan of the distributing corporation alone sufficient or do multiple parties need to be involved in the plan? Can the plan be the plan of a shareholder or multiple shareholders? Can the plan be the plan of the acquiring entity? Can the plan be the plan of one of the distributing or controlled corporation's officers or directors? What about the plan of an investment banker facilitating a distribution and acquisition?

The language in section 355(e) does not address these issues. Logic suggests that the relevant plan can be either the plan of the distributing corporation, the controlled corporation, or "significant" shareholders of the distributing corporation. It is unclear, however, whether a joint plan of two or more persons necessary or whether the plan of a single person is sufficient.(70) For example, if a distributing corporation distributes a controlled corporation for a valid business purpose, and such distribution has the effect of facilitating a potential merger of the distributing corporation with an as-yet unknown party, will the ultimate merger of the distributing corporation into a third party be pursuant to a plan? In addition, if multiple parties are involved, it is unclear whether the plans of the multiple 1 parties must be exactly the same.

Because Congress apparently passed the legislation in order to tax distributions that are part of related acquisitions, the relevant plan should include the plan of the decision-makers involved in carrying out the distribution, most notably, the distributing corporation. Since the distributing corporation's "significant" shareholders have influence over the transactions entered into by the distributing corporation, it seems likely that such shareholders' plan would also be relevant in addition to the plan of the distributing and controlled corporations. In contrast, the acquiring corporation's plan should not be relevant, since such acquirer, acting alone, has no direct influence over the distribution.(71)

c. A "Series of Related Transactions"

In order for section 355(e) to apply, there must be a plan "or series of related transactions." This phrase is not defined in section 355(e). What is a related transaction? Can there be a related transaction that is not part of a plan? Presumably, related means something more than just related in time. It remains to be seen how the IRS will interpret the phrase "related transactions."

d. Four-Year Presumption

Under section 355(e), a plan is presumed to exist if a person or persons acquire 50 percent or more of the distributing or any controlled corporation during the four-year period beginning two years before the distribution, unless it is established otherwise. Thus, the statute creates 4 rebuttable presumption if there is an acquisition within two years before or after the distribution. Furthermore, although the presumption does not apply beyond two years before or after the distribution, acquisitions beyond the four-year period still may be part of a plan, and thus may fall within section 355(e).

A number of questions arise when analyzing the four-year presumption. For instance, what evidence will be required to establish that there is no plan in order to overcome the presumption? The House and Senate Reports merely state that taxpayers may avoid gain recognition within the four-year period if they show that an acquisition "was unrelated to the distribution."(72) Will a representation that a plan did not exist suffice? What if there is an intervening event within the four-year period? Will that fact alone overcome the presumption? Is there an obligation to notify the IRS or file an amended return if there is an acquisition within the two-year period following the distribution?(73) It remains to be seen what positions the IRS will take regarding these issues.

One or More Persons "Acquire Directly or Indirectly" Stock

a. Definition of "Acquire"

In order for section 355(e) to apply, one or more persons must "acquire," directly or indirectly, stock representing a 50-percent or greater interest in the distributing or any controlled corporation. What does the term "acquire" include? The 1997 Conference Report states that whether a corporation is acquired "is determined under rules similar to those of present law section 355(d), except that acquisitions would not be restricted to `purchase' transactions."(74)

Section 355(d)(5) defines purchase as any acquisition, except carryover basis transactions and any transactions under sections 351, 354, 355, and 356. Because the legislative history explicitly states that the term "acquire" is not restricted to purchase transactions, it seems clear that any carryover basis transaction, including section 351, 354, 355, and 356 transactions, is included in the term "acquire," unless specifically excluded by statute or regulation.(75)

b. Looking Through to the Ultimate Shareholders

Under the facts of Example 1, P has obtained 50 percent or more of the value of D, and thus P has "acquired" D. Section 355(e) applies.

Example 2: Same facts as Example 1, except that

in the B reorganization, the shareholders of D

receive 60 percent of the stock of P in exchange for

their D shares.

Technically, a person (P)(76) has acquired a 50-percent or greater interest in the distributing corporation (D). Thus, section 355(e) appears to apply. The historic D shareholders, however, retain, albeit indirectly, a 50-percent or greater interest in D. Clearly, Congress intended that section 355(e) not apply to such a situation.(77)

The attribution rules in section 355(e), in conjunction with the exception in section 355(e)(3)(iv), appear to alleviate this problem. Section 355(e)(4)(C)(ii) provides that the attribution rules of section 318(a)(2) apply (without regard to the 50-percent value threshold in section 318(a)(2)(C)) in determining whether a person holds stock in a corporation for purposes of section 355. Thus, D's historic shareholders would be treated as owning 60 percent of the D stock, and the P shareholders would be treated as owning 40 percent of the D stock. If this is the case, the exception in section 355(e)(3)(A)(iv) would apply, because D's historic shareholders would hold more than 50 percent of the vote and value in D before and after the acquisition.(78) Accordingly, section 355(e) should not apply.(79) The statute, however, is poorly drafted. Section 355(e) does not explicitly state that, under the attribution rules, one must look to the ultimate owners instead of the acquiring entity itself in applying section 355(e). The IRS will presumably clarify this issue in regulations.

c. 50-percent or Greater Interest

Under sections 355(e)(4)(A) and 355(d)(4), a "50-percent or greater interest" means stock possessing at least 50 percent of the total combined voting power of all classes of voting stock, or at least 50 percent of the total value of shares of all classes of stock. Thus, there is an acquisition to which section 355(e) applies if a person or persons acquires 50 percent or more of the vote or value of the stock of the controlled or distributing corporation.(80)

How does the 50-percent rule apply to market trading by shareholders of publicly traded corporations in anticipation of a distribution and acquisition? Are arbitrageurs who anticipate an acquisition and buy stock in the distributing corporation included in the term "one or more persons?" If so, would all market trading in anticipation of such distribution and acquisition count toward the 50-percent threshold? Treasury's Explanation of the Clinton Administration's initial proposal in February 1997 stated that "public trading of the stock of either the distributing or controlled corporation is disregarded, even if that trading occurs in contemplation of the distribution."(81) It is unclear why this provision was not included in the final legislation.

d. Directly or Indirectly

Given the application of the attribution rules to section 355(e), why did Congress need to add the phrase "directly or indirectly" to section 355(e)(2)(A)(ii)? If the IRS applies the attribution rules to look through to the ultimate owners, the phrase "directly or indirectly" seems unnecessary.(82) It is possible that Congress intended the phrase to expand upon the attribution rules. There is no legislative history, however, to support such a view.

The Distributing or "Any" Controlled Corporation

a. Spin-off of Multiple Controlled Corporations

Section 355(e) applies to distributions that are part of a plan pursuant to which one or more persons acquire stock representing a 50-percent or greater interest in "the distributing corporation or any controlled corporation."

Example 3: A publicly traded corporation ("D")

owns all the stock of two controlled corporations

("S" and "C"). In order to facilitate an acquisition

by a third corporation ("P"), D distributes its S

stock and its C stock to its shareholders. Within

two years, P acquires all the stock of S (but not C)

in a section 368(a)(1)(B) reorganization, with the

shareholders of S receiving 40 percent of the stock

of P in exchange for their S stock.

Is D taxed under section 355(e) on the gain in both its S stock and its C stock, or only on the gain in its S stock?(83) Clearly, D will be taxed on the gain in its S stock under section 355(e). Is the distribution of C, however, a distribution that is part of a plan pursuant to which one or more persons acquire stock representing a 50-percent or greater interest in the distributing corporation or any controlled corporation? There would seemingly be no need to use the word "any" (instead of "the") before "controlled corporation" if section 355(e) were not intended to apply to the distribution of C.

Under section 355(e)(1), if there is a distribution to which 355(e)(2)(A) applies, any stock "in the controlled corporation" is treated as non-qualified property.(84) Is C "the" controlled corporation for purposes of applying section 355(e)(1)? There appears to be no policy reason for taxing the gain in the C stock. No one has acquired a 50percent interest in either D or C.

Under section 355(e)(5), the IRS is required to issue regulations as may be necessary to carry out the purposes of section 355(e), including regulations providing for the application of section 355(e) where there are multiple controlled corporations.(85) It remains to be seen what rules the IRS will adopt in such regulations.

b. Acquisitions of Subsidiaries That are Not Distributed

Example 4: A publicly traded corporation ("D")

owns all the stock of two controlled corporations

("S" and "C"). D distributes its C stock to its shareholders.

Within two years, P acquires from D all

the stock of S in a section 368(a)(1)(B) reorganization.

D receives 40 percent of the stock of P in

exchange for its S stock.

Is S "any controlled corporation?" If S is deemed to be a controlled corporation, section 355(e) will apply, because there is a distribution that is part of a plan in which P acquired 50 percent or more of a controlled corporation (S).

An analysis of section 355(a) leads to the conclusion that S should not be treated as a controlled corporation. Under section 355(a), no gain or loss is recognized if a corporation distributes to a shareholder "solely stock or securities of a corporation (referred to in this section as `controlled corporation') which it controls immediately before the distribution."(86) Thus, section 355(a) clearly refers to the term "controlled corporation" in the context of a corporation that is distributed to shareholders.

Since S in the example is not distributed to shareholders, it does not constitute "any controlled corporation" for purposes of section 355(e)(2)(A)(ii). Thus, section 355(e) should not apply to Example 4, because there was no acquisition of the distributing corporation or any controlled corporation.

Exceptions to Section 355(e)

a. Exception to "Plan"

There are several exceptions to section 355. Section 355(e)(2)(C) provides that a plan (or series of related transactions) will not cause gain recognition if, immediately after the completion of the plan or transaction, the distributing and all controlled corporations are members of the same affiliated group. For this purpose, the term "affiliated group" is defined without regard to whether the corporations are includible corporations as defined in section 1504(b). For example, a tax-exempt organization, life insurance company, foreign corporation, real estate investment trust, or a regulated investment company are considered members of the affiliated group for purposes of determining whether the distributing and controlled corporations are in the same affiliated group.(87)

Example 5: A publicly traded corporation ("D")

owns all the stock of a controlled corporation ("C"),

a foreign corporation. A third corporation ("P")

acquires all the stock of D in a section 368(a)(1)(B)

reorganization, with the shareholders of D receiving

40 percent of the stock of P in exchange for

their D stock. As part of the plan of reorganization,

D distributes the stock of C to P.

Even though the distribution of C stock is part of a plan in which the ownership of the group has changed, D is not required to recognize gain under section 355(e), because D, C, and P will remain members of an affiliated group immediately after the completion of the plan. That C is a foreign corporation is disregarded in determining affiliated group status.(88)

b. Exceptions to "Acquisition"

Section 355(e)(3)(A) provides that certain acquisitions are not considered acquisitions for purposes of section 355(e).(89) These exceptions apply only if the stock owned prior to the acquisition was not acquired as part of a plan to acquire a 50-percent or greater interest in either the distributing or controlled corporation.

(1) Acquisition of Controlled Stock by Distributing Corporation. Section 355(e)(3)(A)(i) provides that section 355(e) does not apply to the acquisition of stock in the controlled corporation by the distributing corporation. For example, the receipt of stock of a new controlled corporation in a section 351 exchange or a D reorganization in connection with a spin-off of the controlled corporation will not trigger gain recognition under section 355(e).(90)

(2) Acquisition of Controlled Stock by Shareholders of Distributing Corporation. Section 355(e)(3)(A)(ii) provides that section 355(e) does not apply to the acquisition of stock in a controlled corporation by reason of holding stock in the distributing corporation. Thus, if the distributing corporation engages in a "split-off" transaction in which a shareholder of the distributing corporation that did not own 50 percent of the stock of the distributing corporation before the transaction ends up owning all of the stock of the controlled corporation, section 355(e) will not be triggered.(91)

(3) Acquisition of Successor Stock by Shareholders of Distributing Corporation. Section 355(e)(3)(A)(iii) provides that section 355(e) does not apply to the acquisition of stock in any successor corporation of the distributing corporation or controlled corporation by reason of holding stock in such distributing or controlled corporation.

Example 6: A publicly traded corporation ("D")

owns all the stock of a controlled corporation ("C").

To facilitate an acquisition by a third corporation

("P"), D distributes its C stock to its shareholders.

Within two years, D merges into P in a section

368(a)(1)(A) reorganization, with the shareholders

of D receiving 60 percent of the stock of P.

Because D's assets were apparently acquired by a successor corporation,(92) P, in an A reorganization, section 355(e)(3)(B) provides that the shareholders of P are treated as having acquired the stock of D. The distribution seemingly was part of a plan pursuant to which one or more persons, P's shareholders, acquired at least 50 percent of the stock of D. Thus, section 355(e) would seem to apply. D's shareholders, however, acquired stock in a successor corporation, P, by reason of holding stock in D. Such stock is not taken into account for purposes of applying section 355(e).(93) As a result, only 40 percent of the stock of D was acquired within the meaning of section 355(e), so no gain is recognized by D.(94)

(4) Continuing Control Exception

(a) As Enacted in Section 355(e)(3)(A)(iv). Section 355(e)(3)(A)(iv) provides that section 355(e) does not apply to the "acquisition of stock in a corporation if shareholders owning directly or indirectly stock possessing" more than 50 percent of the vote and value in either "the distributing or any controlled corporation before such acquisition own directly or indirectly stock possessing such vote and value in such distributing or controlled corporation after such acquisition." Literally read, this exception seems to preclude application of section 355(e), because in a typical Morris Trust transaction, there will be no change in the ownership of the corporation holding the "unwanted" assets.

The 1997 Conference Report, however, makes clear Congress's intent. It states that "[t]he conference agreement clarifies that an acquisition does not require gain recognition if the same persons own 50 or more of both corporations, directly or indirectly ... before and after the acquisition and distribution...." Thus, the shareholders must own the requisite interest in both the acquiring corporation and either the distributing or controlled corporation (whichever is not acquired). Congress's use of the disjunctive in section 355(e)(3)(A)(iv) was a technical error. The examples used in the 1997 Conference Report confirm this conclusion.

Example 7: Individual A owns all the stock of a

corporation ("D")), and D owns all the stock of a

controlled corporation ("C"). In order to facilitate

an acquisition by a third corporation ("P"), which

is also owned entirely by A, D distributes its C

stock to A. Within two years, D merges into P in a

section 368(a)(1)(A) reorganization.

The 1997 Conference Report concludes that this is not an acquisition that requires gain recognition, because A owns, directly or indirectly, all of the stock of both P (the successor to D) and C before and after the merger.(95)

(b) The Tax Technical Corrections Act

(i) General Application. The Tax Technical Corrections Act is expected to address this flaw in section 355(e)(4)(A)(iv) by restating the exception, as follows:

(A) Except as provided in regulations, the following

acquisitions shall not be taken into account in

applying paragraph (2)(A)(ii):

(iv) The acquisition of stock in the distributing

corporation or any controlled

corporation to the extent that the percentage

of stock owned directly or indirectly

in such corporation by each person

owning stock in such corporation immediately

before the acquisition does not decrease.

Although this provision appears to clarify that the former shareholders of the acquired corporation must maintain a continuing interest in both the acquiring and the acquired corporations, it does so at the cost of even more complexity. The interests would have to be calculated for each individual shareholder.

Example 8: Individual A owns 10 percent of the

stock of a corporation ("D"), and D owns all the

stock of a controlled corporation ("C"). There are

nine other 10-percent shareholders of D. A also

owns 100 percent of the stock of a third corporation

("C"). In order to facilitate an acquisition by P,

D distributes its C stock to its shareholders. Within

two years, P (worth 900x) acquires all the stock

of D (worth 100x after the spin-off) in a section

368(a)(1)(B) reorganization. After the reorganization,

each of the former D shareholders (except A)

owns one percent of the stock of P, and A owns 91

percent of the stock of P.

In determining whether a 50-percent or greater interest in D has been acquired under the proposed Tax Technical Corrections Act, the interest of each of the continuing shareholders is disregarded only to the extent there has been no decrease in such shareholder's direct or indirect ownership. Thus, the 10-percent interest of A and the 1interest of each of the other former shareholders of D are not counted. The remaining 81 percent ownership of P following the merger (i.e., the decrease of nine percent in the interests of each of the nine former shareholders other than A) is counted. Therefore, a 50-percent or greater interest in D has been acquired.(96)

(ii) Impact of Shareholder-by-Shareholder Approach. One very important change in the language of the proposed Tax Technical Corrections Act is the reference to the ownership interest of "each person," as opposed to "shareholders."(97) Consider the effect of the proposed Tax Technical Corrections Act on the following example.

Example 9: Individuals A and B own 10 percent

and 90 percent, respectively, of the stock of a corporation

("D"). D owns all the stock of a controlled

corporation ("C"). The fair market value of the C

stock is $100. D distributes its C stock to its shareholders,

A and B. Thus, immediately after the distribution,

A owns 10 percent of the stock of C and

B owns 90 percent. Within two years, A invests

200x in Q increasing As ownership interest in C

to 70 percent (and decreasing B's ownership interest

to 30 percent).

A has acquired more than 50 percent of the stock of C as part of a plan, thus triggering section 355(e). Because A and B own all of the stock of C both before and after the acquisition, the exception in section 355(e)(3)(A)(iv) of the statute, as enacted, would seem to apply. However, applying the language of the proposed Tax Technical Corrections Act, it would appear that only 10 percent of As interest and 30 percent of B's interest are not counted for purposes of determining whether an acquisition has occurred. The remaining 60 percent of C's stock would be considered acquired, thus triggering section 355(e).

Successors and Predecessors

Section 355(e)(4)(D) provides that for purposes of section 355(e), any reference to a controlled corporation or a distributing corporation "shall include a reference to any predecessor or successor of such corporation." What is meant by a predecessor or successor in this context? Unfortunately, this phrase is not defined anywhere in section 355 or the legislative history. The phrase is, however, used elsewhere in the Code and regulations (e.g., section 382 net operating loss limitations, section 338 deemed asset purchases, and the consolidated return regulations), and is typically defined with reference to section 381 or other carryover basis transactions.(98) It would seem reasonable to apply a similar rule in the section 355(e) context.(99) Such an approach is consistent with a statement made by a senior staff member of the Joint Committee on Taxation, that the phrase was generally intended to cover predecessors or successors "as in section 381 transactions."(100)

There are still many unanswered questions in interpreting what is meant by the term "any successor or predecessor."

What is a Successor?

Example 10: A publicly traded corporation ("D")

merges into another publicly traded corporation

("P") in a section 368(a)(1)(A) reorganization, with

the shareholders of D receiving 40 percent of the

stock of P in exchange for their D stock. Within

two years, P contributes Division Y to a new controlled

corporation ("C"), and distributes its C

stock to its shareholders. Division Y consists of

assets that were owned b D and assets that were

owned by P prior to the merger.

Presumably, P is a successor to D within the meaning of section 355(e)(4)(D). Accordingly, P's shareholders have acquired 50 percent or more of the stock of D. Thus, P qualifies as a distributing corporation, and P is taxed on the built-in gain in its C stock under section 355(e).

Does it matter what portion of the Division Y assets were held by D prior to the transaction? Arguably, if only P assets were transferred to Q the substance of the transaction is no different from P's distributing the stock of a controlled corporation to its shareholders. Because P was not acquired within the meaning of section 355(e)(2)(A), a distribution by P should not fall within section 355(e). On the other hand, if the assets of Division Y were all held by D prior to the merger, C should be considered a controlled corporation of D, thus triggering section 355(e) upon the distribution. If the assets of Division Y consist of assets held by both P and D prior to the merger, query whether it is possible to keep the assets sufficiently separate and thereby bifurcate the transfer for purposes of the successor rule. Similarly, in the latter situation, should the quality of the assets transferred to C affect the application of the successor rule? For example, if P held the operating assets, and D held office furniture prior to the merger, should P be treated as contributing the Division Y business?

What is a Predecessor?

It is also not clear how the term "predecessor" is intended to apply in the context of section 355(e).

Example 11: A publicly traded corporation ("D")

owns all the stock of a controlled corporation ("C").

D distributes its C stock to its shareholders. Within

two years, P, a small corporation, merges into D

in a section 368(a)(1)(A) reorganization, with the

shareholders of P receiving two percent of the stock

of D.

Under section 355(e)(3)(B), if the assets of the distributing corporation or any controlled corporation are acquired by a successor corporation in an A reorganization, the shareholders of the acquiring corporation are treated as acquiring stock in the corporation from which the assets were acquired. At first glance, it appears that since the assets of neither D nor C are being acquired, section 355(e)(3)(B) will not apply and, hence, section 355(e) will not apply. Section 355(e)(4)(D) states, however, that any reference to a controlled corporation or a distributing corporation includes a reference to a predecessor or successor of such corporation. Thus, under a technical reading of the statute, the assets of a predecessor corporation of the distributing corporation (i.e., P) are acquired by a successor corporation (i.e., D). D's shareholders are treated as acquiring the stock of P.

Applying the language of the statute, there has been a distribution that is part of a plan pursuant to which one or more persons (i.e., D's shareholders) acquired stock representing a 50-percent or greater interest in a predecessor of the distributing corporation (i.e., P). Although this appears to be the classic case at which the exception in section 355(e)(3)(A)(iii) was aimed -- D's shareholders received stock in P by reason of holding stock of D -- the language of the exception refers only to the acquisition of stock "in any successor corporation." Therefore, section 355(e) seemingly applies to this example. Certainly, Congress did not intend this result, and the omission of the term "predecessor corporation" from the exception in section 355(e)(3)(A)(iii) appears to be an oversight. Presumably, this can be fixed by a technical correction or by regulations.

Regulatory Authority Under Section 355(e)

Section 355(e)(5) grants Treasury authority to prescribe regulations to carry out the purposes of section 355(e), including regulations (i) providing for the application of section 355(e) where there is more than one controlled corporation, (ii) treating two or more distributions as one distribution where necessary to prevent the avoidance of such purposes, and (iii) providing for the application of rules similar to section 355(d)(6) where there has been a substantial diminution of risk. What types of transactions should the regulations address?

Section 355(e) applies to the acquisition of a 50-percent or greater interest in "any controlled corporation."(101) As discussed above, where multiple controlled corporations are involved, regulations will likely be necessary to prevent overreaching effects.(102)

Treasury's regulatory authority under section 355(e)(5) also extends to providing rules treating two or more distributions as one distribution where necessary to prevent the avoidance of the purposes of section 355(e). When should such rules apply? Will the rules apply to distributions of more than one controlled corporation, or more than one distribution of the same controlled corporation? What transactions should be targeted to prevent the avoidance of section 355(e)?

In addition, Treasury's regulatory authority under section 355(e)(5) extends to providing rules similar to section 355(d)(6) in situations where a shareholder's risk of loss with respect to its stock is substantially diminished. Section 355(d)(6) provides that the relevant holding period is suspended in any period during which the shareholder's risk of loss is substantially diminished by a transaction such as an option or a short sale. Presumably, Congress was focusing on the four-year presumption period in providing such regulatory authority. Inasmuch as the four-year period is only a presumption (unlike the five-year holding period in section 355(d)), and section 355(e) applies to any distribution that is part of a plan or series of related transactions regardless of whether it occurs within the four-year period, such regulations seem unnecessary.

Operation of Section 355(f)

In General

Section 355(f) provides that section 355 will not apply to intragroup distributions that are part of a plan (or series of related transactions) described in section 355(e)(2)(A)(ii). In addition, section 355(f) will only apply if section 355(e) applies.(103) Thus, if one of the exceptions in section 355(e)(3)(A) applies so that section 355(e)(2)(A)(ii) does not apply, section 355(f) does not apply as well. The examples below explain the operation of section 355(f).(104)

Example 12: A publicly traded corporation ("D")

owns all the stock of a subsidiary corporation ("S"),

which in turn owns all the. stock a controlled corporation

("C"). D, S, and C are members of the

same affiliated group. In order to facilitate an

acquisition by a third corporation ("P"), S distributes

its C stock to D, and D then distributes its C

stock to its shareholders. Within two years, P acquires

all the stock of D in a section 368(a)(1)(B)

reorganization, with the shareholders of D receiving

40 percent of the stock of P in exchange for

their D stock.

Section 355(e) applies to P's acquisition of D. Thus, the following results occur:

* Under section 355(f), section 355 will not apply to the distribution by S of its C stock, and thus the distribution will be a taxable distribution.

* S will recognize deferred intercompany gain as if it had sold its C stock on the date of the distribution (and such gain will be triggered into income upon D's distribution of its C stock to its shareholders). D will receive a taxable dividend, which is eliminated under Treas. Reg. [sections] 1.1502-13(f), and will take a fair market value basis in the C stock. D's basis in its S stock will increase by the amount of the, gain under section 311(b), and decrease by the fair market value of the stock of C.

* Under section 355(e), D will recognize gain as if it had sold its C stock on the date of the distribution. There should be no additional gain, however, because D's basis in the C stock equals its fair market value.

What if P acquires C instead of D in Example 12? Sections 355(f) and 355(e) will operate in the same way as in Example 12. The original House and Senate bills included different measures of gain depending on whether the distributing or controlled corporation was acquired, but as enacted, section 355(e) provides that the gain will be the same whether the distributing or controlled corporation is acquired.

Example 13: Same facts as Example 12, except

that S distributes its C stock to D, D then distributes

its S stock to its shareholders, and, within

two years, P acquires all the stock of D in a section

368(a)(1)(B) reorganization, with the shareholders

of D receiving 40 percent of the stock of P in exchange

for their D stock.(105)

Under section 355(f), S will again recognize gain as if it had sold its C stock on the date of the distribution. In addition, under section 355(e), D will recognize gain as if it sold its S stock on the date of the distribution. Thus, the gain in both subsidiaries is taxed.(106) This makes little sense since only D and C were acquired.(107)

Section 358(g) Regulations

a. Overview

Section 1012(b)(2) of the 1997 Act added section 358(g), which grants Treasury regulatory authority to provide stock basis adjustments in the case of a distribution of stock of one member of an affiliated group to another member under section 355. For this purpose, affiliated group is defined without regard to whether the corporations are includible corporations as defined in section 1504(b) (e.g., tax-exempt organizations, life insurance companies, and foreign corporations). Although the language of section 358(g) grants regulatory authority only with respect to situations that do not fall within section 355(f), such authority may be exercised in conjunction with the authority to provide exceptions to section 355(f). Thus, the 1997 Conference Report notes that Treasury could, by regulation, eliminate gain recognition under section 355(f) in certain circumstances and provide instead for appropriate basis adjustments.(108)

Treasury's regulatory authority under this section is prospective only, except in cases to prevent abuser.(109) What constitutes an abuse for this purpose? For example, does the mere elimination of an ELA or the shifting of basis, which are the apparent targets of new section 358(g), constitute an abuse? Such consequences are simply the result of applying current law.(110) Presumably, certain "aggressive transactions," such as engaging in debt transactions immediately before a spin-off, will be required before a transaction is considered abusive.

As previously discussed, Congress was concerned that affiliated corporations could manipulate their stock bases through the use of tax-free intragroup distributions, either through the elimination of an ELA of a lower tier subsidiary under the consolidated return regulations(111) or through inappropriate shifts of basis as a result of the basis allocation rules of section 358(c). The 1997 Conference Report thus provides that Treasury may promulgate any regulations necessary to address these concerns and other collateral issues. The 1997 Conference Report notes that Treasury may consider rules that require a carryover basis within the group (including a carryover of an ELA) for the stock of the controlled corporation, or a rule that requires a modification of outside basis to reflect the inside basis of the controlled corporation.(112) Similarly, such regulations may provide for a reduction in the basis of the stock of the distributing corporation to reflect the change in the value and basis of the distributing corporation's assets.(113) Importantly, the 1997 Conference Report states that "(t)he Treasury Department may determine that the aggregate basis of distributing and controlled after the distribution may be adjusted to an amount that is less than the aggregate basis of the stock of the distributing corporation before the distribution ...."(114)

b. Consolidated Return ELA Regulations

On August 12, 1994, Treasury issued final consolidated return regulations governing ELAs in a subsidiary's stock.(115) These regulations provide, in general, that an ELA is treated for all federal income tax purposes as negative basis.(116) If the parent corporation is treated as disposing of the subsidiary's stock, the parent is required to take into account its ELA as income or gain from such disposition.(117)

1. Elimination of ELAs

Example 14: A publicly traded corporation ("D") owns

all the stock of a subsidiary ("S") which in turn owns all

the stock of a controlled corporation ("C") D has a $30

ELA in the stock of S, and S has a $90 ELA in the stock

of C. S distributes all of the stock of C to D. At the time

of the distribution, the C stock is worth $100, and the S

stock is worth $300 (including the stock of C).

S's distribution of the C stock is treated as a disposition under Treas. Reg. [sections] 1.1502-19(c)(1). Under section 355(c) and Treas. Reg. [sections] 1.1502-19(b)(2)(i), however, S does not recognize gain as a result of the distribution. Under section 358, S's ELA in the C stock is eliminated, and D's $30 ELA is allocated between the S and the C stock based on their relative values.(118) Thus, D has a $20 ELA in the stock of S and a $10 ELA in the stock of C.(119) If D also distributed the stock of C to its shareholders in a section 355 transaction, D would be required to take its $10 ELA into account, notwithstanding the nonrecognition rules of section 355, because the stock of C is deconsolidated.(120)

In promulgating Prop. Reg. [sections] 1.1502-19, Treasury specifically considered the issue presented by the above example. The preamble to the proposed regulations state, in pertinent part:

The excess loss account (ELA) rules are an extension of

the rules for adjusting stock basis....

An ELA ordinarily arises with respect to a share of S's

stock only if S's losses and distributions are funded with

capital not reflected in the basis of the share. The

reductions are funded by creditors or by other

shareholders, including other members.

In general, an ELA is treated as negative basis for

computational purposes, to eliminate the need for special

ELA rules paralleling the basis rules of the Code.

Similarly, the rules of the Code are generally used to

determine the timing for inclusion of an ELA in income.

For example, if S has an ELA in [C]'s stock and distributes

the stock to [D] in a transaction to which section 355

applies, section 358 eliminates S's ELA (instead, [D]'s

basis in [C]'s stock is an allocable part of [D]'s basis in S's

stock), and section 355 provides that any gain realized by

S from the disposition of [C]'s stock is not recognized.(121)

Treasury apparently believed that the stock basis adjustment rules in Treas. Reg. [sections] 1.1502-32 and the tiering up of adjustments were adequate to support the ELA rules of Treas. Reg. [sections] 1.1502-19. Treasury concluded that the elimination of an ELA in the spin-off of a second tier subsidiary is not improper or abusive, presumably because the relationship between D's basis in S and its value preserve the potential for gain recognition that was reflected in the ELA.

To illustrate the preservation of the gain, if in the above example, D sold S (including C) for its fair market value without the initial spin-off of C, both S and C would cease to be members of the group. Thus, the ELAs with respect to both S and C would be taken into account, with the ELA in C's stock being taken into account first.(122) Thus, the group would recognize a total gain of $330 computed as follows: S would take into account the $90 ELA in its C stock. Under Treas. Reg. [sections] 1.1502-32(b), this gain would result in an increase in D's basis in S's stock from an ELA of $30 to a positive $60 basis. D's gain on its S stock would be $240 (i.e., $300 value less $60 adjusted basis).

Alternatively, assume that S spins off C as in the Example 14. If D sold both S and C (after waiting a sufficient period of time to avoid disqualifying the spin-off), the group's total gain would still be $330 -- D's gain on the sale of S stock would be $220 (i.e., $200 realized plus the $20 ELA in S), and D's gain on the sale of C stock would be $110 (i.e., $100 realized plus the $10 ELA in C). Thus, viewing the group as a whole, the "elimination" of the ELA in C as provided in Treas. Reg. [sections] 1.1502-19(g), Ex. 3, is one in form only. In substance, the amount of the ELA has been preserved as built-in gain in the stock of S and C.

2. Use of Debt

The incurrence of debt by one of the subsidiaries and the transfer of the proceeds to another subsidiary does not affect this gain preservation.

Example 15: Same facts as Example 14, but assume further

that D's $30 ELA in S resulted from debt-financed operating

losses of C that tiered up through S and were reflected on the

consolidated return, and S's additional $60 ELA resulted from

debt-financed distributions from C to S.

Presumably, the additional cash in S as a result of the distributions is reflected in the value of S. The fact that C incurred debt and distributed the proceeds to S should not change this result. D still indirectly owes the debt and holds the proceeds. Indeed, Treasury specifically recognized this possibility in the preamble to Prop. Reg. [sections] 1.1502-19.(123)

Example 16: Same facts as Example 15, except that after S

distributes the stock of C to D, D distributes the stock of C to

its shareholders.

The result should not change. The value of C has been reduced relative to the value of S because of the liability, which will be reflected in the basis of the C stock in the hands of D's shareholders. Moreover, because no change in control has occurred with respect to either S or C, the debt and the proceeds of the debt are still held indirectly by the same persons.

Congress apparently felt that the elimination of S's ELA in C upon the spin-off of C could lead to abuse. Even though the aggregate built-in gain in the stock of S and C had been preserved, as illustrated above, application of the basis allocation rules of section 358 could potentially produce a tax benefit to the group if D later sells only one of the subsidiaries.

Example 17: Same facts as Example 14, except that D causes

S to sell the stock of C in the absence of a spin-off.

S would recognize gain of $190 (i.e., $100 plus $90 ELA) on the sale of the stock. If instead of S selling C, S just distributes C to D and D sells the stock of C (after waiting a sufficient period of time to avoid disqualifying the spin-off), D would recognize a gain of only $110 (i.e., $100 plus $10 ELA). D could then liquidate S under section 332 to avoid recognizing further gain. S's ELA would disappear, and D would succeed to S's basis in its assets. Such results may be exacerbated by further reducing the value of one subsidiary through debt and increasing the value of another subsidiary from the proceeds of such debt.

3. Section 358(g) Regulations Should be Narrow in Scope

Any regulations promulgated pursuant to section 358(g) should be narrowly tailored to address this perceived abuse. If new regulations were to impose a strict carryover basis (or a carryover ELA) requirement, where the relative values of the distributing and controlled corporations are reflected in the basis allocations, they could have the effect of duplicating gain recognized on the ultimate distribution of the subsidiaries.

Example 18: Same facts as Example 14, except that

regulations are in effect to provide for a strict carryover of

basis (or ELAs) in the stock of subsidiaries following a spin-off.

D would inherit a $90 ELA in the stock of C and would retain its $30 ELA in S's stock. As a result, the group's aggregate built-in gain would increase from $330 to $420 (i.e., $100 plus $90 ELA in C and $200 plus $30 ELA in S). This result is inappropriate.

c. Section 358 -- Basis Shifts

In addition to the elimination of ELAs, Congress was concerned with inappropriate shifts of basis and value as a result of the basis allocation rules of section 358(c).

Example 19:A publicly traded corporation ["D"] owns all of

the stock of a subsidiary ("S"). S owns all of the stock of a

corporation ("C"). D's basis in the stock of S is $50; the inside

asset basis of S's assets is $50; and the total value of S's stock

(including the value of C) is $150. S's basis in the stock of C is

$0; the inside basis of C's assets is $0; and the value of C's

stock and assets is $100. S distributes its C stock to D.

Under section 358, D's basis in the stock of S after the distribution is approximately 17 (i.e., 50/150 multiplied by D's $50 basis in S prior to the distribution), and the inside basis of S is $50. D's basis in the stock of C is approximately $33 (i.e., 1001150 multiplied by $50), and the inside asset basis of C is $0. Had D sold the S stock while holding C, the total gain to D would have been $100 (i.e., $150 less $50). After the distribution (and an appropriate waiting period), however, C may be sold at a gain of $67. S's assets may then be sold for $50 with no gain or loss. Thus, S and C could be sold at a total gain of $67, rather than the total gain of $100 that would have been realized without the distribution.(124) Congress felt that the avoidance of gain as a result of shifts of outside stock basis relative to inside net asset basis was inappropriate.

This, however, is simply the result that is obtained by applying the rules of section 358. In general, under section 358(a)(1), the basis of property that is permitted to be received without recognition of gain is the same as the basis of the property exchanged.(125) In the case of a section 355 distribution, section 358(b) provides that, under regulations prescribed by Treasury, the basis shall be allocated between the stock of the controlled corporation received and the stock of the distributing corporation retained. This provision was enacted in 1924 to reflect the theory that such exchanges were "merely changes in form and not in substance," and, therefore, "the property received should be considered as taking the place of the property exchanged.(126) Treasury regulations promulgated under see iron 358 provide that the basis for the allocation required by section 358(b) is the proportionate fair market values of the stock of each corporation.(127)

Accordingly, Congress's suggestion that Treasury issue regulations providing for a reduction in the basis of the stock of the distributing corporation to reflect its net asset value, and its statement that Treasury may determine that the aggregate basis of distributing and controlled after the distribution should be less than such aggregate basis before the distribution in situations like Example 19 is at odds with the statutory language of section 358(b) and its legislative history. If this sort of basis shifting in the context of section 355 distributions, which does not appear to involve any manipulation, concerns Congress, it should repeal or amend section 358(b).

On the other hand, transactions intended to manipulate relative inside and outside bases, such as where one corporation decreases its value by incurring debt and increases the asset basis and value of another corporation by contributing the proceeds of such debt, would appear to be outside the language of section 358(b) and, presumably, should be the target of any such regulations. Such "manipulative" transactions, however, are typically found in cases where an acquisition is contemplated, which are already severely limited by sections 355(d) (e), and (f) as well as the device restrictions of section h5(a)(1)(B). Therefore, such regulations are not necessary.

Control and Step- Transaction Issues

Control

There are two "control" tests that must be satisfied in order to have a tax-free "divisive" D reorganization under sections 368(a)(1)(D) and 355. Under the section 368(a)(1)(D) control test (prior to the 1997 Act), shareholders of a distributing corporation who receive stock in the controlled corporation must own 80 Percent of the voting power and 80 percent of each other class of stock of such controlled corporation immediately after the distribution.(128) Under the section 355(a)(1)(D) control test, the distributing corporation is required to be in control (again, 80 percent of the voting power and 80 percent of each other class of stock) of the controlled corporation immediately before the distribution, and the distributing corporation must distribute to its shareholders all of its stock in the controlled corporation.(129) If a section 355 transaction does not involve a D reorganization, taxpayers need only satisfy the section 355(a)(1)(D) control test.

The 1997 Act reduced the control requirement under section 368(a)(1)(D) from 80 percent to 50 percent.(130) Under new section 368(a)(2)(H)(ii), shareholders who receive stock in a controlled corporation in a section 355 transaction are treated as in control of such corporation if they hold stock representing greater than 50 percent of the vote and value of such controlled corporation.(131) Thus, Congress has made the control test of section 368(a)(1)(D) easier to satisfy.

Prior to the 1997 Act, section 368(a)(1)(D) incorporated the definition of control provided in section 368(c). Section 368(c) provides that the term "control" means "the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation." Thus, the 1997 Act makes two changes. It reduces the percentage of stock required to satisfy the control test, and it converts the test from a "vote and shares of stock" test to a "vote and value" test. Congress apparently adopted this new "greater than 50 percent vote and value" test in order to conform the change in control requirements with the acquisition of control requirements under new section 355(e). Section 355(e)(2)(A)(ii), however, provides a "50 percent or greater" test (i.e., exactly 50 percent is included), whereas section 368(a)(2)(H)(ii) applies a "greater than 50 percent" test.

The 1997 Act's control standards also differ from the standards for "acquisitive" D reorganizations under section 368(a)(2)(H)(i), which simply refers to section 304(c) (which requires ownership of at least 50 percent of the vote or value and provides constructive ownership rules). The new control test does not adopt the section 304(c) standard and, accordingly, does not include constructive ownership rules. These different stock ownership rules make little sense.

The Step-Transaction Doctrine

The IRS has ruled that even if the control tests of section 368(a)(i)(D) and section 355(a)(i)(D) are technically satisfied, the IRS can view a distribution and acquisition under step-transaction principles and reorder the steps of such distribution and acquisition so that the transaction fails one or both of these control tests. The IRS has only applied this step-transaction concept in situations where the controlled corporation, rather than the distributing corporation, is acquired.(132)

a. The Step-Transaction Doctrine and the Section 368(a)(1)(D) Control Requirement

The IRS has applied the step-transaction doctrine and ruled that certain transactions fail the section 368(a)(i)(D) control requirement.

Example 20: A publicly held corporation ("D"), conducts

two businesses, Business 1 and Business 2. D contributes

Business 2 to a new controlled corporation ("C") in

exchange for all of C's stock, and distributes C to its

shareholders. As part of a prearranged plan, C then merges

into an unrelated corporation ("P") with the shareholders

of C receiving less than 80 percent of the stock of P.

Under these facts, the IRS ruled that the transaction does not qualify as a tax-free transaction.(133) The IRS reasoned that the prearranged disposition of C stock as part of the same plan as the distribution prevented the transaction from satisfying the 80-percent shareholder control requirement under section 368(a)(i)(D). The IRS recharacterized the transaction as (1) a direct taxable transfer of assets by D to P in exchange for P stock, followed by (2) a distribution of P stock.(134)

b. The Step-Transaction Doctrine and the Section 355(a)(1)(D) Control Requirement

The IRS apparently will also apply the step-transaction doctrine in the context of the section 355(a)(i)(D) control requirement.

Example 21: A publicly traded corporation ("D") owns all

the stock of a preexisting controlled corporation ("C") For

a valid business purpose, D distributes all of its C stock

to its shareholders. Soon after the distribution, C

commences negotiations with an unrelated corporation

("P") and merges into such corporation, with the

shareholders of C receiving 25 percent of the stock of P.

Under these facts, the IRS ruled that the control requirement of section 355(a)(i)(D) is satisfied.(135) The IRS reasoned that there were no negotiations prior to the distribution, and that the shareholders of C voted after the distribution to merge with P. The IRS implied, however, that it could apply step-transaction principles if there were negotiations prior to the distribution. (136)

Shortly after issuing Rev. Rul. 96-30, the IRS announced that it will not rule on requests for section 355 treatment:

if there have been negotiations, agreements or

arrangements with respect to transactions or events which,

if treated as consummated before the distribution, would

result in the distribution of stock or securities of a

corporation which is not controlled by the distributing

corporation...."(137)

Thus, prior to the 1997 Act, it appeared that the IRS would consider applying the step-transaction doctrine in analyzing both the section 368(a)(1)(D) control test and the section 355(a)(1)(D) control test.

The Step-Transaction Doctrine and Section 355(e)

a. Transactions Where Section 355(e) Applies

Example 22: A publicly traded corporation ("D") owns all

the stock of a controlled corporation ("C"). In order to

facilitate a public offering of the stock of C, D distributes

all of its C stock to its shareholders. Immediately

thereafter, C sells 60 percent of its stock to the public.

Because there is no transfer of property from D to C in Example 22, the control requirement of section 368(a)(1)(D) does not apply. The section 355(a)(1)(D) control requirement, however, does apply. If the IRS applies the step-transaction doctrine and reorders the steps, the section 355 control requirement will not be satisfied, and the entire transaction will be taxed.(138)

Section 355(e) also applies to this example.(139) Accordingly, D will be taxed on the distribution of the stock of C.

Should the IRS continue to apply the step-transaction doctrine where section 355(e) applies? The answer is no. Indeed, the House and Senate Reports stress that one of the reasons Congress added these new provisions was to minimize the difference in treatment between transactions involving the distributing corporation and the controlled corporation.(140) The 1997 Conference Report notes the following:

The House bill does not change the present-law

requirement under section 355 that the distributing

corporation must distribute 80 percent of the voting

power and 80 percent of each other class of stock in the

corporation. It is expected that this requirement will be

applied by the Internal Revenue Service taking into

account the provisions of the proposal regarding plans that

permit certain types of planned restructuring of the distributing

corporation following the distribution, and to treat similar

restructurings of the controlled corporation in a similar

manner. Thus, the 80-percent control requirement is

expected to be administered in a manner that would

prevent the tax-free spinoff of a less-than-80-percent

controlled subsidiary, but would not generally impose

additional restrictions on post-distribution restructurings

of the controlled corporation if such restrictions would

not apply to the distributing corporation.(141)

Accordingly, the IRS should not apply the step-transaction doctrine in Example 22.(142) As previously noted, the IRS will now entertain rulings regarding this issue.(143) Presumably, taxpayers will soon learn how the IRS will apply the step-transaction doctrine in light of the legislative history and the release of Rev. Proc. 97-53.

b. Transactions Where Section 355(e) Does Not Apply

Example 23: Same facts as Example 22, except that C sells

40 percent of its stock to the public.

In Example 23, section 355(e) does not apply.(144) Should the step-transaction doctrine apply where section 355(e) does not apply? Once again, the answer is no. The legislative history of the 1997 Act makes clear that Congress intended that transactions not be treated differently merely because the controlled corporation, as opposed to the distributing corporation, is involved. In fact, the committee reports suggest that Congress intended to accommodate post-division reorganizations and initial public offerings that are not affected by section 355(e). Accordingly, step-transaction principles should not apply to Example 23.(145) Furthermore, in light of the 1997 Conference Report, the IRS should withdraw Rev. Rul. 96-30 and Rev. Rul. 70-225.

In discussing this issue at a public meeting, an IRS official stated that some at the IRS have suggested that the above-quoted legislative history "may not be valid legislative history because the text of section 355(a) was not changed."(146) The official also noted, however, that "a great deal of section 355 has changed," and thus he did not want to suggest that it was not valid legislative history.(147) While the IRS analyzes the new legislation and the legislative history, the official stated, the IRS would continue following its rulings and procedures.

In light of the official's statements, what does the issuance of Rev. Proc. 97-53 (withdrawing the IRS's no-rule position) mean? Does the revocation of the IRS's no-rule position mean that they will no longer apply step-transaction principles to Morris Trust-type transactions, or will the IRS look to the facts of each transaction to determine whether step -transaction principles are applicable? In light of Congress's focus on the imposition of corporate-level tax, the latter result seems inappropriate and unnecessary. 148

Recommendations

The new anti-Morris Trust and intragroup spin provisions are complicated and raise a number of unresolved issues. Absent additional guidance, it will be extremely difficult for taxpayers to determine the scope of sections 355(e) and (f) and 358(g). The IRS should address the following issues:

Plan -- What constitutes a plan or series of related transactions? Whose plan is relevant? What will be necessary to overcome the four-year presumption? Will public trading be treated as part of the plan?

Controlled Corporation -- What is a controlled corporation? Does section 355(e)(1) apply to any controlled corporation, whether or not acquired and whether or not distributed?

Successor/Predecessor Rule -- What is a successor or predecessor for purposes of section 355(e)?

Section 358(g) -- What constitutes an abusive transaction necessitating retroactive regulations? Is it necessary to provide for basis adjustments in cases where there has been no purposeful manipulation of basis?

Step-Transaction Doctrine -- Will the IRS continue to apply the step-transaction doctrine when section 355(e) applies? Will the IRS continue to apply the step-transaction doctrine when section 355(e) does not apply?

Notes

(1) In General Utilities and Operating Co. v. Helvering, 296 U.S. 200 (1936), the Supreme Court held that corporations could distribute appreciated property to their shareholders tax free. The Tax Reform Act of 1986 repealed the General Utilities doctrine, adding section 311(b) to the Internal Revenue Code. Section 311(b) imposes a corporate-level tax on the distribution of appreciated property to shareholders, as if the corporation sold such property for its fair market value.

(2) Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended.

(3) Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966), acq. Rev. Rul. 68-603, 1968-2 C.B. 148. See also Rev. Rul. 78-251, 1978-1 C.B. 89; Rev. Rul. 75-406, 1975-2 C.B. 125; Rev. Rul. 72-530, 1972-2 C.B. 212; Rev. Rul. 70-434, 1970-2 C.B. 83.

(4) Pub. L. No. 105-34 (1997).

(5) Ironically, new section 355(e) would not apply to the facts of the Morris Trust case, because the distributing corporation's shareholders in Morris Trust retained a 50-percent or greater interest in the distributing corporation following the acquisition.

(6) I.R.C. [subsections] 355(e)(1), (2)(A). The transaction otherwise qualifies as a section 355 transaction. Accordingly, the recipient shareholders do not recognize gain. All discussions relating to the application of section 355(e) in this article assume that the distribution or distributions of the controlled corporation stock qualify under section 355(a), unless otherwise noted.

(7) I.R.C. [sections] 355(e)(1) provides that stock in the controlled corporation shall not be treated as qualified property under section 355(c)(2). The amount of gain is measured by the stock of the controlled corporation, regardless of whether the distributing or controlled corporation is acquired. Any gain recognized is treated as long-term capital gain. H.R. Rep. No. 105-220, at 528, 531 (1997) (hereinafter cited as "1997 Conference Report").

(8) 1997 Conference Report 531-32.

(9) I.R.C. [sections] 355(e)(2)(B).

(10) I.R.C. [sections] 355(e)(4)(C). The relevance of the aggregation rules is discussed in note 75, infra.

(11) I.R.C. [sections] 355(e)(3)(B).

(12) I.R.C. [subsections] 355(e)(3)(A)(i)-(iv).

(13) But see text accompanying notes 50-51, infra, for a discussion of the Tax Technical Corrections Act of 1997.

(14) I.R.C. [sections] 355(e)(3)(A).

(15) I.R.C. [sections] 355(e)(2)(C). For this purpose, the term "affiliated group" is defined without regard to whether the corporations are includible corporations as defined in section 1504(b) (e.g., foreign corporations, insurance companies, or tax-exempt organizations). Id.

(16) I.R.C. [subsections] 355(e)(2)(D), (4)(B).

(17) I.R.C. [sections] 355(e)(5).

(18) I.R.C. [sections] 355(e)(4)(E).

(19) I.R.C. [sections] 355(e)(4)(D).

(20) 1997 Act [sections] 1012(d)(1), (3). In general, the amendments do not apply to any distribution pursuant to a plan involving an acquisition occurring after April 16, 1997, if such acquisition is (i) made pursuant to an agreement that was binding on such date and at all times thereafter, GO described in a ruling request submitted to the IRS on or before such date, or (iii) described in a public announcement or in a filing with the Securities and Exchange Commission on or before such date. 1997 Act [sections] 1012(d)(3).

(21) I.R.C. [sections] 355(f). Section 355(f) specifically provides that section 355(e), including the exceptions therein, applies in determining whether the intragroup distribution provisions apply. Id.

(22) I.R.C. [sections] 358(g). In general, Congress was concerned that affiliated corporations could manipulate their outside bases through the use of tax-free intragroup distributions. See text accompanying notes 52-62, infra, for a discussion of purposes of sections 355(e) and (f).

(23) 1997 Act [subsections] 1012(d)(1), (3). For a description of the transition rule, see note 20 supra.

(24) I.R.C. [subsections] 351(c), 368(a)(2)(H).

(25) See H.R. Rep. No. 105-148, at 464 (1997) (hereinafter cited as "House Report"); S. Rep. No. 105-33, at 142 (1997) (hereinafter cited as "Senate Report").

(26) 1997 Act [sections] 1012(d)(2).

(27) This proposal first appeared, in substantially identical form, in the Clinton Administration's 1997 budget, which was publicized in early 1996. See U.S. Department of the Treasury, General Explanation of the Administration's Proposals (Mar. 1996).

(28) U.S. Department of the Treasury, General Explanations of the Administration's Revenue Proposals 62 (Feb. 1997) (hereinafter cited as "Treasury Explanation of Revenue Proposals").

(29) Id.

(30) Id. at 62-63.

(31) Id.

(32) H.R. 1365, 105th Cong., 1st Sess. (1997).

(33) S. 612, 105th Cong., 1st Sess. (1997).

(34) H.R. 1365, [sections] 1(a); S. 612, [sections] 1(a).

(35) The attribution rules of section 355(d)(7) would apply to treat two or more persons acting pursuant to a plan or arrangement as one person.

(36) The introductory statement of Chairman Archer stated that "[w]hether a corporation is acquired would be determined under rules similar to those of present-law section 355(d), except that acquisitions would not be restricted to `purchase' transactions." 143 Cong. Rec. E702 (daily ed. Apr. 17, 1997) (hereinafter cited as "Introductory Statement by Chairman Archer").

(37) The reason for this change was that these transactions were viewed as sales of the distributing or controlled corporation. Thus, if the controlled corporation were acquired, the gain would be measured by the stock of the controlled corporation; if the distributing corporation were acquired, the gain would be measured by the assets of the distributing corporation. See Introductory Statement by Chairman Archer, supra note 36.

(38) H.R. 1365, [sections] 1(b); S. 612, [sections] l(b).

(39) The transition rules were essentially the same as those ultimately enacted. See note 20, supra, for a description of the transition rules.

(40) H.R. 2014, 105th Cong., 1st Sess. [sections] 1012 (1997). Section 1012 of H.R. 2014 was identical to Chairman Archer's mark as well as the House Ways and Means Committee version. Thus, the changes discussed in this part were actually incorporated in Chairman Archer's mark, and the bill passed through the House without change.

(41) Introductory Statement by Chairman Archer, supra note 36.

(42) H.R. 2014, [sections] 1012(c). The House Ways and Means Committee Report notes that the bill does not change the present-law requirement under section 355 that the distributing corporation must distribute 80 percent of the voting power and 80 percent of each class of nonvoting stock of the controlled corporation. House Report 464.

(43) Thus, the provisions discussed at the text accompanying notes 620, supra, apply equally to the Senate bill.

(44) As with the House bill, the Senate bill was identical to Chairman Roth's mark as well as the Senate Finance Committee version. Thus, the changes discussed in this part were actually incorporated in Chairman Roth's mark, and the bill passed through the Senate without change.

(56) See I.R.C. [sections] 355(e)(1). Thus, gain is not measured by reference to the entity acquired. This is similar to the approach taken in section 355(d) and in the Clinton Administration's budget proposal. See notes 27-28, supra, and accompanying text.

(46) I.R.C. [sections] 355(e)(2)(C).

(47) I.R.C. [sections] 355(e)(3)(A)(iv). But see text accompanying notes 50-51, infra, for a discussion of the Tax Technical Corrections Act of 1997.

(48) See I.R.C. [sections] 355(e)(4)(C)(ii). This was the same language that appeared in the Archer/Roth/Moynihan bill.

(49) See I.R.C. [sections] 355(f); 1997 Conference Report 534. Although the Senate bill provided that section 355(f) applies only if the distribution is part of a plan or series of related transactions described in section 355(e)(2)(A)(ii), the 1997 Act clarified that in determining whether an acquisition is described in section 355(e)(2)(A)(ii), all the provisions of section 355(e) are applied. Thus, if the acquisition would otherwise fall within an exception to section 355(e), it is not subject to section 355(f). 1997 Conference Report 534.

(50) Joint Committee on Taxation, Description of the Chairman's Mark of the "Tax Technical Corrections Act of 1997", at 32 (Oct. 8, 1997) (hereinafter cited as "JCT Description of Tax Technical Corrections").

(51) Id. Without a technical correction to section 355(e)(3)(A)(iv), a literal reading of the exception would except every transaction from the application of section 355(e). See text accompanying notes 95-97, infra, for a discussion of this exception.

(52) House Report 462; Senate Report 139.

(53) House Report 462; Senate Report 139-40.

(54) See Joint Committee on Taxation, Description and Analysis of Certain Revenue-Raising Provisions Contained in the President's Fiscal Year 1998 Budget Proposal 54-52 (Mar. 11, 1997) (hereinafter cited as "JCT Description of Budget Proposal"); Introductory Statement by Chairman Archer, supra note 36.

(55) JCT Description of Budget Proposal 51-52.

(56) See also I.R.C. [sections] 337(c).

(57) H.R. Rep. No. 101-881, at 341 (1990).

(58) See note 27, supra, and accompanying text.

(59) See Treas. Reg. [sections] 1.1502-19(g), Ex. 3.

(60) An excess loss account is generally created when a subsidiary corporation that is a member of a consolidated group makes a distribution or incurs a loss that is deducted by the group that exceeds the parent corporation's basis in the stock of the subsidiary. Treas. Reg. [sections] 1.1502-19(a)(2)(i). Such excess loss accounts are treated as negative basis for purposes of the Code and are generally required to be recaptured in certain circumstances, such as when the subsidiary leaves the group. Id. [sections] 1.1502-19(a)(2)(ii), (b). Such excess loss accounts disappear and are not required to be recaptured, however, in certain cases where there is an intragroup spin-off. See id. [sections] 1.1502-19(g), Ex. 3.

(61) See House Report 462; Senate Report 141; 1997 Conference Report 535.

(62) 1997 Conference Report 535. See also House Report 462; Senate Report 141.

(63) If P had instead acquired C, it is unclear whether the IRS would continue to apply the step-transaction doctrine to reorder the steps of the transaction. See Rev. Rul. 70-225, 1970-1 C.B. 80, and Rev. Rul. 96-30, 1996-1 C.B. 36. See also Rev. Proc. 96-39, 1996-2 C.B. 300, and Rev. Proc. 97-3, [sections] 5.17, 1997-1 I.R.B. 84 (issued Nov. 10, 1997), both of which were revoked by Rev. Proc. 97-53. See text accompanying notes 132-48, infra.

(64) The Senate Report uses the phrase "plan or arrangement." Senate Report 140 (emphasis added). The significance of the term "or arrangement" in the legislative history, however, is unclear.

(65) See New Corporate Laws Beg For Interpretive Regs, 97 TNT 196-2 (Oct. 9, 1997) (comments at meeting of D.C. Bar Tax Section's Corporation Tax Committee).

(66) Id.

(67) Id. See A.E. Staley Mfg. Co. v. Commissioner, 97-2 U.S.T.C. (CCH) [paragraph] 50,521 (7th Cir. 1997), rev'g 105 T.C. 166 (1995), where the Tax Court and Seventh Circuit disagreed over whether a transaction was hostile or non-hostile, in the context of the deductibility of acquisition costs. The Clinton Administration's original proposal had stated that "a hostile acquisition of the distributing or controlled corporation commencing after the distribution will be disregarded." See Treasury Explanation of Revenue Proposals 62.

(68) This issue was recently raised in ITT Corp. v. Hilton Hotels Corp., CV-S-97-00893-PMP (RLH) (D.C. Nev. 1997). The ITT case arose out of a transaction where ITT planned to spin off its hotel and casino business, a business that Hilton has been trying to acquire though a hostile takeover. In an affidavit filed with the court, Professor Bernard Wolfman noted that the hostile acquisition "safe harbor" that was in the Administration's original proposal had been eliminated, and thus, "[g]iven this legislative history, the pre-distribution pendency of the Hilton offer, and Hilton's expressed desire to acquire the ... business in particular, there is a likelihood that a post-distribution acquisition by Hilton of [the subsidiary] would be deemed part of a `plan' or `series of related transactions.'" Id. As described in the text accompanying notes 70-71, infra, this analysis seems incorrect, since an acquirer's plan alone should not constitute a "plan." In support of this conclusion, see Affidavit of Lewis R. Steinberg in same matter.

(69) 1996-1 C.B. 696.

(70) Rev. Rul. 96-30, 1996-1 C.B. 36, suggests that a plan of two or more persons is necessary (i.e., the plan of either the distributing corporation or the controlled corporation and the plan of the acquiring corporation).

(71) Thus, the intent of Hilton to acquire ITT should not be relevant, unless either the distributing corporation or the controlled corporation participates in the plan. See note 68, supra (reference to affidavits of Bernard Wolfman and Lewis R. Steinberg).

(72) Senate Report 141; House Report 463. The Administration's proposal contained similar language, and stated that hostile takeovers and public trading among shareholders would be treated as unrelated to the distribution. Treasury Explanation of Revenue Proposals 62. See text accompanying notes 27-31, supra.

(73) Section 355(e)(4)(E) seems to answer this question. It states that the three-year statute of limitations for assessment of deficiencies attributable to section 355(e) does not begin to run until the taxpayer notifies the Secretary that a distribution subject to section 355(e) has occurred. Thus, if a taxpayer does not notify the IRS of an acquisition occurring within the four-year period, the IRS may raise the section 355(e) issue in any future year. As a practical matter, however, it would seem necessary to litigate the substantive section 355(e) issue before deciding whether the statute of limitations has run, because the duty to notify only applies if section 355(e) applies. The IRS should issue guidance explaining what methods of notice will be required in order to begin the running of the statute of limitations.

(74) 1997 Conference Report 528.

(75) It is unclear whether certain transactions, such as gifts or bequests, are intended to be included in the term "acquire." Gifts and bequests to family members arguably should be excluded from application of section 355(e). For example, suppose D, a corporation, spins off a wholly owned subsidiary ("C") one month before D's sole shareholder ("A") dies. Assume that A's interest in D and C is bequeathed to A's spouse ("B"). Has B "acquired" D or C? Under the aggregation rules of sections 355(e)(4)(C)(i) and 355(d)(7)(A), related persons are treated as one person. Under sections 267(b)(1) and W(4), related persons include members of a family, including spouses. Thus, one can argue, A and B are treated as one person, and section 355(e) should not apply.

An argument can also be made, however, that the reference in section 355(e)(4)(C)(i) to section 355(d)(7)(A) intended the phrase "`[f]or purposes of this subsection" in section 355(d)(7)(A) to mean section 355(d) and not section 355(e). In the context of section 355(d), the aggregation rule applies to treat two or more acquirers as a single person. If section 355(e)(4)(C)(i) were read in a similar context, the aggregation rule would not apply to treat A and B as one person. If, however, the aggregation rule were interpreted in this way, there would be no need for it in section 355(e), because section 355(e)(2)(A)(ii) already states that "one or more persons" may acquire the 50-percent or greater interest, as opposed to "any person" as in section 355(d)(2). Finally, new section 355(e), as originally drafted, applied only to "a person" acquiring a 50-percent or greater interest in the distributing or any controlled corporation. Therefore, it may be the case that Congress inadvertently left the aggregation rule of section 355(e)(4)(C)(i) in the final bill after the operating rules were changed. The IRS will presumably issue guidance regarding this issue.

(76) Section 7701(a)(1)) states that the term "person" includes "an individual, a trust, estate, partnership, association, company or corporation."

(77) See I.R.C. [sections] 355(e)(3), which provides exceptions to the application of section 355(e), assumes that the persons to test under section 355(e) are the ultimate owners.

(78) See text accompanying note 95, infra, for a more detailed discussion of the continuing control exception in section 355(e)(3)(A)(iv).

(79) I.R.C. [sections] 355(e)(2)(A)(ii).

(80) 1997 Conference Report 528. In the General Motors/Raytheon deal that has received so much press recently, the Raytheon shareholders acquired 20 percent of the vote and 70 percent of the value of a spun-off General Motors subsidiary. This transaction would be taxed under new section 355(e), because Raytheon's receipt of 70 percent of the value of the subsidiary would constitute an acquisition.

(81) Treasury Explanation of Revenue Proposal 62.

(82) In addition, if a person indirectly owns an interest in a corporation by virtue of the attribution rules, section 355(e) should not apply if such person acquires an equal interest in the corporation directly.

(83) No such question appears to arise if D, as opposed to S, were acquired. Section 355(e) would apply to tax the gain in both the S stock and the C stock.

(84) See I.R.C. [sections] 355(0(2).

(85) See text accompanying notes 101-02, infra, for a more detailed discussion of the IRS's regulatory authority under section 355(e).

(86) I.R.C. [sections] 355(a)(1)(A).

(87) Section 1012 of the 1997 Act contains several references to "affiliated group," though the definitions are not consistent. Affiliated group is defined broadly (i.e., without regard to whether the corporations are includible corporations as defined in section 1504(b)) for purposes of both W the exception to plan where the distributing and controlled corporations are members of the same affiliated group immediately after the distribution and (ii) Treasury's regulatory authority with respect to distributions within affiliated groups under section 358(g). I.R.C. [subsections] 355(e)(2)(C), 358(g). On the other hand, section 355(f), which removes distributions within affiliated groups from section 355, defines affiliated group more narrowly (i.e., as defined in section 1504(a)). I.R.C. [sections] 355(f). Congress presumably intended to grant Treasury broad regulatory authority (hence, the broad definition of affiliated group). The reason for the narrow definition in the rule and the broad definition in the exception is not clear, but it appears to be drafted to the taxpayer's advantage.

(88) See 1997 Conference Report 532 (Ex. 1).

(89) The Tax Technical Corrections Act would clarify the language of section 355(e)(3)(A) so that the excepted acquisitions "shall not be taken into account in applying" section 355(e)(2)(A)(ii), rather than such acquisitions "shall not be treated as described" in section 355(e)(2)(A)(ii), thus excepting only those interests described. See text accompanying notes 50-51, supra, for a description of the Tax Technical Corrections Act of 1997.

(90) See 1997 Conference Report 533.

(91) See 1997 Conference Report 533.

(92) See text accompanying notes 98-100, infra, for an analysis of what the term "successor" means.

(93) I.R.C. [sections] 355(e)(3)(A)(iii).

(94) If P acquired the D stock in a B reorganization, would it be considered a successor within the meaning of section 355(e)(3)(A)(iii) -- or does this exception apply only to asset acquisitions? In the case of a stock acquisition, the continuing control exception in section 355(e)(3)(A)(iv), discussed in the text that follows, may apply.

(95) 1997 Conference Report 533 (Ex. 2). If, instead of A's owning 100 percent of both P and D before the acquisition, 20 different individuals owned five-percent interests in both P and D, the exception would still apply. Id. at 534 (Ex. 3).

(96) JCT Description of Tax Technical Corrections 32-33.

(97) Section 355(e)(3)(A)(iv), as enacted, excepts an "acquisition of stock in a corporation if shareholders owning directly or indirectly stock possessing" more than 50 percent of the vote and value of the distributing or controlled corporation before and after the acquisition. (Emphasis added). The Tax Technical Corrections Act would modify this language to provide that an acquisition is excepted to the extent that the percentage ownership of "each person owning stock in [the distributing or controlled] corporation immediately before the acquisition does not decrease." (Emphasis added).

(98) See, e.g., I.R.C. [sections] 382(1)(8); Treas. Reg. [subsections] 1.382-2T(f)(4)-(5), 1.33840)(6), 1.1502-1(f)(4).

(99) The term "successor corporation" also appears in section 355(e)(3)(A)(iii), which provides an exception for the acquisition of stock in a successor corporation by reason of holding stock in the distributing or controlled corporation, and in section 355(e)(3)(B), which provides that the acquisition of assets by a successor corporation in an A, C, or D reorganization is treated as a stock acquisition. These references to successor corporation seem to be in the context of tax-free reorganizations, which appears to be consistent with defining a successor corporation in terms of section 381 or other carryover basis transactions.

(100) See New Corporate Laws, supra note 65.

(101) I.R.C. [sections] 355(e)(2)(A)(ii).

(102) See text accompanying notes 83-86, supra, for a discussion of the term "any controlled corporation."

(103) See 1997 Conference Report 534.

(104) See text accompanying notes 108-27, infra, for a discussion of particular issues related to section 355(f).

(105) See 1997 Conference Report 534 (Ex. 4).

(106) The result would be the same if P acquired S instead of D.

(107) See text accompanying notes 125-27, infra, for a discussion of basis shifting in order to reduce gain.

(108) 1997 Conference Report 534-35.

(109) Id. at 537.

(110) I.R.C. [subsections] 358(b), (c); Treas. Reg. [subsections] 1.358-2(a)(2), 1.1502-19(g), Ex. 3.

(111) Treas. Reg. [sections] 1. 1502-19(g), Ex. 3.

(112) 1997 Conference Report 536.

(113) Id.

(114) Id.

(115) Treas. Reg. [sections] 1.1502-19, 59 Fed. Reg. 41666 (Aug. 12, 1994).

(116) Id. [sections] 1.1502-19(a)(2)(ii).

(117) Id. [sections] 1.1502-19(b)(1).

(118) I.R.C. [sections] 358(b), (c); Treas. Reg. [sections] 1.358-2(a)(2).

(119) Treas. Reg. [sections] 1.1502-19(g), Ex. 3(b).

(120) Id. [subsections] 1.1502-19(b)(2)(ii), -19(g), Ex. 3(c).

(121) 57 Fed. Reg. 53,634, 53,643 (Nov. 12, 1992).

(122) Treas. Reg. [sections] 1.1502-19(b).

(123) 57 Fed. Reg. at 53,643.

(124) 1997 Conference Report 535-36 (Ex. 5).

(125) In the case of a section 355 distribution, there is a deemed exchange in which the stock of the distributing corporation is treated as surrendered, and received back, in the exchange. I.R.C. [sections] 358(c).

(126) H.R. Rep. No. 68-179, 68th Cong, 2d Sess. 16-17 (1924).

(127) Treas. Reg. [sections] 1.358-2(a)(2).

(128) I.R.C. [subsections] 368(a)(1)(D), 368(c).

(129) I.R.C. [subsections] 355(a)(1)(D)(i), 368(c). If the distributing corporation retains some stock in the controlled corporation, it must at least distribute control of the controlled corporation, and it must show why the retention of the stock was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax. I.R.C. [sections] 355(a)(1)(D)(ii).

(130) The new reduced control requirement also applies to section 351 transactions that are part of section 355 transactions.

(131) See 1997 Conference Report 529. See also I.R.C. [sections] 351(c)(2).

(132) The House and Senate Reports note that "[p]resent law has the effect of imposing more restrictive requirements on certain types of acquisitions or other transfers following a distribution if the company involved is the controlled corporation rather than the distributing corporation." Senate Report 139; House Report 461.

(133) See Rev. Rul. 70-225, 1970-1 C.B. 80.

(134) Id. See also Commissioner v. Court Holding Co., 324 U.S. 331 (1944).

(135) Rev. Rul. 96-30, 1996-1 C.B. 36; see Rev. Rul. 75-406, 1975-2 C.B. 125.

(136) The IRS relied on Court Holding in determining whether the form of the transaction would be respected. If Court Holding principles applied, the transaction presumably would be recharacterized as a disposition by D of its C stock to P, followed by a distribution of the P stock received in the exchange. As recharacterized, the distribution would fail the section 355(a)(1)(D) control requirement because D would not be in control of P.

(137) Rev. Proc. 96-39, 1996-2 C.B. 300; Rev. Proc. 97-3, [sections] 5.17, 1997-1 I.R.B. 84. On November 10, 1997, the IRS issued Rev. Proc. 97-53, revoking the "no-rule" position set forth in Rev. Proc. 97-3 and Rev. Proc. 96-39. See text accompanying notes 138-48, infra, for a discussion of Rev. Proc. 97-53.

(138) If the IRS applies the step-transaction doctrine to these facts, it would presumably reorder the steps as follows. First, C would be treated as selling 60 percent of its stock to the public. Second, D would be treated as distributing its remaining C stock to its shareholders. This distribution would fail the section 355 control requirement, as D held only 40 percent of the C stock. The transaction would not qualify under section 355, and there would be both a corporate and shareholder-level tax. See Rev. Rul. 96-30, 1996-1 C.B. 36.

(139) Section 355(e) applies because there is a section 355 distribution that is part of a plan pursuant to which one or more persons (i.e., the public group) acquire stock representing a 50 percent or greater interest in the controlled corporation.

(140) See Senate Report 140; House Report 462.

(141) 1997 Conference Report 529-30 (emphasis added); see Senate Report 142.

(142) The above analysis should also apply equally to the application of the step-transaction doctrine to the section 368(a)(1)(D) control test, as in Rev. Rul. 70-225.

(143) Rev. Proc. 97-53 (issued Nov. 10, 1997).

(144) Section 355(e) does not apply because there is no section 355 distribution that is part of a plan pursuant to which one or more persons acquire stock representing a 50 percent or greater interest in the controlled corporation. The public only acquires 40 percent of C.

(145) Again, this analysis should also apply equally to the application of the step-transaction doctrine to the section 368(a)(1)(D) control test, as in Rev. Rul. 70-225.

(146) See New Corporate Laws, supra note 65.

(147) Id.

(148) See I.R.C. [sections] 355(e), enacted in 1997, and I.R.C. [sections] 355(d), enacted in 1990.

MARK J. SILVERMAN is a partner and chairs the tax and ERISA group at Steptoe & Johnson LLP.

ANDREW J. WEINSTEIN and LISA M. ZARLENGA are associates with the firm who focus on corporate tax issues. Mr. Silverman is a frequent speaker at educational programs sponsored by Tax Executives Institute.

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