The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 11, June 2002, Panel Publishers, New York, NY.


By Robert W. Wood

M&A Tax Report readers know our fascination with Section 355. Okay, perhaps fascination is the wrong word. Obsession may be more like it. Since Section 355(e) was enacted in 1997, though, there's been a decided chilling effect on Section 355 transactions.

Section 355(e) itself was a big shocker. Based on Commissioner v. Morris Trust, 367 F2d. 794 (4th Cir. 1966), taxpayers were long able to combine a tax-free spinoff with a tax-free reorganization to ensure that a target corporation was lean and mean. The idea was to strip the target of unwanted businesses that were unsuitable to the acquiring company. In the inaptly named Taxpayer Relief Act of 1997, the IRS and Congress got together and, voila, Section 355(e).

Section 355(e) provides that a distributing corporation must recognize gain on the distribution of controlled corporation stock that otherwise would qualify under Section 355 if a couple of requirements are met. The requirements (to disallow the spin) are merely that one or more persons acquire stock representing a 50 percent or greater interest in either the controlled or the distributing corporation pursuant to a plan or series of unrelated transactions that was in existence on the date of the distribution. On August 24, 1999, proposed regulations were issued to define a plan or series of related transactions. For full coverage, see Wood, "Morris Trust Regulations At Last," Vol. 8, No. 3, The M&A Tax Report (October 1999), page 7, and Vol. 8, No. 4, M&A Tax Report (November 1999), page 7. A good bit about Section 355(e) was maddening, particularly the proposed regulations. See Malik, "Living With 355(e)," Vol. 8, No. 11, The M&A Tax Report (June 2000), page 1.

The IRS published proposed regulations on January 2, 2001 dealing with the thorny topic of whether and when a distribution and an acquisition are part of a "plan." See REG-107566-00. These proposed regs were published as temporary regulations on August 3, 2001. See T.D. 8960. See Wood, "Temporary Morris Trust Regs Issued," Vol. 10, No. 3, The M&A Tax Report (October 2001), page 5.

Training Day?

After all the hoopla, the good news is that the anti-Morris Trust rule of Section 355(e) has been enormously liberalized. A new set of proposed and temporary Section 355(e) regulations released in April 2002 provide a good bit of relief. In light of these new proposed and temporary regulations, maybe we should spell relief with a double "e". Before we embark on a brief tour of the new rules, a couple of points.

First, these rules invite taxpayer reliance all the way back to the effective date of Section 355(e) of the Code, i.e., for distributions occurring after April 16, 1997. It is hard to think that anyone would not want to apply these rules, but Treasury is clear that if you do want to apply the regulations back to transactions occurring in the past, you need to apply them in whole (not merely in part). So you can't pick and choose item by item between these temporary and proposed regs and the couple of prior sets of them. Comments and requests for public hearing are due by July 25, 2002.

Look Who's Talking?

At their core, the new temporary and proposed Section 355(e) Regs focus on how much talking is enough to impute a nefarious intent. The basic rule now is that, except in the case of acquisitions involving a public offering, a distribution and a post-distribution acquisition can be part of a "plan" only if there is an agreement, understanding, arrangement, or substantial negotiations regarding the acquisition or a similar acquisition at some time during the two-year period ending on the date of the distribution. This is all to the good.

Bear in mind that the 2001 proposed regulations had identified a number of facts and circumstances that the IRS felt tended to show whether a distribution and an acquisition were part of a plan. Not surprisingly, a whole host of commentators argued that the rules should focus heavily (and perhaps even exclusively) on whether there were bilateral discussions, or even an agreement, understanding or arrangement regarding the acquisition within a certain period of time prior to the distribution. Happily, the revised temporary regulations more narrowly define how one can conclude that a plan exists.

In addition, the list of facts and circumstances in the revised temporary rules that the IRS things tend to show that a distribution and acquisition are part of a plan has been substantially narrowed. This occurs in a couple of ways. One is the concept of what constitutes a "similar acquisition." The 2001 proposed regulations had provided that an acquisition and an intended acquisition could be "similar" even though the identity of the person acquiring stock of the distributing or controlled corporation, the timing of the acquisition, or the terms of the actual acquisition are different from the intended acquisition.

The new 2002 temporary regulations set forth a definition of "similar acquisition" that is a good deal narrower than the earlier one. Now, an actual acquisition (other than a public offering or other stock issuance for cash) will be similar to another potential acquisition if the actual acquisition affects a direct or indirect combination of all or a significant portion of the same business operations as the combination that would have been effected by such other potential acquisition.

One of the big topics of discussion over the past couple of years is how much negotiations would be enough. Even without an agreement, if there is an acquisition near in time to the spinoff and there have been substantial negotiations at the time of the spin, there will be trouble. The term "substantial negotiations" has been thrown around a lot, and it really is subject to differing interpretations.

Fortunately, the 2002 temporary regulations include a definition of "substantial negotiations," providing that, in the case of an acquisition other than a public offering, substantial negotiations generally require discussions of significant economic terms by one or more officers, directors, or controlling shareholders of the distributing or controlled corporation, or another or person or persons with the implicit or explicit permission of one of those individuals. The substantial negotiations by one of those persons have to be with the acquirer or a person or persons with the implicit or explicit permission of the acquirer. Maybe this identification of who the players are doesn't help a lot. It is obviously necessary to also know what the "significant economic terms" would include. They would certainly include the exchange ratio in a reorganization. How much more these significant economic terms might include is not clear. The idea, though, is that this definition of "substantial negotiations" is supposed to clarify that both the content of, and persons engaging in, the discussions will be prohibitive of whether these discussion are truly "substantial."

All About Safe Harbors

There was a good deal of in terrorem effect to the 2001 proposed regulations. Perhaps as a result, the IRS had proposed various safe harbors that would take one out of the soup. Safe Harbors I and II of the 2001 proposed regulations provided certainty that a distribution and acquisition occurring thereafter would not be integrated if, among other conditions, the acquisition happened more than six months after the distribution, and there was no agreement, understanding, arrangement or substantial negotiations concerning the acquisition before that six-month window closed.

One big question about these safe harbors was whether such substantial negotiations would always prevent the safe harbors from being available, or only if something ended up happening. Stated differently, what if there are substantial negotiations within the prohibited window, but those negotiations terminate without an agreement prior to the distribution, and do not resume until six months or one year after the distribution?

Fortunately, the IRS and Treasury now have decided that an agreement, understanding, arrangement or substantial negotiations concerning the acquisition should make Safe Harbors I and II unavailable only if those events exist or occur during that period beginning one year prior to the distribution and ending six months thereafter. That makes Safe Harbors I and II a little more interesting.

Business purpose has also been liberalized. Safe Harbor I of the 2001 proposed regulations states that it can be used only if the distribution was motivated (in whole or in substantial part) by a corporate business purpose other than a business purpose to facilitate an acquisition. Now, only acquisitive business purposes related to the acquired corporation will be considered relevant.

Safe Harbor II has been liberalized, too, to eliminate one of the two percentage tests that had been included within this rule in the 2001 proposed regulations. The old Safe Harbor II included a 33% and a 20% test. The new Safe Harbor II now indicates that no more than 25% (up from 20%) of the acquired corporation can be acquired before a date that is six months after the distribution. Moreover, for purposes of this 25% test, only stock that is acquired or is the subject of an agreement, understanding, arrangement, or substantial negotiations at some time during the period that begins one year before the distribution and ends six months thereafter (other than stock that is acquired in a transaction described in Safe Harbor's V, VI or VII) will be counted.

Safe Harbor V as included in the 2001 regs had provided that an acquisition of stock of the distributing or controlled corporation that is listed on an established market will not be part of a bad "plan" if the acquisition occurs pursuant to a transfer between shareholders neither of whom is a 5% shareholder. This Safe Harbor V has been expanded to extend the Safe Harbor's availability to persons that are neither controlling shareholders nor 10% shareholders either immediately before or immediately after the transfer. Some other refinements to Safe Harbor V are made, so a detailed examination of the new proposed rules should be made.

Safe Harbor VI was also changed a good bit. In particular, that safe harbor was extended to stock acquired by independent contractors in connection with the performance of services, and to stock acquired pursuant to certain stock compensation plans. On the other hand, Safe Harbor VI now will not protect management leveraged buy-outs and going private transactions that are part of a plan that includes a distribution.

Finally, a new safe harbor is added (Safe Harbor VII) to provide that acquisitions of stock of the distributing or controlled corporation by a retirement plan of an employer that qualifies under Section 401(a) or 403(a) will not be treated as part of a plan that includes a distribution. Various limitations are provided.

Still More

There are a number of other refinements made in the 2002 proposed regulations. One topic relates to the question whether, at the time of the distribution, there was "reasonable certainty" that, within six months after the distribution, an acquisition would occur, an agreement, understanding, or arrangement would exist, or substantial negotiations would occur regarding an acquisition. The good news is that the 2002 temporary regulations delete this reasonable certainty rule in light of the new emphasis on discussions or an agreement, understanding, arrangement or substantial negotiations.

Likewise, the 2001 proposed rules had suspended the running of any of the relevant time periods during which risk of loss was diminished. The temporary regs just issued have eliminated this substantial diminution of risk rule, though the preamble to the 2002 proposed regulations indicates that the IRS and Treasury are going to continue considering the proper application of this diminution of risk concept.

Options are also considered in the 2002 proposed regs, and various interpretive rules about options are now provided.


The IRS has concluded that it is difficult to define an auction in a manner that identifies situations in which it is appropriate to apply the auction rules of the 2001 proposed regulations. As a result, the new temporary regulations eliminate the distinction between acquisitions that result from an auction and acquisitions that do not (except in the case of acquisitions involving a public offering).

Business Purpose

The symbiotic relationship between Section 355 and business purpose has long been noted. See Wood, "Spinoff Business Purpose: Two Is Better Than One," Vol. 8, No. 6, M&A Tax Report (January 2000), p. 7. See also Wood, "Spinoffs and Cost Savings: Is It The Business Purpose," Vol. 7, No. 12, The M&A Tax Report (July 1999), p. 1. Don't forget that a good non acquisition related business purpose for a distribution will protect a distribution, even if a later sale of the subsidiary just happens to occur. If a corporation distributes a subsidiary for a good non-acquisition business purpose — even where the market is so hot that it is possible or even reasonably certain that an acquisition of that subsidiary will occur — it should be okay. The distribution and later acquisition in this instance should not be considered part of a plan, as long as there were no substantial negotiations regarding the acquisition before the distribution. That represents a huge liberalization.

"E" Is For Excellent: The New 355(e) Regulations, Vol. 10, No. 11, The M&A Tax Report (June 2002), p. 1.