The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 3, October 2001, Panel Publishers, New York, NY.


By Robert W. Wood

The proposed regulations issued under Section 355 involving Morris Trust transactions have been controversial. Issued almost as a New Years Day present in 2001, the proposed regs focus on defining just what constitutes a plan for purposes of that insidious Code provision, section 355(e). For coverage, see Wood, "New Section 355(e) Rules Save Us!" Vol. 9, No. 7, M&A Tax Report (February 2001), p. 1. Various commentators have sought change. For example, the ABA Section of Taxation Corporate Tax Committee has recommended that the regulations state that a plan cannot be based on the intentions of one party unless that party has the unilateral ability to control all of the necessary steps to achieve its intent. This committee also recommended eliminating the concept of a similar acquisition in example 7. They also recommended modyifying the reasonable certainty operating rule so that a "hot market" would not reflect a business purpose to facilitate an acquisition.

Plus, the committee asked that the scope of the term "substantial negotiations" be clarified, and that the tolling of time periods under the substantial diminution of risk operating rule. They also suggested that the Service ought to issue interim guidance that allows individuals to rely on the proposed regs until further guidance is issued. The ABA also recommended changes to the safe harbor rules. The members of the committee suggested that the first safe harbor should be clarified so that a taxpayer that satisfies the six-month rule would have to demonstrate only the existence of a real nonacquisition business purpose to meet the business purpose test. Finally, the committee recommended expanding safe harbor six on equity comnpensation to include all transfers of stock for services except for services by an independent contractor in conjuction with an acquisition that is a part of a section 355(e) plan.

Temporary Rules

Happily, Temporary Regulations have now been issued on the topic of what constitutes a plan for purposes of section 355 (e). The Temporary Regulations adopt the proposed regulations that were issued back in January 2001, with only a couple of modifications (discussed below). Although the ABA comments mentioned above may have been too late to have any appreciable effect on the Temporary Regs, there is at least some good here. Indeed, a recurrent theme throughout many of the comments on these Proposed Regulations was that some immediate action on the part of the Service was needed.

As noted, the Temporary Regulations, T.D. 8960, effective August 6, 2001, adopt the proposed regulations that were issued on January 2, 2001. However, they reserve Reg. section 1.355-7(e)(6) and Example 7 for further study. The reserved section deals with the suspending of the running of the time period in which there is substantial diminution of risk of loss under section 355(d)(6)(B). Example 7 interprets the term "similar acquisition" in situations involving multiple acquisitions.

Many comments to the Proposed Regulations had indicated that the lack of guidance under section 355(e) hindered their ability to undertake acquisitions and divestitures. Understandably, these comments requested that the Service provide some form of immediate guidance.

What's A Plan?

Because these Temporary Regulations pick up (with the two exceptions noted above) the language of the Proposed Regulations, one needs to look at those. Recall that the underlying theme of Section 355(e) is the existence of an agreement, understanding, arrangement, or — here it comes — mere "substantial negotiations." Both the Temporary Regulations on this point, and the preamble to the Proposed Regulations issued in January (again, the Proposed and Temporary Regulations cover the same ground) are worth noting here.

A binding contract is obviously an agreement. Yet, depending on all of the relevant facts and circumstances, the parties can have an "agreement, understanding or arrangement" even though they have not reached agreement on all terms. In some cases, such as initial public offerings or options of the distributing or controlled corporation stock, an agreement, understanding, arrangement or substantial negotiations can exist regarding an acquisition even if the acquirer has not been specifically identified. This last concept (substantial negotiations being present even when a specific acquirer has not been identified) may seem unduly tough. I think this is a hangover of the IRS' strict regimen that came out in the first set of proposed section 355(e) regulations.

It seems quite troubling — something we noted in reviewing the Proposed Regulations in January 2001 — that there is not more discussion about defining just what an "understanding, arrangement or substantial negotiation" truly is. What body of law applies? Is this just step transaction doctrine theory or what? Most of the case law developed under the step transaction doctrine was pretty favorable to taxpayers. Yet, it seems the Service has some darker thoughts here than merely the kind of binding contract analysis that has been applied in much of the step transaction case law. After all, the Proposed Regulations — and now the Temporary ones — say that mere "substantial negotiations" can be enough.

If one needed any proof that mere negotiations can be enough (if the negotiations are "substantial"), one need only look at the rules governing plan inferences. One of the more troubling plan factors is whether the distribution was motivated by a business purpose to facilitate the acquisition, or a similar acquisition of the distributing or controlled corporation. Evidence of a business purpose to facilitate an acquisition of the distributing or controlled corporation exists if there was a 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. See Temp. Reg. §1.355-7(e)(1)(i). Internal discussions by themselves may be indicative of the business purpose that motivated the distribution.

Another element that can indicate the existence of a plan examines whether the debt allocation between the distributing and the controlled corporations made an acquisition of the distributing or the controlled corporation likely to service the debt. This reference to debt service may be easy to manipulate, but it also may be easy for the Service to use where taxpayers are not careful to monitor their debt structure.

Here's a Plan...

All in all, it is certainly good to have some guidance, as we now do in the form of Temporary Regulations that are already effective. Still, there are nettlesome concerns about section 355(e). Most of us might be happier with section 355 being eradicated from the Code. Of course, this is not likely to happen anytime soon....

Temporary Morris Trust Regs Issued, Vol. 10, No. 3, M&A Tax Report (October 2001), p. 5.