DEVICES UNDER SECTION 355: WHO, ME?
Recently, we looked at one aspect of the "device" rule, which arises
frequently under Section 355. See Wood, "Spinoffs and Cost Savings: Is
It The Business Purpose?" Vol. 7, No. 12 M&A Tax Report (July
1999, p. 1). The regulations under Section 355 are pretty clear as to the
factors it considers "device factors" and those that it considers "nondevice
factors." These should roll off the tongue, perhaps more than the "nondevice"
designation does. It is important to try to list as many factors as you
have in the good side of the column as opposed to the bad.
Pro Rata
Perhaps the best evidence of a device, even though it is a bit of
a tautology, is if the distribution is pro rata. A dividend distribution
would be pro rata. As such, a pro rata distribution under Section 355 would
present the greatest potential for the avoidance of the dividend provisions
of the Code. See Reg. §1.355-2(d)(2)(ii).
Second, a subsequent sale or exchange of the stock is also considered
an indication of a device. The regulations don't give a great deal of guidance,
except to say that the greater the percentage of the stock sold or exchanged
after the distribution, the stronger the evidence of the device generally
is. The shorter the time between the distribution and the sale, the stronger
the evidence of the device. See Reg. §1.355- 2(d)(2)(iii).
What is perhaps more relevant is exactly how the sale or exchange
is negotiated. A sale that is agreed to before the distribution is "substantial
evidence" of a device. On the other hand, a sale that is not made pursuant
to a pre-arranged deal is still evidence of a device. See Reg. §1.355-2(d)(2)(iii)(D)
and (C).
Type of Assets
Another factor that is considered relevant in assessing the device
status of a spin is the nature and use of the assets. The existence of
assets that are not used in a trade or business that satisfies the Section
355(b) requirements will constitute evidence of a device. Typical examples
of such assets include cash and other liquid assets that are not related
to the reasonable needs of the business.
The strength of this evidence of a device depends on all facts and
circumstances, including the ratio of the value of assets not used in a
trade or business to the value of assets that satisfies the Section 355(b)
requirements. A difference in this ratio between the distributing and controlled
corporations is ordinarily not evidence of a device if the distribution
is not pro rata among shareholders of the distributing corporation, and
if the difference is attributable to a need to equalize the value of the
stock distributed and the value of the stock or securities exchanged. Thus,
cash and other liquid assets can be used as equalizing devices in a non-pro
rata spin with much more certainty. See Reg. §1.355-2(d)(2)(iv)(B).
In other words, the standards for non-pro rata spinoffs are substantially
easier, both on the surface and once one begins to look at particular consideration
distributed.
Related Function
The last "device" factor mentioned in the regulations (although there
are some mentioned in other literature) is the "related function." There
will be evidence of a device if a business of either the distributing or
controlled corporations (or a downstream subsidiary) is a secondary business
that continues as a secondary business for a significant period after the
separation, and if the secondary business could be sold without adversely
affecting the business of the other corporation.
What's all this about? A secondary business is one that either the
distributing or controlled corporation operates if its principal function
is to serve the business of the other corporation (or a corporation controlled
by it). A secondary business can include a business transferred to a newly-created
subsidiary or a business which serves a business transferred to a newly-created
subsidiary.
The activities of the secondary business may consist of providing
property or performing services. The regulations refer to an example where
there is evidence of a device if the principal function of a coal mine
continued after the separation and the coal mine could be sold without
adversely affecting the steel business. See Reg. §1.355-3(c), Example
11. Likewise, there would be evidence of a device if the principal function
of a sales operation after a 355 separation, is to sell the output from
the manufacturing operation, and the sales operation could be sold without
adversely affecting the manufacturing operation. See Reg. §1.355-3(c),
Example 10. Regarding the related function device factor, see Reg. §1.355-2(d)(iv)(C).
Non-Device Factors
Whether one agrees with the English grammar associated with the "non-device"
factor, the list is always a helpful one. As we noted recently (see Wood,
"Spinoffs and Cost Savings: Is It The Business Purpose?" Vol. 7, No. 12
M&A Tax Report (July 1999), p. 1.), perhaps the most important non-device
factor is the corporate business purpose. The strength of a corporate business
purpose is evidence of a non-device. The stronger the evidence of the device
(pro rata, let's say), then the stronger the corporate business purpose
will be required in order to refute it.
All this sounds a bit silly, but when one is requesting a ruling
(or, God forbid, litigating over these issues), the importance of the device
and non-device factors cannot be overstated.
The regulations even give a hierarchy for thinking about a corporate
business purpose. Assessing the strength of a business purpose is based
on all facts and circumstances, but at least the following:
Dividends Received Deduction?
Finally, believe it or not, it is a non-device factor if the stock
of the controlled corporation is distributed to one or more domestic corporations
that, if Section 355 did not apply, would be entitled to a dividends received
deduction under Section 243. Once one gets over the headscratching, this
makes eminent sense. It is one facet of the "available alternatives" notion.
If the tax consequence would not be too terrible of not applying Section
355, then presumably there cannot have been intended a device to distribute
earnings and profits.
A dividend, in this case, would have been a dividend qualifying for
the dividends received deduction anyway. For details, see Reg. §1.355-2(d)(3)(iv).
This is kind of a "no-harm-no-foul" concept.
More on Devices
In a future issue, we'll look at more of the lore of the device and
the non-device. The regulations give illustrations of transactions that
are not ordinarily considered devices. As a practical matter, although
these are not classed as "non-device" factors, they seem to have the same
effect. Perhaps the best-known example is the absence of earnings and profits!
(See Reg. §1.355-2(d)(5)(ii).)
Next time, we'll look at some illustrations, as well as some of the
Service's further announcements on the device and non-device debate. Stay
tuned for that coverage.
Devices Under Section 355: Who, Me?, Vol. 8, No. 3, M&A
Tax Report (October 1999), p. 6.
Another non-device factor is present where the distributing corporation
is publicly traded and widely held. Reg. §1.355-2(d)(3)(iii).