March 02, 2020
On February 28, 2020, the Internal Revenue Service (the “IRS”) released PLR 202009002, the first private letter ruling that will potentially permit a tax-free spin-off of a research and development (“R&D”) intensive business with no income prior to the spin-off (the “Ruling”). The Ruling treated an R&D intensive business as satisfying the active trade or business requirement for a tax-free spin-off despite the fact that it had not satisfied the traditional requirement that a trade or business have income to qualify as an active trade or business. The Ruling followed a September 2018 announcement that the IRS was undertaking a study to consider whether to allow R&D intensive businesses to be treated as active in certain circumstances in which revenue had not yet been generated. Although the identity of the taxpayer is not disclosed in the Ruling, the four step process described in the Ruling seems generally comparable to the process for getting a new drug approved by the Food and Drug Administration. The Ruling likely opens the door to those in the life sciences industry and other R&D intensive industries obtaining favorable spin-off private letter rulings in similar situations.
For a spin-off to qualify as tax-free under section 355 of the Internal Revenue Code, each of the distributing corporation (“Distributing”) and the controlled corporation (“Controlled”) must be engaged in a five-year active trade or business immediately after the spin-off. In general, to qualify as a five-year active trade or business, the business must collect income and have expenses during the five-year period preceding the spin-off. Although the IRS has on occasion issued private letter rulings with respect to businesses that did not have income during each year of the five-year period preceding the spin-off, it has always required a business to have some income during the five-year period preceding the spin-off to be treated as an active trade or business. In 2019, the IRS issued a private letter ruling in which a five-year active trade or business had income prior to the spin-off but faced uncertain prospects for earning income following the spin-off. The Ruling is the first private letter ruling publicly released in which the five-year active trade or business in question had no income prior to the spin-off.
In the Ruling, the IRS evaluated a situation in which Distributing created certain products through a four-step process. Prior to the creation of the trade or business to be contributed to Controlled (the “Controlled Business”), in developing new products, Distributing engaged in step 1 and parts of step 2 of the process on its own and in the remainder of step 2 and later steps of the process through license and collaboration agreements with third parties (the “Distributing Business”). Unlike the Distributing Business, the Controlled Business planned to undertake later portions of step 2 and step 3 with respect to a new product. As a result, it appears that the Controlled Business would not start earning income with respect to the new product until a later point in the R&D process because it would not receive income from entering into license and collaboration agreements during step 2 or step 3. The Controlled Business, however, did intend to engage with other industry partners with the knowledge, experience, and salesforce to move the new product through step 4. In step 4, the Controlled Business was expected to earn income through royalties, milestone payments, or profit splits.
Distributing represented to the IRS that it would become easier to earn revenue as the Controlled Business item moved further through the development process. In addition, Distributing stated that after step 3, Controlled would partner with others in the industry in ways in which it would be likely to start earning revenue before the item was fully commercialized. Distributing also provided the IRS with a list of recent comparable products developed by others in the market in which licensing income was earned during later portions of step 2. Based on these facts and representations, the IRS ruled that the absence of the collection of income would not prevent the Controlled Business from satisfying the five-year active trade or business requirement.
Although the IRS prefers issuing published guidance that applies to as many taxpayers as possible, the factually-intensive nature of the Ruling makes it seem likely that the IRS will not issue broadly applicable guidance on this topic for some time to come. In general, the IRS views its private letter ruling program as a laboratory for developing guideposts that can become a part of more broadly applicable published guidance in the future. While the Ruling reflects the particular facts on which the IRS decided it would rule in this instance, the IRS could also be willing to issue favorable spin-off private letter rulings to companies in other industries with different facts. Given the degree to which the IRS’s ruling policy is likely to continue to evolve in this area, companies with research-intensive businesses that they would like to spin-off should have their counsel contact the IRS National Office to discuss their particular facts in advance of submitting a private letter ruling request.