May 12, 2017
The Internal Revenue Service has announced that it will recommence issuing private letter rulings concerning whether a distributing corporation’s transfer of stock or securities of a controlled corporation (or “Spinco”) in exchange for debt of the distributing corporation would qualify for tax-free treatment in cases where such distributing corporation debt is issued in anticipation of a spin-off transaction intended to qualify under Sections 368(a)(1)(D) and 355. This action reverses a policy adopted by the IRS in early 2013 when the IRS announced that it would no longer issue private letter rulings on debt exchanges in any case where the distributing corporation debt was issued in anticipation of the spin-off. The IRS recently has also announced that it will recommence issuing private letter rulings concerning North-South transactions (defined below) and published a Revenue Ruling setting forth in general the IRS’s position on such transactions.
If sections 355 and 361 apply to the issuance of Spinco shares and/or debt securities to the distributing corporation and the subsequent exchange of such Spinco shares or securities for debt of the distributing corporation, the distributing corporation recognizes no gain. This result is notwithstanding that the Spinco shares or securities may have little or no tax basis in the hands of the distributing corporation after such tax basis is reduced to account for any cash received from, or liabilities assumed by, Spinco in exchange for Spinco’s assets. As a commercial and financial matter, debt exchanges allow a distributing corporation to reduce its leverage to take into account the disposition of Spinco assets in the spin-off (including a disproportionate deleveraging). A deleveraging debt exchange allows the distributing corporation to increase its equity value without incurring corporate income tax, which is commonly referred to as a “monetization strategy.” The distributing corporation also may implement as an additional monetization strategy the receipt of cash from Spinco, which is tax-free to the extent of the tax basis in the Spinco assets and so long as the cash is used to promptly repay creditors or distributed in pursuance of the plan of reorganization.
In several cases, before and after the 2013 policy change, distributing corporations have facilitated or enhanced their debt exchanges by issuing, usually to investment banks, short-term debt with a term of ninety or fewer days. After the bank held the debt for a minimum amount of time (typically 5 days), the parties then entered into an exchange agreement under which the bank was required to swap the distributing corporation’s debt for Spinco equity or debt securities, typically 14 days after the bank had acquired the distributing corporation debt, if the spin-off was consummated. Immediately after the exchange, the bank would then sell the Spinco equity or debt securities (through its underwriting desk). Entering into a debt exchange with an initial purchaser of its short-term debt allows the distributing corporation to complete the debt exchange without negotiating with its existing creditors, who may have no interest in holding Spinco equity or debt securities and who may be difficult to locate and aggregate, and without bearing what amounts to a substantial premium to compensate an intermediary that has tendered for existing debt of the distributing corporation in anticipation of acquiring Spinco equity or debt securities in the debt exchange.
When this type of debt exchange was added to the no-ruling list, the IRS indicated that it was studying whether to issue guidance related to such transactions. Although the IRS now will, in certain circumstances, issue private letter rulings on debt exchanges where the retired distributing corporation debt was issued in anticipation of the spin-off, Revenue Procedure 2017-38 does not indicate the situations in which the IRS may rule or the representations the IRS may require and does not articulate the legal analysis the IRS will apply to requests for such rulings. The availability of tax-free treatment for this type of debt exchange under section 361 is clearly rooted in the statute itself, which requires only that the Spinco securities be transferred to “creditors” of the distributing corporation. Any representations required by the IRS in this context may be related to confirming that the exchanging debt holder is in substance a creditor holding the debt of the distributing corporation for its own account as principal rather than an agent or conduit.
The IRS also recently issued guidance, in Revenue Ruling 2017-9, clarifying the treatment of so-called “North-South transactions,” in which property is transferred to the distributing corporation either by the Spinco (before the transfer of assets to the Spinco pursuant to the reorganization) or by the controlling shareholder of the distributing corporation (before or in connection with the spin-off distribution of Spinco stock to that shareholder). Concerns had been raised in North-South transactions whether the ostensibly separate transactions should be integrated. As part of this Ruling, the IRS also removed North-South transactions from the list of no-rule areas; North-South transactions had been added to the no-rule list in early 2013 along with the debt exchanges discussed above.
The Ruling concludes, in Situation 1, that a transfer of assets by a controlling shareholder to a distributing corporation that otherwise qualifies as a non-recognition transaction (if analyzed without taking into account the spin-off), will not be treated as part of an exchange for the Spinco stock received by the shareholder, regardless of whether the purpose of the asset transfer was to allow the spin-off to qualify under Section 355 or whether the asset transfer would not have occurred in the absence of the spin-off. As a result, the distribution-of-control requirement for spin-offs, which generally requires a distribution of 80% of the Spinco stock, will not be violated by such transfer because the amount of Spinco stock treated as distributed in the spin-off will not be reduced by treating some or all of the Spinco stock as exchanged for the assets received from the shareholder.
In contrast, the Ruling concludes, in Situation 2, that where the Spinco transfers cash and/or other nonqualifying property to the distributing corporation in pursuance of the plan of reorganization pursuant to which the parties complete a divisive reorganization under Sections 368(a)(1)(D) and 355, the parties cannot treat Spinco’s transfer as a distribution under Section 301 (regardless of whether the transfer might have occurred in the absence of the reorganization). Instead, Spinco will be treated as transferring unqualified property (“boot”) to which Section 361(b) applies, with the result that the boot must be distributed to shareholders or creditors in order for the receipt of the boot to be tax-free. The IRS now will consider providing letter rulings on North-South transactions that apply the holdings and reasoning of Revenue Ruling 2017-9.
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If you wish to receive more information on spin-offs, mergers and acquisitions or the IRS letter ruling process generally, you may contact your regular Shearman & Sterling contact person or any contact person listed in this publication.
 Rev. Proc. 2017 38, 2017 22 I.R.B. 1 (May 9, 2009). Unless otherwise noted, all section references herein are to the Internal Revenue Code of 1986, as amended (the “Code”).
 Rev. Proc. 2013-3, section 5.01(10), 2013-3 I.R.B. 113 (Dec. 31, 2013).
 Rev. Rul. 2017-9, 2017-21 I.R.B. 1 (May 3, 2017).