Device prohibition, active trade or business requirement under section 355

Device prohibition, active trade or business

The Treasury Department and IRS today released for publication in the Federal Register proposed regulations (REG-134016-15) to provide additional guidance regarding the device prohibition under section 355(a)(1)(B) (the “Device Prohibition”), and to clarify the application of the active trade or business requirement under section 355(b) (the “ATB Requirement”) by establishing a minimum threshold for the assets of one or more active trades or businesses of the distributing corporation (“Distributing”) and each controlled corporation (“Controlled”).

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If finalized, these “Proposed Regulations” would affect Distributing and each Controlled, as well as their respective shareholders and security holders.

Read text of the Proposed Regulations [PDF 355 KB] which will appear in the Federal Register on Friday, July 15, 2016. Comments and requests for a public hearing about the Proposed Regulations must be received by a date that is 90 days after July 15, 2016.

Reasons for “Proposed Regulations”

The Treasury Department and IRS provide through the Proposed Regulations’ preamble, a summary of the requirements under section 355; a discussion regarding the legislative history and the development of current law and IRS practice under section 355 and underlying regulations; and the rationale for the Proposed Regulations.  

“Proposed Regulations”

Device prohibition: With respect to the Non-Device Requirement, the Proposed Regulations focus on the existence and allocation of “Non-Business Assets” and, although generally retaining the “all-facts-and-circumstances” inquiry of the existing regulations, introduce a per se rule that would find the existence of a device in certain circumstances.  

Unlike Rev. Proc. 2015-43, 2015-40 I.R.B. 467, and Notice 2015-59, 2015-40 I.R.B. 459, which focused on “Investment Assets,” the Proposed Regulations distinguish between “Business Assets” and “Non-Business Assets.”  

  • Business Assets are defined as assets used in one or more “Businesses.” A Business generally is defined as an active trade or business within the meaning of section 355(b) without regard to the five-year requirement (and the new 5% minimum threshold imposed by the Proposed Regulations with respect to section 355(b)).  
  • Nonbusiness Assets are defined as assets other than Business Assets.

Business Assets include cash and cash equivalents held as a “reasonable amount” of working capital and assets “required (by binding commitment or legal requirement) to be held to provide for exigencies related to a Business or for regulatory purposes with respect to a Business” (emphasis added).  

The Proposed Regulations introduce the term “Nonbusiness Asset Percentage,” which is the percentage calculated by dividing the gross fair market value of the Nonbusiness Assets by the gross fair market value of the total assets.  

In elaborating on the existing device and non-device factors in the current regulations, the Proposed Regulations provide that the existence of Nonbusiness Assets, and a disproportionality as to such assets between Distributing and Controlled, generally constitute evidence of device. However, the Proposed Regulations provide that, ordinarily, ownership or allocation of Nonbusiness Assets is not evidence of device if: 

  1. The Nonbusiness Asset Percentage for each of Distributing and Controlled is less than 20%, or 
  2. (x) The difference in the Nonbusiness Asset Percentage of Distributing and Controlled is less than 10 percentage points, or (y) the distribution is not pro rata and the difference is attributable to the need to equalize value. 

The Proposed Regulations contain rules permitting the ability to look through: (1) partnerships whose businesses would be attributed to Distributing or Controlled for section 355(b) purposes and (2) a member of a “50-Percent-Owned Group” (which generally incorporates a separate affiliated group (“SAG”) concept but replaces the 80% ownership threshold with a 50% threshold).

The Proposed Regulations add a per se rule providing that a distribution is considered to have been used principally as a device, notwithstanding the presence of nondevice factors, when: 

  1. The Nonbusiness Asset Percentage of Distributing or Controlled is 66⅔ % or more, and 
  2. Certain disparities exist between the Nonbusiness Asset Percentages of Distributing and Controlled. 

This second prong is based upon a sliding scale.  Specifically, the per se rule will apply (subject to the exceptions described below) if: 

  1. (x) The Nonbusiness Asset Percentage of either Distributing or Controlled is greater than or equal to 66⅔ % and less than 80% and (y) the Nonbusiness Asset Percentage of the other corporation is less than 30%;
  2. (x) The Nonbusiness Asset Percentage of either Distributing or Controlled is greater than or equal to 80% and less than 90%, and (y) the Nonbusiness Asset Percentage of the other corporation is less than 40%; or 
  3. (x) The Nonbusiness Asset Percentage of either Distributing or Controlled is greater than or equal to 90% and (y) the Nonbusiness Asset Percentage of the other corporation is less than 50%.

The per se rule does not apply to distributions that are ordinarily not a device under the Proposed Regulations (for example, distributions that are redemptions under section 302(a) for all distributee shareholders) or to distributions to domestic corporations that would be entitled to an 80%-or-more dividends-received deduction.  

In order to prevent avoidance of the purposes of these provisions, the Proposed Regulations contain broad anti-abuse rules.

The Proposed Regulations also limit the ability of a corporate business purpose to serve as evidence of nondevice with respect to Nonbusiness Assets, in the absence of a relationship described therein. In particular, the Proposed Regulations provide that a corporate business purpose relating to the difference in Nonbusiness Asset Percentage among Distributing and Controlled can outweigh a device factor related to such a disparity; however, a corporate business purpose relating to the separation of Nonbusiness Assets from one or more Businesses or Business Assets “is not evidence of nondevice unless the business purpose involves an exigency that requires an investment or other use of the Nonbusiness Asset in one or more Business of the distributing corporation, the controlled corporation, or both.”

Active trade or business requirement: Finally, the Proposed Regulations add Prop. Reg. section 1.355-9, which provides that the gross fair market value of any active trade or business of Distributing’s or Controlled’s SAG (when aggregated with other active trades or businesses of such SAG) must equal or exceed 5% of the total gross fair market value of the Distributing or Controlled SAG. This proposed requirement adopts the valuation and timing rules utilized in the newly proposed Device Prohibition regulations, as well as the look-through rules related to partnerships (but not the 50-Percent-Owned Group rule). In addition, the new minimum threshold contains a broad anti-abuse rule to prevent avoidance.

Effective date

Subject to certain transition rules, the proposed Device Prohibition and ATB Requirement regulations would apply to transactions occurring on or after the date on which the regulations are finalized.  

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