Section — Internal Revenue Bulletin 2003-29

26 CFR 1.355–2: Business purpose.

Section 355 management ruling. Where two different businesses operate within the same corporate group, and senior management wishes to focus on only one, the separation of the businesses to enable the management of each to concentrate on its own business satisfies the business purpose requirement of section 1.355–2(b) of the regulations.

extent that the obligor of one issue is neither the obligor of the other issue nor a related party with respect to the obligor of the other issue. § 1.150–1(d)(2)(ii)(A).

In general, § 1.150–1(d)(2)(ii)(B) provides that the obligor of an issue means the actual issuer of the issue, except that the obligor of the portion of an issue properly allocable to an investment in a purpose investment means the conduit borrower under that purpose investment. Section 1.150–1(b) defines the term “conduit borrower” as the obligor on a purpose investment (as defined in § 1.148–1). For example, if an issuer invests proceeds in a purpose investment in the form of a loan, lease, installment sale obligation, or similar obligation to another entity and the obligor uses the proceeds to carry out the governmental purpose of the issue, the obligor is a conduit borrower. The obligor of an issue used to finance qualified mortgage loans, qualified student loans, or similar program investments (as defined in § 1.148–1) does not include the ultimate recipient of the loan ( e.g., the homeowner, the student). § 1.150–1(d)(2)(ii)(B).

Section 1.148–1(b) defines the terms “purpose investment” and “program investment”. A purpose investment is an investment that is acquired to carry out the governmental purpose of an issue. A program investment is a purpose investment that is part of a governmental program in which, among other requirements, at least 95 percent (90 percent for qualified student loans under § 144(b)(1)(A)) of the cost of the purpose investments acquired under the program represents one or more loans to a substantial number of persons representing the general public, states or political subdivisions, 501(c)(3) organizations, persons who provide housing and related facilities, or any combination of the foregoing.

Section 1.150–1(b) defines the issue date of an issue as the first date on which the issuer receives the purchase price in exchange for delivery of the evidence of indebtedness representing any bond included in the issue. In reference to a bond, the issue date is the date on which the issuer receives the purchase price in exchange for that bond. In no event is the issue date earlier than the first day on which interest begins to accrue on

the bond or bonds for federal income tax purposes.

The proceeds of the Bonds loaned to the Borrower are used to pay principal, interest, or redemption price on another issue, the Prior Bonds. Thus, under the general definition of refunding issue contained in § 1.150–1(d)(1), the portion of the Bonds allocable to the loan to the Borrower constitutes a refunding issue. There is no change in obligor under § 1.150–1(d)(2)(ii) to alter this conclusion. The loan to the Borrower from proceeds of the Bonds is a purpose investment, and it is not a “similar program investment” within the meaning of § 1.150–1(d)(2)(ii)(B). Although the loans of proceeds of the Bonds may be program investments, loans to governmental units to finance or refinance their governmental projects are not similar to qualified mortgage loans or qualified student loans for purposes of § 1.150–1(d)(2)(ii)(B) because they are not loans made to natural persons not engaged in a trade or business (with respect to the loans). Thus, the Borrower is an obligor of the Bonds. The Borrower is also the obligor of the Prior Bonds. Accordingly, the portion of the Bonds allocable to the loan to the Borrower constitutes a refunding issue. Because the redemption date of the Prior Bonds is more than 90 days after the issue date of the Bonds, the portion of the Bonds allocable to the loan to the Borrower are advance refunding bonds within the meaning of § 149(d)(5).

HOLDING

The portion of the Bonds allocable to the loan to the Borrower are advance refunding bonds within the meaning of § 149(d)(5) if X loans proceeds of the Bonds to the Borrower, and within 90 days of the date the loan is made, but more than 90 days after the issue date of the Bonds, the Borrower uses the proceeds to redeem the Prior Bonds.

DRAFTING INFORMATION

The principal authors of this revenue ruling are David White and Rebecca Harrigal of the Office of the Associate Chief Counsel (Tax-Exempt and Government Entities), Internal Revenue Service.

2003-29 I.R.B. 77 July 21, 2003

Rev. Rul. 2003–74

ISSUE

Whether, in the situation described below, the distribution of the stock of a controlled corporation by a distributing corporation to enable the management of each corporation to concentrate on its own business satisfies the business purpose requirement of § 1.355–2(b) of the Income Tax Regulations.

FACTS

Distributing is a publicly traded corporation that conducts a software technology business. Controlled, a wholly owned subsidiary of Distributing, conducts a paper products business. One shareholder, who does not actively participate in the management or operations of Distributing or Controlled, owns eight percent of the outstanding Distributing stock.

The software business develops and markets software for various applications. It is a high-growth business that depends for its success on innovation and acquisitions of related businesses. It is the business around which Distributing originally developed and remains the core operation. The paper products business manufactures and distributes paper products. It was acquired five years ago to support the software business and is significantly smaller than the software business. The paper products business grows at a slow to moderate rate largely through increased efficiencies in productivity.

Distributing's senior management devotes more of its time to the software business because it believes that business presents better opportunities for growth. Indeed, it would like to concentrate solely on the software business but is prevented from doing so by the need to service the paper products business. The management of the paper products business, on the other hand, believes that the disproportionate attention paid the software business deprives the paper products business of the management resources needed for its full development.

To enable Distributing's senior management to concentrate on the software business and the management of the paper products business to concentrate on its own operation, Distributing distributes the

Controlled stock to Distributing's shareholders, pro rata . Because Distributing's senior management would have continued responsibility for the paper products business as long as Distributing owns a controlling interest in the stock of the corporation operating the paper products business, there is no other nontaxable transaction that would permit Distributing's senior management to concentrate on the software business and permit the paper products business to have a senior management that adequately serves that business. Distributing's directors and senior management expect that each business will benefit in a real and substantial way from the separation.

Following the distribution, no officer will serve both Distributing and Controlled. However, two of Distributing's eight directors will also serve on Controlled's six-person board. Director A will help with administrative aspects of the transition. His term will expire after two years, and he cannot seek reelection. Director B is recognized as an expert in corporate finance. His presence on the Controlled board is intended to reassure the financial markets by providing a sense of continuity. His term will expire after six years, at which time he may seek reelection. Both directors are officers of Distributing, but neither will be an officer or employee of Controlled.

Apart from the issue of whether the business purpose requirement of § 1.355–2(b) is satisfied, the distribution meets all of the requirements of § 355.

LAW

Section 355 provides that if certain requirements are met, a corporation may distribute stock and securities in a controlled corporation to its shareholders and security holders without causing the distributing corporation or the distributees to recognize gain or loss.

and substantial non-federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group to which the distributing corporation belongs. Section 1.355–2(b)(2). The principal reason for the business purpose requirement is to provide nonrecognition treatment only to distributions that are incident to readjustments of corporate structures required by business exigencies and that effect only readjustments of continuing interests in property under modified corporate forms. Section 1.355–2(b)(1). If a corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of stock of a controlled corporation and that is neither impractical nor unduly expensive, then the separation is not carried out for that corporate business purpose. Section 1.355–2(b)(3).

ANALYSIS

The distribution of Controlled stock by Distributing to Distributing's shareholders will enable Distributing's senior management to concentrate its efforts on the software business, which it believes presents better opportunities for growth, and allow the management of the paper products business to secure for that business the management resources needed for its full development. There is no other nontaxable transaction that would permit Distributing's senior management to concentrate on the software business and permit the paper products business to have a senior management that adequately serves that business, and it is expected that the separation of the two businesses will enhance the success of each business in a real and substantial way.

Although the continuing relationship between Distributing and Controlled evidenced by the two common directors appears inconsistent with the assertion that the software business and the paper products business require independent management teams, this relationship does not conflict with the business purpose for the separation. Director A will serve for only a short period and will further that purpose by aiding in the creation of two independently administered operations. Director B will assist the separation by calming market concerns that might

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than the tax matters agreement, each agreement will terminate after two years absent extraordinary circumstances, in which case the affected agreement may be extended on arm's-length terms for a limited period. Following the separation, there will be no cross-guarantee or cross-collateralization of debt between Distributing and Controlled, and an arm's-length loan from Distributing to Controlled for working capital will have a term of two years.

Apart from the issue of whether the business purpose requirement of § 1.355–2(b) is satisfied, the distribution meets all the requirements of § 355.

LAW

To qualify as a distribution described in § 355, a distribution must, in addition to satisfying the statutory requirements of § 355, satisfy certain requirements in the regulations, including the business purpose requirement. Section 1.355–2(b)(1) provides that a distribution must be motivated, in whole or substantial part, by one or more corporate business purposes. A corporate business purpose is a real and substantial non-federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group to which the distributing corporation belongs. Section 1.355–2(b)(2). The principal reason for the business purpose requirement is to provide nonrecognition treatment only to distributions that are incident to readjustments of corporate structures required by business exigencies and that effect only readjustments of continuing interests in property under modified corporate forms. Section 1.355–2(b)(1). If a corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of stock of a controlled corporation and that is neither impractical nor unduly expensive, then the separation is not carried out for that corporate business purpose. Section 1.355–2(b)(3).

otherwise adversely affect one or both businesses. Further, the two directors together constitute only a minority of each board.

Hence, the distribution of Controlled stock by Distributing to Distributing's shareholders is motivated in whole or substantial part by a real and substantial non-federal tax purpose germane to the businesses of Distributing and Controlled and satisfies the corporate business purpose requirement of § 1.355–2(b).

HOLDING

In the situation described above, the distribution of the stock of a controlled corporation by a distributing corporation to enable the management of each corporation to concentrate on its own business satisfies the business purpose requirement of § 1.355–2(b).

DRAFTING INFORMATION

The principal author of this revenue ruling is Richard M. Heinecke of the Office of Associate Chief Counsel (Corporate). For further information regarding this revenue ruling, contact Mr. Heinecke at (202) 622–7930 (not a toll-free call).

Section 355 capital allocation ruling. Where two different businesses within the same corporate group are competing for limited capital, the separation of these businesses to resolve the capital allocation problem satisfies the business purpose requirement of section 1.355–2(b) of the regulations.

Rev. Rul. 2003–75

ISSUE

Whether, in the situation described below, the distribution of the stock of a controlled corporation to resolve a capital allocation problem between the distributing and controlled corporations satisfies the business purpose requirement of § 1.355–2(b) of the Income Tax Regulations.

FACTS

Distributing is a publicly traded corporation that conducts a pharmaceuticals

business. Controlled, a wholly owned subsidiary of Distributing, conducts a cosmetics business. One shareholder, who does not actively participate in the management or operations of Distributing or Controlled, owns six percent of the outstanding Distributing stock.

The pharmaceuticals business develops, manufactures, and markets specialty drugs. It is a high-margin business that emphasizes rapid growth through innovation. The cosmetics business develops, manufactures, and markets cosmetics. It is a low-margin business that grows at a moderate rate by increasing its productivity and market share. Both businesses require substantial capital for reinvestment and research and development.

Distributing does all of the borrowing for both Distributing and Controlled and makes all decisions regarding the allocation of capital spending between the pharmaceuticals and cosmetics businesses. Because Distributing's capital spending in recent years for both the pharmaceuticals and cosmetics businesses has outpaced internally generated cash flow from the businesses, it has had to limit total expenditures to maintain its credit ratings. Although the decisions reached by Distributing's senior management regarding the allocation of capital spending usually favor the pharmaceuticals business due to its higher rate of growth and profit margin, the competition for capital prevents both businesses from consistently pursuing development strategies that the management of each business believes are appropriate.

To eliminate this competition for capital, Distributing distributes the Controlled stock to Distributing's shareholders, pro rata . Because the total capital available to the two businesses would continue to be limited as long as the two businesses remained within the same corporate group, there is no other nontaxable transaction that would solve the competition problem. It is expected that both businesses will benefit from the separation, and that the cosmetics business will benefit in a real and substantial way as a result of increased control over its capital spending and direct access to the capital markets.

To facilitate the separation, Distributing and Controlled will enter into transitional agreements that relate to information technology, benefits administration, and accounting and tax matters. Other

2003-29 I.R.B. 79 July 21, 2003

LAW

Section 368(a)(1)(C) defines a reorganization to include the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of substantially all of the properties of another corporation.

Section 368(a)(1)(D) defines a reorganization to include a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under § 354, 355, or 356.

In Helvering v. Elkhorn Coal Co., 95 F.2d 732 (4 ^th Cir. 1937), cert. denied, 305 U.S. 605, reh'g denied, 305 U.S. 670 (1938), Elkhorn Coal, in anticipation of being acquired by Mill Creek, transferred part of its operating assets to a newly formed subsidiary and distributed the subsidiary's stock to Elkhorn Coal's shareholders. The court concluded that the distribution of subsidiary stock prevented the subsequent acquisition from qualifying under a predecessor of § 368(a)(1)(C) because, as a result of the distribution, Mill Creek did not acquire substantially all of Elkhorn Coal's historical assets.

In Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966), aff'g 42 T.C. 779 (1964), the taxpayer, in anticipation of a merger with a national bank, contributed its insurance business to a new subsidiary and distributed the subsidiary's stock to its shareholders. The divestiture was necessary to comply with national banking laws. The court held that the distribution satisfied the requirements for nonrecognition under § 355(a) and, therefore, that the contribution qualified as a reorganization under § 368(a)(1)(D).

In Rev. Rul. 68–603, 1968–2 C.B. 148, the Internal Revenue Service announced that it would follow the decision in Mary

ANALYSIS

The operation of the pharmaceuticals business and the cosmetics business within the same corporate group causes capital allocation problems that prevent each business from pursuing the development strategies most appropriate to its operation. The separation of the two businesses is the only nontaxable transaction that will resolve these problems. It is expected that both businesses will benefit from the separation, and that the separation will enhance the success of the cosmetics business in a real and substantial way.

The limited continuing relationship between Distributing and Controlled evidenced by the various administrative agreements and the loan for working capital is not incompatible with the extent of separation contemplated by § 355. The administrative agreements, except for the tax matters agreement, and the loan are transitional and short-term, and all are designed to facilitate, rather than impede, the separation of the pharmaceuticals business from the cosmetics business.

Hence, the distribution of Controlled stock by Distributing to Distributing's shareholders is motivated in whole or substantial part by a real and substantial non-federal tax purpose germane to the business of Controlled and satisfies the corporate business purpose requirement of § 1.355–2(b).

HOLDING

In the situation described above, the distribution of the stock of a controlled corporation to resolve a capital allocation problem between the distributing and controlled corporations satisfies the business purpose requirement of § 1.355–2(b).

DRAFTING INFORMATION

(Also: §§ 368(a)(1)(D), 368(a)(1)(C) and 1.368–2.)

Section 355 reverse Morris trust. The acquisition by an unrelated corporation of

all the assets of a newly formed controlled corporation following distribution of the controlled corporation’s stock under section 355 will satisfy the "substantially all" requirement of section 368(a)(1)(C) even though the acquired assets represent only half of the assets held by the distributing corporation before it formed the controlled corporation.

Rev. Rul. 2003–79

ISSUE

Whether the acquisition by an unrelated corporation of all the assets of a newly formed controlled corporation following the distribution of the stock of the controlled corporation by a distributing corporation will satisfy the requirement of § 368(a)(1)(C) of the Internal Revenue Code that substantially all of the properties of the acquired corporation be acquired where the assets of the controlled corporation represent less than substantially all of the assets that the distributing corporation held before it formed the controlled corporation.

FACTS

D, a domestic corporation, directly conducts Business X and Business Y. D's assets are equally divided between the two businesses. A, a domestic corporation unrelated to D, conducts Business X and wishes to acquire D's Business X, but not D's Business Y.

To accomplish the acquisition, D and A agree to undertake the following steps in the following order: (i) D will transfer its Business X assets to C, a newly formed domestic corporation, in exchange for 100 percent of the stock of C, (ii) D will distribute the C stock to D's shareholders, (iii) A will acquire all the assets of C in exchange solely for voting stock of A, and (iv) C will liquidate. Apart from the question of whether the acquisition of C's assets by A will satisfy the requirement of § 368(a)(1)(C) that the acquiring corporation acquire substantially all of the properties of the acquired corporation, steps (i) and (ii) together meet all the requirements of § 368(a)(1)(D), step (ii) meets all the requirements of § 355(a), and steps (iii) and (iv) together meet all the requirements of § 368(a)(1)(C).

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ANALYSIS

Section 1012 of the 1997 Act, as amended by § 6010(c) of the 1998 Act, evidences the intention of Congress that a corporation formed in connection with a distribution that qualifies for nonrecognition under § 355 will be respected as a separate corporation for purposes of determining (i) whether the corporation was a controlled corporation immediately before the distribution and (ii) whether a pre-distribution transfer of property to the controlled corporation satisfies the requirements of § 368(a)(1)(D) or § 351, even if a post-distribution restructuring causes the controlled corporation to cease to exist. See Rev. Rul. 98–44, 1998–2 C.B. 315; Rev. Rul. 98–27, supra ; S. Rep. No. 105–174, supra . Therefore, the controlled corporation should also be considered independently from the distributing corporation in determining whether an acquisition of the controlled corporation will qualify as a reorganization under § 368. Accordingly, in determining under § 368(a)(1)(C) whether an acquiring corporation has acquired substantially all of the properties of a newly formed controlled corporation, reference should be made solely to the properties held by the controlled corporation immediately following the distributing corporation's transfer of properties to the controlled corporation, rather than to the properties held by the distributing corporation immediately before its formation of the controlled corporation.

Hence, the acquisition by A of all the properties held by C immediately after the distribution will satisfy the requirement of § 368(a)(1)(C) that A acquire substantially all the properties of C. This result obtains even though an acquisition by A of the same properties from D would have failed this requirement if D had retained Business X, contributed Business Y to C, and distributed the stock of C. See Helvering v. Elkhorn Coal Co., supra .

HOLDING

The acquisition by an unrelated corporation of all the assets of a newly formed controlled corporation following the distribution of the stock of the controlled corporation by a distributing corporation will satisfy the requirement of

Archer W. Morris Trust to the extent it held that (1) the active business requirements of § 355(b)(1)(A) were satisfied even though the distributing corporation, immediately after the spin-off, merged into the unrelated acquiring corporation, (2) the control immediately after requirement of § 368(a)(1)(D) implies no limitation upon a reorganization of the transferor corporation (the distributing corporation) after the distribution of the stock of the controlled corporation, and (3) there was a business purpose for the spin-off and the merger.

Rev. Rul. 98–27, 1998–1 C.B. 1159, states that the Service will not apply any formulation of the step transaction doctrine to determine whether the distributed corporation was a controlled corporation immediately before a distribution under § 355(a) solely because of any post-distribution acquisition or restructuring of the distributed corporation, whether prearranged or not. The holding of Rev. Rul. 98–27 is based on § 1012(a) and § 1012(c) of the Taxpayer Relief Act of 1997 (the “1997 Act”), Pub. L. No. 105–34, 111 Stat. 788, 916–17. Section 1012(c) amended the control requirements of §§ 368(a)(1)(D) and 351 to provide that, generally for transactions seeking qualification after August 5, 1997, under either provision and § 355, the shareholders of the distributing corporation must own stock possessing more than 50 percent of the voting power and more than 50 percent of the total value of the controlled corporation's stock immediately after the distribution. See §§ 368(a)(2)(H) and 351(c). Section 1012(a) amended § 355 by adding subsection (e), which provides rules for the recognition of gain on certain distributions of stock or securities of a controlled corporation in connection with acquisitions of stock representing a 50 percent or greater interest in the distributing corporation or any controlled corporation.

The Conference Report accompanying the 1997 Act states, in part, that:

The . . . bill does not change the present-law requirement under section 355 that the distributing corporation must distribute 80 percent of the voting power and 80 percent of each other class of stock of the controlled corporation. It is expected that this requirement will be applied by the Internal Revenue

Service taking account of the provisions of the proposal regarding plans that permit certain types of planned restructuring of the distributing corporation following the distribution, and to treat similar restructurings of the controlled corporation in a similar manner. Thus, the 80-percent control requirement is expected to be administered in a manner that would prevent the tax-free spin-off of a less-than-80-percent controlled subsidiary, but would not generally impose additional restrictions on post-distribution restructurings of the controlled corporation if such restrictions would not apply to the distributing corporation. H.R. Rep. No. 105–220, at 529–30 (1997); 1997–4 C.B. 1457, at 1999–2000.

Section 6010(c)(2) of the Internal Revenue Service Restructuring and Reform Act of 1998 (the “1998 Act”), P.L. 105–206, 1998–3 C.B. 145, amended § 1012(c) of the 1997 Act to provide that, in the case of a § 368(a)(1)(D) or § 351 transaction that is followed by a § 355 transaction, solely for purposes of determining the tax treatment of any transfer of property by the distributing corporation to the controlled corporation, the fact that the shareholders of the distributing corporation dispose of part or all of the controlled corporation's stock after the § 355 distribution shall not be taken into account in determining whether the control requirement of either § 368(a)(1)(D) or § 351 has been satisfied.

The Senate Report accompanying the 1998 Act contains three examples in which distributing corporation D transfers appreciated business X to newly created subsidiary C in exchange for at least 85 percent of the C stock and then distributes its C stock to the D shareholders. As part of the same plan, C then merges into unrelated acquiring corporation A. Each example concludes that if the distribution satisfies the requirements of § 355, the control immediately after requirement will be satisfied solely for purposes of determining the tax treatment of the transfer of business X by D to C. See S. Rep. No. 105–174, at 173–176 (1998); 1998–3 C.B. 537, at 709–712.

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§ 368(a)(1)(C) that substantially all of the properties of the acquired corporation be acquired where the assets of the controlled corporation represent less than substantially all of the assets that the distributing corporation held before it formed the controlled corporation.

DRAFTING INFORMATION

The principal author of this revenue ruling is Gene Raineri of the Office of Associate Chief Counsel (Corporate). For further information regarding this revenue ruling, please contact Mr. Raineri at (202) 622–7530 (not a toll-free call).