Tax Case Studies

TAX-FREE SPIN-OFF OF SUBSIDIARY

Situation: Company A, a conglomerate, sought to distribute its stock in one of its subsidiaries to its shareholders on a tax-free basis. Following the "spin-off", the subsidiary would merge with a REIT and the combined business would seek to qualify as a REIT. The merger would result in the shareholders of the conglomerate owning at least 60% of the newly organized REIT. The parties applied for a private letter ruling with the IRS and, following a delay of many months, the IRS refused to rule on whether the spin-off qualifies as tax-free under Section 355. 

Issue: The primary issue on which the tax-free status of the spin-off could be challenged is whether Company A, the distributing corporation, had a valid corporate business purpose for undertaking the spin-off. This is a subjective test but can be confirmed and corroborated by objective evidence - e.g., board meeting minutes, correspondence, etc. A second issue - whether an "active business" was spun-off - usually is an objective test that may not require insurance. However, in this case, as the newly organized business had to qualify as a REIT (which is essentially passive), this was an additional issue for which the insured sought coverage.

IRC Section: §355

TRANSFER OF CONTROL FOLLOWING SPIN-OFF

Situation: Company A effectuated a tax-free spin-off to its shareholders of its stock in Subsidiary X. The corporate business purpose of the spin-off was to allow Subsidiary X to effectively raise capital. More than six months later, Company A received an unsolicited, unexpected offer to be purchased at a significant premium to its widely accepted value. Because the offer came within two years of the spin off of Subsidiary X, it is likely that the tax-free status of the spin-off will be challenged by the IRS. 

Issue: A "change of control" of either Company A or its Subsidiary X following a spin-off could, if found to be part of a plan (or series of transactions), requires Company A to recognize gain as if it sold Subsidiary X for fair market value. The Tax Insurance policy insures Company A (or its successor) from tax liability resulting from the spin-off being stripped of its tax-free status. 

IRC Section Implicated: § 355(e) 

TAX-FREE CORPORATE REORGANIZATION

Situation: Company A has acquired Company B in a statutory merger. Forty percent of the purchase price was paid in Company A voting stock and the remainder was paid in cash. After the deal closed, the parties became concerned that a portion of the compensation paid to certain Company B executives under employment agreements entered into in connection with the transaction could be re-characterized by the IRS as additional consideration for the Company B stock. If so, such a re-characterization could jeopardize the tax-free status of the merger. 

Issue: In order to qualify as a tax-free statutory merger, the parties must satisfy, among other things, a "continuity of interest" requirement. This requirement in general is satisfied where at least 40% of the consideration is paid in stock of the acquiring company. If a portion of the executive compensation is re-characterized as consideration for Company B stock, which results in the cash consideration in the transaction exceeding 60% of the purchase price, the transaction may not qualify as a tax-free reorganization. As a result, Company B shareholders would have to recognize gain on the difference between the fair market value of the shares and their basis in the stock. The Tax Insurance policy insures the Company B shareholders for this risk. 

IRC Section Implicated: § 368(a)(1)(A)