In our recent article on spin-offs (click here), we discussed an announcement made by the Internal Revenue Service (IRS) signaling a change in the application of the active trade or business (ATB) requirement under Section 355 of the Internal Revenue Code of 1986, as amended (the Code) to business ventures involving lengthy pre-income-generating phases, such as research and development or oil and gas exploration. Specifically, the IRS indicated that it was revisiting the requirement that, in order to be considered an ATB, a business must be collecting income and paying expenses, which generally excluded such business ventures from qualifying (resulting either in delay or inability to effectuate a spin-off, depending on whether the business at issue ultimately generates sufficient income). Further to that announcement, the IRS now has issued Revenue Ruling 2019-09, which suspends two 1957 revenue rulings (the 1957 Rulings) until the IRS completes its study on the ATB requirement, potentially resulting in an expansion of the types of business ventures that qualify for tax-free treatment under Section 355.
In general, Section 355 of the Code permits a corporation (Distributing) to distribute a subsidiary it “controls” (Controlled) to its shareholders in a tax-free transaction, provided that a number of conditions are met, including that the transaction is not primarily a device for distributing earnings and profits in a tax-free manner, as opposed to paying a taxable dividend. The ATB rules require each of Distributing and Controlled to be engaged in an active trade or business during the five-year period preceding the distribution. The Treasury Regulations clarify that an ATB generally must include the recognition of income and the payment of expenses (but are otherwise lacking in specifics).
Prior to Revenue Ruling 2019-09, and in the absence of specific regulations or any obvious exceptions, the 1957 Rulings were the clearest examples of regulatory guidance on the ATB requirement under Section 355 of the Code. The 1957 Rulings largely were decided on the basis of whether the business in question generated sufficient income to be considered ATB. In Revenue Ruling 57-464, for example, the IRS held that the distribution of a controlled corporation that held rental properties did not satisfy the ATB requirement in part because the net income earned from the rental property was negligible after deductions for depreciation and other expenses.
Revenue Ruling 57-492 involved a corporation engaged in refining and selling petroleum products that began exploring for oil as a separate operation. After several years of geological analysis, negotiating for mineral rights, obtaining the required government permits, and commencing drilling, the corporation formed a separate corporation for the drilling operation and distributed such corporation to its shareholders in exchange for its stock. The IRS concluded that the preliminary steps in oil exploration, such as geological analysis, did not qualify as an active business because they did not produce income.
Because of the stringent ATB requirements and the IRS’s focus on the magnitude of income generated by the activities under consideration (as evidenced by the 1957 Rulings), businesses in the pharmaceutical and technology industries largely have been unable to effect otherwise timely business separations through spin-off transactions in a tax-efficient way. Businesses in these industries frequently engage in lengthy periods of preliminary activities involving significant financial expenditures before ever generating income, and, therefore, are virtually foreclosed from effecting a spin-off until they are mature profit-generating ventures. As Revenue Ruling 57-492 illustrates, oil and gas businesses also suffer, given how time intensive their central, but non-income-producing activities tend to be.
Nevertheless, it never has been particularly clear why the tax rules should favor low start-up cost businesses such as service businesses over cost-intensive businesses like oil production or pharmaceuticals. The 1957 Rulings provided taxpayers with clarity, but are arguably over-inclusive with respect to the types of activities that do not satisfy the ATB requirement. If the rationale of Section 355 of the Code is to provide a tax-efficient mechanism for business separations that are not mere devices for distributing earnings and profits, this disparate treatment of businesses with longer runways to market does not make much sense. Moreover, one would be hard-pressed to include certain activities that require greater initial costs, such as pharmaceutical development and sales or oil and gas exploration, in the category of passive investment activity.
Even if the IRS was seeking a bright line test for determining ATB, this could have been accomplished without fully excluding or fully including all activities that do not immediately earn income. There is precedent for this approach. For example, the IRS could have looked to a rule in the international context for determining whether a foreign corporation is a “passive foreign investment company” (or PFIC) with respect to a U.S. shareholder. A PFIC generally is a foreign corporation the income of which is primarily passive, or the assets of which are primarily held to generate passive, investment-type income. However, there is a limited exception for nascent companies that generally provides corporations with one taxable year to get an active business up and running. This exception has been significant for U.S. shareholders of technology and start-up companies (though it too arguably fails to provide these companies with sufficient ramp-up time).
Although a similar approach could have been applied to the ATB requirement, this issue has not been addressed until now. Practitioners are cautiously optimistic that the IRS’s plans to study “whether a business can qualify as an ATB if entrepreneurial activities, as opposed to investment or other non-business activities, take place with the purpose of earning income in the future, but no income has yet been collected” signal a sea change in the approach to spin-off transactions, the first of multiple rule changes that will liberalize tax-free spin-off treatment and make it less scrutinized. On the other hand, the IRS’s move simply may be an acknowledgement that other rules currently in existence, such as the device rule and the business purpose rule (among others) already are sufficient to prevent the tax-free bail out of corporate earnings, and that together with rules to combat so-called cash rich split-offs that limit tax-free distributions of corporations with significant passive assets, the stringent ATB rules simply caused certain tech-centric sectors to suffer unnecessarily. Either way, we can be sure that Revenue Ruling 2019-09 represents a step away from the IRS’s historical enmity to tax-free spin-offs and the elevation of income generation as the most important, if not the only, factor in distinguishing ATB from passive investment activity.