Internal Revenue Service Issues New Revenue Procedure Addressing Debt Exchanges in Spin-offs

On May 1, 2024, the IRS published procedures (Rev. Proc. 2024-24) relating to private letter ruling requests for transactions intended to qualify under Section 355 of the Code as tax-free spin-offs. The guidance was accompanied by IRS Notice 2024-38, which requests taxpayer comments with respect to all provisions in the guidance, including new ruling requirements that depart from published guidance and current practice.

Among the most significant aspects of Rev. Proc. 2024-24 are new representation and information requirements for spin-off transactions where (i) the distributing corporation (“Distributing”) distributes equity representing “control” of a subsidiary (“Controlled”) in the spin-off, but retains Controlled stock or securities or (ii) Distributing debt is expected to be exchanged for stock or securities of Controlled. On the whole, these new requirements significantly limit the circumstances where the IRS will provide rulings on tax-efficient capital structure adjustments in connection with a spin-off.

Delayed Distributions and Retention Transactions

In a typical spin-off, a Distributing corporation may restructure to shift leverage from Distributing to Controlled, or to decrease the aggregate debt levels of both companies. In many cases, these types of transactions can be achieved in a tax-efficient manner by using a “Debt-for-Debt Exchange” in which longer-maturity Controlled debt qualifying as “securities” for tax purposes is exchanged to retire Distributing debt, or a “Debt-for-Equity Exchange” in which Controlled stock is exchanged to retire Distributing debt (either of such transactions, an “Exchange Transaction”). These transactions can achieve some of the benefits of a sale for cash. Properly structured, an Exchange Transaction can be accomplished without triggering additional tax to Distributing or Controlled. In order to effect one of these transactions, it is frequently necessary for Distributing to retain Controlled stock or debt securities for some period of time after the spin-off. For practical reasons relating to the operation of capital markets, an Exchange Transaction often cannot be performed on the same day the spin-off closes.

In order for an Exchange Transaction occurring after the original spin-off closing date to be treated as tax-free, the Exchange Transaction generally needs to be considered part of the tax-free spin-off or “in pursuance of the plan of reorganization.” In addition, if stock or securities of Controlled are retained following the original spin-off closing date and not distributed in a way that is so linked with the rest of the spin-off, the entire spin-off can be taxable (not simply the equity exchanged in the subsequent steps). This outcome can be rebutted if the taxpayer establishes, to the satisfaction of the Secretary of the Treasury (through the IRS), that the retention was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax. Given that a typical taxable Exchange Transaction could trigger a significant tax, and the even higher costs of a spin-off that is disqualified from tax-free status, Taxpayers have a strong incentive to seek advance rulings from the IRS on this subject before attempting an Exchange Transaction.

In contrast to prior IRS ruling policy which allowed greater overall flexibility, Rev. Proc. 2024-24 includes new requirements regarding taxpayer representations, information, and analysis that narrow the circumstances under which Distributing would be able to retain an interest in Controlled while satisfying the above tests. Rev. Proc. 2024-24 in particular distinguishes Section 355 transactions involving “Delayed Distributions” from those involving “Retentions,” and sets forth new ruling requirements for each.

a. Delayed Distribution

When the continued ownership of Controlled stock by Distributing in connection with a spin-off is only temporary, as is typically the expectation in a Debt-for-Debt Exchange or Debt-for-Equity Exchange, Rev. Proc. 2024-24 imposes a limit of 12 months for the delayed distribution of any securities of Controlled retained by Distributing, and requires an explanation of any delay longer than 90 days. While this requirement is generally similar to practice, the IRS will no longer provide a back-up ruling to allow a taxable transaction up to five years later. Effectively, taxpayers need to decide up front to make a distribution. Rev. Proc. 2024-24 notes that in the past, taxpayers were able to simultaneously request rulings in regard to the retention of Controlled stock, and also the delayed distribution of such Controlled stock. Under Rev. Proc. 2024-24, the IRS noted that they view these as separate ruling requests and that they will not entertain both simultaneously in connection with a private letter ruling request. This limitation may create significant practical difficulties for Distributing corporations in executing Exchange Transactions, because an attempt to rush an Exchange Transaction in order to meet the IRS’s preferred timeline could run up against countervailing market conditions and capital markets considerations—possibly resulting in Distributing being forced to dispose of Controlled stock or securities at unfavorable prices or exchange ratios, or in some cases not being able to meet the deadline at all and disqualifying the entire spin-off from tax-free treatment.

b. Retentions

For purposes of obtaining a ruling that a retention of Controlled stock that is not intended to constitute a Delayed Distribution is not primarily being performed for purposes of avoiding federal income tax, taxpayers are required under Rev. Proc. 2024-24 to provide additional representations to rebut the presumption of such a prohibited purpose. These include representations to the effect that (i) Controlled stock will be widely held, (ii) the business purpose of the retention exists at the time of distribution, and (iii) key employees or officers of Distributing will not retain control of Controlled by being appointed to key positions at Controlled. Additionally, if certain adverse factors are present that indicate ongoing entanglements between Distributing and Controlled, Distributing may further need to establish to the satisfaction of the IRS the existence of a business exigency that outweighs the adverse factors and directly causes the need for the retention of Controlled stock.

Debt Exchange Mechanisms

A second significant way in which Rev. Proc. 2024-24 makes Exchange Transactions more difficult is by reducing Distributing corporations’ flexibility as to the steps they may use to retire their existing debt.

Since the holders of Distributing debt, in a typical situation, may not want to hold Controlled stock or securities, effecting an Exchange Transaction in many cases involves an intermediary bank (“Intermediary”). The Intermediary ordinarily facilitates an end result in which holders of Distributing debt receive cash and that Distributing debt is retired, and persons who do wish to hold Controlled stock or securities pay cash to obtain that stock. There are in theory multiple potential ways to reach that end result. An Intermediary could buy newly issued debt from Distributing, and then Distributing could use the cash proceeds to retire other Distributing debt, and also exchange the Controlled stock or securities to the Intermediary to retire the newly issued Distributing debt (a “Direct Issuance”); the Intermediary could then sell the Controlled stock or securities for cash to market participants. Alternatively, the Intermediary could buy existing Distributing debt from the third parties who hold it, and then Distributing could exchange the Controlled stock or securities to the Intermediary to retire that Distributing debt (an “Intermediated Exchange”); and again, the Intermediary could sell the Controlled stock or securities for cash to market participants. Direct Issuances are typically easier and faster (and more cost-effective) to execute than Intermediated Exchanges.

The IRS’s ruling policy on whether and when Direct Issuances are permissible has changed multiple times over the past two decades, but Rev. Proc. 2024-24 practically always requires an Intermediated Exchange, rather than a Direct Issuance, in order to obtain an IRS ruling on an Exchange Transaction. Under Rev. Proc. 2024-24, the only time the IRS will rule favorably on a Direct Issuance is when the Intermediary acquires the Distributing debt more than 60 days before the date of the first public announcement, binding agreement, or board approval of the spin-off (the “Earliest Applicable Date”)—which would be an unusually long time for an Intermediary to hold Distributing debt. This policy change may force many Distributing corporations to use the more cumbersome Intermediated Exchange format for Exchange Transactions. Further, delays caused by the Intermediated Exchange process may increase a Distributing corporation’s risk of failing to meet the 12-month-or-less timeline set forth in a Delayed Distribution ruling, which could cause significant adverse tax consequences as noted above.

Retired Distributing Debt and Debt Levels

Rev. Proc. 2024-24 also limits taxpayers’ flexibility to effect Exchange Transactions by imposing restrictions on which Distributing debt may be retired, and on re-borrowing following an Exchange Transaction, if an IRS ruling is sought. The Distributing debt to be retired must have been issued before the Earliest Applicable Date; recently borrowed debt is ineligible. The total amount of Distributing debt to be retired also cannot exceed its eight-quarter historical average level prior to the Earliest Applicable Date. And the retired Distributing debt cannot be replaced with borrowing that Distributing or certain related persons anticipate or are committed to prior to the spin-off—subject to limited exceptions for ordinary-course draws on revolving debt or unanticipated changes in circumstances. All of these rules make it more difficult to use a spin-off with an Exchange Transaction to achieve benefits similar to a sale of the Controlled business for cash.

Conclusions

Rev. Proc. 2024-24 does not entirely shut the door on Exchange Transactions—but it creates significant new obstacles and risks for Distributing corporations that are considering one. For taxpayers who wish to obtain an IRS ruling on an Exchange Transaction and then successfully execute that transaction in the manner contemplated by the ruling, the post-Rev. Proc. 2024-24 environment appears likely to be difficult terrain.

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Rev. Proc. 2024-24 is available by clicking this link, and Notice 2024-38 is available at this link. For further information about the impact of the IRS guidance on your particular situation, please contact your regular Ropes & Gray contact.