Business Letter Announcing Company Split - Download as PDF

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					                                                     Business Purpose Under
            ALSO AVAILABLE                           Section 355 Expanding?
          FROM TAX INSTITUTE:                        by Robert W. Wood· San Francisco

David J. Cartano [NEW!]
                                                     I tunder Section 355 concernsthe key requirements
                                                         is no surprise that one of
                                                                                    business purpose. We
                                                     have catalogued some of these in the past ("To Spin
Taxation of Damage Awards and Settlement             or Not to Spin?" 3 M&A Tax Report 3 (October
Payments, by Robert W. Wood
                                                     1994), p. 1). Tax professionals know that very
The Manual of California Taxes, by Kathleen K.       frequently there is an overall business goal (for
Wright and Richard J. Ayoob
                                                     example, focusing on particular industries) that the
Tax Guide for Church & Clergy, by Mark A.            tax professionals are then expected to convert into
                                                     something qualifying for a Section 355 ruling. Far
The Home Office Tax Guide, by Robert W. Wood         from involving strictly legal considerations,
For more information, call or write today:           sometimes this can amount to rewriting history.
                                                     Interestingly, Treasury has recently received
            TAX INSTITUTE
                                                     comments from one of the large New York law
     235 Montgomery Street #972
       San Francisco, CA 94104                       firms asserting that the "core b~siness" rationale
(800) 852-5515     Fax (415) 834-1888                                                   Continued on Page 7

BUSINESS PURPOSE                  Continued from Page 6       of the combined businesses. The line of business or
should simply be regarded as an acceptable business           method of operation of one business may not fit
purpose under Section 355. The authors of the letter          into the long-term business plan of the other.
to Treasury suggest that this core business notion
                                                              Safe Harbor Proposed
refers to the strategy by which a company pares
back its nonessential operations, thus focusing on            Perhaps the most helpful contribution made by the
those businesses in which it has strategic or                 authors of the letter to Treasury concerns their
competitive expertise. The authors of the letter also         suggestion as to a safe harbor. Although one might
suggest that there should be a safe harbor for this           predict Treasury's response will be less than
kind of a business purpose.                                   lukewarm, a safe harbor notion for certain business
                                                              purposes is an interesting idea that deserves
The authors of the letter to Treasury, Kathryn                attention. Their goal is to introduce a modicum of
Bristor and Adam Ingber, of Skadden, Arps,                    certainty into taxpayers relying on a particular
Slate, Meagher & Flom, set forth a number of                  business purpose to effectuate a spinoff.
common-sensical views in the letter. They note,
for example, that valid business considerations               The contemplated "core business safe harbor" as
may dictate a separation of non-core businesses               envisioned by the author would basically require
from the core business. A separation, for example,            satisfying three tests. First, the taxpayer would need
can enable management to focus its expertise on               to demonstrate that the business to be spun off is a
the growth and development of the remaining                   non-core business. Second, the taxpayer seems to be
core business. Ditto for the necessary resources              required to provided substantiating documentation
of the company.                                               that real and substantial business reasons exist for
                                                              the spinoff. This second requirement would obviate
However, the letter to Treasury focuses upon some             any notion that merely separating a core from a
aspects that may be viewed as traditional Section             non-core business would itself constitute a business
355 ruling grounds. For example, the authors note             purpose. The third requirement the authors suggest
that businesses may commence competing against                is a "complete separation" requirement,
one another for access to capital. Alternatively, the         necessitating that the taxpayer demonstrate that the
poor credit rating of one business may adversely              spinoff would result in a complete separation of the
affect the other business' ability to raise capital.          businesses.
Irreconcilable differences may arise between                  The authors define a "non-core business" as
management teams for each business which are                  meeting two subtests. First, it must be a business
attributable to differences in management style,              having its primary operations focused on a
corporate culture, or vision of the future direction          market that is distinct from the market in which
                                                              the remaining business or businesses operate. A
                                                              second requirement that a business would need to
                                                              meet in order to be considered a non-core
   TAXATION OF COMPENSATION AND BENEFITS,                     business is that either: (1) the average pre-tax
   by David J. Cartano.                                       earnings of the business to be spun off over the
   Over 900 pages of material, covering everything            three years preceding the year of the spinoff must
   from nonqualified deferred compensation and                represent 30% or less of the average pre-tax
   phantom stock to cafeteria plans, split dollar life
                                                              earnings of the remaining business or businesses
   insurance and reasonable compensation. A
   veritable compendium! Softbound, $99 (plus $10             over the same period of time; or (2) the fair market
   shipping and handling and $8.42 California sales           value of the business to be spun off must represent
   tax on California orders).                                 less than 30% of the total fair market value of the
                 TAX INSTITUTE
           235 Montgomery Street #972                         There is a question, of course, as to precisely what
            San Francisco, CA 94104                           constitutes a "market" for purposes of this proposed
   (800) 852-5515              Fax (415) 834-1888
                                                                                                 Continued on Page 8

BUSINESS PURPOSE                   Continued from Page 7       historically not been sufficient to constitute a good
safe harbor. The authors suggest that a market                 business purpose.
should be defined broadly to include not only a                The final condition of the three-pronged safe harbor
particular territorial or geographical region, product         proposed by the authors relates to the complete
line, or stage in the production and distribution              separation of the businesses. Although this
cycle. The authors suggest that a business that                separation requirement seems to be a fundamental
primarily focuses upon manufacturing product X                 feature of Section 355, it has sometimes been
would be engaged in a different market than a                  abrogated. Consequently, the authors suggest that
business that primarily focused on selling product X           there be a three-year period following the spinoff
at retail. The primary focus of each business, they            during which there be a prohibition on the taxpayer,
argue, would be on different stages of the                     and all persons related to the taxpayer, from owning
production cycle in such a case.                               any interest in a business which operates in the
                                                               same market in which the spun off business
Business Purpose, Too
                                                               operated. The authors further contemplate that no
The second proposed test of the safe harbor would              cross-management would be permitted to any
be the age-old business purpose test. Here, it is              extent.
phrased as requiring the taxpayer to substantiate at
least one significant non-tax business reason                  Final Word?
compelling a spinoff of the non-core business. The             I would be highly surprised (although delighted) to
authors suggest that this test should be satisfied             find that the Treasury Department would adopt the
upon the submission by the taxpayer of credible                safe harbor, much less the core business rationale
documentation verifying the existence of the                   itself. Indeed, although this would seem to make an
problem or problems that the core business strategy            enormously positive contribution to the exceedingly
is being implemented to address. The authors even              important area of Section 355 transactions, it seems
enumerate what they envision as satisfying this                safe to conclude that nothing remotely close to this
documentation requirement, including any of the                proposal will be forthcoming in the near term. •
                                                                                 THE M&A TAX REPORT
    An outside professional or internal report                                         Tax Institute
    illustrating the incompatibility of the                                    235 Montgomery Street #972
    businesses;                                                                  San Francisco, CA 94104

    Outside professional or internal reports                     Call (800) 852-5515                      Fax (415) 397-4020
    documenting a conflict between the                           D Yes! Enter my subscription to The M&A Tax Report at the
    management of the businesses;                                price of only $275 for twelve full issues, including postage and
                                                                 handling charges. I enclose full payment by check or credit card. For
    Reports from a rating agency demonstrating                   Mastercard and Visa orders, enter card information below or call
    the favorable effects that a spinoff would                   (800) 852-5515_ Full money-back guarantee applies to unused part of
    have on the credit rating of the remaining or
    spun off businesses; or                                      o   Yes! Enter my subscription for $275 and bill me.

    For a public company, an annual report,                      Name _________________________________
    press release or other publicly released                     Title __________________ _______                  ~

    materials documenting a decision by the                      Firm ______________________________
    company to focus its resources and                           Street ___________________________
    personnel on its core business.                              City/State/Zip _____________________
                                                                 Telephone (_) _________________
It stands to reason that many of the items on this
list of business purposes will be somewhat weak in                             For Credit Card Orders:
the eyes of the government. Particularly the fourth              o   Mastercard #_ _ _ _ _ __                            Exp. __
item would seem to fall on deaf ears, since a                    o   Visa # _ _ _ _ _ _ _ __        Exp. __
decision to focus on certain core businesses has                 Authorized Signature ___________________


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