One comment raises concerns about how the regulations would operate in practice. This comment states that turning the questioning of a witness over to a third-party contractor may cause the IRS officer or employee in charge of the interview to lose control of the interview. The comment further states that having multiple persons “on the record” – an IRS officer or employee, a contractor, a witness, and a representative of the witness – may lead to a cluttered, incomprehensible transcript of the interview. To address these concerns, the comment suggests that instead of having the contractor question the witness directly, the IRS officer or employee should announce to the court reporter that he or she needs a moment to confer with the contractor, and after consultation ask to go back on the record to resume questioning.

These concerns are unfounded. When the IRS hires a contractor to assist the IRS in reviewing books and records, analyzing data, or receiving sworn testimony from a summoned witness, the IRS determines what information will be requested via a summons and who the summons will request to testify. An IRS officer or employee is present during the interview and remains in charge of the interview. A contractor asking questions does not present any additional difficulties for the IRS officer or employee in retaining control of that interview. Rather, the IRS officer or employee in charge of the interview may be in a better position to maintain control of the overall interview if someone else is asking the questions. The IRS officer or employee always has the ability to ask the court reporter to go off the record to confer with the contractor, if necessary.

Further, since 2002, § 301.7602–1(b)(1) has provided that a summoned witness may be required to appear before “one or more” IRS officers or employees to give testimony, including Chief Counsel attorneys. During this time, the IRS experience with multiple persons asking questions of summoned persons has not resulted in cluttered interview transcripts as compared to those transcripts in which only one person from the IRS asks a witness questions. Instead, the IRS has generally found that allowing multiple IRS persons to question a summoned witness results in more thorough and complete coverage of the appropriate interview topics. This is particularly true when a person asking questions for the IRS has the chance to focus questions on particular subject areas with which the questioner is most familiar. Furthermore, the IRS has found that significant value is also added when multiple persons have the opportunity to ask questions to address gaps in prior questioning or clarify answers by a witness.

Accordingly, for the reasons discussed above, the proposed regulations have not been amended as suggested by this comment.

Both comments state section 7602 does not authorize a contractor to question a witness during an IRS summons interview. Specifically, the comments state that the regulations improperly delegate to the contractor the Secretary’s authority under section 7602(a)(3) to take testimony under oath. According to one of the comments, because section 7701(a)(11)(B) defines the term “Secretary” to include a delegate, and section 7701(a)(12)(A) defines a “delegate” of the Secretary, in part, as a duly authorized “officer, employee or agency of the Treasury Department,” the regulations improperly attempt to treat a “third party agent” (a contractor under section 6103(n)) as an “agency of the Treasury Department.” The other comment adds that this type of treatment of a contractor would be unprecedented under various IRS Delegation Orders and Internal Revenue Manual provisions and that a statutory authorization is required for “such delegation.” Both comments state that section 6306, regarding the IRS’s use of private collection agencies to perform certain tax collection functions, was an example of such authorization by statute.

Further, both comments question whether under the regulations inherently governmental functions will continue to be performed by IRS officers or employees, and state that reference to this in the preamble to the temporary regulations was included to allay potential concerns about improper delegation. The comment also asserts that taking testimony by asking questions, reviewing books or papers, and analyzing other data, as allowed by the regulations, is inherently governmental. In support of this, the comment states that when contractors ask questions that taxpayers are compelled to answer under oath, the contractor is deciding what information must be produced by the taxpayer. The comment asserts that it is clear that questioning a witness under oath and with compulsion, or directing counsel for a witness to clarify an objection or assertion of privilege, in an extra-judicial governmental investigation such as an IRS audit is inherently governmental. This comment states that the fact that a contractor’s participation in a summons interview will only be done in the presence and under the guidance of an IRS officer or employee suggests that participation in a summons interview is inherently governmental.

These comments state further that the reference to § 301.7602–2(c)(1)(i)(B) and (c)(1)(ii) Example 2 in the preamble to the temporary regulations means that the regulations are delegating authority under section 7602(a) to the contractor.

The IRS has broad information gathering authority under section 7602(a). See United States v. Arthur Young & Co., 465 U.S. 805, 816 (1984). Section 7602(a) provides that, for the purpose of ascertaining the correctness of any return, making a return where none has been made, or determining the liability of any person for any internal revenue tax, the Secretary (and the IRS as the Secretary’s delegate) is authorized to examine books and records, issue summonses seeking documents and testimony, and take testimony from witnesses under oath. When a contractor assists the IRS in gathering facts by reviewing books and records or asking questions of a witness during a summons interview, the contractor is merely assisting in carrying out the powers granted to the Secretary. Nothing in section 7602(a) prohibits participation by a contractor in a summons interview, nor does it prescribe procedures that the IRS must follow during the summons interview.

Moreover, nothing in these regulations delegates authority under section 7602(a). The IRS’s authority to engage contractors to assist with fact gathering has always existed under section 7602, and the comments acknowledge this authority. For instance, the comment addressing the impact of multiple questioners on the clarity of the transcribed record of the summons interview suggests as an alternative that the contractor provide the IRS with the questions to ask. Given that the commentators acknowledge that the IRS is authorized to have a contractor communicate the question off the record to the IRS, it seems implausible that having the contractor actually ask the question on the record, in the presence of and under the supervision of the IRS, is substantively different.

Section 6306, dealing with qualified tax collection contracts, does not support the contention in the comments that congressional action is required to engage a contractor to perform services for the IRS. Long before section 6306 was added to the Code in 2004, the IRS collection function had contracted with private persons (for example, locksmiths, tow truck drivers, storage facilities, property appraisers and auctioneers) for tax administration purposes to facilitate IRS seizures of property by levy and IRS sales of such property, pursuant to the statutory powers conferred on the Secretary by sections 6301, 6331, and 6335. In fiscal years 1996 and 1997, without making any modifications to the Code, Congress earmarked $13 million for the IRS to test the use of private debt collection companies. In 2004, rather than say it was authorizing the IRS to enter into collection agreements with outside contractors to assist the IRS in collecting tax debts, Congress instead said in section 6306(a) that “[n]othing in any provision of law shall be construed to prevent the Secretary from entering into a qualified tax collection contract.” Therefore, section 6306 was a congressional clarification of the IRS’s existing authority to engage outside contractors to assist with collection. Accordingly, contrary to the comments’ assertions, no explicit congressional authorization was needed to permit the IRS to hire outside contractors to assist in the collection of taxes, a role outside contractors had been playing for years prior to enactment of section 6306. As a result, enactment of section 6306 does not support the contention in the comments that having a contractor ask questions during a summons interview is inconsistent with authority under section 7602.

The comments are also incorrect that the regulations include an improper delegation to perform certain examination functions. One comment assumes that the role of questioner must be accompanied by the power to compel the witness to answer under oath. That is not accurate. While the contractor will ask questions during a summons interview, an IRS officer or employee will determine whether the questions must be answered by pursuing judicial enforcement. Only if an IRS officer or employee pursues the matter by seeking judicial enforcement can a witness be compelled to answer the question asked by the contractor. Similarly, a contractor can ask counsel for a witness to clarify an objection or assertion of privilege, but only an IRS officer or employee can pursue resolution of the claim of privilege by seeking judicial enforcement. Accordingly, the comment incorrectly equates the act of compelling a witness to answer a question asked with the mere act of asking the question. Further, the Federal Activities Inventory Reform Act of 1998, Public Law 105–270 (31 U.S.C. 501 Note (FAIR Act)), defines “inherently governmental function” as “a function that is so intimately related to the public interest as to require performance by Federal Government employees.” FAIR Act section 5(2)(A). Inherently governmental functions include activities that require “the exercise of discretion in applying Federal Government authority,” including “the interpretation and execution of the laws of the United States so as . . . to bind the United States to take or not to take some action.” Id. at section 5(2)(B)(i). However, Congress further specified in FAIR Act section 5(2)(C)(i) that an inherently governmental function does not normally include “gathering information for or providing advice, opinions, recommendations, or ideas to Federal Government officials.”

In 2009, Congress further directed the Office of Management and Budget (OMB) to refine the definition of “inherently governmental function” applicable to all agencies and provide guidance to improve internal agency management of functions that are inherently governmental. Public Law. 110–417, section 321. Toward these ends, and after notice and comment, OMB’s Office of Federal Procurement Policy (OFPP) issued its Policy Letter 11–01 on September 12, 2011. 76 FR 56227. The Policy Letter clarified the “discretion” that a contractor may appropriately exercise as the circumstances “where the contractor does not have the authority to decide on the overall course of action, but is tasked to develop options or implement a course of action, and the agency official has the ability to override the contractor’s action.” Id., at section 5–1(a)(1)(ii)(B), 76 FR at 56237. The Policy Letter further explains that “contractors routinely, and properly, exercise discretion in performing functions for the Federal Government when, providing advice, opinions, or recommended actions, emphasizing certain conclusions, and . . . deciding what techniques and procedures to employ, whether and whom to consult, [and] what research alternatives to explore given the scope of the contract.” Id., 76 FR at 56237–38. The Policy Letter recognizes that in addition to functions that are inherently governmental, there are also many functions closely associated with inherently governmental functions. The Policy Letter cautions that when a contractor function is closely associated with an inherently governmental one, the agency should “limit or guide the contractor’s exercise of discretion,” by “establishing in advance a process for subjecting the contractor’s discretionary decisions and conduct to meaningful oversight and, whenever necessary, final approval by an agency official.” Id., at section 5–2(a)(4)(ii) and Appendix C, section(1)(ii), 76 FR at 56238–39 and 56241–42.

Accordingly, the preamble to the temporary regulations described the inherently governmental functions associated with section 7602(a) as including the ultimate decisions to issue a summons, whom to summon, what information must be produced or who will be required to provide testimony, as well as issuing the summons. The final decision to issue an IRS summons may “bind the United States to take or not take some action,” within the meaning of the FAIR Act section 5(2)(B)(i). For example, serving an IRS summons pursuant to sections 7609(f) and (g) requires prior court approval, and IRS summonses issued for an examination purpose to third parties generally expose the United States to a court action the taxpayer may commence to quash a summons under section 7609(b)(2) or obligate the IRS to pay certain search and reproduction costs incurred by the summoned witness under section 7610. The final decision to include or not include certain document or testimony requests in an IRS summons also limits going forward what information or documents the IRS may ask a court to require a witness to produce in any future summons enforcement proceeding regarding that summons. The final decision to seek judicial enforcement of an IRS summons pursuant to sections 7402(b) and 7604 is also an inherently governmental function. These inherently governmental actions associated with issuing or seeking to enforce an IRS summons will continue to be performed by IRS officers and employees under these regulations.

As discussed above, pursuant to these regulations, contractors may assist IRS officers and employees when the IRS has summoned a witness, by receiving and reviewing books, papers, records, or other data produced in compliance with a summons and, in the presence and under the guidance of an IRS officer or employee, ask questions in the interview of the summoned witness. The contractor’s assistance to the IRS officer or employee presiding over a summons interview is closely associated with the inherently governmental summons functions performed by an IRS employee, within the meaning of OFPP Policy Letter 11–01, without crossing the line into the performance of inherently governmental functions. A contractor participating fully in a summons interview will not, for example, be permitted to bind or otherwise disadvantage the IRS by making any unauthorized, premature statements that the summoned party has produced all of the summoned information or has fully answered all of the questions asked by the IRS in the interview. Similarly, the contractor has no authority to commit the IRS to pursue judicial enforcement of a summons for any documents or answers to questions that a witness failed to provide.

The contractor’s “discretion” in pursuing any potentially relevant line of questioning in a summons interview is permissible under Policy Letter 11–01 standards because the contractor will not have the authority to decide on the overall course of action adopted by the IRS with respect to the summons interview. The IRS officer or employee presiding over IRS receipt of documents and evidence from the summoned witness will also be present for any questioning pursued by the contractor and will have the ability to override the contractor’s actions, if necessary and appropriate. Rather than proving that a contractor would be performing an inherently governmental function under these regulations, the additional safeguards the comment points to – that a contractor’s participation in a summons interview will only be done in the presence and under the guidance of an IRS officer or employee – show the IRS heeded the instructions of Policy Letter 11–01 to establish a process for subjecting the contractor’s discretionary decisions and conduct under these regulations to meaningful IRS oversight.

The comments incorrectly interpret the purpose of the reference in the preamble of the temporary regulations to § 301.7602–2(c)(1)(i)(B) and (c)(1)(ii) Example 2. The purpose of referencing that regulation, which implements the provisions of section 7602(c) (requiring notice of third party contacts) in the case of a section 6103(n) contractor, was instead intended to highlight the fact that the IRS had been allowing contractors, under the guidance of an IRS officer or employee, to hold discussions and ask questions of witnesses for many years and that the proposed regulations were in the nature of a clarification. The purpose was not to demonstrate that the IRS is delegating authority to contractors as the comments incorrectly state.

Therefore, for the reasons above, Treasury and the IRS disagree with the comments’ assertion that the regulations improperly delegate authority under section 7602. The statute permits section 6103(n) contractors to receive books, papers, records, or other data summoned by the IRS and, in the presence and under the guidance of an IRS officer or employee, participate fully in the interview of a person who the IRS has summoned as a witness to provide testimony under oath.

One of the comments suggests that the proposed regulations raise issues relating to confidentiality of taxpayer information. First, the comment states that the regulations place confidential taxpayer information unnecessarily at risk of unauthorized disclosure under section 6103. According to the comment, this is because placing taxpayer information in the hands of outside contractors under section 6103(n) increases the risk of misuse and unlawful disclosure because outside contractors are not subject to the same rules of conduct as IRS employees and may have loyalties to other clients besides the IRS and the public fisc.

Next, the comment questions whether the disclosure of confidential information to outside counsel is permitted under section 6103(n). The comment explains that in 1990 the phrase “other services” was added to section 6103(n) to cover outside experts, in part, because these experts are objective and the IRS is not. The comment continues that outside counsel, as an advocate, is not objective and, therefore, is not covered by the phrase “other services” in section 6103(n).

Finally, the comment states that the IRS has failed to demonstrate that government employees cannot effectively and more appropriately perform the function contemplated by the temporary regulations.

These comments do not address the clarification made by the proposed and temporary regulations (that is, that section 6103(n) contractors may be present at summons interviews, ask questions at a summons interview, and review summoned books, papers, records, or other data). Further, the comments do not explain why the proposed regulations place confidential taxpayer information at risk of unauthorized disclosure at all. Rather, these comments address disclosure to experts under section 6103(n), which is not the subject of these regulations. Therefore, the comments do not address issues under the regulations.

Regardless of the relevance of the comments to these regulations, the IRS takes protection of the confidentiality of taxpayer information seriously and will not disclose taxpayer information unless authorized under the law. “Return information” and “taxpayer return information” are in general broadly defined in sections 6103(b)(2) and (b)(3), as including information concerning a taxpayer’s identity, the nature, source or amount of his income, payments, receipts, deductions, exemptions, credits, assets, liabilities, net worth, tax liabilities, tax withheld, owed, or paid, whether the taxpayer is being or will be examined or investigated, to the extent such information is filed with or furnished to the IRS by or on behalf of the taxpayer to whom such information relates.

Section 6103(n) authorizes the IRS to disclose confidential taxpayer information to persons who provide services to the IRS, including outside experts. The legislative history of section 6103(n) indicates that Congress added the words “other services” in 1990 to ensure that persons who provide services to the IRS, such as expert witnesses, and to whom the IRS discloses returns and return information pursuant to section 6103, would clearly be subject to the same confidentiality standards and penalties for unauthorized disclosure as are IRS employees.

In sections 7431, 7213, and 7213A, Congress created parallel civil and criminal deterrents for outside contractors (to those applicable to IRS employees) to punish any misuse of taxpayer return information through unlawful inspection or unlawful disclosure of such information. Specifically, section 7431(a)(2) authorizes taxpayers to file the same type of civil action for damages against an IRS contractor for knowingly, or by reason of negligence, making any unauthorized inspection or unauthorized disclosure of taxpayer return information, as may be filed against the United States for the same type of conduct committed by any officer or employee of the United States. Similarly, in sections 7213(a)(1) and 7213A(a)(1)(B) (by references to persons described in section 6103(n)), Congress made it a crime punishable by up to five years or up to one year of imprisonment, plus a fine, for an IRS contractor to willfully make an unauthorized disclosure or an unauthorized inspection of taxpayer return information, respectively. If an IRS officer or employee is convicted under sections 7213 or 7213A, such person will also be dismissed or discharged from Federal employment. Before any conviction, if the IRS determines that a contractor has violated its taxpayer return information disclosure obligations under its contract, the IRS may also suspend or terminate the contract, pursuant to § 301.6103(n)–1(e)(4)(iii). Moreover, § 301.6103(n)–1(e)(4) provides further safeguards against unlawful disclosures or inspections of taxpayer return information by contractors.

Finally, it is unclear what connection the comment is making between protecting confidentiality of taxpayer information and objectivity of the section 6103(n) contractor. First, there is no obligation under section 6103(n) or the regulations thereunder for a contractor under section 6103(n) to be objective. Second, whether a contractor is objective has no relation to whether the contractor has an obligation to protect confidential taxpayer information from disclosure or the contractor’s ability to do so.

For these reasons, the Treasury and the IRS disagree that the regulations place confidential taxpayer information unnecessarily at risk of unauthorized disclosure.

One comment states that including a provision to allow an IRS contractor in a summons interview to question a witness under oath in the final regulations would result in time-consuming and costly litigation for the IRS, taxpayers, third party witnesses, and the courts, and that these costs would outweigh the potential benefits to the IRS from a contractor directly questioning a summoned witness under oath. The comment does not indicate how it came to this conclusion, nor does it provide any support for its concern.

The IRS makes the decision of whether to issue a summons or to pursue summons enforcement actions on a case-by-case basis, analyzing each situation in the light of its particular facts and weighing the desired information against the tax liability involved, the time and expense of obtaining the records, and the adverse effect on voluntary compliance by others if the enforcement actions are not successful. A contractor’s participation in a summons interview does not factor into the IRS’s decision to request the Department of Justice to institute enforcement action or lead the taxpayer ultimately to file a deficiency action in the United States Tax Court or a refund claim in a United States District Court or the Court of Federal Claims. As a practical matter, the IRS will likely hire contractors to assist in the factual development of an examination only in significant cases. These are cases in which litigation over summons enforcement is already likely to occur if the IRS examination team faces resistance from taxpayers to providing requested information. Accordingly, there should not be considerably more litigation as a result of these final regulations. Moreover, when there is summons enforcement litigation, it will be because the IRS has determined that such litigation is in the best interest of tax administration.

One of the comments states that the temporary regulations were not issued in accordance with the Administrative Procedure Act (APA). The temporary regulations were promulgated in full compliance with the APA. In addition, this document finalizes proposed regulations contained in a notice of proposed rulemaking that cross-referenced the temporary regulations. The proposed regulations were also promulgated in full compliance with the APA. Because these final regulations adopt the proposed regulations, it is not necessary to address concerns regarding procedural issues relating to promulgation of the temporary regulations.

Par. 2. Section 301.7602–1T is removed.

Par. 3. Section 301.7602–1 is amended by adding paragraph (b)(3) and revising paragraph (d) to read as follows:

* * * * *

(b)(3) Participation of a person described in section 6103(n). For purposes of this paragraph (b), a person authorized to receive returns or return information under section 6103(n) and § 301.6103(n)–1(a) of the regulations may receive and review books, papers, records, or other data produced in compliance with a summons and, in the presence and under the guidance of an IRS officer or employee, participate fully in the interview of a witness summoned by the IRS to provide testimony under oath. Fully participating in an interview includes, but is not limited to, receipt, review, and use of summoned books, papers, records, or other data; being present during summons interviews; questioning the person providing testimony under oath; and asking a summoned person’s representative to clarify an objection or assertion of privilege.

* * * * *

(d) Applicability date. This section is applicable after September 3, 1982, except for paragraphs (b)(1) and (2) of this section which are applicable on and after April 1, 2005 and paragraph (b)(3) of this section which applies to summons interviews conducted on or after July 14, 2016. For rules under paragraphs (b)(1) and (2) that are applicable to summonses issued on or after September 10, 2002 or under paragraph (b)(3) that are applicable to summons interviews conducted on or after June 18, 2014, see 26 CFR 301.7602–1T (revised as of April 1, 2016).

Approved: May 27, 2016.

This document contains proposed regulations that would amend 26 CFR part 1 under section 355 of the Code. The proposed regulations would provide additional guidance regarding the device prohibition of section 355(a)(1)(B) and provide a minimum threshold for the assets of one or more active trades or businesses, within the meaning of section 355(a)(1)(C) and (b), of the distributing corporation and each controlled corporation (in each case, within the meaning of section 355(a)(1)(A)).

This Background section of the preamble (1) summarizes the requirements of section 355, (2) discusses the development of current law and IRS practice under section 355 and the regulations thereunder, and (3) explains the reasons for the proposed regulations.

Generally, if a corporation distributes property with respect to its stock to a shareholder, section 301(b) provides that the amount of the distribution is equal to the amount of money and the fair market value of other property received. Under section 301(c), this amount is treated as (1) the receipt by the shareholder of a dividend to the extent of the corporation’s earnings and profits, (2) the recovery of the shareholder’s basis in the stock, and/or (3) gain from the sale or exchange of property. The corporation recognizes gain under section 311(b) to the extent the fair market value of the property distributed exceeds the corporation’s adjusted basis in the property. However, section 355 provides that, under certain circumstances, a corporation (Distributing) may distribute stock and securities in a corporation it controls within the meaning of section 368(c) (Controlled) to its shareholders and security holders without causing either Distributing or its shareholders or security holders to recognize income, gain, or loss on the distribution.

Section 355 has numerous requirements for a distribution to be tax-free to Distributing and its shareholders. Some of these requirements are intended to prevent a distribution from being used inappropriately to avoid shareholder-level tax on dividend income. As examples, section 355(a)(1)(B) provides that the transaction must not be used principally as a device for the distribution of the earnings and profits of Distributing or Controlled or both (a device), and section 355(a)(1)(C) and (b) require Distributing and Controlled each to be engaged, immediately after the distribution, in the active conduct of a trade or business (an active business). To qualify for this purpose, an active business must have been actively conducted throughout the five-year period ending on the date of the distribution and must not have been acquired, directly or indirectly, within this period in a transaction in which gain or loss was recognized. Section 355(b)(2)(B), (C), and (D).

Distributions of the stock of Controlled generally take three different forms: (1) A pro rata distribution to Distributing’s shareholders of the stock of Controlled (a spin-off), (2) a distribution of the stock of Controlled in redemption of Distributing stock (a split-off), or (3) a liquidating distribution in which Distributing distributes the stock of more than one Controlled, either pro rata or non-pro rata (in either case, a split-up).

The earliest predecessor of section 355 was section 202(b) of the Revenue Act of 1918, ch. 18 (40 Stat. 1057, 1060), which permitted a tax-free exchange by a shareholder of stock in a corporation for stock in another corporation in connection with a reorganization. This section did not allow tax-free spin-offs. In section 203(c) of the Revenue Act of 1924, ch. 234 (43 Stat. 253, 256), Congress amended this provision to allow tax-free spin-offs pursuant to plans of reorganization.

Taxpayers tried to use this provision to avoid the dividend provisions of the Code by having Distributing contribute surplus cash or liquid assets to a newly formed Controlled and distribute the Controlled stock to its shareholders. See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935). Congress reacted to this abuse by eliminating the spin-off provision in the Revenue Act of 1934, ch. 277 (48 Stat. 680). The legislative history states that the provision had provided a method for corporations “to pay what would otherwise be taxable dividends, without any taxes upon their shareholders” and that “this means of avoidance should be ended.” H.R. Rep. No. 73–704, at 14 (1934).

In section 317(a) of the Revenue Act of 1951, ch. 521 (65 Stat. 452, 493), Congress re-authorized spin-offs pursuant to plans of reorganization:

During debate on this legislation, Senator Hubert Humphrey expressed concerns about spin-offs and argued that these restrictions were necessary. See, e.g., 97 Cong. Rec. 11812 (1951) (“Unless strictly safeguarded, [a spin-off provision] can result in a loophole that will enable a corporation to distribute earnings and profits to stockholders without payment of the usual income taxes.”); Id. (“Clauses (A) and (B) of section 317 provide very important safeguards against the tax avoidance which would be possible if section 317 were adopted without clauses (A) and (B).”). See also 96 Cong. Rec. 13686 (1950) (“It was the viewpoint of the committee that [a spin-off] must be strictly a bona fide transaction, not colorable, not for the purpose of evading the tax.”).

Until 1954, a spin-off, split-off, or split-up was eligible for tax-free treatment only if Distributing transferred property to Controlled as part of a reorganization. In 1954, Congress adopted section 355 as part of the 1954 Code. As a significant innovation, section 355 allowed spin-offs, split-offs, and split-ups to be tax-free without a reorganization, and this innovation remains in effect.

Courts applying section 355 (or a predecessor provision) have generally placed greater emphasis on the substance of the transaction than on compliance with the technical requirements of the statute. Thus, some courts have determined that a transaction does not qualify under section 355 (or a predecessor provision), notwithstanding strict statutory compliance, on the basis that the substance of the transaction was inconsistent with congressional intent. For example, in Gregory, the Supreme Court held that compliance with the letter of the spin-off statute was insufficient if the transaction was otherwise indistinguishable from a dividend. The Supreme Court observed that the transaction in Gregory was “an operation having no business or corporate purpose–a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character.” Gregory, 293 U.S. at 469.

Other courts have found that a transaction does qualify under section 355 despite its failure to comply with all of the statutory requirements. For example, in Commissioner v. Gordon, 382 F.2d 499 (2d Cir.1967), rev’d on other grounds, 391 U.S. 83 (1968), the court addressed section 355(b)(2)(C). Pursuant to that section, a corporation is treated as engaged in the active conduct of a trade or business only if the trade or business was not acquired in a transaction in which gain or loss was recognized in whole or in part within the five-year period ending on the date of the distribution. The court concluded that, despite the fact that gain was recognized when Distributing transferred a trade or business to Controlled, section 355(b)(2)(C) was not violated because new assets were not brought within the combined corporate shells of Distributing and Controlled. The court stated:

Id. at 507.

Regulations under section 355 of the 1954 Code were issued in 1955 (the 1955 regulations). TD 6152 (20 FR 8875). These regulations included § 1.355–2(b)(3), which provided the following:

Additional regulations under section 355 were issued in 1989 (the 1989 regulations). TD 8238 (54 FR 283). These regulations provide substantially more guidance than the 1955 regulations to determine whether a distribution was a device. Section 1.355–2(d)(1) provides that “a tax-free distribution of the stock of a controlled corporation presents a potential for tax avoidance by facilitating the avoidance of the dividend provisions of the Code through the subsequent sale or exchange of stock of one corporation and the retention of the stock of another corporation. A device can include a transaction that effects a recovery of basis.”

This provision clarifies that, although the device prohibition primarily targets the conversion of dividend income to capital gain, a device can still exist if there would be a recovery of stock basis in lieu of receipt of dividend income and even if the shareholder’s federal income tax rates on dividend income and capital gain are the same.

The 1989 regulations also expand on the statement in the 1955 regulations that the device analysis takes into account all of the facts and circumstances by specifying three factors that are evidence of device and three factors that are evidence of nondevice. One of the device factors, described in § 1.355–2(d)(2)(iv)(B), expands the statement in the 1955 regulations that consideration will be given to the nature, kind, and amount of the assets of Distributing and Controlled immediately after the transaction (the nature and use of assets device factor). First, this provision provides that “[t]he existence of assets that are not used in a trade or business that satisfies the requirements of section 355(b) is evidence of device. For this purpose, assets that are not used in a trade or business that satisfies the requirements of section 355(b) include, but are not limited to, cash and other liquid assets that are not related to the reasonable needs of a business satisfying such section.” This provision continues to provide that “[t]he strength of the evidence of device depends on all the facts and circumstances, including, but not limited to, the ratio for each corporation of the value of assets not used in a trade or business that satisfies the requirements of section 355(b) to the value of its business that satisfies such requirements.” Finally, the provision provides that “[a] difference in the ratio described in the preceding sentence for the distributing and controlled corporation is ordinarily not evidence of device if the distribution is not pro rata among the shareholders of the distributing corporation and such difference is attributable to a need to equalize the value of the stock distributed and the value of the stock or securities exchanged by the distributees.”

Although this provision describes the factor, it provides little guidance relating to the quality or quantity of the relevant assets and no guidance on how the factor relates to other device factors or nondevice factors.

The nondevice factors in § 1.355–2(d)(3) are the presence of a corporate business purpose, the fact that the stock of Distributing is publicly traded and widely held, and the fact that the distribution is made to certain domestic corporate shareholders.

Section 1.355–2(d)(5) specifies certain distributions that ordinarily are not considered a device, notwithstanding the presence of device factors, because they ordinarily do not present the potential for federal income tax avoidance in converting dividend income to capital gain or using stock basis to reduce shareholder-level tax. These transactions include a distribution that, in the absence of section 355, with respect to each distributee, would be a redemption to which sale-or-exchange treatment applies.

Section 1.355–3 provides rules for determining whether Distributing and Controlled satisfy the active business requirement. Proposed regulations issued in 2007 would amend § 1.355–3. REG–123365–03 (72 FR 26012). The Treasury Department and the IRS continue to study the active business requirement issues considered in those proposed regulations.

The fact that Distributing’s or Controlled’s qualifying active business is small in relation to all the assets of Distributing or Controlled is generally recognized as a device factor. A separate issue is whether a relatively small active business satisfies the active business requirement. In Rev. Rul. 73–44 (1973–1 CB 182), Controlled’s active business represented a “substantial portion” but less than half of the value of its total assets. The revenue ruling states:

The IRS has taken the position, in letter rulings and internal memoranda, that an active business can satisfy the active business requirement regardless of its absolute or relative size. However, no published guidance issued by the Treasury Department or the IRS takes this position.

In 1996, the Treasury Department and the IRS issued Rev. Proc. 96–43 (1996–2 CB 330), which provided that (1) the IRS ordinarily would not issue a letter ruling or determination letter on whether a distribution was described in section 355(a)(1) if the gross assets of the active business would have a fair market value that was less than five percent of the total fair market value of the gross assets of the corporation directly conducting the active business, but (2) a ruling might be issued “if it can be established that, based upon all relevant facts and circumstances, the trades or businesses are not de minimis compared with the other assets or activities of the corporation and its subsidiaries.” This no-rule provision was eliminated in Rev. Proc. 2003–48 (2003–2 CB 86). Since that time, until the publication of Rev. Proc. 2015–43 (2015–40 IRB 467) and Notice 2015–59 (2015–40 IRB 459), discussed in Part D.1 of this Background section of the preamble, the IRS maintained its position that the relative size of an active business is a device factor rather than a section 355(b) requirement. The IRS issued numerous letter rulings on section 355 distributions involving active businesses that were de minimis in value compared to the other assets of Distributing or Controlled.

The IRS interpreted section 355(b) in this manner in part as a result of the mechanical difficulties of satisfying the active business requirement. These mechanical difficulties are discussed further in Part D.3.c of this Background section of the preamble.

As an example, until section 355(b) was amended by section 202 of the Tax Increase Prevention and Reconciliation Act of 2005, Public Law 109–222 (120 Stat. 345, 348); Division A, section 410 of the Tax Relief and Health Care Act of 2006, Public Law 109–432 (120 Stat. 2922, 2963); and section 4(b) of the Tax Technical Corrections Act of 2007, Public Law 110–172 (121 Stat. 2473, 2476) (the Separate Affiliated Group, or SAG, Amendments), if, immediately after the distribution, a corporation did not directly engage in an active business, it could satisfy the active business requirement only if substantially all of its assets consisted of stock and securities of corporations it controlled that were engaged in an active business (the holding company rule). See section 355(b) prior to the SAG Amendments. Because of the limited application of the holding company rule, corporations often had to undergo burdensome restructurings prior to section 355 distributions merely to satisfy the active business requirement. See, e.g., H.R. Rep. No. 109–304, at 54 (2005).

As another example, until 1992, no guidance provided that Distributing or Controlled could rely on activities conducted by a partnership to satisfy the active business requirement, even if Distributing or Controlled held a substantial interest in the partnership and participated in its management. This situation changed after the Treasury Department and the IRS published revenue rulings permitting this reliance. See Rev. Rul. 92–17 (1992–1 CB 142) amplified by Rev. Rul. 2002–49 (2002–2 CB 288) and modified by Rev. Rul. 2007–42 (2007–2 CB 44).

The device prohibition continues to be important even though the federal income tax rates for dividend income and capital gain may be identical for many taxpayers. In Rev. Proc. 2003–48, the Treasury Department and the IRS announced that the IRS would no longer rule on whether a transaction is a device or has a business purpose. As a result, since the publication of Rev. Proc. 2003–48, the IRS has made only limited inquiries as to device and business purpose issues raised in requests for private letter rulings under section 355.

As explained in Part C of this Background section of the preamble, section 355 and its predecessors have had a long and contentious history. Despite the safeguards in the Code and regulations, and the courts’ interpretations in accordance with congressionally-articulated statutory purposes, taxpayers have attempted to use section 355 distributions in ways that the Treasury Department and the IRS have determined to be inconsistent with the purpose of section 355.

On September 14, 2015, the Treasury Department and the IRS issued Rev. Proc. 2015–43 and Notice 2015–59 in response to concerns relating to distributions involving relatively small active businesses, substantial amounts of investment assets, and regulated investment companies (RICs) or real estate investment trusts (REITs). The notice states that the Treasury Department and the IRS are studying issues under sections 337(d) and 355 relating to these transactions and that these transactions may present evidence of device, lack an adequate business purpose or a qualifying active business, or circumvent the purposes of Code provisions intended to implement repeal of the General Utilities doctrine, a doctrine under which a corporation generally could distribute appreciated property to its shareholders without recognizing gain (General Utilities repeal). The notice invited comments with respect to these issues and one commenter (the commenter) submitted a comment letter.

The proposed regulations in this notice of proposed rulemaking would address the device prohibition (including the business purpose requirement as it pertains to device) and the active business requirement. Congress has addressed certain other issues discussed in Notice 2015–59. See section 311 of the Protecting Americans from Tax Hikes Act of 2015, Public Law 114–113 (129 Stat. 3040, 3090), in which Congress added section 355(h), which generally denies section 355 treatment if either Distributing or Controlled is a REIT unless both are REITs immediately after the distribution, and section 856(c)(8), which generally provides that Distributing or Controlled will not be eligible to make a REIT election within the ten-year period after a section 355 distribution. Separate temporary and proposed regulations address transactions that avoid the application of sections 355(h) and 856(c)(8). See REG–126452–15 (Certain Transfers of Property to RICs and REITs) (81 FR 36816), cross-referencing TD 9770 (81 FR 36793). The Treasury Department and the IRS continue to study issues relating to General Utilities repeal presented by other transactions involving the separation of nonbusiness assets from business assets, and are considering issuing guidance under section 337(d) to address these issues. See Part D.4 of this Background section of the preamble.

The commenter believes that new rules are not needed for transactions that raise the purely shareholder-level concerns that are the subject of the device prohibition. According to the commenter, those transactions likely do not qualify under section 355 under current law and are infrequent. Although largely agreeing with this statement, the Treasury Department and the IRS have determined that certain clarifying changes should be made to the device rules. As discussed in Part C.3.b of this Background section of the preamble, the current regulations relating to device are not specific as to the quality or quantity of assets relevant in the nature and use of assets device factor or the appropriate weighing of the device and nondevice factors. The Treasury Department and the IRS have determined that, in some situations, insufficient weight has been given to the nature and use of assets device factor and that device factors have not been balanced correctly against nondevice factors.

For example, if, after a distribution, Distributing or Controlled holds mostly liquid nonbusiness assets, the shareholders of that corporation can sell their stock at a price that reflects the value of the nonbusiness assets, and such a sale is economically similar to a distribution of the liquid nonbusiness assets to the shareholders that would have been treated as a dividend to the extent of earnings and profits of the corporation. See, e.g., Gregory. If Distributing’s ratio of nonbusiness assets to total assets differs substantially from Controlled’s ratio, the distribution could facilitate a separation of the nonbusiness assets from the business assets by means of the sale of the stock in the corporation with a large percentage of nonbusiness assets. No corporate-level gain, and possibly little or no shareholder-level gain, would be recognized.

Taxpayers have taken the position that nondevice factors in the regulations can outweigh the substantial evidence of device presented in such distributions. For example, certain taxpayers have viewed even a weak business purpose, combined with the fact that the stock of Distributing is publicly traded, as offsetting evidence of device presented by distributions effecting a separation of nonbusiness assets from business assets, even if pressure from public shareholders was a significant motivation for the distribution. The Treasury Department and the IRS do not agree that these types of nondevice factors should outweigh the substantial evidence of device presented by a distribution that separates nonbusiness assets from business assets.

Accordingly, the Treasury Department and the IRS have determined that the regulations should provide clearer, more objective guidance regarding the nature and use of assets device factor and the appropriate weighing of device factors and nondevice factors. The Treasury Department and the IRS also have determined that if a high enough proportion of assets of Distributing or Controlled consists of nonbusiness assets, and if the assets of the other corporation include a much lower proportion of nonbusiness assets, the evidence of device is so strong that nondevice factors generally should not be allowed to overcome the evidence of device.

The commenter also noted that the importance of device, traditionally understood as reflecting shareholder-level policies, has diminished in the context of a unified rate regime for long-term capital gains and qualified dividend income for some taxpayers. However, because of continuing differences in the federal income tax treatment of capital gains and dividends, including the potential for basis recovery (see § 1.355–2(d)(1)) and the availability of capital gains to absorb capital losses, the device prohibition continues to be important.

The commenter stated that section 355 is meant to apply to genuine separations of businesses, and that section 355(b) should not function as a formality. Nevertheless, the commenter does not believe that the active business requirement needs to be strengthened through the adoption of a requirement of a minimum amount of active business assets.

After studying this issue, the Treasury Department and the IRS have determined that Distributing or Controlled should not satisfy the active business requirement by holding a relatively de minimis active business. As described in the remainder of this Part D.3, the Treasury Department and the IRS have determined that interpreting section 355(b) as having meaning and substance and therefore requiring an active business that is economically significant is consistent with congressional intent, case law, and the reorganization provisions. In addition, given the developments in the tax law described in Part D.3.c of this Background section of the preamble, the Treasury Department and the IRS have determined that allowing a de minimis active business to satisfy the active business requirement is not necessary to reduce the burden of compliance with the active business requirement. Furthermore, requiring a minimum relative size for an active business is not inconsistent with the facts of Rev. Rul. 73–44 or with its conclusion. See Part D.3.d of this Background section of the preamble.

Allowing section 355(b) to be satisfied with an active business that is economically insignificant in relation to other assets of Distributing or Controlled is not consistent with the congressional purpose for adopting the active business requirement. It is generally understood that Congress intended section 355 to be used to separate businesses, not to separate inactive assets from a business. See S. Rep. No. 83–1622, at 50–51 (section 355 “contemplates that a tax-free separation shall involve only the separation of assets attributable to the carrying on of an active business” and does not permit “the tax free separation of an existing corporation into active and inactive entities”); see also Coady v. Commissioner, 33 T.C. 771, 777 (1960), aff’d, 289 F.2d 490 (6th Cir. 1961) (stating that a function of section 355(b) is “to prevent the tax-free separation of active and inactive assets into active and inactive corporate entities”) (emphasis in original); § 1.355–1(b) (“[s]ection 355 provides for the separation . . . of one or more existing businesses”). Additionally, when the active business of Distributing or Controlled is economically insignificant in relation to its other assets, it is unlikely that any non-federal tax purpose for separating that business from other businesses is a significant purpose for the distribution. See § 1.355–2(b)(1) (“Section 355 applies to a transaction only if it is carried out for one or more corporate business purposes. . . . The potential for the avoidance of Federal taxes by the distributing or controlled corporations . . . is relevant in determining the extent to which an existing corporate business purpose motivated the distribution.”).

Further, as the Supreme Court held in Gregory, transactions are to be taxed in accordance with their substance. The reorganization regulations adopt the same principle. For example, § 1.368–1(b) provides that “[b]oth the terms of the specifications [of the reorganization provisions] and their underlying assumptions and purposes must be satisfied in order to entitle the taxpayer to the benefit of the exception from the general rule.” Additionally, § 1.368–1(c) provides that “[a] scheme, which involves an abrupt departure from normal reorganization procedure in connection with a transaction on which the imposition of tax is imminent, such as a mere device that puts on the form of a corporate reorganization as a disguise for concealing its real character, and the object and accomplishment of which is the consummation of a preconceived plan having no business or corporate purpose, is not a plan of reorganization.”

Accordingly, when a corporation that owns only nonbusiness assets and a relatively de minimis active business is separated from a corporation with another active business, the substance of the transaction is not a separation of businesses as contemplated by section 355.

In the past, the active business requirement was more difficult to satisfy than it is today, in part because of the limited application of the holding company rule, discussed in Part C.5 of this Background section of the preamble. However, several developments in the tax law have occurred that make the active business requirement easier to satisfy and negate the historical need to reduce the administrative burden of complying with section 355(b).

In the SAG Amendments, Congress amended section 355(b) to adopt the separate affiliated group rules of section 355(b)(3). Section 355(b)(3)(A) provides that, for purposes of determining whether a corporation meets the requirements of section 355(b)(2)(A), all members of the corporation’s separate affiliated group (SAG) are treated as one corporation. Section 355(b)(3)(B) provides that a corporation’s SAG is the affiliated group which would be determined under section 1504(a) if the corporation were the common parent and section 1504(b) did not apply.

Additionally, as discussed in Part C.5 of this Background section of the preamble, section 355(b) now can be satisfied through the ownership of certain interests in a partnership that is engaged in an active business. See Rev. Rul. 2007–42 and Rev. Rul. 92–17. Similarly, § 301.7701–3 now allows an eligible entity to elect to be disregarded as an entity separate from its owner and permits a corporation to satisfy the active business requirement through a tax-free acquisition without having to assume liabilities relating to an active business. Finally, the expansion rules of § 1.355–3(b)(3)(ii) have been developed so that it is easier to acquire the assets of an active business in a taxable transaction while complying with section 355(b). See, e.g., Rev. Rul. 2003–18 (2003–1 CB 467) and Rev. Rul. 2003–38 (2003–1 CB 811) (both describing facts and circumstances to be considered in determining whether one trade or business is in the same line of business as another).

Rev. Rul. 73–44 is sometimes cited in support of the proposition that a de minimis active business satisfies the section 355(b) requirement. However, Rev. Rul. 73–44 states only that there is no requirement in section 355(b) that a specific percentage of a corporation’s assets be devoted to the active conduct of a trade or business, not that any size active business can satisfy section 355(b). In fact, the size of the active business in that ruling represented a substantial portion of Controlled’s assets, although less than half of Controlled’s value. Accordingly, Rev. Rul. 73–44 does not validate a section 355 distribution involving a de minimis active business, and the proposed regulations in this notice of proposed rulemaking addressing the minimum relative size of active businesses would not change the conclusion set forth in that revenue ruling. Nevertheless, the Treasury Department and the IRS intend to modify Rev. Rul. 73–44 with regard to the statement in the revenue ruling that there is no requirement that a specific percentage of a corporation’s assets be devoted to the active conduct of a trade or business.

The Treasury Department and the IRS have observed, as noted in Notice 2015–59, that taxpayers may attempt to use section 355 distributions in ways that are inconsistent with the purpose of General Utilities repeal. Specifically, the Treasury Department and the IRS are concerned that certain taxpayers may be interpreting the current regulations under sections 337(d) and 355 in a manner allowing tax-free distributions motivated in whole or substantial part by a purpose of avoiding corporate-level taxation of built-in gain in investment or nonbusiness assets. See § 1.355–1(b) (“Section 355 provides for the separation . . . of one or more existing businesses formerly operated, directly or indirectly, by a single corporation . . . .”). The Treasury Department and the IRS continue to study whether permitting tax-free separations of large amounts of nonbusiness assets from business assets, especially when the gain in the nonbusiness assets is expected to be eliminated, is consistent with General Utilities repeal in all circumstances. Comments are welcome on potential additional guidance under section 337(d) addressing such transactions.

The proposed regulations would modify § 1.355–2(d), which addresses transactions that are or are not a device. The proposed regulations would modify the nature and use of assets device factor in § 1.355–2(d)(2)(iv), modify the corporate business purpose nondevice factor in § 1.355–2(d)(3)(ii), and add a per se device test.

The Treasury Department and the IRS have determined that device potential generally exists either if Distributing or Controlled owns a large percentage of assets not used in business operations compared to total assets or if Distributing’s and Controlled’s percentages of these assets differs substantially. A proposed change to the nature and use of assets device factor in § 1.355–2(d)(2)(iv) would focus on assets used in a Business (Business Assets) (each as defined in proposed § 1.355–2(d)(2)(iv)(B)) rather than assets used in an active business meeting the requirements of section 355(b) (a Five-Year-Active Business, as defined in proposed § 1.355–9(a)(2)). In general, Business would have the same meaning as a Five-Year-Active Business, but without regard to whether the business has been operated or owned for at least five years prior to the date of the distribution or whether the collection of income requirement in § 1.355–3(b)(2)(ii) is satisfied. Business Assets would be gross assets used in a Business, including reasonable amounts of cash and cash equivalents held for working capital and assets required to be held to provide for exigencies related to a Business or for regulatory purposes with respect to a Business. The Treasury Department and the IRS have determined that the presence of Business Assets generally does not raise any more device concerns than the presence of assets used in a Five-Year-Active Business (Five-Year-Active-Business Assets). Thus, the proposed regulations would modify § 1.355–2(d)(2)(iv)(B) to take into account Business Assets, not just Five-Year-Active-Business Assets.

Rev. Proc. 2015–43 (now incorporated into Rev. Proc. 2016–3 (2016–1 IRB 126)) and Notice 2015–59 focus on investment assets (using a modified section 355(g) definition) of a corporation as assets that may raise device concerns. However, after further study, the Treasury Department and the IRS have determined that investment assets as defined therein may include certain assets that do not raise device concerns, such as cash needed by a corporation for working capital, and may not include other assets that do raise device concerns, such as real estate not related to the taxpayer’s Business. The Treasury Department and the IRS have determined that focusing on Nonbusiness Assets, as defined in the proposed regulations, is a better method of evaluating device or nondevice as compared to using investment assets as described in Rev. Proc. 2016–3 and Notice 2015–59. Thus, the proposed regulations would focus on Nonbusiness Assets rather than investment assets.

The proposed regulations would provide thresholds for determining whether the ownership of Nonbusiness Assets (gross assets that are not Business Assets) and/or differences in the Nonbusiness Asset Percentages (the percentage of a corporation’s Total Assets (its Business Assets and Nonbusiness Assets) that are Nonbusiness Assets) for Distributing and Controlled are evidence of device. If neither Distributing nor Controlled has Nonbusiness Assets that comprise 20 percent or more of its Total Assets, the ownership of Nonbusiness Assets ordinarily would not be evidence of device. Additionally, a difference in the Nonbusiness Asset Percentages for Distributing and Controlled ordinarily would not be evidence of device if such difference is less than 10 percentage points or, in the case of a non-pro rata distribution, if the difference is attributable to a need to equalize the value of the Controlled stock and securities distributed and the consideration exchanged therefor by the distributees. Accordingly, the Treasury Department and the IRS propose to treat such circumstances as ordinarily not constituting evidence of device.

The Treasury Department and the IRS also propose to revise the nondevice factor in § 1.355–2(d)(3)(ii), which relates to corporate business purpose for a transaction as evidence of nondevice. Under the proposed revision, a corporate business purpose that relates to a separation of Nonbusiness Assets from one or more Businesses or from Business Assets would not be evidence of nondevice, unless the business purpose involves an exigency that requires an investment or other use of the Nonbusiness Assets in a Business. The Treasury Department and the IRS have determined that, absent such an exigency, such separations are not consistent with the intent of Congress to prevent section 355 from applying to a distribution that is used principally as a device.

The Treasury Department and the IRS also propose to add a per se device test to the device determination in proposed § 1.355–2(d)(5). Under proposed § 1.355–2(d)(5), if designated percentages of Distributing’s and/or Controlled’s Total Assets are Nonbusiness Assets, the transaction would be considered a device, notwithstanding the presence of any other nondevice factors, for example, a corporate business purpose or stock being publicly traded and widely held. By their nature, these transactions present such clear evidence of device that the Treasury Department and the IRS have determined that the nondevice factors can never overcome the device potential. The only exceptions to this per se device rule would apply if the distribution is also described in § 1.355–2(d)(3)(iv) (distributions in which the corporate distributee would be entitled to a dividends received deduction under section 243(a) or 245(b)) or in redesignated § 1.355–2(d)(6) (§ 1.355–2(d)(5) of the current regulations, relating to transactions ordinarily not considered as a device).

The per se device test would have two prongs, both of which must be met for the distribution to be treated as a per se device.

The first prong would be if Distributing or Controlled has a Nonbusiness Asset Percentage of 66 ⅔ percent or more. If 66 ⅔ percent or more of the Total Assets of either corporation consist of Nonbusiness Assets, a strong device potential exists.

The second prong of the test would compare the Nonbusiness Asset Percentage of Distributing with that of Controlled. The comparison would be similar to the comparison, in § 1.355–2(d)(2)(iv)(B) of the current regulations, between Distributing’s ratio of assets not used in a Five-Year-Active Business to assets used in a Five-Year-Active Business and Controlled’s ratio of such assets. However, the Treasury Department and the IRS recognize that valuation of assets may be difficult and that determining whether certain assets are Business Assets also may be difficult. Accordingly, rather than requiring Distributing and Controlled to make exact determinations of their Nonbusiness Asset Percentages, which would then be compared to the other corporation’s Nonbusiness Asset Percentage, the second prong of the per se device test would provide for three bands in making this comparison. These bands generally would provide for the comparison of the Nonbusiness Asset Percentages of Distributing and Controlled but require less precision in asset valuation.

In the first band, if one corporation’s Nonbusiness Asset Percentage is 66 ⅔ percent or more, but less than 80 percent, the distribution would fall within the band if the other corporation’s Nonbusiness Asset Percentage is less than 30 percent. In the second band, if one corporation’s Nonbusiness Asset Percentage is 80 percent or more, but less than 90 percent, the distribution would fall within the band if the other corporation’s Nonbusiness Asset Percentage is less than 40 percent. In the third band, if one corporation’s Nonbusiness Asset Percentage is 90 percent or more, the distribution would fall within the band if the other corporation’s Nonbusiness Asset Percentage is less than 50 percent. All of these bands represent cases in which the Nonbusiness Asset Percentages of Distributing and Controlled are significantly different.

If both prongs of the per se device test are met, that is, if the Nonbusiness Asset Percentage for either Distributing or Controlled is 66 ⅔ percent or more and the Nonbusiness Asset Percentages of Distributing and Controlled fall within one of the three bands, the distribution would be a per se device. Otherwise, the general facts-and-circumstances test of § 1.355–2(d), as modified by these proposed regulations, would apply to determine if the transaction was a device.

In making the determination of which assets of a corporation are Business Assets and which are Nonbusiness Assets, if Distributing or Controlled owns a partnership interest or stock in another corporation, the proposed regulations would provide four operating rules.

First, all members of a SAG with respect to which Controlled is the common parent (CSAG) and all members of a SAG with respect to which Distributing is the common parent excluding Controlled and its SAG (DSAG) would be treated as a single corporation. Thus, any stock owned by one member of a SAG in another member of the same SAG and any intercompany obligations between the same SAG members would be disregarded.

Second, a partnership interest would generally be considered a Nonbusiness Asset. However, if, by reason of a corporation’s ownership interest or its ownership interest and participation in management of the partnership, the corporation is considered to be engaged in the Business conducted by such partnership (based on the criteria that would be used to determine whether such corporation is considered to be engaged in the Five-Year-Active Business of such partnership under Rev. Ruls. 92–17, 2002–49, and 2007–42), the fair market value of the partnership interest would be allocated between Business Assets and Nonbusiness Assets in the same proportion as the proportion of the fair market values of the Business Assets and the Nonbusiness Assets of the partnership.

Third, a rule similar to the partnership interest rule would apply for corporate stock owned by Distributing or Controlled. That is, stock in a corporation, other than a member of the DSAG or the CSAG, would generally be a Nonbusiness Asset. However, there would be an exception for stock in a Member of a 50-Percent-Owned Group. For this purpose, a 50-Percent-Owned Group would have the same meaning as SAG, except substituting “50-percent” for “80-percent,” and a Member of a 50-Percent-Owned Group would be a corporation that would be a member of a DSAG or CSAG, with such substitution. If a Member of a 50-Percent-Owned Group with respect to Distributing or Controlled owns stock in another Member of such 50-Percent-Owned Group (other than a member of the DSAG or the CSAG, respectively), the fair market value of such stock would be allocated between Business Assets and Nonbusiness Assets in the same proportion as the proportion of the fair market values of the Business Assets and the Nonbusiness Assets of the issuing corporation.

Fourth, the proposed regulations would provide for adjustments to prevent distortion if Distributing or Controlled owes money to or is owed money by a partnership or Member of a 50-Percent-Owned Group.

The partnership rules and the 50-Percent-Owned Group rules are designed to recognize that ownership of a partnership interest or stock in a Member of a 50-Percent-Owned Group may reflect an investment in Business Assets, Nonbusiness Assets, or both, while minimizing the significance of changes in the form of ownership of Business Assets and Nonbusiness Assets.

If a transaction involves distributions by Distributing of the stock of more than one Controlled, proposed §§ 1.355–2(d)(2)(iv) and 1.355–2(d)(5) would apply to all such Controlleds. To the extent any rule would require a comparison between characteristics of Distributing and Controlled, there would have to be a comparison between Distributing and each Controlled and between each Controlled and each other Controlled. If any comparison under proposed § 1.355–2(d)(2)(iv) or § 1.355–2(d)(5) would result in a determination that a distribution is a device, then all distributions involved in the transaction would be considered a device.

Section 355(b) does not literally provide a minimum absolute or relative size requirement for an active business to qualify under section 355(b). Nevertheless, as discussed in Part D.3 of the Background section of the preamble, the Treasury Department and the IRS have determined that Congress intended that section 355(b) would require that distributions have substance and that a distribution involving only a relatively de minimis active business should not qualify under section 355 because such a distribution is not a separation of businesses as contemplated by section 355.

To ensure that congressional intent is satisfied and to reduce uncertainty, the Treasury Department and the IRS propose to add new § 1.355–9. This section would provide that, for the requirements of section 355(a)(1)(C) and (b) to be satisfied with respect to a distribution, the Five-Year-Active-Business Asset Percentage (the percentage determined by dividing the fair market value of a corporation’s Five-Year-Active-Business Assets by the fair market value of its Total Assets) of each of Controlled (or the CSAG) and Distributing (or the DSAG excluding Controlled and other CSAG members) must be at least five percent. Similar to the proposed definition of Business Assets, Five-Year-Active-Business Assets would include reasonable amounts of cash and cash equivalents held for working capital and assets required to be held to provide for exigencies related to a Five-Year-Active Business or for regulatory purposes with respect to a Five-Year-Active Business.

In making the determination of the percentage of a corporation’s assets that are Five-Year-Active-Business Assets, if a corporation is considered to be engaged in a Five-Year-Active Business of a partnership, the fair market value of the partnership interest would be allocated between Five-Year-Active-Business Assets and Non-Five-Year-Active-Business Assets (assets other than Five-Year-Active-Business Assets) in the same proportion as the proportion of the fair market values of Five-Year-Active-Business Assets and Non-Five-Year-Active-Business Assets of the partnership.

Except in the case of a member of its SAG, neither Distributing nor Controlled would be considered to be engaged in the Five-Year-Active Business of a corporation in which it owns stock. Accordingly, such stock in a corporation would be considered a Non-Five-Year-Active-Business Asset. Although the proposed regulations relating to the device prohibition would provide an allocation rule for assets held by a Member of a 50-Percent-Owned Group, discussed in Part A.4 of this Explanation of Provisions section of the preamble, the Treasury Department and the IRS believe the SAG Amendments, discussed in Parts C.5 and D.3.c of the Background section of the preamble, limit the ability to take into account assets held by subsidiaries for purposes of the active business requirement. Accordingly, proposed § 1.355–9 would not provide a similar allocation rule for stock owned by Distributing or Controlled.

The commenter stated that the regulations should not provide a minimum size requirement for an active business in any distribution and that such a requirement could be especially problematic in intra-group distributions in preparation for a distribution outside of a group. Internal distributions often are necessary to align the proper assets within Distributing and Controlled prior to a distribution of the stock of Controlled outside the group. If a minimum size requirement is imposed on each of these internal distributions, taxpayers may have to undertake movements of active businesses within groups to meet the minimum size requirement for each internal distribution.

In enacting the SAG Amendments, Congress did not provide an exception to the requirements of section 355(b) for internal distributions that are preparatory to external distributions, although Congress permitted Distributing and Controlled to rely on active businesses held by members of their respective SAGs, even if such assets were distributed or sold within the SAG in a taxable transaction. Under the commenter’s rationale, the regulations should not only permit an internal distribution with a de minimis active business, but could also permit tax-free treatment for taxable distributions or sales of assets within the SAG if such assets need to be moved in preparation of the external distribution. The Treasury Department and the IRS have determined that each distribution must meet all the requirements of section 355, including the requirement that Distributing and each Controlled conduct an active business immediately after the distribution. Accordingly, the proposed regulations would provide a five-percent minimum Five-Year-Active-Business Asset Percentage requirement for all distributions.

For purposes of determining whether a transaction would be considered a device and whether one or more Five-Year-Active Businesses would meet the five-percent minimum Five-Year-Active-Business Asset Percentage requirement of proposed § 1.355–9, the assets held by Distributing and by Controlled must be identified, and their character and fair market value must be determined. The assets under consideration would be the assets held by Distributing and by Controlled immediately after the distribution. Thus, for example, the stock of Controlled that is distributed would not be an asset of Distributing for this purpose. The character of the assets held by Distributing and by Controlled, as Business Assets or Nonbusiness Assets or as Five-Year-Active-Business Assets or Non-Five-Year-Active-Business Assets, also would be the character as determined immediately after the distribution.

The proposed regulations would provide, however, that the fair market value of assets would be determined, at the election of the parties on a consistent basis, either (a) immediately before the distribution, (b) on any date within the 60-day period before the distribution, (c) on the date of an agreement with respect to the distribution that was binding on Distributing on such date and at all times thereafter, or (d) on the date of a public announcement or filing with the Securities and Exchange Commission with respect to the distribution. The parties would be required to make consistent determinations between themselves, and use the same date, for purposes of applying the device rules of proposed § 1.355–2(d) and the five-percent minimum Five-Year-Active-Business Asset Percentage requirement of proposed § 1.355–9. If the parties do not meet these consistency requirements, the valuation would be determined as of immediately before the distribution unless the Commissioner determines that the use of such date is inconsistent with the purposes of section 355 and the regulations thereunder.

The proposed regulations would also provide anti-abuse rules. Under the anti-abuse rules, a transaction or series of transactions (such as a change in the form of ownership of an asset; an issuance, assumption or repayment of indebtedness; or an issuance or redemption of stock) would not be given effect if undertaken with a principal purpose of affecting the Nonbusiness Asset Percentage of any corporation in order to avoid a determination that a distribution was a device or affecting the Five-Year-Active-Business Asset Percentage of any corporation in order to avoid a determination that a distribution does not meet the requirements of § 1.355–9. The transactions covered by the anti-abuse rules generally would not include an acquisition or disposition of assets, other than an acquisition from or disposition to a person the ownership of whose stock would, under section 318(a) (other than paragraph (4) thereof), be attributed to Distributing or Controlled, or a transfer of assets between Distributing and Controlled. However, such transactions would not be given effect if they are transitory, for example, if Distributing contributes cash to Controlled and retains some of the stock of Controlled or Controlled debt instruments, and there is a plan or intention for Controlled to return the cash to Distributing in redemption of the stock or repayment of the debt.

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(d) * * *

(1) * * * However, if a transaction is specified in paragraph (d)(5)(iii) of this section, then it is considered to have been used principally as a device unless it is also specified in paragraph (d)(3)(iv) of this section or paragraph (d)(6) of this section. If a transaction is specified in paragraph (d)(6) of this section, then it is ordinarily considered not to have been used principally as a device.

(2) * * *

(iv) * * * (A) In general. The determination of whether a transaction was used principally as a device will take into account the nature, kind, amount, and use of the assets of the distributing corporation and the controlled corporation.

(B) Definitions. The following definitions apply for purposes of this paragraph (d)(2)(iv):

(1) Business. Business means the active conduct of a trade or business, within the meaning of section 355(b) and § 1.355–3, without regard to—

(i) The requirements of section 355(b)(2)(B), (C), and (D), and § 1.355–3(b)(3) and (4) (relating to active conduct throughout the five-year period preceding a distribution and acquisitions during such period);

(ii) The collection of income requirement in § 1.355–3(b)(2)(ii); and

(iii) The requirement of § 1.355–9 (relating to Minimum Percentage of Five-Year-Active-Business Assets (as defined in § 1.355–9(a)(3))).

(2) Business Assets. Business Assets of a corporation means its gross assets used in one or more Businesses. Such assets include cash and cash equivalents held as a reasonable amount of working capital for one or more Businesses. Such assets also include assets required (by binding commitment or legal requirement) to be held to provide for exigencies related to a Business or for regulatory purposes with respect to a Business. For this purpose, such assets include assets the holder is required (by binding commitment or legal requirement) to hold to secure or otherwise provide for a financial obligation reasonably expected to arise from a Business and assets held to implement a binding commitment to expend funds to expand or improve a Business.

(3) Nonbusiness Assets. Nonbusiness Assets of a corporation means its gross assets other than its Business Assets.

(4) Total Assets. Total Assets of a corporation means its Business Assets and its Nonbusiness Assets.

(5) Nonbusiness Asset Percentage. The Nonbusiness Asset Percentage of a corporation is the percentage determined by dividing the fair market value of its Nonbusiness Assets by the fair market value of its Total Assets.

(6) Separate Affiliated Group, SAG, CSAG, and DSAG. Separate Affiliated Group (or SAG) means a separate affiliated group as defined in section 355(b)(3)(B), CSAG means a SAG with respect to which a controlled corporation is the common parent, and DSAG means a SAG with respect to which a distributing corporation is the common parent, excluding the controlled corporation and any other members of the CSAG.

(7) 50-Percent-Owned Group, Member of a 50-Percent-Owned Group. 50-Percent-Owned Group has the same meaning as SAG, except that “50-percent” is substituted for “80-percent” each place it appears in section 1504(a)(2), for purposes of section 355(b)(3)(B). A Member of a 50-Percent-Owned Group is a corporation that would be a member of a DSAG or a CSAG, with the substitution provided in this paragraph (d)(2)(iv)(B)(7).

(C) Presence of Nonbusiness Assets as evidence of device—(1) Ownership of Nonbusiness Assets. Ownership of Nonbusiness Assets by the distributing corporation or the controlled corporation is evidence of device. The strength of the evidence will be based on all the facts and circumstances, including the Nonbusiness Asset Percentage for each corporation. The larger the Nonbusiness Asset Percentage of either corporation, the stronger is the evidence of device. Ownership of Nonbusiness Assets ordinarily is not evidence of device if the Nonbusiness Asset Percentage of each of the distributing corporation and the controlled corporation is less than 20 percent.

(2) Difference between Nonbusiness Asset Percentages. A difference between the Nonbusiness Asset Percentage of the distributing corporation and the Nonbusiness Asset Percentage of the controlled corporation is evidence of device, and the larger the difference, the stronger is the evidence of device. Such a difference ordinarily is not itself evidence of device (but may be considered in determining the presence or the strength of other device factors) if—

(i) The difference is less than 10 percentage points; or

(ii) The distribution is not pro rata among the shareholders of the distributing corporation, and the difference is attributable to a need to equalize the value of the controlled stock and securities (if any) distributed and the value of the distributing stock and securities (if any) exchanged therefor by the distributees.

(3) Cross-reference. See paragraph (d)(5) of this section for a rule under which a distribution is considered to have been used principally as a device when the distributing corporation or the controlled corporation has a large Nonbusiness Asset Percentage and there is a large difference between Nonbusiness Asset Percentages of the two corporations.

(D) Operating rules. The following operating rules apply for purposes of this paragraph (d)(2)(iv):

(1) Multiple controlled corporations. If a transaction involves distributions by a distributing corporation of the stock of more than one controlled corporation, this paragraph (d)(2)(iv) applies to all such controlled corporations. If any provision in this paragraph (d)(2)(iv) requires a comparison between characteristics of the distributing corporation and the controlled corporation, the provision also requires such a comparison between the distributing corporation and each of the controlled corporations and between each controlled corporation and each other controlled corporation. If any distribution involved in the transaction is determined to have been used principally as a device by reason of this paragraph (d)(2)(iv), all distributions involved in the transaction are considered to have been used principally as a device.

(2) Treatment of SAG as a single corporation. The members of a DSAG are treated as a single corporation, the members of a CSAG are treated as a single corporation, references to the distributing corporation include all members of the DSAG, and references to the controlled corporation include all members of the CSAG.

(3) Time to identify assets and determine character of assets. The assets of the distributing corporation and the controlled corporation that are relevant in connection with this paragraph (d)(2)(iv), and the character of these assets as Business Assets or Nonbusiness Assets, must be determined by the distributing corporation and the controlled corporation immediately after the distribution. Accordingly, for purposes of this paragraph (d)(2)(iv), the assets of the distributing corporation do not include any asset, including stock of the controlled corporation, that is distributed in the transaction.

(4) Time to determine fair market value of assets—(i) In general. The distributing corporation and the controlled corporation each must determine the fair market value of its assets at the time of the distribution as of one of the following dates: Immediately before the distribution; on any date within the 60-day period before the distribution; on the date of an agreement with respect to the distribution that was binding on the distributing corporation on such date and at all times thereafter; or on the date of a public announcement or filing with the Securities and Exchange Commission with respect to the distribution.

(ii) Consistency. The distributing corporation and the controlled corporation must make the determinations described in paragraph (d)(2)(iv)(D)(4)(i) of this section in a manner consistent with each other and as of the same date for purposes of this paragraph (d)(2)(iv), paragraph (d)(5) of this section, and § 1.355–9. If these consistency requirements are not met, the fair market value of assets will be determined immediately before the distribution for purposes of all such provisions, unless the Commissioner determines that the use of such date is inconsistent with the purposes of section 355 and the regulations thereunder.

(5) Fair market value. The fair market value of an asset is determined under general federal tax principles but reduced (but not below the adjusted basis of the asset) by the amount of any liability that is described in section 357(c)(3) (relating to exclusion of certain liabilities, including liabilities the payment of which would give rise to a deduction, from the amount of liabilities assumed in certain exchanges) and relates to the asset (or to a Business with which the asset is associated). Any other liability is disregarded for purposes of determining the fair market value of an asset.

(6) Interest in partnership—(i) In general. Except as provided in paragraph (d)(2)(iv)(D)(6)(ii) of this section, an interest in a partnership is a Nonbusiness Asset.

(ii) Exception for certain interests in partnerships. A distributing corporation or controlled corporation may be considered to be engaged in one or more Businesses conducted by a partnership. This determination will be made using the same criteria that would be used to determine for purposes of section 355(b) and § 1.355–3 whether the corporation is considered to be engaged in the active conduct of a trade or business conducted by the partnership (relating to the corporation’s ownership interest or to its ownership interest and participation in management of the partnership). If a distributing corporation or controlled corporation is considered to be engaged in one or more Businesses conducted by a partnership, the fair market value of the corporation’s interest in the partnership will be allocated between Business Assets and Nonbusiness Assets in the same proportion as the proportion of the fair market values of the Business Assets and Nonbusiness Assets of the partnership.

(7) Stock in corporation—(i) In general. Except as provided in paragraph (d)(2)(iv)(D)(7)(ii) of this section, stock in a corporation other than a member of the DSAG or the CSAG is a Nonbusiness Asset.

(ii) Exception for stock in Member of a 50-Percent-Owned Group. If a Member of a 50-Percent-Owned Group with respect to the distributing corporation or the controlled corporation owns stock in another Member of the 50-Percent-Owned Group (other than a member of the DSAG or the CSAG, respectively), the fair market value of such stock will be allocated between Business Assets and Nonbusiness Assets in the same proportion as the proportion of the fair market values of the Business Assets and Nonbusiness Assets of the issuing corporation. This computation will be made with respect to lower-tier Members of the 50-Percent-Owned Group before the computations with respect to higher-tier members.

(8) Obligation between distributing corporation or controlled corporation and certain partnerships or Members of 50-Percent-Owned Groups. If an obligation of the distributing corporation or the controlled corporation is held by a partnership described in paragraph (d)(2)(iv)(D)(6)(ii) of this section or by a Member of its 50-Percent-Owned Group, or if an obligation of a partnership described in paragraph (d)(2)(iv)(D)(6)(ii) of this section or of a Member of its 50-Percent-Owned Group, with respect to the distributing corporation or the controlled corporation, is held by the distributing corporation or the controlled corporation, proper adjustments will be made to prevent double inclusion of assets or inappropriate allocation between Business Assets and Nonbusiness Assets of the distributing corporation or the controlled corporation on account of such obligation. See Examples 6 and 7 of paragraph (d)(4) of this section.

(E) Anti-abuse rule. A transaction or series of transactions undertaken with a principal purpose of affecting the Nonbusiness Asset Percentage of any corporation will not be given effect for purposes of applying this paragraph (d)(2)(iv). For this purpose, a transaction or series of transactions includes a change in the form of ownership of an asset; an issuance, assumption, or repayment of indebtedness or other obligations; or an issuance or redemption of stock. However, this paragraph (d)(2)(iv)(E) generally does not apply to a non-transitory acquisition or disposition of assets, other than an acquisition from or disposition to a person the ownership of whose stock would, under section 318(a) (other than paragraph (4) thereof), be attributed to the distributing corporation or the controlled corporation, or to a non-transitory transfer of assets between the distributing corporation and the controlled corporation.

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(3) * * *

(ii) Corporate business purpose. A corporate business purpose for the transaction is evidence of nondevice. The stronger the evidence of device (such as the presence of the device factors specified in paragraph (d)(2) of this section), the stronger the corporate business purpose must be to prevent the determination that the transaction is being used principally as a device. Evidence of device presented by ownership of Nonbusiness Assets (as defined in paragraph (d)(2)(iv)(B)(3) of this section) can be outweighed by the existence of a corporate business purpose for the ownership. Evidence of device presented by a difference between the Nonbusiness Asset Percentages (as defined in paragraph (d)(2)(iv)(B)(5) of this section) of the distributing corporation and the controlled corporation can be outweighed by the existence of a corporate business purpose for the difference. A corporate business purpose that relates to a separation of Nonbusiness Assets from one or more Businesses or Business Assets (as defined in paragraph (d)(2)(iv)(B) of this section) is not evidence of nondevice unless the business purpose involves an exigency that requires an investment or other use of the Nonbusiness Assets in one or more Businesses of the distributing corporation, the controlled corporation, or both. The assessment of the strength of a corporate business purpose will be based on all of the facts and circumstances, including, but not limited to, the following factors:

* * * * *

(4) Examples. The provisions of paragraphs (d)(1) through (3) of this section may be illustrated by the following examples. For purposes of these examples, A and B are individuals; P is a partnership; D and C are the distributing corporation and the controlled corporation, respectively; D and C each has no assets other than those described; there is no other evidence of device or nondevice other than as described; D has accumulated earnings and profits; and D distributes the stock of C in a distribution which, but for the issue of whether the transaction has been used principally as a device, satisfies the requirements of section 355(a).

Example 1. Sale after distribution (device). A owns all of the stock of D, which is engaged in the warehousing business. D owns all of the stock of C, which is engaged in the transportation business. All of D’s and C’s assets are Business Assets. D employs B, who is extremely knowledgeable of the warehousing business in general and the operations of D in particular. B has informed A that he will seriously consider leaving D if he is not given the opportunity to purchase a significant amount of stock of D. Because of his knowledge and experience, the loss of B would seriously damage the business of D. B cannot afford to purchase any significant amount of stock of D as long as D owns C. Accordingly, D distributes the stock of C to A and A subsequently sells a portion of his D stock to B. However, instead of A selling a portion of the D stock, D could have issued additional shares to B after the distribution. In light of the fact that D could have issued additional shares to B, the sale of D stock by A is substantial evidence of device. The transaction is considered to have been used principally as a device. See paragraph (d)(1), (2)(i), (ii), and (iii)(A), (B), and (D), and (3)(i) and (ii) of this section.

Example 2. Disproportionate division of Nonbusiness Assets (device)—(i) Facts. D owns and operates a fast food restaurant in State M and owns all of the stock of C, which owns and operates a fast food restaurant in State N. The value of the Business Assets of D’s and C’s fast food restaurants are $100 and $105, respectively. D also has $195 cash which D holds as a Nonbusiness Asset. D and C operate their businesses under franchises granted by competing businesses F and G, respectively. G has recently changed its franchise policy and will no longer grant or renew franchises to subsidiaries or other members of the same affiliated group of corporations operating businesses under franchises granted by its competitors. Thus, C will lose its franchise if it remains a subsidiary of D. The franchise is about to expire. The lease for the State M location will expire in 24 months, and D will be forced to relocate at that time. While D has not made any plans, it is weighing its option to purchase a building for the relocation. D contributes $45 to C, which C will retain, and distributes the stock of C pro rata among D’s shareholders.

(ii) Analysis. After the distribution, D’s Nonbusiness Asset Percentage is 60 percent ($150/$250), and C’s Nonbusiness Asset Percentage is 30 percent ($45/$150). D’s and C’s ownership of Nonbusiness Assets of at least 20 percent of their respective Total Assets is evidence of device with respect to each. The difference between D’s Nonbusiness Asset Percentage and C’s Nonbusiness Asset Percentage is 30 percentage points, which is also evidence of device. The corporate business purpose for the distribution does not relate to a separation of Nonbusiness Assets from one or more Businesses or Business Assets and is evidence of nondevice. However, D has no corporate business purpose for the difference of Nonbusiness Asset Percentages. While D is considering purchasing a building for use in the State M location, this purchase is not required by any exigency. The fact that the distribution is pro rata is also evidence of device. Based on all the facts and circumstances, the transaction is considered to have been used principally as a device. See paragraph (d)(1), (2)(i), (ii), (iv)(A) and (C), and (3)(i) and (ii)(A), (B), and (C) of this section.

Example 3. Proportionate division of Nonbusiness Assets (nondevice). The facts are the same as in Example 2, except that D contributes $95 of the cash to C instead of $45. After the distribution, D’s Nonbusiness Asset Percentage is 50 percent ($100/$200) and C’s Nonbusiness Asset Percentage is 47.5 percent ($95/$200), each of which is evidence of device. The difference between D’s Nonbusiness Asset Percentage and C’s Nonbusiness Asset Percentage (2.5 percentage points) is less than 10 percentage points and thus is not evidence of device. The corporate business purpose for the distribution is evidence of nondevice. Based on all the facts and circumstances, the transaction is considered not to have been used principally as a device. See paragraph (d)(1), (2)(i), (ii), (iv)(A) and (C), and (3)(i) and (ii)(A), (B), and (C) of this section.

Example 4. Disproportionate division of Nonbusiness Assets (nondevice).

The facts are the same as in Example 2, except that the lease for the State M location will expire in 6 months instead of 24 months, and D will use $80 of the $150 cash it retains to purchase a nearby building for the relocation. After the distribution, D’s Nonbusiness Asset Percentage is 60 percent, and C’s Nonbusiness Asset Percentage is 30 percent. D’s and C’s ownership of Nonbusiness Assets of at least 20 percent of their respective Total Assets is evidence of device with respect to each. The difference between D’s Nonbusiness Asset Percentage and C’s Nonbusiness Asset Percentage is 30 percentage points, which is also evidence of device. However, D has a corporate business purpose for a significant part of the difference of Nonbusiness Asset Percentages because D’s use of $80 is required by business exigencies. The fact that the distribution is pro rata is also evidence of device. The corporate business purpose for the distribution is evidence of nondevice. Based on all the facts and circumstances, the transaction is not considered to have been used principally as a device. See paragraph (d)(1), (2)(i), (ii), (iv)(A) and (C), and (3)(i) and (ii)(A), (B), and (C) of this section.

Example 5. Nonbusiness Asset Percentage (50-Percent-Owned Group)—(i) Facts. C’s assets consist of 50% of the stock of S1 and other assets consisting of $10,000 of Business Assets and $5,000 of Nonbusiness Assets. S1’s assets consist of 40% of the stock of S2, 60% of the stock of S3 and other assets consisting of $1,000 of Business Assets and $500 of Nonbusiness Assets. S1 has $500 of liabilities, owed to unrelated persons. S2’s assets consist of $500 Business Assets and $100 Nonbusiness Assets. S2 has $200 of liabilities. S3’s assets consist of $3,000 Business Assets and $1,500 Nonbusiness Assets. S3 has $3,500 of liabilities, owed to unrelated persons.

(ii) Determination of S1’s Business Assets and Nonbusiness Assets. Because C owns at least 50% of the stock of S1, S1 is a member of C’s 50-Percent-Owned Group. See paragraph (d)(2)(iv)(B)(7) of this section. In determining the amount of C’s Business Assets and Nonbusiness Assets, whether S1’s stock in S2 and S3 are Nonbusiness Assets or partially Nonbusiness Assets and partially Business Assets must first be determined. See paragraph (d)(2)(iv)(D)(7)(ii) of this section (computations are made with respect to lower-tier Members of a 50-Percent-Owned Group before the computations with respect to higher-tier members). The fair market value of S1’s stock in S2 is $160 (40% of $400 ($500 + $100 – $200)). Because S1 owns less than 50% of the stock of S2, S2 is not a member of C’s 50-Percent-Owned Group, and thus the S2 stock is a $160 Nonbusiness Asset in the hands of S1. See paragraph (d)(2)(iv)(B)(7) and (D)(7)(i) of this section. The fair market value of S1’s stock in S3 is $600 (60% of $1,000 ($3,000 + $1,500 – $3,500)). Because C owns at least 50% of the stock of S1 and S1 owns at least 50% of the stock of S3, S3 is a member of C’s 50-Percent-Owned Group. See paragraph (d)(2)(iv)(B)(7) of this section. Thus, the fair market value of the S3 stock is allocated between Business Assets and Nonbusiness Assets in the same proportion as S3’s proportion of Business Assets and Nonbusiness Assets. See paragraph (d)(2)(iv)(D)(7)(ii) of this section. Because S3 has Business Assets of $3,000 and Nonbusiness Assets of $1,500, this proportion is 66 ⅔% Business Assets ($3,000/$4,500) and 33 ⅓% Nonbusiness Assets ($1,500/$4,500). The $600 fair market value of S1’s stock in S3 is allocated $400 to Business Assets ($600 x 66 ⅔%) and $200 to Nonbusiness Assets ($600 x 33 ⅓%). Thus, S1’s assets consist of $1,400 of Business Assets ($1,000 held directly + $400 allocated from S3) and $860 of Nonbusiness Assets ($500 held directly + $160 fair market value of its S2 stock + $200 allocated from S3).

(iii) Determination of C’s Business Assets and Nonbusiness Assets. The fair market value of C’s stock in S1 is $880 (50% of $1,760 ($160 + $600 + $1,000 + $500 – $500)). Because C owns at least 50% of the stock of S1, S1 is a member of C’s 50-Percent-Owned Group. See paragraph (d)(2)(iv)(B)(7) of this section. Thus, the fair market value of the S1 stock is allocated between Business Assets and Nonbusiness Assets in the same proportion as the proportion of S1’s Business Assets and Nonbusiness Assets. See paragraph (d)(2)(iv)(D)(7)(ii) of this section. Because S1 has Business Assets of $1,400 and Nonbusiness Assets of $860, this proportion is 61.95% Business Assets ($1,400/$2,260) and 38.05% Nonbusiness Assets ($860/$2,260). The $880 fair market value of C’s S1 stock is allocated $545 to Business Assets ($880 x 61.95%) and $335 to Nonbusiness Assets ($880 x 38.05%). Thus, C’s assets consist of $10,545 of Business Assets ($10,000 + $545) and $5,335 of Nonbusiness Assets ($5,000 + $335), for Total Assets of $15,880. C’s Nonbusiness Asset Percentage is 33.6% ($5,335/$15,880).

Example 6. Partnership interest held by Distributing. (i) Facts. D has directly-held Business Assets of $1,000, directly held Nonbusiness Assets of $2,000, and a 40% partnership interest in P. P has $450 of Business Assets and $1,350 of cash, which P holds as a Nonbusiness Asset, and owes a liability of $800.

(ii) Analysis. Pursuant to paragraph (d)(2)(iv)(D)(6)(ii) of this section, D is allocated $100 of Business Assets from P ($400 (value of D’s 40% interest in P) x 25% ($450/$1,800)) and $300 of Nonbusiness Assets from P ($400 (value of D’s 40% interest in P) x 75% ($1,350/$1,800)), which are added to D’s directly held Business Assets and Nonbusiness Assets, respectively. D’s Nonbusiness Asset Percentage is 67.6% ($2,300 Nonbusiness Assets/$3,400 Total Assets).

Example 7. Borrowing by Distributing from partnership. (i) Facts. The facts are the same as in Example 6, except that D borrows $500 from P and invests the proceeds in a Nonbusiness Asset. P’s directly-held Nonbusiness Assets increase by $500. The D obligation is a Nonbusiness Asset in P’s hands.

(ii) Analysis. D’s directly-held Nonbusiness Assets increase by $500, to $2,500. There is no corresponding decrease in the amount of Business Assets or Nonbusiness Assets allocated to D from P, because a Nonbusiness Asset of P ($500 cash) has been replaced by another $500 Nonbusiness Asset, the obligation from D. Effectively, because D has a 40% interest in P, D has borrowed $200 (40% of $500) from itself. Accordingly, D’s Nonbusiness Assets must be decreased by $200. D’s Business Assets will continue to be $1,100 ($1,000 directly held plus $100 allocated from P), and D’s Nonbusiness Assets will be $2,600 ($2,500 directly held, plus $300 allocated from P less the $200 decrease to prevent double inclusion of the obligation and the obligation proceeds).

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(5) Distributions involving separation of Business Assets from Nonbusiness Assets—(i) In general. A distribution specified in paragraph (d)(5)(iii) of this section is considered to have been used principally as a device, notwithstanding the presence of nondevice factors described in paragraph (d)(3) of this section or other facts and circumstances. However, this paragraph (d)(5)(i) does not apply to a distribution that is described in paragraph (d)(3)(iv) of this section (distributions to domestic corporations entitled to certain dividends received deductions absent application of section 355(a)) or paragraph (d)(6) of this section (transactions ordinarily not considered to be a device).

(ii) Definitions and operating rules. The definitions in paragraph (d)(2)(iv)(B) of this section and the operating rules in paragraph (d)(2)(iv)(D) of this section apply for purposes of this paragraph (d)(5). For purposes of paragraph (d)(2)(iv)(D)(1), (2), and (3), references to paragraph (d)(2)(iv) of this section are treated as references to this paragraph (d)(5).

(iii) Certain distributions involving separation of Nonbusiness Assets from Business Assets. A distribution is specified in this paragraph (d)(5)(iii) if both—

(A) The Nonbusiness Asset Percentage of the distributing corporation or the controlled corporation is 66 ⅔ percent or more, and

(B) If the Nonbusiness Asset Percentage of the distributing corporation or the controlled corporation is—

(1) 66 ⅔ percent or more but less than 80 percent, and the Nonbusiness Asset Percentage of the other corporation (the controlled corporation or the distributing corporation, as the case may be) is less than 30 percent;

(2) 80 percent or more but less than 90 percent, and the Nonbusiness Asset Percentage of the other corporation (the controlled corporation or the distributing corporation, as the case may be) is less than 40 percent; or

(3) 90 percent or more, and the Nonbusiness Asset Percentage of the other corporation (the controlled corporation or the distributing corporation, as the case may be) is less than 50 percent.

(iv) Anti-abuse rule. The anti-abuse rule in paragraph (d)(2)(iv)(E) of this section applies for purposes of this paragraph (d)(5), with references to paragraph (d)(2)(iv) of this section treated as references to this paragraph (d)(5) and references to paragraph (d)(2)(iv)(E) of this section treated as references to this paragraph (d)(5)(iv).

(6) Transactions ordinarily not considered as a device—(i) In general. This paragraph (d)(6) specifies three distributions that ordinarily do not present the potential for federal tax avoidance described in paragraph (d)(1) of this section. Accordingly, such distributions are ordinarily considered not to have been used principally as a device, notwithstanding the presence of any of the device factors described in paragraph (d)(2) of this section or a separation of Business Assets from Nonbusiness Assets as described in paragraph (d)(5) of this section. A transaction described in paragraph (d)(6)(iii) or (iv) of this section is not protected by this paragraph (d)(6) from a determination that it was used principally as a device if it involves the distribution of the stock of more than one controlled corporation and facilitates the avoidance of the dividend provisions of the Code through the subsequent sale or exchange of stock of one corporation and the retention of the stock of another corporation.* * *

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(i) Effective/applicability date—(1) Paragraph (d) of this section—(i) In general. Except as provided in paragraph (i)(1)(ii) of this section, paragraph (d) of this section applies to transactions occurring on or after the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register.

(ii) Transition rule. Paragraph (d) of this section does not apply to a distribution that is—

(A) Made pursuant to an agreement, resolution, or other corporate action that is binding on or before the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register and at all times thereafter;

(B) Described in a ruling request submitted to the Internal Revenue Service on or before July 15, 2016; or

(C) Described in a public announcement or filing with the Securities and Exchange Commission on or before the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register.

(2) Paragraph (g) of this section. Paragraph (g) of this section applies to distributions occurring after October 20, 2011. For rules regarding distributions occurring on or before October 20, 2011, see § 1.355–2T(i), as contained in 26 CFR part 1, revised as of April 1, 2011.

Par. 5. Reserved § 1.355–8 is added to read as follows:

(a) Definitions. The following definitions apply for purposes of this section:

(1) Distributing, Controlled. Distributing means the distributing corporation within the meaning of § 1.355–1(b). Controlled means the controlled corporation within the meaning of § 1.355–1(b).

(2) Five-Year-Active Business. Five-Year-Active Business means the active conduct of a trade or business that satisfies the requirements and limitations of section 355(b)(2) and § 1.355–3(b).

(3) Five-Year-Active-Business Assets. Five-Year-Active-Business Assets of a corporation means its gross assets used in one or more Five-Year-Active Businesses. Such assets include cash and cash equivalents held as a reasonable amount of working capital for one or more Five-Year-Active Businesses. Such assets also include assets required (by binding commitment or legal requirement) to be held to provide for exigencies related to a Five-Year-Active Business or for regulatory purposes with respect to a Five-Year-Active Business. For this purpose, such assets include assets the holder is required (by binding commitment or legal requirement) to hold to secure or otherwise provide for a financial obligation reasonably expected to arise from a Five-Year-Active Business and assets held to implement a binding commitment to expend funds to expand or improve a Five-Year-Active Business.

(4) Non-Five-Year-Active-Business Assets. Non-Five-Year-Active-Business Assets of a corporation means its gross assets other than its Five-Year-Active-Business Assets.

(5) Total Assets. Total Assets of a corporation means its Five-Year-Active-Business Assets and its Non-Five-Year-Active-Business Assets.

(6) Five-Year-Active-Business Asset Percentage. The Five-Year-Active-Business Asset Percentage of a corporation is the percentage determined by dividing the fair market value of its Five-Year-Active-Business Assets by the fair market value of its Total Assets.

(7) Separate Affiliated Group, SAG, CSAG, and DSAG. Separate Affiliated Group (or SAG), CSAG, and DSAG have the same meanings as in § 1.355–2(d)(2)(iv)(B)(6).

(b) Five percent minimum Five-Year-Active-Business Asset Percentage. For the requirements of section 355(a)(1)(C) and section 355(b) to be satisfied with respect to a distribution, the Five-Year-Active-Business Asset Percentage of each of Distributing and Controlled must be at least five percent.

(c) Operating rules. The following operating rules apply for purposes of this section:

(1) Treatment of SAG and fair market value. The operating rules in § 1.355–2(d)(2)(iv)(D)(2) (treatment of SAG as a single corporation) and (5) (fair market value) apply.

(2) Time to identify assets, determine character of assets, and determine fair market value of assets. The provisions of § 1.355–2(d)(2)(iv)(D)(3) (time to identify assets and determine character of assets) apply, except that references to paragraph (d)(2)(iv) are treated as references to this section and “Business Assets or Nonbusiness Assets” is replaced with “Five-Year-Active-Business Assets or Non-Five-Year-Active-Business Assets,” and the provisions of § 1.355–2(d)(2)(iv)(D)(4) (time to determine fair market value of assets) apply.

(3) Interest in partnership—(i) In general. Except as provided in paragraph (c)(3)(ii) of this section, an interest in a partnership is a Non-Five-Year-Active-Business Asset.

(ii) Exception for certain interests in partnerships. If Distributing or Controlled is considered to be engaged in one or more Five-Year-Active Businesses conducted by a partnership, the fair market value of the corporation’s interest in the partnership will be allocated between Five-Year-Active-Business Assets and Non-Five-Year-Active-Business Assets in the same proportion as the proportion of the fair market values of the Five-Year-Active-Business Assets and Non-Five-Year-Active-Business Assets of the partnership.

(d) Anti-abuse rule. A transaction or series of transactions undertaken with a principal purpose of affecting the Five-Year-Active-Business Asset Percentage of any corporation will not be given effect for purposes of applying this § 1.355–9. For this purpose, a transaction or series of transactions includes a change in the form of ownership of an asset; an issuance, assumption, or repayment of indebtedness or other obligations; or an issuance or redemption of stock. However, this paragraph (d) generally does not apply to a non-transitory acquisition or disposition of assets, other than an acquisition from or disposition to a person the ownership of whose stock would, under section 318(a) (other than paragraph (4) thereof), be attributed to Distributing or Controlled, or to a non-transitory transfer of assets between Distributing and Controlled.

(e) Effective/applicability date—(1) In general. Except as provided in paragraph (e)(2) of this section, this section applies to transactions occurring on or after the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register.

(2) Transition rule—This section does not apply to a distribution that is—

(i) Made pursuant to an agreement, resolution, or other corporate action that is binding on or before the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register and at all times thereafter;

(ii) Described in a ruling request submitted to the Internal Revenue Service on or before July 15, 2016; or

(iii) Described in a public announcement or filing with the Securities and Exchange Commission on or before the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register.