A regulated utility's tax-free spin-off lets it move certain assets to an affiliate that can earn a return on them

Plain-English summary

A publicly traded utility holding company has assets ("Business 2 Assets") stuck in a regulated subsidiary that, under the regulator's rules, cannot include those assets in its rate base, so the group earns no return on them. A sister company in the group is regulated differently and could recover the cost of those assets through its rates. To fix this, the group plans to drop the assets into a new corporation ("Controlled"), spin Controlled up the ownership chain through a series of distributions to the parent, and then merge Controlled into the sister company. The group asked the IRS to confirm the tax treatment. The IRS issued 14 favorable rulings: the contribution plus first distribution qualify as a tax-free "D" reorganization under §§ 368(a)(1)(D) and 355, neither the distributing companies nor the recipients recognize gain or loss, basis and holding periods carry over, and the follow-on merger doesn't spoil the reorganization. As usual, the IRS did not rule on business purpose, device, or the § 355(e) plan questions.

Ruling snapshot

• Question: Do the contribution, chained distributions, and follow-on merger to relocate the utility assets qualify as tax-free under §§ 355 and 368?
• Outcome: Approved (14 rulings; reorganization and distributions are tax-free, subject to the stated caveats)
• Key authorities: IRC §§ 355, 368(a)(1)(D), 361, 362(b), 1032(a), 1223, 312(h); Rev. Proc. 2017-52; Rev. Rul. 62-138

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202036001 Third Party Communication: None
Release Date: 9/4/2020 Date of Communication: Not Applicable
Index Number: 355.00-00, 355.03-00,
368.00-00, 368.04-00 Person To Contact:
-----------------------, ID No. -----------------
---------------------------- Telephone Number:
--------------------------- --------------------
----------------------------------------------------- Refer Reply To:
----------------------- CC:CORP:B05
------------------------------- PLR-100167-20
Date:
June 05, 2020

Legend

Parent = -----------------------------------------------------

Acquiring = ---------------------------------------------------

Subsidiary 1 = -----------------------------------------------------------------------

-----------------------------------------------------------------------------

LLC 1 = ----------------------------------------------

Distributing 1 = -----------------------------------------------------------

Distributing 2 = ---------------------------------------------------------

State A = -------------
PLR-100167-20 2

State B = --------------

State C = -------------

Business 1 = -----------------------------------------------------------
------------------------------------------

Business 2 = -----------------------------------------------------------------------

                                         -------------------------------------

Business 3 = -----------------------------------------------------------
-----------------------------------------------------

Business 2 Assets = ---------------------------------------------------------
------------------------------------------------------------------------
------------------------------------------------------------------------
---------------------------------------------

Regulatory Authority 1 = -----------------------------------------------------

Regulatory Authority 2 = ------------------------------------------------

Organization 1 = -------------------------------------

Year 1 = -------

Year 6 = -------

Year 7 = -------

Month 1 = ------

Month 2 = -----

Dear --------------:

This letter responds to your authorized representative’s letter dated December 9, 2019,
as supplemented by subsequent information and documentation, requesting rulings on
certain federal income tax consequences of a series of proposed transactions described
herein (the “Proposed Transactions”). The material information submitted in that letter
and in subsequent correspondence is summarized below.
PLR-100167-20 3

This letter is issued pursuant to Rev. Proc. 2017-52, 2017-41 I.R.B. 283, as amplified
and modified by Rev. Proc. 2018-53, 2018-43 I.R.B. 667, regarding one or more
“Covered Transactions” under sections 355 and 368 of the Internal Revenue Code (the
“Code”) and pursuant to section 6.03(2) of Rev. Proc. 2020-1, 2020-01 I.R.B. 1,
regarding one or more significant issues under section 355 of the Code that only
address one or more discrete legal issues involved in the transaction. The rulings
contained in this letter are based upon information and representations submitted by the
taxpayer and accompanied by a penalty of perjury statement executed by an
appropriate party. This office has not verified any of the material submitted in support of
the request for rulings. Verification of the information, representations, and other data
may be required as part of the audit process.

This Office has made no determination regarding whether each of Distribution 1 and
Distribution 2 (defined below): (i) satisfies the business purpose requirement of Treas.
Reg. § 1.355-2(b); (ii) is used principally as a device for the distribution of the earnings
and profits of the distributing corporation or the controlled corporation or both (see
section 355(a)(1)(B) and Treas. Reg. § 1.355-2(d)); or (iii) is part of a plan (or series of
related transactions) pursuant to which one or more persons will acquire directly or
indirectly stock representing a 50-percent or greater interest in the distributing
corporation or the controlled corporation, or any predecessor or successor of the
distributing corporation or the controlled corporation, within the meaning of Treas. Reg.
§ 1.355-8 (see section 355(e)(2)(A)(ii) and Treas. Reg. § 1.355-7).

                                Summary of Facts

Parent is a publicly-traded State A corporation that is the common parent of an affiliated
group of corporations that join in the filing of a consolidated U.S. federal income tax
return (the “Parent Group”). Parent wholly owns Subsidiary 1, a State A corporation;
Acquiring, a State B corporation; and Distributing 2, a State C limited liability company
that has elected to be treated as a corporation for U.S. federal income tax purposes.
Distributing 2 owns all the interests of LLC 1, a State C limited liability company that is
disregarded from Distributing 2 for U.S. federal income tax purposes. LLC 1 owns all of
the stock of Distributing 1, a State B corporation.

Distributing 1 is engaged in Business 1 and Business 2 in State B. Distributing 1’s
Business 1 and Business 2 operations are conducted by employees of Acquiring and
Subsidiary 1 pursuant to intercompany service agreements. Distributing 1 is regulated
by Regulatory Authority 1, which approves the rates that Distributing 1 is able to charge
for the service it provides through Business 1. Distributing 1 is a member of
Organization 1, a not for profit corporation established under the authority of, and
subject to regulation by, Regulatory Authority 1. Organization 1 independently
administers the operation of the Business 1 assets of its members and serves as their
agent for billing and collection. Organization 1’s members are required to comply with
Organization 1’s operating rules, which among other things, define the types of
PLR-100167-20 4

Business 1 assets that its members are able to include in their rate base for purposes of
setting rates charged to users of the Business 1 assets operated by Organization 1.
Organization 1’s operating rules provide that Business 2 Assets may not be properly
included in the rate base of a Business 1 business. As a result, the Parent Group is
currently unable to earn a return on its investment in the Business 2 Assets.

In order to comply with Organization 1 rules, Parent (through the Organization 1 billing
and collection process) has implemented the following remedies: (i) Year 6 revenue
collected with respect to the Business 2 Assets by Distributing was credited to
customers in their Month 1 Year 6 Organization 1 billings, (ii) revenue collected with
respect to the Business 2 Assets by Distributing for Year 1 to Year 7, excluding Year 6,
is expected to be credited to customers ((i) and (ii), collectively, the “Credited
Revenue”), and (iii) revenue collected with respect to the Business 2 Assets by
Distributing ceased in Month 2, Year 7 and will continue until the date of the Proposed
Transaction (the “Uncollected Revenue”).

Financial information has been submitted indicating that Business 1 has had gross
receipts and operating expense representing the active conduct of a trade or business
for each of the past five years. Financial information has been submitted indicating that
Business 2 had gross receipts representing the active conduct of a trade or business
prior to Month 2, Year 7 (although this has or will become the Credited Revenue) and
operating expense representing the active conduct of a trade or business for each of the
past five years.

Acquiring is engaged in Business 3 in State B. Acquiring is regulated by Regulatory
Authority 1 and Regulatory Authority 2. Under the rules of Regulatory Authority 2,
Acquiring may recover the cost of Business 2 Assets through the rates charged to
customers of its Business 3 business. Therefore, Parent desires to cause the transfer
of the Business 2 Assets from Distributing 1 to Acquiring in order to allow the Parent
Group to earn a return on its investment in the Business 2 Assets.

                             Proposed Transaction

For what are represented to be valid business purposes, the Parent Group proposes to
engage in the following transaction (the “Proposed Transaction”):

  1. Distributing 1 will contribute the Business 2 Assets to Controlled in exchange
     for all of the Controlled stock (the “Contribution”);

  2. Distributing 1 will distribute all of the stock of Controlled to LLC 1 (the “First
     Distribution”);

  3. LLC 1 will distribute all of the stock of Controlled to Distributing 2;

PLR-100167-20 5

  4. Distributing 2 will distribute all of the stock of Controlled to Parent (the
     “Second Distribution”); and

  5. Pursuant to state law, Controlled will merge with and into Acquiring with
     Acquiring surviving (the “Merger”). Parent will not receive any additional
     shares of Acquiring in exchange for its Controlled stock.
                               Representations

With respect to the Contribution and First Distribution, Distributing 1 and Controlled
have made all the representations in section 3 of the Appendix to Rev. Proc. 2017-52,
except as set forth below.

Distributing 1 has made the following alternative representations:

  Representations 3(a); 8(a);15(a); 22(a); 31(a); 41(a).

Distributing 1 has not made the following representations, which do not apply to the
Distribution:

  Representations 7; 19; 20; 24; 25; 35; 42.

Distributing 1 has made the following modified representations:

  Representation 10: With respect to the business relied on by Distributing 1 to
  meet the active trade or business requirement of section 355(b), there has been
  no substantial operational changes since the end of Distributing 1’s most recent
  taxable year. With respect to the business relied on by Controlled to meet the
  active trade or business requirement of section 355(b), other than ceasing the
  collection of Uncollected Revenue and the crediting of the Credited Revenue
  (both as described above), there has been no substantial operational changes
  since the end of Controlled’s most recent taxable year.

  Representation 11: Following the First Distribution, Distributing 1 and Controlled
  (until immediately after the Merger, then Acquiring) will each continue,
  independently and with Acquiring and Subsidiary 1 employees, the active
  conduct of the business on which it relies to meet the active trade or business
  requirement of section 355(b).

  Representation 33: Payments made in connection with all continuing
  transactions, if any, between Distributing 1 and Controlled after the First
  Distribution and prior to the Merger, and between Distributing 1 and Acquiring
  after the Merger will be at cost basis without markup or as otherwise required by
  the Regulatory Authority 1 or Regulatory Authority 2, as the case may be.

Distributing 1 has not made Representation 40.
PLR-100167-20 6

Distributing 1 has made the following additional representation:

  The incorrect inclusion of the Business 2 Assets in the rate base for Business 1
  was inadvertent, and Parent identified the issue and brought it to the attention of
  Organization 1 and Regulatory Authority 1.

With respect to the Distribution 2, Distributing 2 and Controlled have made all the
representations in section 3 of the Appendix to Rev. Proc. 2017-52, except as set forth
below.

Distributing 2 has made the following alternative representations:

  Representations 3(a); 8(a); 15(a); 22(a); 31(a); 41(a).

Distributing 2 has not made the following representations, which do not apply to
Distribution 2:

  Representations 7; 17-20; 24; 25; 35; 39; 42; 46.

Distributing 2 has made the following modified representations:

  Representation 10: With respect to the business relied on by Distributing 2 to
  meet the active trade or business requirement of section 355(b), there has been
  no substantial operational changes since the end of Distributing 2’s most recent
  taxable year. With respect to the business relied on by Controlled to meet the
  active trade or business requirement of section 355(b), other than ceasing the
  collection of Uncollected Revenue and the crediting of the Credited Revenue
  (both as described above), there has been no substantial operational changes
  since the end of Controlled’s most recent taxable year.

  Representation 11: Following Distribution 2, Distributing 2 and Controlled (until
  immediately after the Merger, then Acquiring) will each continue, independently
  and with Acquiring and Subsidiary 1 employees, the active conduct of the
  business on which it relies to meet the active trade or business requirement of
  section 355(b).

  Representation 33: Payments made in connection with all continuing
  transactions, if any, between Distributing 2 and Controlled after Distribution 2 and
  prior to the Merger, and between Distributing 2 and Acquiring after the Merger
  will be at cost basis without markup or as otherwise required by the Regulatory
  Authority 1 or Regulatory Authority 2, as the case may be.

Distributing 2 has not made Representation 40.

                                    Rulings

PLR-100167-20 7

The Contribution and the First Distribution

  (1)    The Contribution, together with the First Distribution will be a
         reorganization under section 368(a)(1)(D). Distributing 1 and Controlled
         each will be “a party to a reorganization” within the meaning of section
         368(b).

  (2)    No gain or loss will be recognized by Distributing 1 on the Contribution
         (section 361(a)).

  (3)    No gain or loss will be recognized by Controlled on the Contribution
         (section 1032(a)).

  (4)    The basis of each asset received by Controlled in the Contribution will
         equal the basis of that asset in the hands of Distributing 1 immediately
         before the Contribution (section 362(b)).

  (5)    The holding period of each asset received by Controlled in the
         Contribution will include the period during which Distributing 1 held that
         asset (section 1223(2)).

  (6)    No gain or loss will be recognized by Distributing 1 on the First Distribution
         (section 361(c)(1)).

  (7)    No gain or loss will be recognized by (and no amount will be included in
         the income of) Distributing 2 on the First Distribution (section 355(a)(1)).

  (8)    The holding period of the Controlled stock received by Distributing 2 in the
         First Distribution will include the holding period of the Distributing 1 stock
         with respect to which the First Distribution is made, provided the
         Distributing 1 stock is held as a capital asset on the date of the First
         Distribution (section 1223(1)).

  (9)    Earnings and profits, if any, will be allocated between Distributing 1 and
         Controlled in accordance with section 312(h) and Treas. Reg. sections
         1.312-10(a) and 1.1502-33(f)(2).

The Second Distribution

  (10)   No gain or loss will be recognized by Distributing 2 on the Second
         Distribution (section 355(c)(1) and Rev. Rul. 62-138, 1962-2 C.B. 95).

  (11)   No gain or loss will be recognized by (and no amount will be included in
         the income of) Parent on the Second Distribution (section 355(a)(1)).

  (12)   The holding period of the Controlled stock received by Parent in the
         Second Distribution will include the holding period of the Distributing 2

PLR-100167-20 8

          stock with respect to which the Second Distribution is made, provided the
          Distributing 2 stock is held as a capital asset on the date of the Second
          Distribution (section 1223(1)).

   (13)   Earnings and profits, if any, will be allocated between Distributing 2 and
          Controlled in accordance with section 312(h) and Treas. Reg. sections
          1.312-10(a) and 1.1502-33(f)(2).

The Merger

   (14)   The qualification of the Contribution and the First Distribution as a
          reorganization described in sections 368(a)(1)(D) and 355 and the Second
          Distribution as a distribution described in section 355 will not be affected
          by the Merger.

                                      Caveats

No opinion is expressed or implied about the tax treatment of the Proposed Transaction
under any other provisions of the Code or regulations or the tax treatment of any
conditions existing at the time of, or effects resulting from, the Proposed Transaction
that are not specifically covered by the above rulings.

                             Procedural Statements

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this ruling letter must be attached to the federal income tax return of each
taxpayer involved for the taxable year in which the transactions described herein are
completed. Alternatively, a taxpayer filing its return electronically may satisfy this
requirement by attaching a statement to its federal income tax return that sets forth the
date and control number of this ruling letter.

                                   Sincerely,

                                       Mark Weiss
                                   Mark Weiss
                                   Chief, Branch 2
                                   Office of Associate Chief Counsel (Corporate)

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