[Federal Register Volume 81, Number 136 (Friday, July 15, 2016)]
[Proposed Rules]
[Pages 46004-46019]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-16512]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-134016-15]
RIN 1545-BN47


Guidance Under Section 355 Concerning Device and Active Trade or 
Business

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under section 355 
of the Internal Revenue Code (Code). The proposed regulations would 
clarify the application of the device prohibition and the active 
business requirement of section 355. The proposed regulations would 
affect corporations that distribute the stock of controlled 
corporations, their shareholders, and their security holders.

[[Page 46005]]


DATES: Written or electronic comments and requests for a public hearing 
must be received by October 13, 2016.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-134016-15), Room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20224. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
134016-15), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC 20224. Submissions may also be sent 
electronically via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG-134016-15).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Stephanie D. Floyd or Russell P. Subin at (202) 317-6848; concerning 
submissions of comments and/or requests for a public hearing, Regina 
Johnson at (202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

A. Introduction

    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.

B. Section 355 Requirements

    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).

C. Development of Current Law and IRS Practice

1. Early Legislation
    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:

. . . unless it appears that (A) any corporation which is a party to 
such reorganization was not intended to continue the active conduct 
of a trade or business after such reorganization, or (B) the 
corporation whose stock is distributed was used principally as a 
device for the distribution of earnings and profits to the 
shareholders of any corporation a party to the 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.
2. Case Law
    Courts applying section 355 (or a predecessor provision) have 
generally

[[Page 46006]]

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:

    We think that the draftsmen of Section 355 intended these 
subsections to apply only to the bringing of new assets within the 
combined corporate shells of the distributing and the controlled 
corporations. Therefore, it is irrelevant in this case whether gain 
was recognized on the intercorporate transfer.

Id. at 507.
3. Device Regulations
a. 1955 Regulations
    Regulations under section 355 of the 1954 Code were issued in 1955 
(the 1955 regulations). TD 6152 (20 FR 8875). These regulations 
included Sec.  1.355-2(b)(3), which provided the following:

    In determining whether a transaction was used principally as a 
device for the distribution of the earnings and profits of the 
distributing corporation or of the controlled corporation or both, 
consideration will be given to all of the facts and circumstances of 
the transaction. In particular, consideration will be given to the 
nature, kind and amount of the assets of both corporations (and 
corporations controlled by them) immediately after the transaction. 
The fact that at the time of the transaction substantially all of 
the assets of each of the corporations involved are and have been 
used in the active conduct of trades or businesses which meet the 
requirements of section 355(b) will be considered evidence that the 
transaction was not used principally as such a device.
b. 1989 Regulations
    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 Sec.  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 Sec.  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.
4. Active Business Requirement Regulations
    Section 1.355-3 provides rules for determining whether Distributing 
and Controlled satisfy the active business requirement. Proposed 
regulations issued in 2007 would amend Sec.  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.
5. Administration of the Active Business Requirement
    The fact that Distributing's or Controlled's qualifying active 
business

[[Page 46007]]

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:

    There is no requirement in section 355(b) that a specific 
percentage of the corporation's assets be devoted to the active 
conduct of a trade or business. In the instant case, therefore, it 
is not controlling for purposes of the active business requirement 
that the active business assets of the controlled corporation, Y, 
represent less than half of the value of the controlled corporation 
immediately after the distribution.

    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).
6. Administration of the Device Prohibition
    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.

D. Reasons for Proposed Regulations

1. Rev. Proc. 2015-43 and Notice 2015-59
    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

[[Page 46008]]

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.
2. Comments Regarding Device
    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 Sec.  1.355-2(d)(1)) and the availability of 
capital gains to absorb capital losses, the device prohibition 
continues to be important.
3. Comments Regarding Active Business
a. Section 355(b) Requires Minimum Size Active Business
    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.
b. Consistent With Congressional Intent, Case Law, and the 
Reorganization Provisions
    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); Sec.  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 Sec.  
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.'').

[[Page 46009]]

    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, Sec.  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, Sec.  
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.
c. Developments in the Tax Law Reduce the Burden of Complying With 
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, 
Sec.  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 Sec.  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).
d. Rev. Rul. 73-44
    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.
4. General Utilities Repeal
    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 Sec.  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.

Explanation of Provisions

A. Modification of Device Regulations

    The proposed regulations would modify Sec.  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 
Sec.  1.355-2(d)(2)(iv), modify the corporate business purpose 
nondevice factor in Sec.  1.355-2(d)(3)(ii), and add a per se device 
test.
1. Nature and Use of Assets
    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 Sec.  1.355-2(d)(2)(iv) would focus on 
assets used in a Business (Business Assets) (each as defined in 
proposed Sec.  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 Sec.  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 Sec.  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

[[Page 46010]]

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 
Sec.  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.
2. Corporate Business Purpose
    The Treasury Department and the IRS also propose to revise the 
nondevice factor in Sec.  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.
3. Per se Device Test
    The Treasury Department and the IRS also propose to add a per se 
device test to the device determination in proposed Sec.  1.355-
2(d)(5). Under proposed Sec.  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 Sec.  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 Sec.  
1.355-2(d)(6) (Sec.  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\2/3\ percent or more. If 66\2/3\ 
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 Sec.  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\2/3\ 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\2/3\ 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 Sec.  1.355-2(d), as modified by these 
proposed regulations, would apply to determine if the transaction was a 
device.
4. Certain Operating Rules
    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

[[Page 46011]]

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.
5. Multiple Controlleds
    If a transaction involves distributions by Distributing of the 
stock of more than one Controlled, proposed Sec. Sec.  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 Sec.  
1.355-2(d)(2)(iv) or Sec.  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.

B. Minimum Size for Active Business

    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 
Sec.  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 Sec.  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.

[[Page 46012]]

    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.

C. Timing of Asset Identification, Characterization, and Valuation

    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 Sec.  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 Sec.  1.355-2(d) and the five-
percent minimum Five-Year-Active-Business Asset Percentage requirement 
of proposed Sec.  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.

D. Anti-Abuse Rules

    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 Sec.  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.

Statement of Availability of IRS Documents

    IRS revenue procedures, revenue rulings, notices, and other 
guidance cited in this document are published in the Internal Revenue 
Bulletin (or Cumulative Bulletin) and are available from the 
Superintendent of Documents, U.S. Government Printing Office, 
Washington, DC 20402, or by visiting the IRS Web site at http://www.irs.gov.

Effect on Other Documents

    Section 3 of Notice 2015-59 is obsolete as of July 15, 2016. The 
IRS will modify Rev. Rul. 73-44, as of the date the Treasury decision 
adopting these regulations as final regulations is published in the 
Federal Register, as necessary to conform to Sec.  1.355-9 of these 
proposed regulations. The IRS solicits comments as to whether other 
publications should be modified, clarified, or obsoleted.

Special Analyses

    Certain IRS regulations, including this one, are exempt from the 
requirements of Executive Order 12866, as supplemented and reaffirmed 
by Executive Order 13563. Therefore, a regulatory impact assessment is 
not required. It has also been determined that section 553(b) of the 
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to 
these proposed regulations. Pursuant to the Regulatory Flexibility Act 
(5 U.S.C. chapter 6), it is hereby certified that this regulation will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based on the fact that these 
regulations primarily affect larger corporations operating more than 
one business and with a substantial number of shareholders. Thus, these 
regulations are not expected to affect a substantial number of small 
entities. Accordingly, a regulatory flexibility analysis is not 
required. Pursuant to section 7805(f) of the Code, these regulations 
will be submitted to the Chief Counsel for Advocacy of the Small 
Business Administration for comment on their impact on small business.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written or electronic comments that 
are submitted timely to the IRS as prescribed in this preamble under 
the ADDRESSES heading. The Treasury Department and the IRS request 
comments on all aspects of the proposed regulations, including--
    1. Whether there should be any exceptions to the application of 
proposed Sec.  1.355-9.
    2. Whether additional exceptions should be incorporated into the 
per se device rule in proposed Sec.  1.355-2(d)(5).
    3. The scope of the safe harbors relating to presence of 
Nonbusiness Assets as evidence of device under

[[Page 46013]]

proposed Sec.  1.355-2(d)(2)(iv)(C)(1) and (2) and whether additional 
safe harbors should be added to proposed Sec.  1.355-2(d).
    4. Whether the definition of Business Assets in proposed Sec.  
1.355-2(d)(2)(iv)(B)(2) should be revised, for example, to include 
additional categories of assets or to include cash or cash equivalents 
expected to be used for other categories of expenditures.
    5. Whether the operating rules applicable to proposed Sec.  1.355-
2(d)(2)(iv)(D)(6) through (8) concerning the allocation of the value of 
a partnership interest between Business Assets and Nonbusiness Assets 
to its partners, the allocation of the value of the stock of a Member 
of a 50-Percent-Owned Group between Business Assets and Nonbusiness 
Assets to its shareholders, and certain borrowings should be modified, 
including whether the partnership rule should allocate an allocable 
share of the partnership's gross assets to its partners, whether 
different allocation rules should be used for partnership interests 
with different characteristics(for example, limited liability vs. non-
limited liability), and whether the rules relating to borrowing between 
a partnership and a partner or between a Member of a 50-Percent-Owned 
Group and a shareholder should be made more specific.
    6. Whether the anti-abuse rules in the proposed regulations 
pertaining to device and the five-percent minimum Five-Year-Active-
Business Assets requirement should be revised, for example, to include 
or exclude additional transactions or to include a reference to 
acquisitions of assets by Distributing or Controlled on behalf of 
shareholders.
    7. Whether the absence of any device factor, for example, a small 
difference in Nonbusiness Asset Percentages for Distributing and 
Controlled, should be considered a nondevice factor.
    All comments will be available at www.regulations.gov or upon 
request.
    A public hearing will be scheduled if requested in writing by any 
person that timely submits written or electronic comments. If a public 
hearing is scheduled, notice of the date, time, and place for the 
public hearing will be published in the Federal Register.

Drafting Information

    The principal authors of these proposed regulations are Stephanie 
D. Floyd and Russell P. Subin of the Office of Associate Chief Counsel 
(Corporate). Other personnel from the Treasury Department and the IRS 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 6 U.S.C. 7805 * * *

0
Par. 2. Section 1.355-0 is amended by:
0
1. Removing from the introductory text ``1.355-7'' and adding ``1.355-
9'' in its place.
0
2. Revising the entry for Sec.  1.355-2(d)(2)(iv)(B).
0
3. Adding entries for Sec.  1.355-2(d)(2)(iv)(B)(1), (2), (3), (4), 
(5), (6), and (7).
0
4. Redesignating the entry for Sec.  1.355-2(d)(2)(iv)(C) as the entry 
for Sec.  1.355-2(d)(2)(iv)(F).
0
5. Adding a new entry for Sec.  1.355-2(d)(2)(iv)(C).
0
6. Adding entries for Sec.  1.355-2(d)(2)(iv)(C)(1), (2), and (3).
0
7. Adding an entry for Sec.  1.355-2(d)(2)(iv)(D).
0
8. Adding entries for Sec.  1.355-2(d)(2)(iv)(D)(1), (2), (3), and (4).
0
9. Adding entries for Sec.  1.355-2(d)(2)(iv)(D)(4)(i) and (ii).
0
10. Adding entries for Sec.  1.355-2(d)(2)(iv)(D)(5) and (6).
0
11. Adding entries for Sec.  1.355-2(d)(2)(iv)(D)(6)(i) and (ii).
0
12. Adding an entry for Sec.  1.355-2(d)(2)(iv)(D)(7).
0
13. Adding entries for Sec.  1.355-2(d)(2)(iv)(D)(7)(i) and (ii).
0
14. Adding an entry for Sec.  1.355-2(d)(2)(iv)(D)(8).
0
15. Adding an entry for Sec.  1.355-2(d)(2)(iv)(E).
0
16. Redesignating the entry for Sec.  1.355-2(d)(5) as the entry for 
Sec.  1.355-2(d)(6).
0
17. Adding a new entry for Sec.  1.355-2(d)(5).
0
18. Adding entries for Sec.  1.355-2(d)(5)(i), (ii), (iii), and (iv).
0
19. Adding entries for Sec.  1.355-2(i)(1), (i)(1)(i) and (ii), and 
(i)(2).
0
20. Adding an entry for Sec.  1.355-8.
0
21. Adding entries for Sec.  1.355-9.
    The revisions and additions read as follows:


Sec.  1.355-0  Outline of sections.

* * * * *
Sec.  1.355-2 Limitations.
* * * * *
    (d) * * *
    (2) * * *
    (iv) * * *
    (B) Definitions.
    (1) Business.
    (2) Business Assets.
    (3) Nonbusiness Assets.
    (4) Total Assets.
    (5) Nonbusiness Asset Percentage.
    (6) Separate Affiliated Group, SAG, CSAG, and DSAG.
    (7) 50-Percent-Owned Group, Member of a 50-Percent-Owned Group.
    (C) Presence of Nonbusiness Assets as evidence of device.
    (1) Ownership of Nonbusiness Assets.
    (2) Difference between Nonbusiness Asset Percentages.
    (3) Cross-reference.
    (D) Operating rules.
    (1) Multiple controlled corporations.
    (2) Treatment of SAG as a single corporation.
    (3) Time to identify assets and determine character of assets.
    (4) Time to determine fair market value of assets.
    (i) In general.
    (ii) Consistency.
    (5) Fair market value.
    (6) Interest in partnership.
    (i) In general.
    (ii) Exception for certain interests in partnerships.
    (7) Stock in corporation.
    (i) In general.
    (ii) Exception for stock in Member of a 50-Percent-Owned Group.
    (8) Obligation between distributing corporation or controlled 
corporation and certain partnerships or Members of 50-Percent-Owned 
Groups.
    (E) Anti-abuse rule.
* * * * *
    (5) Distributions involving separation of Business Assets from 
Nonbusiness Assets.
    (i) In general.
    (ii) Definitions and operating rules.
    (iii) Certain distributions involving separation of Nonbusiness 
Assets from Business Assets.
    (iv) Anti-abuse rule.
* * * * *
    (i) * * *
    (1) Paragraph (d) of this section.
    (i) In general.
    (ii) Transition rule.
    (2) Paragraph (g) of this section.
* * * * *
Sec.  1.355-8 Reserved.

Sec.  1.355-9 Minimum percentage of Five-Year-Active-Business 
Assets.

    (a) Definitions.
    (1) Distributing, Controlled.
    (2) Five-Year-Active Business.
    (3) Five-Year-Active-Business Assets.
    (4) Non-Five-Year-Active-Business Assets.
    (5) Total Assets.
    (6) Five-Year-Active-Business Asset Percentage.
    (7) Separate Affiliated Group, CSAG, and DSAG.
    (b) Five percent minimum Five-Year-Active-Business Asset 
Percentage.
    (c) Operating rules.

[[Page 46014]]

    (1) Treatment of SAG and fair market value.
    (2) Time to identify assets, determine character of assets, and 
determine fair market value of assets.
    (3) Interest in partnership.
    (i) In general.
    (ii) Exception for certain interests in partnerships.
    (d) Anti-abuse rule.
    (e) Effective/applicability date.
    (1) In general.
    (2) Transition rule.

0
Par. 3. Section 1.355-2 is amended by:
0
1. Adding the language ``federal'' before the language ``tax 
avoidance'' in the second sentence of paragraph (d)(1).
0
2. Removing the last sentence of paragraph (d)(1) and adding two 
sentences at the end of the paragraph.
0
3. Revising paragraphs (d)(2)(iv)(A) and (B).
0
4. Redesignating paragraph (d)(2)(iv)(C) as (d)(2)(iv)(F).
0
5. Adding new paragraphs (d)(2)(iv)(C), (D), and (E).
0
6. Revising paragraph (d)(3)(ii).
0
7. Removing from paragraph (d)(3)(ii)(A) the language ``the business'' 
and adding the language ``one or more Businesses (as defined in 
paragraph (d)(2)(iv)(B)(1) of this section) of the distributing 
corporation, the controlled corporation, or both'' in its place.
0
8. Revising paragraph (d)(4).
0
9. Redesignating paragraph (d)(5) as (d)(6).
0
10. Adding a new paragraph (d)(5).
0
11. Revising newly designated paragraph (d)(6)(i).
0
12. Removing from newly designated paragraph (d)(6)(v) the language 
``subparagraph (5)'' and adding the language ``paragraph (d)(6)'' in 
its place.
0
13. Removing from the last sentence of newly designated paragraph 
(d)(6)(v) Example 1 the language ``(d)(5)(i)'' and adding the language 
``(d)(6)(i)'' in its place.
0
14. Removing from the sixth sentence of newly designated paragraph 
(d)(6)(v) Example 2 the language ``(d)(5)(i)'' and adding the language 
``(d)(6)(i)'' in its place.
0
15. Removing from the last sentence of newly designated paragraph 
(d)(6)(v) Example 2 the language ``made from all the facts'' and adding 
the language ``made from either the presence of a separation of 
Business Assets from Nonbusiness Assets as described in paragraph 
(d)(5) of this section or from all the facts'' in its place.
0
16. Adding to paragraph (h) the language ``and Sec.  1.355-9 (relating 
to Minimum Percentage of Five-Year-Active-Business Assets)'' 
immediately before the language ``are satisfied''.
0
17. Revising paragraph (i).
    The revisions and additions read as follows:


Sec.  1.355-2  Limitations.

* * * * *
    (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 Sec.  1.355-3, 
without regard to--
    (i) The requirements of section 355(b)(2)(B), (C), and (D), and 
Sec.  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 Sec.  1.355-
3(b)(2)(ii); and
    (iii) The requirement of Sec.  1.355-9 (relating to Minimum 
Percentage of Five-Year-Active-Business Assets (as defined in Sec.  
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

[[Page 46015]]

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 Sec.  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 Sec.  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

[[Page 46016]]

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.
* * * * *
    (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

[[Page 46017]]

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\2/
3\% Business Assets ($3,000/$4,500) and 33\1/3\% 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\2/3\%) and $200 to 
Nonbusiness Assets ($600 x 33\1/3\%). 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).
* * * * *
    (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\2/3\ percent or more, 
and
    (B) If the Nonbusiness Asset Percentage of the distributing 
corporation or the controlled corporation is--
    (1) 66\2/3\ 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

[[Page 46018]]

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. * * *
* * * * *
    (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 
Sec.  1.355-2T(i), as contained in 26 CFR part 1, revised as of April 
1, 2011.
0
Par. 5. Reserved Sec.  1.355-8 is added to read as follows:


Sec.  1.355-8  [Reserved]

0
Par. 6. Section 1.355-9 is added to read as follows:


Sec.  1.355-9  Minimum percentage of Five-Year-Active-Business Assets.

    (a) Definitions. The following definitions apply for purposes of 
this section:
    (1) Distributing, Controlled. Distributing means the distributing 
corporation within the meaning of Sec.  1.355-1(b). Controlled means 
the controlled corporation within the meaning of Sec.  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 Sec.  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 
Sec.  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 
Sec.  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 Sec.  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 
Sec.  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 Sec.  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

[[Page 46019]]

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.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2016-16512 Filed 7-14-16; 8:45 am]
 BILLING CODE 4830-01-P