The IRS has issued proposed regulations (NPRM REG-134016-15) that would clarify the application of the device prohibition and the active business requirement of Code Sec. 355. The proposed regulations are intended to address transactions that may present evidence of device, lack an adequate business purpose or a qualifying active business, or circumvent the purposes of the General Utilities repeal. The proposed regulations will apply generally to transactions on or after the regulations are published as final, subject to certain transition rules.

Modification of Device Regulations

The proposed regulations would modify the nature and use of the assets device factor in Reg. §1.355-2(d)(2)(iv) and the corporate business purpose nondevice factor in Reg. §1.355-2(d)(3)(ii), and would add a per se device test.

The proposed change to the nature and use of assets device factor would focus on assets used in a Business (Business Assets) rather than assets used in an active business meeting the Code Sec. 355(b) test (a Five-Year-Active Business). 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. 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.

In evaluating device or nondevice, the proposed regulations will focus on Nonbusiness Assets, as defined in the proposed regulations, rather than investment assets as described in Rev. Proc. 2016-3, I.R.B. 2016-1, 126, and Notice 2015-59, I.R.B. 2015-40, 459. The proposed rules would provide thresholds for determining whether the ownership of Nonbusiness Assets and/or differences in the Nonbusiness Asset Percentages 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. Also, a difference in the Nonbusiness Asset Percentages for Distributing and Controlled ordinarily would not be evidence of device if it 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 for it by the distributees.

In addition, under the proposed regulations, 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.

Further, the proposed regulations add a two-prong per se device test. Under this test, 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. By their nature, these transactions present such clear evidence of device that the nondevice factors can never overcome the device potential. The only exceptions to this per se device rule would apply for distributions in which the corporate distributee would be entitled to a dividends received deduction or for transactions that are ordinarily not considered as a device under the current regulations.

Modification of Active Business Requirement

The proposed regulations would provide a five-percent minimum 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) requirement for all distributions. Thus, the requirements of Code Sec. 355(a)(1)(C) and (b) will be satisfied with respect to a distribution if the Five-Year-Active-Business Asset Percentage of each of Controlled and Distributing is at least five percent. Except in the case of a member of a separate affiliated group (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.

Timing of Asset Identification, Characterization and Valuation

For purposes of determining whether a transaction would be considered a device and whether the five-percent minimum Five-Year-Active-Business Asset Percentage requirement is met, the assets held by Distributing and by Controlled immediately after the distribution will be considered. In addition, the fair market value of the assets would be determined, at the election of the parties on a consistent basis, either:

• 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 Distributing 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.

Anti-Abuse Rule

Under proposed anti-abuse rules, a transaction or series of transactions would not be given effect if undertaken with a principal purpose of (i) affecting the Nonbusiness Asset Percentage of any corporation in order to avoid a determination that a distribution was a device, or (ii) affecting the Five-Year-Active- Business Asset Percentage of any corporation in order to avoid a determination that a distribution does not meet the five-percent minimum Five-Year-Active-Business Asset Percentage requirement.

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, 1973-1 CB 182, as of the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register, as necessary to conform to Proposed Reg. §1.355-9 . The IRS solicits comments as to whether other publications should be modified, clarified, or obsoleted.

Comments and Requests for Public Hearing

Written or electronic comments and requests for a public hearing must be received by October 12, 2016. All submissions may be mailed to: CC:PA:LPD:PR (REG-134016-15), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20224. Submissions may also 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, D.C. 20224, or submitted electronically via the Federal eRulemaking Portal (IRS REG-134016-15).

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