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IRS Hints That ATB Rulings for Some REIT Spinoffs May Be at Risk

Posted on July 21, 2015 by Amy S. Elliott

This article first appeared in the July 14, 2015 edition of Tax Notes Today.

A real estate investment trust spinoff with a leaseback may not be eligible for a letter ruling on some significant issues raised by the spinoff if there are extensive continuing arrangements between OpCo and PropCo, IRS officials indicated June 11, while also discussing how the significant issue ruling policy is trending toward a narrower wording of rulings.

Speaking at the New York State Bar Association Tax Section summer meeting in Bolton Landing, New York, Larry Garrett of EY said that while a spinoff is supposed to effectuate a genuine separation of OpCo (Distributing) and PropCo (Controlled) and their respective subsidiaries, "often there are various kinds of continuing entanglements, if you will, between Distributing and Controlled," some of which aren't transitional but long term.

Joshua M. Holmes of Wachtell, Lipton, Rosen & Katz pointed out that some of those continuing arrangements might involve ancillary functions such as administrative support services, while others might be a core part of the business. Garrett added that continuing arrangements could implicate no-rule issues like business purpose and device as well as significant issues that are potentially eligible for a ruling like active trade or business (ATB).

In REIT spinoffs, it's relatively common for OpCo to enter into long-term, arm's-length, triple-net leases with PropCo to use the spun-off real estate assets in its business (such as in completed REIT spinoffs by Penn National Gaming Inc. and Windstream Holdings Inc. and the planned REIT spinoff by Darden Restaurants Inc.). It's believed the IRS addressed the Penn Gaming spinoff in LTR 201337007 and the Windstream spinoff in LTR 201528006, both of which mention continuing transactions between Distributing and Controlled.

In their slides, the presenters cited two pre-significant-issue rulings (LTR 201512001 and LTR 201416005) containing examples of various other continuing arrangements between Distributing and Controlled, which can arise in any tax-free separation, not just REIT spinoffs.

Although none of the speakers at the bar event mentioned REIT spinoffs specifically -- their comments were limited to continuing arrangements broadly -- it is widely acknowledged that continuing arrangements between Distributing and Controlled commonly occur after REIT spinoffs with leasebacks.

Speaking May 1 on tax-free spinoffs at the Illinois Institute of Technology Chicago-Kent College of Law's Federal Tax Institute, Robert Willens of Robert Willens LLC said that in OpCo-PropCo transactions, PropCo's primary activity "is to lease the distributed real estate to [OpCo]. Obviously there are extensive post-distribution inter-corporate dealings there, but we haven't thought at least to this point that the device test was seriously at risk of being flunked." The July 11 comments by IRS officials signal that that may have changed.

According to Filiz Serbes, branch 3 chief, IRS Office of Associate Chief Counsel (Corporate), if the intercompany dealings between Distributing and Controlled are transitional, then "you're bordering on a comfort ruling request because we've always expressed the fact that we're not really troubled" by that.

Holmes said that in some cases, the duration of the continuing arrangements is longer than two years. Serbes responded that as the arrangements extend for longer periods, that affects the IRS's ability to accept the taxpayer's business purpose and device representation, and it may not be able to provide a ruling.

Garrett asked whether Serbes was referring only to situations in which the extent and nature of the continuing arrangements are extreme. He pointed out that a taxpayer wouldn't necessarily make a representation concerning its business purpose or device if it's simply coming in for a significant issue ruling. "Are you going to say, 'As long as we have some level of concern, we're just not going to touch this'?" he asked.

If the IRS has concerns and thinks that issuing a ruling wouldn't be in the interest of sound tax administration, it won't issue a ruling, Serbes said.

The IRS's annual guidance outlining its procedures for issuing private letter rulings (Rev. Proc. 2015-1, 2015-1 IRB 1) states that "the Service may decline to issue a letter ruling or a determination letter when appropriate in the interest of sound tax administration, including due to resource constraints, or on other grounds whenever warranted by the facts or circumstances of a particular case."

"We see the material questions around these types of arrangements as being inherently bound up with business purpose and device-type issues," said Erik Corwin, IRS deputy chief counsel (technical), adding that he thinks that weighs "against ruling on these types of issues under the significant issue program."

Corwin later told Tax Analysts that he was speaking specifically about arrangements involving the sharing of employees to enable one company to conduct its purported active trade for an extended or potentially indefinite period.

Karen Gilbreath Sowell of EY asked Corwin why the IRS couldn't issue a limited ruling on either the ATB or complete separation issues that simply contains a caveat that no opinion is expressed regarding whether the transaction satisfies the business purpose requirement or is being used principally as a device.

"I don't want to close any doors here, but I think there is the concern perhaps that in some of these cases . . . the overlap with business purpose and device-type concerns may be so extensive that we're just not comfortable going there on a ruling basis, because perhaps there's more halo effect value in it than there is actual substantive legal value in it," Corwin said.

Speaking earlier about the IRS's significant issue ruling policy, Corwin said, "We're very uncomfortable with the notion that this policy would cause us to have to put blinders on as to everything else that's going on." He also noted that the reason the IRS first added device and business purpose -- and plan rulings under section 355(e)-- to the no-rule list (Rev. Proc. 2003-48, 2003-2 C.B. 86) is that "those issues were seen as inherently factual and not so much legal."

Holmes said that most practitioners believe that the halo effect is real because if a taxpayer comes in for a ruling on a fact pattern that is particularly "offensive to the underlying principles of section 355," the IRS would be generally "disinclined to rule even on a narrow, technical requirement that might be satisfied."


ATB Size Study

As for the status of the ATB size study underway at the IRS Office of Associate Chief Counsel (Corporate), Corwin said, "We are continuing to process rulings in the normal course, but we note that that may change depending on the outcome of our review." He added that the office isn't ready to say whether the outcome of the review will result in a change in ruling policy, substantive guidance, both, or neither.

"We are looking at all aspects of the issue, including the connection with business purpose and device and how the pieces fit together," Corwin said.

As the IRS considers the so-called hot dog stand, or de minimis, ATB issue, the agency is "primarily focused on relative size, but it is also possible that other facts and circumstances relating to the composition and use of the assets may make a difference," Corwin said. Both the planned spinoff by Darden and the planned spinoff by Yahoo Inc. implicate the ATB size issue.

Holmes said that "people were a little surprised . . . and perhaps a little worried" by the IRS's announcement that it was studying the ATB size issue. He said practitioners had been lulled into thinking that ATB size was a fairly simple requirement to meet, adding that in their minds "any candy store, hot dog stand, or lemonade stand is a technical solution to a technical requirement."

Andy Braiterman of Hughes Hubbard & Reed LLP said that it's odd for the IRS to give an ATB ruling on a spinoff of a hot dog stand and substantial liquid assets without addressing the related device and spinoff concerns. He questioned how much assurance such a ruling would give a taxpayer and whether the IRS would really give such a ruling and later challenge the transaction on device and business purpose concerns raised by the size of the active business. "The whole thing just seems weird to me," he said.


Changes to Ruling Policy

Serbes also addressed the latest thinking on the IRS's reconsideration of its significant issue policy (Rev. Proc. 2013-32, 2013-28 IRB 55). She said that the program "is getting a fresh eye" and that Corwin and Robert Wellen, the new IRS associate chief counsel (corporate), are looking closely "at the results so far in the program to figure out where to go."

Serbes said that in the 12 months between April 1, 2014, and March 31, 2015, the corporate office received 84 requests for private letter rulings but fielded more than double that -- 185 requests -- over that same period from 2011-2012. (During the summer of 2013, which isn't covered by Serbes's data, there was an uptick in requests by those wanting full rulings before the significant issue limitation went into effect.)

"We were thinking that the numbers would go down initially . . . but then we kind of figured things would pick up," Serbes said. "It's not quite turning out that way."

Corwin said that the program was rolled out as part of an effort by the IRS to intelligently manage its workload given declining resources. "I don't think we knew exactly how it would turn out, and I think we're still kind of figuring it out," he said. "We are willing to consider whether it's serving its purpose. But the pressure point of declining resources hasn't gotten any easier either."

Serbes said that over the years, the corporate office has shrunk from a high of 72 attorneys to its current roster of 42 attorneys.


Ruling Formulation

Serbes acknowledged that if a taxpayer's facts aren't "on all fours" with regulatory guidance or a revenue ruling such that questions are raised about the proper application of the guidance to the taxpayer's proposed transaction, the taxpayer might be eligible for a significant issue ruling.

But Corwin said that even as the IRS rules on significant issues, it has recently been phrasing the rulings in a narrower way.

For example, during the continuing arrangements discussion, the slides outlined three possible ruling formulations. They can be phrased in a way that's more broad: "the continuing arrangements will not preclude the spinoff from qualifying" under section 355(a); in between: "the continuing arrangements will not preclude the spin off from effecting a genuine separation of the businesses within the meaning" of reg. section 1.3551(b); or more narrow: "the continuing arrangements will not preclude Distributing or Controlled from satisfying the active trade or business requirement of Section 355(b)."

Corwin didn't address the ruling formulations specifically dealing with continuing arrangements in ATB rulings but commented on the IRS's phrasing of significant issue rulings more generally. "Of late we seem to be trending toward the more narrow formulation, which is based on the idea that that is the most targeted way to focus on a single, significant issue," he said. "I don't think we have a template that has been applied consistently across all rulings."

Serbes said that the corporate office is "beefing" up its existing mechanisms to ensure consistency in its rulings across all branches.