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One of the more creative (and highly effective) transactions we have encountered over the years is the so-called cash-rich split-off. Its utility may soon terminate, however, because the Bush administration’s budget proposal, introduced on Feb. 7, specifically targets the cash-rich split-off as ripe for reform. However, the effective date of any such legislation would not be until after the new proposal is actually enacted into law. Moreover, the very fact that the administration feels that new legislation is warranted to combat this transaction suggests that there is little the Internal Revenue Service can do, under current law, to attack cash-rich split-offs that have already been consummated and that are currently in the planning stage. The technique was instituted by Janus Capital Group and DST Systems Inc. and has been emulated by three other sets of taxpayers. Such a split-off has been undertaken by Houston Exploration Co. (with Keyspan Corp. as the relevant shareholder); by Liberty Media Corp. (with respect to its stock owned by Comcast Corp.); and by Clorox Co., in connection with the re-acquisition of its stock owned by Henkel KGaA. In each case, a corporate taxpayer (for example, Janus) owned a highly appreciated equity stake in another corporation (DST) that it sought to dispose of in a “tax-efficient” manner. The stake could not be distributed to the corporate taxpayer’s shareholders on a tax-free basis because the corporate taxpayer did not possess “control” of the other corporation as that term is defined in �368: that is, ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote as well as ownership of at least 80 percent of the total number of shares of each class, if any, of nonvoting stock. In the Janus-DST case, DST created a Newco to which it transferred an “active” business, amounting to some 10 percent of the value of the Newco’s total assets, and to which it transferred a substantial amount of cash — accounting for approximately 90 percent of the value of the Newco’s assets. The Newco stock was promptly distributed by DST, to Janus, in exchange for substantially all of Janus’ stock in DST. Each other cash-rich split-off has followed a similar path except that, as the technique has evolved, and in the interest of “prudence,” we have seen increasingly larger percentages of active business assets in the Newco and correspondingly smaller percentages of cash and liquid assets. It seems clear, assuming that the transaction is carried out for a corporate business purpose, that the distribution of the Newco’s stock qualifies as a tax-free split-off. The active business test is clearly met because there is no requirement, for purposes of that test, that any specific percentage of the corporation’s assets be devoted to the active conduct of a trade or business. All that is necessary is that the corporation be engaged in the active conduct of a trade or business. (See, in this regard, Revenue Ruling 73-44.) Moreover, despite the fact that the Newco’s ratio of “inactive” assets to “active” assets differs from the distributing corporation’s ratio — a condition that is evidence that the transaction was used principally as a prohibited “device” for distributing earnings and profits — the device test need not be confronted in the first instance because the distribution of the Newco’s stock is a non-pro-rata distribution. Such a transaction does not implicate the device test because the test is designed to prevent the use of �355 to avoid the tax law’s dividend provisions. In a split-off, by definition, those provisions cannot be avoided because if the distribution were taxable it would qualify under �302(a) as a payment in exchange for stock rather than as a “Section 301 distribution.” See Reg. �1.355-2(d)(iv) and Rev. Ruls. 64-102 and 71-384. The IRS, it seems clear, realizes that, under current law, the cash-rich split-off — assuming the transaction is motivated in whole or substantial part by one or more corporate business purposes — is impregnable. However, the administration’s budget proposal regarding cash-rich split-offs, which because it is being advertised as a revenue raiser and a “loophole closer” stands an excellent chance of being enacted, would reduce, but certainly not eliminate, the utility of this technique. The proposal states that in the case of a non-pro-rata distribution (a split-off), to satisfy the active business test, as of the date of the split-off, at least 50 percent of the assets (of each party to the split-off), by value, must be used or “held for use” in a business that satisfies the requirements of �355(b): that is, in a trade or business that satisfies the active business test. Thus, the proposal would eliminate the so-called de minimis rule — which, as articulated in Rev. Rul. 73-44, states that no particular percentage of a corporation’s assets must consist of active business assets (so long as the corporation is engaged in the active conduct of a trade or business) — in the case of non-pro-rata distributions and, for the first time in the annals of spinoffs, impose a strict quantitative requirement with respect to the size of the active business that a corporation possesses. Until enactment, however, corporations should probably feel more confident that these transactions are efficacious under current law. If these transactions could be successfully attacked under current law, there would probably be no need for a legislative proposal of the sort the administration is offering. Thus, it may well be that Liberty Media and News Corp., as has been speculated on numerous occasions, may yet choose to disentangle their complicated relationship through the mechanism of a “timely” cash-rich split-off. Robert Willens is a tax and accounting specialist at Lehman Brothers Inc. He is also an adjunct professor of finance at Columbia Business School. Copyright �2005 TDD, LLC. All rights reserved.

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