IRS Approves Complex Cross-Border Spin-Off With Share Retention for Debt Repayment

IRS Blesses Multi-Tiered Cross-Border Split and Share Retention

A foreign parent company (Distributing 3) secured IRS approval for a complex, multi-step separation of two business lines involving both U.S. and foreign entities. The IRS ruled the transaction—including two internal U.S. spin-offs and a final external demerger—qualifies as tax-free under sections 355 and 368(a)(1)(D). Crucially, the IRS permitted the parent to retain a stake in the spun-off company specifically to pay down debt.

The Global Web: Unwinding a Multi-National Structure

Following the IRS's favorable ruling on the overall transaction, understanding the initial corporate structure is key. Distributing 3, a publicly traded foreign entity based in Country A, sat atop a complex web of U.S. and foreign subsidiaries. This group, referred to as the "Distributing 3 Group," engaged in multiple businesses both within the United States and internationally, specifically "Business A" and "Business B." The structure included direct ownership of entities like DRE 1 and DRE 2 (both in Country B), and FSub 1 (in Country A). It also featured indirect ownership of FSub 2 (in Country C). Downstream, FSub 3 (Country B) held Distributing 2, a U.S. corporation and the common parent of a U.S. consolidated group, which in turn owned Distributing 1, a U.S. corporation operating both Business A and Business B. This deep, multi-tiered ownership structure required significant simplification to achieve the separation of Business A and Business B, a move the taxpayer asserted was for valid business reasons to satisfy the business purpose requirement of Treas. Reg. § 1.355-2(b), which mandates a real and substantial non-Federal tax purpose germane to the business.

The Mechanics: Double U.S. Spins and a Foreign 'Flip-Up'

The transaction involved a carefully orchestrated series of steps, beginning with internal restructuring and culminating in a cross-border separation of Business A and Business B.

First, assets related to Business B were reorganized within the U.S. structure. Distributing 1 formed several limited liability companies (LLCs), including LLC 2, LLC 3, and LLC 4. Under U.S. tax law, an LLC with a single member is typically treated as a disregarded entity (DRE), meaning its activities are treated as if they were conducted directly by its owner. Distributing 1 then transferred its shares in Sub 1 to LLC 2 and moved Business B assets through these newly formed LLCs. Ultimately, Distributing 1 contributed its equity interests in Sub 2, LLC 2, and LLC 4 (collectively, the "U.S. Business B Subsidiaries") to Controlled 1, another LLC initially treated as a DRE.

The structure then underwent a series of spin-offs. Under Section 355, a corporation can distribute stock of a controlled subsidiary tax-free to its shareholders if certain requirements are met. The first spin-off, the "First U.S. Spin-Off," involved Controlled 1 electing to be taxed as a corporation under Treas. Reg. § 301.7701-3(c). Following this election, Distributing 1 distributed the shares of Controlled 1 to Distributing 2. The second spin-off, the "Second U.S. Spin-Off," involved Distributing 2 contributing the shares of Controlled 1 to Controlled 2, also electing to be taxed as a corporation, and then distributing the shares of Controlled 2 to FSub 3. Subsequent distributions moved the Controlled 2 shares to Distributing 3.

The final stage involved an "External Spin-Off" to fully separate the businesses outside the U.S. This consisted of a "Demerger" and a "Flip-Up." The "Demerger" was defined as Distributing 3 transferring all of its interests in DRE 3 to Controlled 3 in a three-cornered dividend demerger under Country A law. Under the terms of a demerger agreement, Distributing 3 declared an interim dividend that was satisfied by Controlled 3 issuing shares to Distributing 3’s shareholders. The "Flip-Up" involved DRE 2 being granted a put option, allowing it to transfer its FSub 4 shares to Controlled 3 in exchange for shares constituting a proportionate interest in Controlled 3. DRE 2 was expected to exercise this put option.

The Retention Strategy: Keeping Shares to Pay Debt

Following the "Flip-Up," Distributing 3 planned to dispose of its 'h percent' interest in Controlled 3 (the "Retained Shares") within five years. According to the ruling, Distributing 3 intended to use the proceeds from selling these Retained Shares to cover the costs of the separation and to repay external debt of the Distributing 3 Group maturing after the separation. This rationale was termed the "Retention Business Purpose."

The IRS specifically addressed whether this retention of shares violated the requirements for a tax-free distribution under Section 355(a)(1)(D)(ii). This section allows a distributing corporation to retain stock in the controlled corporation, provided it distributes enough stock to constitute "control" as defined in Section 368(c) – generally, at least 80% of the voting power and 80% of each class of non-voting stock. The IRS also requires that the retention not be part of a plan with a principal purpose of avoiding federal income tax, per Treas. Reg. § 1.355-2(b), which requires a real and substantial business purpose. The IRS ruled that, based on the facts presented, Distributing 3's retention of the 'h percent' interest did not violate these tax-free requirements (Ruling 29). This outcome aligns with the historical IRS practice of permitting retentions of up to 19.9% of stock when justified by valid business reasons, such as satisfying debt obligations.

Regulatory Impact: IRS Confirms Tax-Free Status

Building on the allowance of retained stock, the IRS confirmed the tax-free nature of the overall transaction. Specifically, the IRS ruled that the First U.S. Spin-Off qualified as a reorganization under Section 368(a)(1)(D) of the Internal Revenue Code. Section 368(a)(1)(D) defines a specific type of corporate reorganization involving the transfer of assets to a controlled corporation, followed by a distribution of the controlled corporation's stock to the transferor's shareholders. The IRS also confirmed that it met the requirements of Section 355, which governs tax-free distributions of stock of a controlled corporation to its shareholders.

The IRS further ruled that the Second U.S. Spin-Off similarly qualified as a reorganization under Sections 368(a)(1)(D) and 355. Finally, the External Spin-Off was also deemed to qualify as a tax-free reorganization under Sections 368(a)(1)(D) and 355.

This ruling reinforces the viability of using retained stock in a spin-off to manage corporate leverage, provided the shares are disposed of within five years, as stipulated in Ruling 29. This aligns with existing guidance, per Revenue Procedure 2025-30 (reinstating historical ruling standards from Rev. Proc. 2017-52 and 2018-53), offering taxpayers flexibility when structuring spin-offs with share retention for valid business purposes.