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Congress Extends Reduced Rates and Modifies Spin-Off Rules

From this Wachtell Lipton memo in our “Spin-Offs” Practice Area: “Last week, the President signed the Tax Increase Prevention and Reconciliation Act of 2005 (the “Act”). The Act extends reduced tax rates for capital gains and qualified dividend income that would have otherwise expired and includes provisions that directly impact tax-free spin-offs.

1. Extension of Reduced Rates on Capital Gains and Qualified Dividends
Under prior law, individuals were generally taxed on any “qualified dividend income” received and long-term capital gains recognized prior to January 1, 2009 at a maximum rate of 15%. The Act extends the application of the 15% maximum rate to any qualified dividends received and long-term capital gains recognized prior to January 1, 2011.

2. Changes to the Rules Governing Tax-Free Spin-Offs

The Act significantly simplifies the “active business” test that applies to tax-free spin-offs. That test requires each of the distributing corporation and the distributed subsidiary to be engaged in an active trade or business immediately after the distribution. Under prior law, a business conducted by a subsidiary was not automatically attributed to its parent. Consequently, most spin-offs required significant internal restructuring to meet this test. The Act simplifies the active business test by treating the entire affiliated group of the distributing corporation and of the distributed subsidiary, respectively, as a single corporation for purposes of determining whether the requirement is met. This new provision expires on December 31, 2010.

Separately, the Act also curtails “cash rich” split-off transactions, which had been used to repurchase blocks of stock from significant corporate holders on a tax-free basis. The Act now denies tax-free treatment to distributions where either the distributing corporation or the distributed subsidiary is a “disqualified investment corporation” and any person owns a 50% or greater interest in the disqualified investment corporation as a result of the distribution. A corporation is a disqualified investment corporation under the Act if it holds investment assets (such as cash or securities, whether or not liquid) in excess of certain thresholds (75% or more of the value of the corporation’s total assets during the first year after enactment and 662/3% thereafter), and the Act contains look-through rules for purposes of making this determination. The Act also contains a transition rule exempting transactions that were made pursuant to agreements that were binding on the date of enactment or described in a ruling request, public announcement or public filing with the Securities and Exchange Commission on or before the date of enactment.