rr-03-75.pdf

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Part I

Section 355.BDistribution of Stock and Securities of a Controlled Corporation

26 CFR 1.355-2: Business Purpose

Rev. Rul. 2003-75

ISSUE

Whether, in the situation described below, the distribution of the stock of a
controlled corporation to resolve a capital allocation problem between the distributing
and controlled corporations satisfies the business purpose requirement of ' 1.355-2(b)
of the Income Tax Regulations.
FACTS
Distributing is a publicly traded corporation that conducts a pharmaceuticals business.
Controlled, a wholly owned subsidiary of Distributing, conducts a cosmetics business.
One shareholder, who does not actively participate in the management or operations of
Distributing or Controlled, owns six percent of the outstanding Distributing stock.

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The pharmaceuticals business develops, manufactures, and markets specialty
drugs. It is a high-margin business that emphasizes rapid growth through innovation.
The cosmetics business develops, manufactures, and markets cosmetics. It is a low-
margin business that grows at a moderate rate by increasing its productivity and market
share. Both businesses require substantial capital for reinvestment and research and
development.
Distributing does all of the borrowing for both Distributing and Controlled and
makes all decisions regarding the allocation of capital spending between the
pharmaceuticals and cosmetics businesses. Because Distributing’s capital spending in
recent years for both the pharmaceuticals and cosmetics businesses has outpaced
internally generated cash flow from the businesses, it has had to limit total expenditures
to maintain its credit ratings. Although the decisions reached by Distributing’s senior
management regarding the allocation of capital spending usually favor the
pharmaceuticals business due to its higher rate of growth and profit margin, the
competition for capital prevents both businesses from consistently pursuing
development strategies that the management of each business believes are
appropriate.
To eliminate this competition for capital, Distributing distributes the Controlled
stock to Distributing’s shareholders, pro rata. Because the total capital available to the
two businesses would continue to be limited as long as the two businesses remained
within the same corporate group, there is no other nontaxable transaction that would
solve the competition problem. It is expected that both businesses will benefit from the
separation, and that the cosmetics business will benefit in a real and substantial way as

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a result of increased control over its capital spending and direct access to the capital
markets.
To facilitate the separation, Distributing and Controlled will enter into transitional
agreements that relate to information technology, benefits administration, and
accounting and tax matters. Other than the tax matters agreement, each agreement will
terminate after two years absent extraordinary circumstances, in which case the
affected agreement may be extended on arm=s-length terms for a limited period.
Following the separation, there will be no cross-guarantee or cross-collateralization of
debt between Distributing and Controlled, and an arm's-length loan from Distributing to
Controlled for working capital will have a term of two years.
Apart from the issue of whether the business purpose requirement of ' 1.355-
2(b) is satisfied, the distribution meets all the requirements of ' 355.
LAW
Section 355 provides that if certain requirements are met, a corporation may
distribute stock and securities in a controlled corporation to its shareholders and
security holders without causing the distributing corporation or the distributees to
recognize gain or loss.
To qualify as a distribution described in § 355, a distribution must, in addition to
satisfying the statutory requirements of § 355, satisfy certain requirements in the
regulations, including the business purpose requirement. Section 1.355-2(b)(1)
provides that a distribution must be motivated, in whole or substantial part, by one or
more corporate business purposes. A corporate business purpose is a real and
substantial non-Federal tax purpose germane to the business of the distributing

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corporation, the controlled corporation, or the affiliated group to which the distributing
corporation belongs. Section 1.355-2(b)(2). The principal reason for the business
purpose requirement is to provide nonrecognition treatment only to distributions that are
incident to readjustments of corporate structures required by business exigencies and
that effect only readjustments of continuing interests in property under modified
corporate forms. Section 1.355-2(b)(1). If a corporate business purpose can be
achieved through a nontaxable transaction that does not involve the distribution of stock
of a controlled corporation and that is neither impractical nor unduly expensive, then the
separation is not carried out for that corporate business purpose. Section 1.355-2(b)(3).
ANALYSIS
The operation of the pharmaceuticals business and the cosmetics business
within the same corporate group causes capital allocation problems that prevent each
business from pursuing the development strategies most appropriate to its operation.
The separation of the two businesses is the only nontaxable transaction that will resolve
these problems. It is expected that both businesses will benefit from the separation,
and that the separation will enhance the success of the cosmetics business in a real
and substantial way.
The limited continuing relationship between Distributing and Controlled
evidenced by the various administrative agreements and the loan for working capital is
not incompatible with the extent of separation contemplated by § 355. The
administrative agreements, except for the tax matters agreement, and the loan are
transitional and short-term, and all are designed to facilitate, rather than impede, the
separation of the pharmaceuticals business from the cosmetics business.

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Hence, the distribution of Controlled stock by Distributing to Distributing’s
shareholders is motivated in whole or substantial part by a real and substantial non-
Federal tax purpose germane to the business of Controlled and satisfies the corporate
business purpose requirement of ' 1.355-2(b).
HOLDING
In the situation described above, the distribution of the stock of a controlled
corporation to resolve a capital allocation problem between the distributing and
controlled corporations satisfies the business purpose requirement of ' 1.355-2(b).
DRAFTING INFORMATION
The principal author of this revenue ruling is Richard M. Heinecke of the Office of
Associate Chief Counsel (Corporate). For further information regarding this revenue
ruling contact Richard M. Heinecke on (202) 622-7930 (not a toll-free call).