Often, a divisive D reorganization precedes a Section 355 spin-off for the reason that the corporation must first segregate the assets and liabilities of the business to be spun off in a separate entity before it can spin off the business. Thus, the spin-off is actually comprised of two steps. Step 1: the parent corporation ("P") transfers the assets representing the business to be spun off to a subsidiary corporation ("S") in exchange for consideration including stock of the subsidiary. Step 2: P spins off the business by distributing the S stock received in the exchange to its shareholders so that after the transaction, the P shareholders own stock in two corporations: P and S.
The corporate level exchange that occurs in step 1 is governed by I.R.C. § 361. In this respect, P recognizes no gain or loss if it receives back solely corporate stock or securities. I.R.C. § 361(a). But often, the consideration consists of cash or "boot" in addition to stock or securities of S. One way to avoid gain recognition despite the receipt of boot is for P to distribute the boot received to its shareholders or creditors under I.R.C. § 361(b). With respect to the latter, an interesting question arises in the context of defeasance.
Defeasance is a financial accounting concept whereby a company can eliminate indebtedness from its financial statements without actually paying it off. At the most basic level, the company establishes an independent trust which is funded with high-grade government securities (AAA). Upon maturity, those securities will be sufficient to satisfy the entire amount of the debt. In essence, then, the company is collateralizing its debt with government securities rather than satisfying them. In any event, if properly structured, the company may treat the collateralized indebtedness as satisfied for financial accounting purposes. Such treatment allows the company to remove the liability represented by the collateralized indebtedness from its financial statements (with a corresponding reduction in assets, of course) which, in turn, favorably impacts financial ratios. That's the financial accounting treatment. But financial accounting and tax consequences often vary.
Is Defeasance a Distribution to a Creditor Under I.R.C. § 361(b)?
In the spinoff context, the question ultimately becomes whether use of the cash boot to collateralize a debt as described above constitutes a distribution to a creditor under I.R.C. § 361(b) which purges the transaction of the boot taint and preserves non-recognition treatment. It depends.
More specifically, it depends on the type of defeasance involved. As a matter of law, there are two types of defeasance: (1) legal defeasance; and (2) covenant (aka in substance) defeasance. In the case of a legal defeasance, the creditor no longer has a claim against the debtor corporation once the securities have been deposited into the trust. That is, the debtor corporation is released from liability, and the creditor must look solely to the trust for repayment. In the case of a covenant defeasance, on the other hand, the corporate debtor remains technically liable for the debt. That is, while the debt will be repaid from the trust, privity remains between the debtor corporation and the creditor such that the debtor corporation remains liable on the debt despite the collateralization.
Because a legal defeasance results in extinguishment of the creditor's rights against the debtor corporation, the tax law treats a legal defeasance as if the corporate debtor used the assets which were used to fund the trust as currency to satisfy the debt. By contrast, because a covenant defeasance does not result in extinguishment of the debtor corporation's liability or the creditor's rights against the corporation, the tax law treats a covenant defeasance as not in repayment of the debt.
A legal defeasance is treated as a distribution to a creditor, but a covenant defeasance is not. Thus, P's use of the boot received to effect a legal defeasance is sufficient to purge the transaction of the boot taint and preserve non-recognition treatment. By contrast, P's use of the boot received to effect a covenant defeasance is not sufficient to purge the transaction of the boot taint, and P would be subject to gain recognition despite the defeasance.