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Abstract
Rev. Proc. 2003-48 represents the latest assault by the IRS National Office on its own letter ruling process. This assault, combined with prior similar assaults, is detrimental to both taxpayers and the IRS, and therefore to tax administration in general. As illustrated by both Rev. Proc. 89-34 and now Rev. Proc. 2003-48, the National Office has been constructing the letter ruling process because its resources can be more effectively used to produce guidance applicable to a broad range of taxpayers and not just specific taxpayers. With all due respect, this is balderdash. First, it violates the "Cardinal Rule" of tax practice - that tax advice can never be any better than the facts upon which it is based. Second, it is unlikely that the National Office will actually issue more broad-based guidance.
Full text
Rev. Proc. 2003-48, 29 IRB XXX, which was published on June 24, represents the latest assault by the IRS National Office on its own letter ruling process.1 This assault, combined with prior similar assaults, is detrimental to both taxpayers and the IRS, and therefore to tax administration in general. For decades the National Office has been issuing letter rulings to taxpayers on proposed transactions, a practice that has resulted in the issuance of literally tens of thousands of letter rulings. Each of these letter rulings has facilitated overall national tax administration in a number of ways. The benefits to taxpayers are evident - letter rulings give taxpayers virtual assurance regarding the tax consequences of the particular transactions they have proposed. The benefits to the IRS (and to optimal tax administration in general) may be less evident, but they are equally real. Through the letter ruling process, the National Office has been made aware of the existence of specific pending transactions and has been given the opportunity to analyze and comment on these transactions before they are consummated. This, in turn, has provided the National Office with an increased awareness of new types of transactions occurring in the ever-evolving business community, and has afforded the IRS the opportunity to seek changes in those transactions to comport with existing tax law (or, at least with the wishes of the National Office). Finally, once a letter ruling is issued, the audit process is simplified (for both the IRS and taxpayers), because there is no material audit issue with respect to the ruled-upon transaction for the IRS Field Offices to address in conducting its audit.
Thus, the letter ruling process is not today, nor has it ever been, a one-way street solely for the benefit of taxpayers. To the contrary, this process has been mutually beneficial for taxpayers and the IRS, resulting in clearer and more consistent tax administration.2 Despite these mutual benefits, however, the trend is clear - over the past 13 years, the National Office has been curtailing its involvement in the letter ruling process.
The comfort ruling
Perhaps the starting point for this discussion is not Rev. Proc. 2003-48, but Rev. Proc. 89-34, 1989-1 CB 917. Rev. Proc. 89-34 ushered in the broad-based era of the so-called "comfort ruling"; i.e., a ruling that the IRS would not provide, because it concerned a fact pattern that was "clearly and adequately" addressed by a statute, regulation, decision of the Supreme Court, tax treaty, revenue ruling, revenue procedure, notice, or other authority published in the Internal Revenue Bulletin. Of course, what is and what is not "clearly and adequately" addressed in any form of precedent is a matter that reasonable minds can differ about, and that fact alone casts doubt on the notion that some requested rulings are mere "comfort rulings."
Nevertheless, as expressed in Rev. Proc. 89-34, the real concern of the National Office seems to be that letter rulings address themselves to only one taxpayer and that this one-at-a-time approach to tax administration is not an effective use of IRS resources. According to Rev. Proc. 89-34, tax administration would be better served if the IRS could "devote its resources more efficiently to resolving issues in need of attention by the public in general through the issuance of regulations, revenue rulings and other published guidance."
Rev. Proc. 2003-48 echoes this theme. This new revenue procedure announces that the National Office will, after August 8, no longer issue letter rulings on certain aspects of transactions under Section 355; i.e., certain spin-off transactions.3 The aspects of a spin-off transaction that will no longer be ruled upon by the National Office are (1) whether the transaction is being undertaken for one or more corporate business purposes, (2) whether the transaction is being used principally as a device for the distribution of earnings and profits,4 and (3) whether the spin-off and an acquisition are part of plan under Section 355(e). Prior to the publication of Rev. Proc. 2003-48 each of these aspects of the spin-off was a topic the IRS National Office would normally rule upon. As in Rev. Proc. 89-34, the reason stated for curtailing letter rulings on spin-offs is, "The Service has concluded that it . . . can better serve taxpayers by dedicating its resources to increasing the amount of published guidance regarding section 355 . . . ."
As illustrated by both Rev. Proc. 89-34 and now Rev. Proc. 2003-48, the National Office has, for more than a decade, been constricting the letter ruling process because, in its view, its resources can be more effectively used to produce guidance applicable to a broad range of taxpayers and not just specific taxpayers.
With all due respect, this is balderdash. First, it violates the "Cardinal Rule" of tax practice - that tax advice can never be any better than the facts upon which it is based. Even the smallest of factual changes can (and often must) completely alter the tax advice given. It is fair to say that this Cardinal Rule is dogma in the tax community and is repeated by tax advisors to their clients at every opportunity. By its nature, broad-based tax guidance must assume certain facts or address itself to a generalized set of facts. This may well provide some guidance to some of the people some of the time, but it is likely to provide virtually no guidance whatsoever to taxpayers whose facts differ, in even the smallest detail, from the fact pattern addressed in the broad-based guidance. Without a robust letter ruling process, how can these gray-area fact patterns be resolved?
Second, as will be illustrated below, it is unlikely that the National Office will actually issue more broad-based guidance. According to both revenue procedures discussed above, broad-based guidance to taxpayers takes the form of regulations (either temporary or final),5 revenue rulings, and revenue procedures. To be sure, these three forms of guidance can be relied upon by taxpayers to resolve their tax issues, but only subject to the dictates of the Cardinal Rule - the facts in the published guidance must be the same as the taxpayer's facts in all material aspects. Moreover, if the IRS is correct and a curtailment of the letter ruling process will lead to an expansion of broad-based guidance, one would certainly expect to see an increase in the number of regulations, revenue rulings, and revenue procedures issued over the past 13 years; so, lets look at the record, which is set forth in Exhibit 1 and Exhibit 2.6
Exhibit 1 shows the number of revenue rulings, revenue procedures, and Treasury decisions7 issued in the decade preceding the publication of Rev. Proc. 89-34 (1980 through 1989). As can be seen from this exhibit, the average number of revenue rulings issued each year from 1980 through 1989 was a fraction over 200 per year. For this same time period the average number of revenue procedures issued each year was a fraction over 67 and the average number of Treasury decisions issued each year was a fraction over 62.
Exhibit 2 shows the number of revenue rulings, revenue procedures, and Treasury decisions issued each year for the 13 years following the publication of Rev. Proc. 89-34 (1990 through 2002). As can be seen from this exhibit, the average number of revenue rulings issued each year during this period was a fraction over 77, the average number of revenue procedures issued each year during this period was a fraction over 65, and the average number of Treasury decisions issued each year during this period was a fraction over 61. Thus, the average number of revenue procedures and Treasury decisions issued in the 13-year period following the publication of Rev. Proc. 89-34 remained virtually unchanged when compared with the average number issued during the decade preceding the publication of Rev. Proc. 89-34. As for revenue rulings, however, the numbers declined dramatically, from 200 to 77. These numbers are all the more surprising when one recalls that at the end of 1986, the Internal Revenue Code underwent its greatest revision in history. One might well think that with this massive legislative upheaval, the decade of the 90's would have seen an out-pouring of broad-based guidance. Apparently, that was not was the case, and apparently, the pronouncements of Rev. Proc. 89-34 notwithstanding, broad-based guidance simply did not increase in the 13-year period after its publication.
So, if over the past 13 years the number of revenue rulings fell by nearly two-thirds and the number of revenue procedures and Treasury decisions remained static, it is not at all clear that the National Office used its resources in the decade plus since the publication of Rev. Proc. 89-34 to actually provide taxpayers with more broad-based guidance than they did previously. To the contrary, this data indicates that less broad- based guidance was made available to taxpayers during the period. And, given that the rationale for Rev. Proc. 2003-48 is ostensibly the same as that for Rev. Proc. 89-34, no one should be surprised if the IRS's curtailment of the letter ruling process in the Section 355 arena fails to produce more broad-based Section 355 guidance.
Broad-based based Section 355 guidance
Lest we jump too quickly to this conclusion, however, we must acknowledge that in the weeks before, and concurrent with, the publication of Rev. Proc. 2003-48, the National Office did publish a spate of broad-based rulings regarding Section 355. No fewer than six revenue rulings addressing issues under Section 355 were published in the two-month period prior to the publication of Rev. Proc. 2003-48.8 By any measure, the publication of six revenue rulings addressing issues under one Code Section in a two- month period is outstanding, and the National Office should be commended for this achievement. But, do these published rulings really take the place of letter rulings and provide for a better and more efficient administration of our tax system? Perhaps we should take a closer look.
Of the six published rulings, one (Rev. Rul. 2003-38) addresses the active trade or business requirement of Section 355, four (Rev. Ruls. 2003-52, 2003-55, 2003-74, and 2003-75) address the business purpose requirement of Section 355, and one (Rev. Rul. 2003-79) addresses two concepts - the distribution of control requirement of Section 355 and the substantially all requirement of Section 368. The discussion that follows will not attempt to analyze the technical merits of these rulings, but instead will focus on whether they succeed in providing the sort of broad-based guidance the IRS promised.
Rev. Rul. 2003-38 addresses a business expansion question - if a corporation has been engaged in a business for several years and it then begins to offer its business service via the internet, is the internet business a new business (such that it could not be spun off for five years) or is it an expansion of the existing business so that the business history tacks.9 To qualify for tax-free treatment under Section 355, both the Distributing corporation and the Controlled corporation must be engaged in the active conduct of a five-year trade or business immediately after the distribution of the Controlled corporation's stock. Thus, determining what constitutes a five-year trade or business is fundamental to Section 355. To the extent this published ruling addresses a decision to embark upon a new set of activities via the internet, it may well help address concerns of businesses that choose to expand through this new medium. As internet businesses have certainly proliferated in the past decade, this ruling may well prove useful in addressing the concerns of those businesses. The Cardinal Rule, however, demonstrates the limitations of the usefulness of this ruling. Rev. Rul. 2003-38 contains a precise set of facts, including the fact that the internet business used the name of the historical business. Moreover, the ruling's conclusion states that "the web site's success will depend in large measure on the goodwill associated with the [historical business and its name]." So, what if the next taxpayer's web site used a name different from that taxpayer's historical business name? What, if any, guidance would this ruling provide? Clearly, there are endless means of expanding or changing a business, and any of these could represent an expansion for purposes of Section 355, but which ones are expansions and which are not? Perhaps, as reflected in this published ruling, the determination hinges on a name. But if not that, then what factual changes are determinative? Only the letter ruling process can address those questions.
Similar comments can be made about three of the four published rulings addressing business purpose. Rev. Rul. 2003-52 generally instructs that a permissible business purpose for a Section 355 transaction exists if the primary owners of a business each want to focus on discrete aspects of the business to the exclusion of other aspects. In the ruling, a family-owned business is engaged in raising livestock and growing grain. The ruling describes in some detail the relationships and desires of family members including the fact that a sister's husband and brother dislike each other. Would the conclusion in this ruling have been different had these two gentlemen been friends? The answer to this question is almost certainly "no." But, if taxpayers merely want to engage in discrete aspects of their business, but the family relationships and desires are not the same as in the published ruling, would this ruling provide the level of comfort needed to proceed with the transaction or mightn't the taxpayers still prefer to obtain a letter ruling to assure themselves that their facts are sufficiently similar to the facts in Rev. Rul. 2003-52?
Rev. Ruls. 2003-74 and 2003-75 also address highly fact-specific situations and conclude that satisfactory business purposes exist to support Section 355 distributions. The first of these rulings addresses a situation in which two businesses need to be separated to resolve certain management problems that arise from having the businesses together (this is generally referred to as a "fit and focus" business purpose, because the spin-off is designed to allow the businesses to address managerial issues related to how the businesses "fit" together and how management "focuses" its time on the operation of the businesses). At the same time, however, the taxpayers in the ruling want to retain certain common members of the two separate boards of directors after the spin-off. Historically, the IRS has been reluctant to approve a fit and focus business purpose unless the management of the businesses to be separated, including the boards of directors, were independent of one another after the transaction. Rev. Rul. 2003-74 seems to break new ground on this question, but once again, what if a taxpayer's particular facts differ? What if instead of two overlapping board members (one overlapping for two years and the other for six years as in the Rev. Rul.), the taxpayers would like to retain three overlapping board members for six years, and what if the reasons those overlapping members are needed are different from the reasons set forth in Rev. Rul. 2003-74? Are three overlapping board members too many? How about four? If four directors overlap, would the business reasons for the overlapping board members be strong enough to overcome the IRS's historical bias against such an overlap? If a taxpayer's facts did not fit this ruling "on all fours" wouldn't that taxpayer want to seek a letter ruling?
The second of these two business purpose rulings, Rev. Rul. 2003-75, also addresses a very specific fact pattern. In that ruling, two businesses are split up because they compete for capital and this competition is stifling business growth. As might be expected, following the spin-off these now-separate corporations have certain agreements regarding shared technology, benefits administration, and accounting and tax matters. Each of these agreements lasts for a finite period of time. The IRS concludes that these particular continuing relationships between these now-separate corporations will not prevent a successful spin-off. But once again, the ruling provides little reliable guidance, unless a given taxpayer's continuing relationships (and the time period of these relationships) in their proposed transaction are virtually identical to those in the ruling.
The point here is that many published rulings are highly fact-specific and outside the precise facts of the published ruling, one proceeds at one's peril. Maybe the ruling is guidance, maybe not. It is all a matter of degree - are your facts close enough to the published facts or is their a material difference?
Whatever may be said about the four revenue rulings described above, Rev. Ruls. 2003-55 and 2003-79 are clearly examples of bona fide broad-based guidance.10 The first of these rulings addresses the often-asked question, "What if we do a spin-off and then, for unforeseen reasons, the business environment changes such that the business purpose that supported the spin-off is no longer important?" This happens with some degree of regularity if, for example, the business purposes relates to an initial public offering of stock of either the Distributing or the Controlled corporation. Rev. Rul. 2003-55 provides the broad guidance that if the spin-off is undertaken for a bona fide business reason, an unforeseen change in circumstances thereafter will not cause the spin-off to fail the business purpose test; the test is applied at the time of the spin-off, not after.
Rev. Rul. 2003-79 also provides the sort of broad-based guidance that can be relied upon by many taxpayers. It involves a spin-off followed by an acquisition of the Controlled corporation. Ironically, this ruling, like a great many of its predecessors, finds its genesis in the letter ruling process. The fact pattern addressed in the published ruling is one that the National Office has repeatedly been asked to address in private letter rulings.11 Although it is of course appropriate to use broad-based guidance such as Rev. Rul. 2003-79 to supplant the need to continue to issue letter rulings on a given set of facts, it is equally appropriate to ask whether in the absence of a robust letter ruling process the IRS would have learned of the need to issue that guidance. As noted above, the letter ruling process is not something that benefits only taxpayers; it is also the IRS's window on the evolving world of tax planning and it is a window they are closing on themselves.
Certainly the National Office should take pride in its recent efforts to provide broad-based guidance on Section 355 and certainly the general notion of providing broad-based guidance is one that tax practitioners and taxpayers alike endorse. But, if past is prologue, the needed broad-based guidance will not materialize, at least not to a sufficient extent to warrant abandoning an active letter ruling process. After all, the mission of the IRS is to "Provide America's taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all."12 For decades the letter ruling process has been a vital cog in the IRS machinery used to achieve this stated mission. Curtailment of the letter ruling process is bad for taxpayers, bad for the IRS, and bad for tax administration.
1 For another discussion of Rev. Proc. 2003-48, see Rothman, "The IRS's New Policy on Spin-Off Rulings Leaves Practitioners with a Sinking Feeling," elsewhere in this issue.
2 Having worked at the National Office as a docket attorney issuing letter rulings and also in private practice representing taxpayers in the letter ruling process, the author has had the opportunity to view this process from both sides.
3 Although section 355 transactions encompass spin-offs, split-offs, and split-ups, the term spin-off will be used here for all three.
4 The device test of section 355 generally seeks to determine if the transaction is designed to convert dividend income into capital gain. In light of recent changes to the tax law providing a uniform tax rate of 15% to both dividends and capital gains, one wonders about the vitality of the device test in any event.
5 Proposed regulations are excluded from the ambit of broad-based guidance because they cannot be relied upon by taxpayers (absent express permission in the proposed regulation), and therefore, they do not offer any guidance to taxpayers.
6 The numbers in the Exhibits are as reported in the Cumulative Bulletins for the relevant years.
7 Treasury decisions are the means of publishing either temporary or final regulations.
8 See Rev. Ruls. 2003-38, 2003-17 IRB 811; 2003-52, 2003-22 IRB 960; 2003-55, 2003-22 IRB 961; 2003-74, 2003-29 IRB 1; 2003-75, 2003-29 IRB 1; 2003-79, 2003-29 IRB 1.
9 See generally Reg. 1.355-3(c), Ex. 7 & Ex. 8.
10As stated above, no inference should be drawn from any comment in this article regarding the technical merits of these rulings.
11See Ltr. Rul. 200113019; Ltr. Rul. 200211019; Ltr. Rul. 200215031.
12Internal Revenue Service, Publication 1 (August 2000).
Richard W. Bailine is the Principal-in-Charge of the Washington National Tax Corporate Tax practice of KPMG LLP. The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP.
Copyright Thomson Tax and Accounting d/b/a RIA Sep/Oct 2003