Pre-revenue development business qualifies for section 355 active-business test

Plain-English summary

A public company proposed separating an established research business from a development business through a contribution to a new controlled corporation followed by a pro rata stock distribution. The development business had operated for more than five years, employed personnel, and incurred significant expenses, but it had deliberately postponed collecting income while advancing a product toward a more valuable stage. The company represented that the business could have generated licensing or collaboration income earlier and supplied comparable third-party transactions. The IRS ruled on one significant issue only: the absence of actual income collection did not prevent the development activity from being a trade or business for the section 355 active-business requirement. The ruling did not address the proposed transaction's overall tax consequences.

Ruling snapshot

• Question: Does a development business's lack of collected income prevent it from qualifying as an active trade or business for a section 355 distribution?
• Outcome: approved
• Key authorities: IRC §§ 355 and 368(a)(1)(D); Treas. Reg. § 1.355-3(b)(2)(ii)

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 202009002                                             Third Party Communication: None
Release Date: 2/28/2020                                       Date of Communication: Not Applicable
Index Number: 355.00-00, 355.01-00,
              355.03-00, 355.03-01                            Person To Contact:
                                                              ---------------------, ID No. -----------------
----------------------------                                  Telephone Number:
-------------------------------                               --------------------
-----------------------------------------                     Refer Reply To:
------------------------------                                CC:CORP:B04
--------------------------------------------------            PLR-103889-18
                                                              Date:
                                                              September 04, 2019



Legend

Distributing             = -----------------------------------------------------------
                           -----------------------

State A                  = -------------

Industry A               = -----------------------------------------------------------
                           ------------------------

Industry AA              = --------------------------------

Step 1                   = ---------------------------

Step 2                   = ------------------------------------------

Step 2A                  = ---------------------

Step 2B                  = ------------------------------

Step 2C                  = ------------------------------

Step 2C1                 = -------------------------------------

Step 2C2                 = --------------------------------------------

Step 2D                  = ------------------------------
PLR-103889-18                                     2

Step 3           = ----------------------------

Step 4           = -----------------------------------------------------------
                   ------------------------------

Products A       = -----------------------------------------------------------
                   -------------

Business 1       = -----------------------------------------------

Business 2       = ----------------------------------------------

Item A           = --------------------

Item 1           = ------------

Date A           = ----------------

Year A           = -------

Larger Scale     = -----------------------------------------------------------
                   -----------------------------------------------------------
                   --------------------------

Several          = -----------------------------------------------------------
Collaborators      -----------------------------------------------------------
                   ------------------------

Collaborator A   = -----------------------------------------------------------
                   -----------------------------------------------------------
                   ----------------

Collaborator     = -----------------------------------------------------------
Agreement          -----------------------------------------------------------
                   -----------------------------------------------------------
                   --------------------------------------------------------

Investment       = ---------------------
Banker

a                = -------------

b                = --

Sub1             = -----------------------------------------------------------
PLR-103889-18                                           3

                              -----------------------

Dear ---------------------:

       This letter responds to your letter dated February 1, 2018, requesting a ruling on
certain federal income tax consequences of the Proposed Transaction, defined below.
The information submitted in that letter and in subsequent correspondence is
summarized below.

       The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for the ruling, it is subject to verification on examination.

       This letter is issued pursuant to section 4 of Rev. Proc. 2017-52, 2017-41 I.R.B.
283, amplified and modified by Rev. Proc. 2018-53, 2018-43 I.R.B. 667, and section
6.03(2) of Rev. Proc. 2018-1, 2018-1 I.R.B. 1, regarding a significant issue under
section 355 of the Internal Revenue Code. The ruling contained in this letter only
addresses one significant issue involved in the Proposed Transaction. This office
expresses no opinion as to the overall tax consequences of the Proposed Transaction
or as to any issue not specifically addressed by the ruling below.

                                              Summary of Facts

       Distributing, a State A corporation, is publicly traded and owns all the outstanding
stock of Sub 1, its only subsidiary. Distributing is an Industry A company. Industry A
companies seek to create Items A and are also considered to be Industry AA
companies. Typically, for Items A to be commercialized they go through a four step
process: Step 1, Step 2, Step 3, and Step 4. Each step is composed of subparts.
Specifically, Step 2 is composed of four subparts: Step 2A, Step 2B, Step 2C, and Step
2D. Step 2C is composed of Step 2C1 and Step 2C2.

Business 1 (Step 1 through Step 2C1)

        Distributing’s historic business consists of the activities in Step 1 through Step
2C1 (“Business 1”). Distributing’s Business 1 relies on its research and development to
identify and create new Products A. Products A are then tested and modified to create
Items A for later testing and ultimate commercialization. Over the years Distributing has
created Items A and continues to create other Items A.

        Prior to the commencement of Distributing’s Business 2, described below, Steps
2C2 through 4 (the remaining steps to bring Items A to commercialization) were not a
part of Distributing’s business. Instead, for the Items A developed through Business 1,
these steps were performed by third party Industry AA companies pursuant to license
and collaboration agreements.
PLR-103889-18                                4

       Item 1, a type of Item A, has progressed through Business 1 from Step 1 through
Step 2C1. At Step 2C1, Item 1 has been tested in a variety of possible conditions and
its development is typical of Distributing’s Business 1 practice.

Business 2 (Steps 2C2 through Step 3)

        On Date A (more than five years before the date of the Proposed Transaction),
Distributing began conducting research, development, testing, and regulatory functions
for Item 1 developed in Business 1, through Step 2C1. Distributing intends that it will
develop Item 1 from Step 2C2 through Step 3 (“Business 2”). Step 2D generally
consists of duplicating tests performed in Step 2C2 but on a Larger Scale. Item 1 has
not progressed beyond Step 2C2.

        After Step 3 but before Step 4, Business 2 will partner or collaborate with one or
more Industry AA partners that have the experience, knowledge, and a salesforce to
move Item 1 efficiently through the next steps. However, despite a progression to Step
4, Step 3 activities will still need to be conducted and Business 2 will conduct those
activities.

       Since Date A, Distributing has allocated managerial and operational employee
time to support Business 2 and has more recently devoted employees full time to
Business 2. As a result, Distributing has incurred significant salary and wage expense
in connection with Business 2.

Business 1 Income

       For more than five years, Business 1 consistently generated income through
contractual relationships with Industry AA companies from research-oriented contracts
or certain licensing. For example, Distributing received income from agreements with
Several Collaborators and Collaborator A which are all Industry AA companies. In Year
A, Distributing and Collaborator A entered into the Collaborator Agreement whereby
Collaborator A received access to all of Distributing’s Items A except Item 1. In
exchange, Distributing received an upfront cash licensing fee and annual research and
reimbursement of at least $a per year for at least b years. The Items A that were part of
the Collaborator Agreement consisted of Items A that were in Step 2C1 or earlier.

Potential Income for Business 2

        Even though Business 2 has never generated income, Distributing believes that
Business 2 had the ability to generate income since Date A through licensing of certain
rights to Item 1 or partnering with Industry AA companies. Distributing represents that,
based on the Items A that were included in the Collaborator Agreement, it believes that
it could have entered into a partnership or collaboration agreement with Collaborator A
for the development and commercialization of Item 1 similar to the Collaborator
Agreement, and that Item 1 has greater potential and value. Distributing also
represents that it is easier to obtain income from Items A the further they have
PLR-103889-18                                  5

progressed through the steps. Distributing submitted a list, provided to it by Investment
Banker, of deals within the past five years, between parties unrelated to Distributing,
involving licenses of other Items A in Step 2C with upfront cash payments by the
licensee to the licensor. Distributing has stated that the listed Items A are similar and
comparable to Item 1.

        However, Distributing has decided to forego immediate collection of income from
Business 2 in favor of the prospect of collecting significantly greater income after Step 3
is completed with respect to Item 1. As indicated above, after Step 3 but before Item 1
is commercialized, Business 2 intends to partner or collaborate with Industry AA
partners that have the experience, knowledge, and a salesforce to move Item 1
efficiently through to the next steps. Business 2 will then generate income at this step
through receipts of royalties, milestone payments, or profit-splits.

                                  Proposed Transaction

       For what are represented to be valid corporate business purposes, Distributing
proposes to engage in the following transaction to separate Business 1 from Business 2
(the “Proposed Transaction”).

      1. Distributing will form a State A corporation (“Controlled”) and contribute
         Business 2 to Controlled in exchange for all of the stock of Controlled and the
         assumption by Controlled of all of Business 2’s liabilities (the “Contribution”).

      2. Distributing will distribute all of the stock of Controlled pro rata to Distributing’s
         shareholders (the “Distribution”).

     Following the Distribution, Distributing will continue to conduct Business 1, and
Controlled will conduct Business 2.

                                      Representations

    Distributing makes the following representations with respect to the Proposed
Transaction:

       1. Except for the issue of whether the absence of income collection prevents
          Distributing’s Business 2 from constituting a “trade or business” within the
          meaning of Treas. Reg. § 1.355-3(b)(2)(ii), the Contribution and the
          Distribution will qualify as a transaction in which no gain or loss is recognized
          to Distributing, Controlled, or Distributing’s shareholders, and no amount is
          included in the income of Distributing’s shareholders, under section
          368(a)(1)(D) and section 355.

       2. Immediately after the Distribution, the fair market value of the gross assets of
          the trade or business in which each of Distributing and Controlled will rely to
          satisfy the active trade or business requirement of section 355(b) will be, in
PLR-103889-18                                6

          each case, at least 5 percent of the fair market value of the total gross assets
          of that corporation. For purposes of determining the fair market value of the
          total gross assets of Distributing and the gross assets of Business 1,
          Distributing and Sub 1 are treated as one corporation.

       3. Immediately after the Distribution, the fair market value of the gross
          investment assets of each of Distributing and Controlled will be less than two-
          thirds of the fair market value of its total gross assets. For purposes of
          determining the fair market value of Distributing’s and Controlled’s gross
          investment assets and total gross assets: (i) Distributing and Sub 1 are
          treated as one corporation; (ii) the term “investment assets” has the meaning
          as defined in section 5.01(3) of Rev. Proc. 2018-3, 2018-1 I.R.B. 130; and (iii)
          no assets have been disposed of or acquired with a principal purpose of
          making this representation.

                                          Ruling

   Based solely on the facts and information submitted and the representations made,
we rule as follows:

       The absence of income collection does not prevent Distributing’s Business 2
       from constituting a “trade or business” within the meaning of Treas. Reg.
       § 1.355-3(b)(2)(ii) for purposes of determining whether the Distribution
       satisfies the active trade or business requirement of section 355.

                                Procedural Statements

       This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

       A copy of this letter must be attached to any income tax return to which it is
relevant. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of this letter.
PLR-103889-18                                  7

         In accordance with the power of attorney on file with this office, a copy of this
letter is being sent to your authorized representatives.


                                           Sincerely,



                                           ___________________________
                                           Russell P. Subin
                                           Senior Counsel, Branch 3
                                           Office of Associate Chief Counsel (Corporate)




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