Is Income Generation Required for a Business to Qualify as an Active Trade or Business for Successful Section 355 Spin Off? IRS and the Treasury Department are Reviewing.
By Michelle E. Espey, Moritt Hock & Hamroff LLP
Rev. Rul. 57-464 and Rev. Rul. 57-492 have recently been suspended pending completion of a study by the Treasury Department and Internal Revenue Service concerning the five-year, active trade or business requirement that must be met for a business to qualify for a tax-free spin-off under Sec. 355. See Rev. Rul. 2019-09. According to the Internal Revenue Service's September 25, 2018 statement regarding the active trade or business requirement for section 355 distributions, the goal of the study is to determine "whether a business can qualify as an active trade or business if entrepreneurial activities, as opposed to investment or other non-business activities, take place with the purpose of earning income in the future, but no income has yet to be collected."
Section 355(a)(1) of the Internal Revenue Code provides that, if certain requirements are met, a corporation may distribute stock and securities of a controlled corporation to its shareholders and security holders without recognition of gain or loss or income to the recipient shareholders or security holders. One of the requirements is that both the distributing corporation and the controlled corporation be engaged in an active trade or business immediately after the distribution. Sections 355(a)(1)(C) and (b), and §1.355-3(a)(1)(i). Each trade or business must have been actively conducted throughout the five-year period ending on the date of the distributions. Section 355(b)(2)(B) and §1.355-3(b)(3). Although the regulations under section 355(b) provide that an active trade or business “ordinarily must include the collection of income and the payment of expenses,” this interpretation may no longer be suitable.
Over the years, there has been an emergence of entrepreneurial ventures with activities focused on research and development with the purpose of earning income in the future. Entrepreneurial ventures traditionally collect little to no income and incur significant financial expenditures, while day-to-day operational and managerial functions that have historically evidenced an “active” business are performed. The Treasury Department and Internal Revenue Service are now considering guidance to address whether a business can qualify as an active trade or business when income is not immediately generated. The Internal Revenue Service has suspend Rev. Rul. 57-464 and Rev. Rul. 57-492 while this issue is examined, as each ruling could easily be interpreted as requiring income generation for a business to qualify as an active trade or business.
In Rev. Rul. 57-464, the Internal Revenue Service held that the separation of a corporation's manufacturing business from a group of real estate assets did not satisfy the active trade or business requirement. The use of an old factory building for storage "was not in itself the active operation of a business," the rental activities of the corporation "produced only nominal rental" and "negligible" net income, and the properties "were acquired either as an investment or as a convenience to employees of the manufacturing business." In Rev. Rul. 57-492, a corporation engaged in refining, transporting, and marketing petroleum products began a separate operation to explore for and produce oil. The operations incurred significant expenditures but likewise "did not include any income producing activity or any source of income” until less than five years preceding its separation from the primary, refining, transportation, and marketing operation. The Internal Revenue Service held that the exploration and production activities failed to qualify as an active trade or business because, "[before] oil was discovered in commercial quantities…, the venture…did not include any income producing activity or any source of income." Both rulings focus on the issue of income generation.
It is not yet known if the “collection of income” requirement will be modified, withdrawn or expanded or if an exception will be made for business with unique characteristics. As we wait for an answer, the Internal Revenue Service has said that it will entertain requests for private letter rulings regarding the active trade or business qualifications of corporations that have not collected income.
Antitrust Law; Higher Education
Student-Athletes Prevail in Challenge to NCAA Rules Capping Education-Related Financial Support and Benefits
By Alicia Downey
In findings and rulings issued on March 8, 2019, after a 10-day bench trial held this past fall, a California federal judge found that NCAA rules capping benefits that schools may offer to student-athletes were arbitrary, anticompetitive and unlawful. Although she left intact rules capping compensation and benefits unrelated to education, U.S. district judge Claudia Wilken enjoined the NCAA from limiting payments to athletes for education-related expenses (such as undergraduate and postgraduate degree scholarships, computers, science equipment, musical instruments, tutoring and expenses related to studying abroad and internships), finding that the defendants had offered “no cogent explanation for why limits or prohibitions on these education-related benefits are necessary to preserve demand.” Click In re NCAA Athletic Grant-in-Aid Cap Antitrust Litigation (N.D. Cal. March 8, 2019) to download the decision.
Antitrust Law; Trade Regulation
European Commission Fines Google Nearly $1.7 Billion for Abusive Practices in Online Advertising
By Alicia Downey
In a press release issued March 20, 2019, the EC announced its decision to fine Google LLC €1.49 billion (approximately US$1.7 billion) for illegal abuse of Google’s dominant position in the market for online search advertising intermediation. After an investigation that began in 2016, the Commission found that Google maintained its dominant position and effectively prevented competitors such as Microsoft and Yahoo from competing in the online ad market by means of exclusive dealing contracts and other contractual requirements imposed on website publishers. As noted in the press release, this is the third time since 2017 that the EU has levied a multibillion dollar fine on Google for anticompetitive practices.
Mergers & Acquisitions; Antitrust Law
D.C. Circuit Upholds AT&T/Time Warner Merger Victory
By Alicia Downey
On February 26, 2019, in U.S. v. AT&T, __ F.3d __ (D.C. Cir. Feb. 26, 2019), the United States Circuit Court of Appeals for the District of Columbia rejected the Department of Justice Antitrust Division’s appeal from the lower court ruling that cleared AT&T’s acquisition of Time Warner. In affirming the denial of an order enjoining the proposed transaction. the panel cited evidence of dynamic competition from emerging content providers such as Netflix and Hulu, and the failure of the government to contend with the defense expert’s analysis of real-world data for prior vertical mergers in the industry, which showed “no statistically significant effect on content prices.” DOJ has indicated it does not plan to appeal the ruling.
California District Court Upholds Default Rate on Commercial Construction Loan
By Robert K. Olsen, Aldrich & Bonnefin, PLC
In East West Bank v. Altadena Lincoln Crossing, LLC, 2019 U.S. Dist. LEXIS 36200 (C.D. Cal. March 6, 2019), a Los Angeles federal court upheld the validity of a default interest rate on a large commercial construction loan, rejecting assertions by the borrower that the default rate was an improper form of liquidated damages. The United States District Court for the Central District of California reversed an order by the Bankruptcy Court to hold that a default interest rate provision allowing for a 5% increase on a fully matured commercial loan is enforceable under California law.
The court first looked to California precedent to hold that the default interest rate provision was not liquidated damages but rather “alternative performance.” Alternatively the court analyzed the default rate under Cal. Civ. Code Section 1671(b) which provides a presumption of validity for liquidated damages provisions in commercial transactions. According to the court, even if Section 1671(b) applied, the borrower did not meet its burden to rebut the presumption of the default rate’s validity because it could not demonstrate that at the time of contract formation, the increase did not represent a reasonable estimate of the potential harm to East West Bank upon default. The court noted that East West’s imposition of additional fees upon default did not make the added interest a penalty. The court also relied on the testimony of the Bank’s expert as to the diminution in the value of the loan due to the borrower’s default. The District Court’s decision has not been appealed as of this writing.
Private Flood Insurance Rule in the Works
By Robert K. Olsen, Aldrich & Bonnefin, PLC
The FDIC and OCC have each posted a notational private flood insurance (“PFI”) final rule on their websites. If all of the federal banking agencies formally issue this rule, it will implement the 2012 Biggert-Waters Act’s requirement for mandatory acceptance of PFI and will be effective on July 1, 2019. If adopted and published in the Federal Register the rule will require regulated financial institutions in some cases to accept private flood insurance in fulfillment of their obligations under the federal flood insurance regulations. In the meantime, lenders may but are not yet required to accept PFI on designated loans.
U.S. Supreme Court Issues Unanimous FDCPA Opinion
By Anastasia Caton, Hudson Cook, LLP
The U.S. Supreme Court issued its unanimous opinion in Obduskey v. McCarthy & Holthus, LLP, holding that an attorney that engages in nothing more than non-judicial foreclosure is not a “debt collector” under the federal Fair Debt Collection Practices Act. The Court clarified that such attorneys would still be subject to 15 U.S.C. § 1692f(6), which prohibits certain unfair practices, including making false threats to repossess property. Justice Sotomayor filed a concurring opinion, encouraging Congress to amend the FDCPA if it disagrees with the Court’s holding and pointing out that she joined the majority primarily because of the narrow scope of its holding (it only applies to exempt entities that engage in the types of foreclosure activities expressly authorized by law, and is not a “license to engage in abusive debt collection practices”).
CFPB Report on Fair Debt Collection Practices Act Activities
Eric Mogilnicki, Covington & Burling LLP
On March 20, 2019 the CFPB released its annual report to Congress on the Bureau’s administration of the Fair Debt Collection Practices Act (the “FDCPA”). The report describes the Bureau’s supervisory activities over the debt collection market in 2018, including enforcement actions, litigation, consumer outreach, policy research, and rulemaking activities.
This year’s report also incorporates the enforcement activities of the Federal Trade Commission (the “FTC”). The FTC shares enforcement authority with the Bureau over the FDCPA, and the two agencies have coordinated their FDCPA-related activities pursuant to a Memorandum of Understanding signed in February 2019.
Highlights from the 2018 report include:
- The Bureau received approximately 81,500 debt collection complaints in 2018, and contacted companies regarding 51,700 of these complaints. The largest category of complaints related to attempts to collect debt that the consumer reported was not owed (e.g., because it was not the consumer’s debt, or due to identity theft). The second-largest category related to written notices regarding the debt. Most complaints (78%) were closed following an explanation from the company.
- The Bureau filed briefs in two FDCPA-related cases in 2018. One case, Obduskey v. McCarthy & Holthus, LLP, was just decided on March 20. In a 9–0 decision, the U.S. Supreme Court agreed with the Bureau’s position that actions that are required to carry out a non-judicial foreclosure are generally not treated as debt collection under the FDCPA.
- The Bureau brought six public enforcement actions arising from alleged FDCPA violations in 2018. In one such action against National Credit Adjusters, LLC (“NCA”), the Bureau imposed civil money penalties of $6 million after finding that NCA knowingly or with reckless disregard continued to place debt with collection companies that were engaging in illegal debt collection practices. The FTC brought or resolved seven debt collection-related cases in 2018, collectively resulting in nearly $60 million in judgments. * The Bureau’s 2018 consumer outreach activities included the launch of Misadventures in Money Management, an online learning experience intended for ROTC and servicemembers focusing on various personal finance topics.
CFPB Director Kraninger’s Testimony Before the Senate Banking Committee
Eric Mogilnicki, Covington & Burling LLP
Following her March 7, 2019 testimony before the House Financial Services Committee, CFPB Director Kathy Kraninger appeared before the Senate Banking Committee on March 12, 2019.
Democrats on the Committee were highly critical of actions taken by Director Kraninger and former Acting Director Mick Mulvaney. Some of the key moments were as follows:
- Several Committee Democrats criticized former Acting Director Mulvaney's decision to end the Bureau's supervision of Military Lending Act compliance and Director Kraninger's continuation of that policy. Senators Catherine Cortez Masto (D-NV), Jack Reed (D-RI), and Chris Van Hollen (D-MD), in particular, asked for the Bureau to justify its withdrawal from such supervision. Director Kraninger reiterated Mr. Mulvaney's position that Dodd–Frank does not provide the necessary authority, but she refused to provide any supporting legal analysis, citing the "protection of the deliberative process" of the Bureau.
- Committee Ranking Member Sherrod Brown (D-OH) questioned the decision not to dismiss Supervision, Enforcement, and Fair Lending (“SEFL”) Policy Associate Director Eric Blankenstein and suggested that Director Kraninger was tacitly sanctioning his past blog posts. Director Kraninger appealed to “due process” and sought to defer to the ongoing investigation by the Federal Reserve's Inspector General. Sen. Brown argued that the decision of entrusting fair lending enforcement to the originator of “racist statement after racist statement” should not be approached as a question of “due process in a court of law.”
- Senator Elizabeth Warren (D-MA) took issue with the overall level of Bureau enforcement activity following former Director Cordray's departure, stating that the number of enforcement actions has declined dramatically and that new settlements are averaging 1/25th their previous size. Sen. Warren called on Director Kraninger to police the industry more aggressively or to resign.
CFPB Issues ANPR for PACE Loans Rulemaking
Eric Mogilnicki and Sam Adriance, Covington & Burling LLP
On March 4, 2019 the CFPB issued an advanced notice of proposed rulemaking (“ANPR”) on residential Property Assessed Clean Energy (“PACE”) financing. Section 307 of the Economic Growth, Regulatory Relief, and Consumer Protection Act (“EGRRCPA”) amended the Truth in Lending Act (“TILA”) to direct the CFPB to prescribe regulations to (1) carry out the purposes of the Bureau’s existing TILA ability-to-repay (“ATR”) requirements and (2) apply TILA’s general civil liability provision for violations of the ATR rules to PACE loans.
The ANPR requests five categories of information from the public:
- Written materials associated with PACE financing transactions;
- Descriptions of current standards and practices in the PACE financing origination process;
- Information relating to civil liability for violations of the ATR requirements in connection with PACE financing, as well as rescission and borrower delinquency and default;
- Information about what features of PACE financing make it unique and how the Bureau should address those unique features; and
- Views concerning the potential implications of regulating PACE financing under TILA.
The comment period closes on May 7, 2019.
4th Circuit Holds Tax Payment Agreement Subject to TILA and EFTA
Jeffrey T. Karek, Maurice Wutscher LLP
The U.S. Court of Appeals for the Fourth Circuit recently held that a tax payment agreement (“TPA”) entered into pursuant to Virginia Code was a consumer credit transaction subject to federal Truth in Lending Act (“TILA”) and Electronic Funds Transfer Act (“EFTA”). In reaching its ruling, the Fourth Circuit noted that although credit has been defined to generally exclude tax liens and tax assessments in the official CFPB interpretation of TILA’s implementing regulation (“Staff Commentary”), the Staff Commentary clarifies that “third-party financing of such obligations (for example, a bank loan obtained to pay off a tax lien) is credit for the purposes of the regulation.”
The Court determined that the TPA provided for third-party financing of a tax obligation because the defendant agreed to pay the plaintiff’s taxes in exchange for installment payments, and because it created third-party obligations between the defendant and plaintiff. The Fourth Circuit further held that the plaintiff had Spokeo standing to assert his EFTA claim, because the claim that the TPA required him to consent to an electronic fund transfer (“EFT”) authorization when he entered into it, and allegedly waived his right to cancel preauthorized EFTs as required by EFTA, was not merely for “a bare procedural violation,” but instead alleged “a substantive violation of the rights conferred by EFTA.”
House Democrats Request Documents Regarding CFPB Settlements
By Eric Mogilnicki and Lucy Bartholomew, Covington & Burling LLP
On February 7, 2019, Reps. Maxine Waters (D-Calif.) and Al Green (D-Tex.) requested documents from Director Kraninger regarding recent Bureau settlements that have not required companies to pay restitution to consumers. In particular, the House Representatives requested documents regarding the Bureau’s settlements with: * NDG Financial Corp., where the Bureau required neither a civil money penalty nor restitution from the company for alleged misrepresentations related to loan repayment amounts when an obligation did not exist under state law; * Sterling Jewelers Inc., which agreed to pay the Bureau a $10 million civil money penalty for allegedly enrolling customers in payment protection insurance without adequate consent, but where the Bureau did not require the company to pay restitution to consumers; and * Enova International, Inc., which agreed to pay the Bureau a $3.2 million civil money penalty for allegedly debiting consumers’ bank accounts without authorization, but where the Bureau did not require the company to pay restitution to consumers.
Reps. Waters and Green noted that they were “deeply troubled that the Consumer Bureau would allow a company to keep the profits they made from their illegal sales practices” and that “[t]he Committee [on Financial Services] has serious concerns with how the Consumer Bureau is exercising its enforcement authority.” The Representatives have requested documents by no later than March 5, 2019.
22 State AGs Oppose Fintech Sandbox and No-Action Letter Proposals
By Eric Mogilnicki and Luis Urbina, Covington & Burling LLP
On February 11, 2019, twenty-two state attorneys general (“AGs”) (all Democrats) wrote to CFPB Director Kraninger opposing the Bureau’s fintech sandbox proposal and the Bureau’s proposed new No-Action Letter (“NAL”) policy. Led by New York Attorney General Letitia James, the AGs argued against the proposals on both substantive policy and administrative procedure grounds. The AGs argued that the NAL proposal would result in indefinite and binding NALs, which would be especially undesirable in the context of novel and sophisticated technologies. The AGs also argued that the NAL policy would cover too broad a list of legal issues (such as UDAAP) and entities (such as trade associations). The letter stated that the proposed streamlined process would likely result in the Bureau granting NALs “hastily” and without adequate information.
The AGs expressed similar concerns with the Bureau’s sandbox proposal and argued that the Bureau lacks the statutory authority to grant immunity from state enforcement actions and private lawsuits, as proposed. Here too, the AGs’ letter emphasized the uncertainty involved with new technologies and suggested that the 2008 financial crisis was caused in part by regulators embracing market innovators too enthusiastically. The AGs argued that both proposals require notice-and-comment rulemaking under the Administrative Procedure Act. Noting that the CFPB described the NAL proposal as consisting of “substantive revisions,” and the relief contemplated under the sandbox proposal as “legally binding,” the letter stated that “[c]ourts have consistently held that agency rules altering the substantive standards the agency applies in determining whether to take discretionary actions are subject to the APA’s rulemaking procedures.”
Altogether, the letter strongly suggests that the proposals, if finalized, are likely to meet swift legal challenges from at least some state AGs.
CFPB Releases Proposed Revisions to Payday Lending Rule
By Eric Mogilnicki and Lucy Bartholomew, Covington & Burling LLP
On February 6, 2019, the CFPB released its much-anticipated proposed amendments to the payday lending rule. The proposed revision is Bureau Director Kathy Kraninger’s first major regulatory initiative since becoming the director of the CFPB. The amendments would: (i) repeal the mandatory underwriting provisions in the payday lending rule and (ii) delay the compliance date for those provisions until November 19, 2020, which would allow the Bureau to consider comments and issue a final rule before the underwriting provisions take effect. The Bureau’s proposed revisions would not amend or delay the effective date of the payment provisions of the payday lending rule, although the preamble to one of the proposed rules makes clear that the Bureau may separately consider whether revisions to the payment requirements are appropriate.
CFPB Publishes Complaint Snapshot
By Eric Mogilnicki and Sam Adriance, Covington & Burling LLP
On January 29, 2019, the CFPB published a Complaint Snapshot focusing on mortgages. As the report notes, the Bureau considers “collecting, investigating, and responding to consumer complaints” as “[o]ne of its primary functions.” Snapshots provide a “high-level overview of trends in consumer complaints,” and can provide insight into areas that may see future Bureau action. The Snapshot notes that:
- In the 24 months ending with October 31, 2018, approximately 11% of complaints the Bureau received were about mortgages.
- The most common categories of mortgage complaints were “trouble during payment process” (42 percent) and “struggling to pay mortgage” (36 percent).
- There were 15 percent fewer mortgage complaints from August 2018 to October 2018 compared to August 2017 to October 2017.
More broadly, the Snapshot also notes that the largest increase in complaint volume over the last year was in complaints related to checking/savings accounts, and the largest decrease was in complaints related to student loans.
CFPB Releases Sixth Annual Report of the Office of Servicemember Affairs
Eric Mogilnicki and Aimee Ezzell, Covington & Burling LLP
On January 24, 2019, the CFPB released the sixth annual report from the Bureau’s Office of Servicemember Affairs (“OSA”). The OSA works to educate servicemembers, veterans, and military families (collectively, “servicemembers”) so that they can make better informed decisions regarding consumer financial products and services. The OSA also monitors and analyzes complaints by servicemembers in order to provide data and analysis regarding issues confronting servicemembers in in the financial marketplace.
For this reporting period, there were approximately 48,800 complaints filed by servicemembers, the majority of which were credit or consumer reporting complaints (37%), followed by complaints about debt collection (26%) and mortgages (11%). The report also identifies the following as emerging issues and continuing trends revealed by the complaints: (i) medical, telecommunications, and VA debts on servicemembers’ credit reports; (ii) student loan servicing obstacles; and (iii) automobile add-on products in the car buying process.