Companies would face new hurdles in completing tax-free spinoffs of appreciated assets under rules being proposed Thursday by the U.S. Treasury Department.

The government would make it harder for firms to complete some types of spinoffs, though the rules likely wouldn't alter the tax landscape for routine separations of two operating businesses.

The rules provide a numerical standard—5%—for the amount of a spun-off company that must be an active trade or business for the transaction to avoid capital gains taxes. This is known in tax circles as the "hot dog stand" area of the law, for the theory that companies could make a spinoff qualify for tax-free treatment by attaching a tiny fast-food restaurant to a much larger pot of assets.

The rules also attempt to set clearer standards for determining when a spinoff is an impermissible "device" for distributing earnings and profits to shareholders. Under the proposal, the government would look askance at spinoff transactions in which at least two-thirds of one company is made up of nonbusiness assets and the other company has much less.

If there is too big a gap, measured using formulas in the proposed rule, the transaction would be deemed a "device" and would be taxable.

Treasury and the Internal Revenue Service signaled their intention in September 2015 to study this area of the law. The government expressed concerns about what "some taxpayers" were doing with spinoffs that resulted in one company owning a significant amount of cash, stock or other investments.

The government's notice didn't cite any cases specifically, though the most prominent deal being discussed at the time was Yahoo Inc.'s proposed spinoff of its appreciated investment in Alibaba Group Holding Ltd., which it had planned to pair with a much smaller Yahoo operating division. Yahoo later abandoned that plan after the IRS declined to give it advance blessing, creating the risk of a multibillion-dollar tax bill.

The rules being issued Thursday are prospective. They would take effect only after the Treasury Department makes them final, and even then, they wouldn't affect some transactions planned before that date and completed afterward.

Write to Richard Rubin at richard.rubin@wsj.com

(END) Dow Jones Newswires

July 14, 2016 09:05 ET (13:05 GMT)

Copyright (c) 2016 Dow Jones & Company, Inc.
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