United States: Key Tax Considerations In Spin-Offs

A critical consideration in the disposition of any business is the tax cost.  If properly structured, a disposition structured as a spin-off can be tax free to both the distributing corporation and its stockholders, while at the same time permitting the distributing corporation to pay down debt or buy back its stock, which otherwise would utilize the company's cash.  In contrast, federal and state corporate tax in excess of 40 percent (depending on the state) is imposed on a more straightforward sale by a corporation of a business unit.  The stockholders also are subject to tax if the corporation distributes the proceeds as a dividend or in redemption of some of its stock.  Numerous requirements must be satisfied to obtain the tax-advantaged treatment of a spin-off at both the corporate and stockholder level.  This article sets forth some of the more critical tax considerations associated with a spin-off transaction.  Of particular note, the Internal Revenue Service (IRS) recently announced that it will no longer provide rulings on certain critical aspects of spin-off transactions, a move which may leave taxpayers with less certainty than desired regarding the tax consequences when engaging in such a significant transaction.

Legal Opinion or Private Letter Ruling 

A threshold question for any corporation undertaking a spin-off transaction is whether to obtain a tax opinion from counsel or seek a private letter ruling from the IRS.  The stakes are usually very high.  If the distribution of the stock of the controlled corporation does not qualify for tax-free treatment, the distributing corporation pays tax on the gain, and the recipient stockholders are taxable on the receipt of the controlled corporation stock.  Often the gain inherent in controlled corporation stock is significant.  Additionally, although the dividend to the stockholders generally should qualify for the lower qualified dividend rate, the stockholder generally will not be able to offset the gain with any basis the stockholder may have in the stock of the distributing corporation.  Further, because a spin-off transaction is generally not coupled with a liquidity event, there is no cash generated in the transaction to fund the resulting income taxes. 

The decision whether to obtain a ruling often is dictated by time constraints and the level of certainty required.  If the distributing corporation is publicly traded, a ruling may be required.  Even if a tax opinion is the chosen route, there often may be specific issues for which a ruling is sought, either because a legal opinion at the desired level is not feasible or the issue is one on which the IRS will rule but for which it is difficult to render an opinion.  Similarly, in most cases where a ruling is obtained, one or more tax opinions also are obtained because there are certain issues on which the IRS will not provide a ruling (for example, the IRS will not issue a ruling that the spin-off satisfies the business purpose requirement).  Unfortunately, recent IRS guidance expands the list of issues for which the IRS will not provide a ruling, resulting in less certainty available to taxpayers.  Further, although recently the IRS sought to provide spin-off rulings in 10 weeks (provided the taxpayer complied with certain requirements, including timely providing information to the IRS), the IRS recently abandoned the 10-week program, leaving the timing of an IRS ruling more uncertain.

Pre-Transaction Restructuring 

In most cases, the separation of one or more businesses in a spin-off transaction requires significant restructuring to align the separate businesses.  These restructuring transactions often involve multiple legal entities, both U.S. and non-U.S., which often operate both the distributing and controlled businesses.  The separation of these businesses raises issues under U.S. and non-U.S. tax law.  For example, a U.S. parent corporation may have an international structure with a single operating subsidiary in each of the relevant jurisdictions.  If each of these entities operates both the distributing and controlled businesses, the businesses must be separated from each legal entity prior to the spin-off.  Often it is desirable to form a new subsidiary to hold the separated business.  However, the legal, tax and regulatory regimes in each of these jurisdictions must be carefully analyzed, in addition to U.S. tax issues.  One transaction that often occurs in connection with a spin-off may raise what has become known as a "north-south" issue.  Simply put, this transaction involves the contribution of certain assets to a subsidiary (the south portion), in conjunction with a distribution of property, generally stock of a lower-tier subsidiary from the recipient corporation (the north portion).  The concern is that the properties are treated as transferred in exchange for one another, creating an unintended taxable event.  Historically, the IRS provided comfort to taxpayers via private letter rulings that the north and south transaction would not be integrated to create a taxable event, provided that the taxpayer was able to make certain representations.  However, effective for 2013, the IRS announced that it would no longer provide rulings on this issue.  Thus, taxpayers are left with more uncertainty as to the treatment of these critical pre-spin-off transactions and likely will seek advice of counsel. 

For many spin-offs, the pre-transaction restructuring steps garner the most time and cost, particularly the restructuring steps involving non-U.S. businesses.  Companies considering a spin-off should create an efficient work plan early in the process to manage the restructuring steps, utilizing the correct team of advisors to assist in the process. 

Capital Structure 

One of the requirements for a tax-free spin-off is that the distributing corporation must distribute "control" of the controlled corporation.  Control is defined as stock constituting 80 percent of the voting stock and 80 percent of all other classes of stock.  If the distributing corporation owns less than 80 percent of the overall value of the stock of the controlled corporation, it often can recapitalize shortly before the transaction to achieve the requisite 80 percent ownership by using high-vote/low-vote stock.  Generally, nothing precludes converting the stock back to a single class of voting stock.  Notwithstanding the "temporary" nature of the "control," the IRS generally has blessed this approach in private letter rulings, notwithstanding that it may have been difficult for counsel to provide a tax opinion at the desired level.  This is no longer the case.  T

he IRS announced in early 2013 that it would no longer rule on whether the control requirement is satisfied if, in anticipation of the spin-off, (i) the distributing corporation acquires control of the controlled corporation in any transaction involving an exchange of higher-vote stock for stock with lesser voting power, or (ii) the controlled corporation issues stock with a different voting power per share than the stock held by the distributing corporation.  As a result, the certainty that taxpayers historically could obtain from the IRS has been significantly limited, and taxpayers likely will rely on advice of counsel to determine whether these transactions will be respected in connection with the spin-off.

Establishing the capital structure of the distributing and controlled corporations is critical.  It is often desirable for the distributing corporation to retire a portion of its outstanding debt securities by transferring certain debt securities of the controlled corporation to its security holders.  These debt-for-debt exchanges can be structured to be tax-free to the distributing corporation.  Under current law, these debt-for-debt exchanges can be accomplished in a tax-efficient manner without regard to the tax basis the distributing corporation has in the stock of the controlled corporation; however, there have been legislative efforts to limit this type of exchange.  Often the debt-for-debt exchange utilizes a financial intermediary that purchases the distributing corporation's debt on the public market, receives the controlled corporation's debt securities in exchange for the newly purchased distributing corporation securities, and sells the controlled corporation's debt securities on the public market.  These transactions raise a number of technical questions under the spin-off rules.  In recent years, the IRS provided guidance in private letter rulings that permitted these transactions on a tax-free basis, including permitting the new issuance of distributing corporation debt prior to, and in contemplation of, the spin-off, provided the taxpayer could demonstrate certain facts and make certain representations.  However, in early 2013, the IRS announced that it would no longer rule on the tax-free nature of a distribution of controlled corporation debt securities in exchange for distributing debt securities, if the distributing debt securities are issued in anticipation of the spin-off.  However, it is believed that the IRS will continue to rule on transactions in which financial intermediaries acquire distributing debt securities from third parties and then such securities are exchanged for debt securities of the controlled corporation.

Tax Sharing/Matters Agreements 

In connection with a spin-off, it is common for the distributing and controlled corporations to enter into an agreement that governs the responsibility for taxes.  This agreement is commonly referred to as a "tax sharing agreement" or "tax matters agreement."  The label "tax matters agreement" often is chosen to avoid having two key spin-off agreements (the transition services agreement and the tax sharing agreement) with the acronym TSA.  The agreement generally governs the responsibilities and rights of the parties following the spin-off with respect to known tax liabilities, unknown/contingent tax liabilities, tax return preparation and filing, tax audits, tax controversies and tax attribute utilization.  In addition, the agreement generally prohibits certain post-transaction acts that could jeopardize the intended tax-free nature of the spin-off. 

Many different approaches have been adopted.  For example, if the businesses historically have been separately operated in separate corporate entities, it is often the case that the distributing and controlled corporations each will assume the tax liabilities associated with their respective businesses, and in turn, retain power over tax returns, audits and controversies related to those liabilities.  However, where businesses have been historically operated as divisions of a single corporation, it is not uncommon to see an agreement that assigns all historic liabilities to the distributing corporation (particularly if the distributing corporation is larger), with the distributing corporation maintaining control of tax returns, audits and controversies (generally with input and cooperation of the controlled corporation).  In many cases, the end result falls somewhere in between these two approaches.  Companies engaging in a spin-off should recognize that they will have to live, often for many years, with the agreement they adopt.  Thus, careful consideration should be given to the level of granularity of the agreement.  While it is often tempting to attempt to solve any potential issue that could arise, in many cases this is not practical and results in the companies having far more interaction than desirable or anticipated at the time of the spin-off.  The process of drafting an agreement can become contentious (even though the companies are not yet separated) if there are clear divisions within the company advocating for each of the soon-to-be-separated companies.  However, often conflict can be avoided with an initial understanding that the goal of the agreement is to maximize stockholder value and consistency with other inter-company agreements (e.g., the separation and distribution agreement). 

Sales in Connection with Spin-Offs 

In many cases, the rationale for a spin-off is that holding disparate businesses does not maximize investment return under a single corporate structure.  For example, a single corporation may operate a high-growth international business and simultaneously operate a more mature U.S. business with stable cash flows but lower growth opportunities.  The separation of the businesses is often believed to maximize the prospects (and, in turn, the stock trading price in the case of public companies) for each.  In many cases, one or both of the distributing or controlled corporations may be attractive to potential acquirors.  Section 355(e) prevents the avoidance of corporate-level tax for dispositions of 50 percent or more of the distributing or controlled corporation stock that are undertaken as part of the same plan that includes the spin-off.  The rationale for this rule is to prevent corporations that desire to sell a business from undertaking a spin-off in order to avoid the corporate-level tax.  The regulations under section 355(e) contain a number of factors that are used to determine whether a sale is part of the plan that included the spin-off.  In addition, the regulations contain certain safe harbors that can be satisfied to avoid the application of section 355(e).  The regulations contain a presumption that a sale is part of the same plan that includes the spin-off if the sale occurs within two years of the spin-off.  The taxpayer must rebut this presumption through factual proof that no such plan existed.

Companies engaging in a spin-off should carefully consider those facts that could be subsequently used to show the existence or absence of a "plan," including any level of discussion of a potential sale.  Similarly, companies considering the acquisition of a target that was recently part of a spin-off (i.e., within the previous two years) should carefully consider the application of section 355(e) and the possibility of inheriting certain tax liabilities associated with the spin-off.  Note that the IRS will not provide a ruling as to whether a sale of the distributing or controlled corporation is part of the same plan that includes a spin-off.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.