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.

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