SPIN-OFFS
An Overview
John R. Allender, Head of Tax, US
Kevin Trautner, Partner, M&A/Securities
Fulbright & Jaworski LLP
December 12, 2013
79289972.4
Speaker
John R. Allender
Head of Tax, United States – Partner
Jack's practice focuses on taxation and corporate matters with an
emphasis on federal income taxation. Jack is frequently involved in the
planning and negotiation of mergers and acquisitions, corporate
restructuring, spin-offs, tax planning for corporations and individuals
and selected tax controversy matters. He has significant experience in
federal tax matters relating to corporate taxation, reorganizations,
incorporations, consolidated tax returns and related tax issues.
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Speaker
Kevin Trautner
Partner
Kevin Trautner has a broad-based corporate and securities practice with
extensive experience in mergers and acquisitions and securities offerings.
Kevin represents buyers and sellers in mergers and in stock and asset
purchases. He also represents issuers, including master limited
partnerships, and underwriters in a variety of public and private debt and
equity securities offerings, including IPOs, debt offerings under Rule
144A, and shelf debt and equity offerings. He regularly counsels public
companies on securities law compliance and corporate governance
matters.
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What is a tax-free spin-off?
A tax-free spin-off is a corporate transaction whereby a corporation
(“Parent”) distributes to its stockholders shares of stock of a
subsidiary corporation (“Spinco”) representing at least 80% of the
voting power of all shares entitled to vote and 80% of the shares of
each other class of stock of Spinco in a transaction described in
section 355 of the Internal Revenue Code of 1986, as amended
(the “Code”).
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The most common types of spin-offs and split-offs
A classic spin-off transaction would involve a distribution of the Spinco stock
by Parent, pro-rata to the Parent stockholders. A recent spin-off transaction
involved ConocoPhillip’s distribution of one-half share of stock of Phillips 66
with respect to each outstanding share of ConocoPhillips stock.
Stockholders
After Spin-off
Distribution of
Spinco stock
Stockholders
Parent
Parent
Spinco
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Spinco
The different types of spin-offs and split-offs
A classic split-off is a variation of a spin-off where instead of a prorata distribution of Spinco stock to Parent stockholders, the Parent
stockholders have to make a decision as to whether they keep their
Parent stock or choose to exchange that stock for Spinco stock. In
a split-off, Parent stockholders have the right to elect to receive
Spinco stock in exchange for their Parent stock or to retain their
Parent stock. Thus, a split-off involves a non pro-rata distribution of
Spinco stock, while reducing the number of outstanding shares of
Parent. A recent example of a split-off is Pfizer’s distribution of
approximately 402 million shares of Zoetis common stock in
exchange for approximately 405 million shares of Pfizer common
stock.
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The different types of spin-offs and split-offs
After Split-off
Stockholders
Parent
Parent
Spinco
Stockholders
Stockholders
Distribution of
Spinco stock
to electing
stockholders
Parent
Spinco
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Spinco
Why consider a spin-off?
• To divide the businesses into separate companies so they may
operate more efficiently; the sum of the parts should be worth
more than the whole.
• To simplify the businesses to make it easier for outsiders to
evaluate and potentially to reduce financing costs.
• To separate disparate /conflicting businesses.
• To provide an opportunity to incentivize management of each
respective business with ownership or stock options in the specific
businesses they are managing.
• Hedge fund activism or competitive pressures may serve as
catalyst for corporate clarity.
• Often a more tax-efficient and lower execution risk relative to a
sale.
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Overview of tax consequences of a spin-off
• Successful tax-free spin-off
– A successful tax-free spin-off under section 355 of the Code will be tax-free to
Parent, Spinco and the Parent stockholders, whether structured as a spin-off or
as a split-off.
• Failed taxable spin-off
– If a spin-off fails to meet the requirements of section 355, the distribution by
Parent of Spinco stock to Parent stockholders will be taxable to Parent to the
extent the fair market value of the Spinco stock exceeds Parent’s tax basis in
such stock and will be taxable to the Parent stockholders upon the receipt of
the Spinco stock. If the distribution is a pro-rata failed spin-off, the distribution
would generally be treated as a taxable dividend to the Parent stockholders
equal to the fair market value of such stock. If the transaction is structured as a
split-off, the distribution will be treated as a taxable redemption of Parent stock
for Spinco stock and will be taxed to Parent stockholders as either capital gain
or a dividend, depending on whether certain tests under section 302 of the
Code are satisfied.
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Overview of tax consequences of a spin-off (continued)
– As a result, a spin-off that fails to qualify under section 355 of the Code can
result in double taxation, once to Parent and once to the Parent stockholders.
As a result of the potential for significant tax costs of a failed spin-off, there is a
lot of pressure on corporate advisors to insure that a spin-off qualifies as taxfree.
• IRS private letter rulings
– Since failure to qualify as tax-free can result in double taxation, historically
many corporations have requested private letter rulings from the IRS to provide
assurances that a spin-off is tax-free. Over the years, the IRS has reduced the
number of spin-off related tax issues on which it would rule, but recently the
IRS has changed its policy and has determined that it will not issue a private
letter ruling on spin-offs under section 355 of the Code. As a result, private
letter rulings are generally not available on spin-off transactions, and
corporations will, in most situations, request favorable tax opinions from their
advisors before proceeding with a spin-off.
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Tax requirements for a spin-off
• Parent must distribute all of the shares of Spinco that it owns to its
stockholders, and those shares must represent “control” of
Spinco. Control consists of shares of stock representing 80% of
the total combined voting power of all shares entitled to vote and
80% of the total number of all shares of other classes of stock of
Spinco.
• Immediately after the distribution, both Parent and Spinco must be
engaged in the active conduct of a trade or business which must
have been actively conducted for five (5) years prior to the spinoff.
• The spin-off cannot be a device for the distribution of earnings and
profits of either Parent or Spinco.
• There must be a non-tax corporate business purpose for the spinoff (not a stockholder business purpose).
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Tax requirements for a spin-off (continued)
• After a spin-off, one or more persons who directly or indirectly
were owners of Parent before the spin-off must own in the
aggregate an amount of stock which would satisfy the continuity of
interest in each of Parent and Spinco.
• Parent and Spinco must continue to operate the business existing
prior to the spin-off.
• A 50 percent or greater interest in stock in Parent or Spinco could
not have been acquired by purchase during five-year period
ending on date of distribution. (355(d))
• Distribution cannot be part of a plan pursuant to which one or
more persons acquire directly or indirectly a 50-percent or greater
interest in Parent or Spinco. (355(e))
• A 50 percent or greater interest means stock possessing at least
50 percent of the total combined voting power of all classes of
stock entitled to vote or 50 percent of the total value of all classes
of stock.
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Corporate mechanics of a spin-off
• Assets and liabilities are transferred into Spinco to be spun-off
• In connection with a spin-off/split-off transaction, Parent often
wishes to allocate a portion of its existing debt to Spinco because
such debt was used to finance Spinco’s businesses or because
Parent wishes to extract value from Spinco
• Desired capital structure typically can be achieved through a
combination of the following:
– Contributions by Parent or distributions by Spinco of cash,
– Assumption by Spinco of Parent debt (if permitted by the terms thereof),
– Debt-for-debt exchanges, and
– Stock-for-debt-exchanges
• If the value to be extracted from the business to be distributed
exceeds Parent’s tax basis therein, Parent is at risk of recognizing
taxable income or gain
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Corporate mechanics of a spin-off (continued)
• Under SEC interpretive guidance set forth in Staff Legal Bulletin
No. 4 (“SLB 4”), a typical spin-off may be undertaken without
registration under the Securities Act
• SLB 4 sets forth five conditions that must be satisfied in order to
qualify for this treatment:
– Stockholders of Parent must not provide consideration for the spun-off shares
of Spinco
– A transfer by Parent of Spinco shares for value would constitute a “sale”
under the Securities Act, and therefore would come within the registration
requirements under Section 5 of the Securities Act absent another available
exemption
– In a conventional spin-off, Spinco shares are distributed by dividend to Parent
stockholders, and thus the stockholders do not provide any consideration in
the transaction
– The spin-off distribution must be pro-rata to Parent stockholders
– In a spin-off distribution that is not pro rata, the relative interests of Parent
stockholders in Spinco change and
– Some stockholders thereby give up value in the transaction, requiring
Securities Act registration
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Corporate mechanics of a spin-off (continued)
– Parent must provide adequate information about the spin-off and Spinco to its
stockholders and to the trading markets
– SLB 4 guidance varies depending upon whether Spinco is a reporting entity
under the Exchange Act prior to the transaction or whether it is domestic or
foreign
– For a Spinco that is a non-reporting company, Parent gives its stockholders
an information statement that describes the spin-off and complies with
Regulation 14A or Regulation 14C and Spinco registers the spun-off
securities under the Exchange Act
– Accomplished by filing with the SEC a Form 10 Registration Statement to
which the 14C-compliant information statement is attached as an exhibit
– Content of the Form 10/information statement is substantially similar to
content required for a Form S-1 Registration Statement, and SEC review
process is substantially the same
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Corporate mechanics of a spin-off (continued)
– Parent must have a valid business purpose for the spin-off
– If Parent is spinning off “restricted securities” (as defined in Rule 144), it must
have held those securities for at least two years
– Does not apply in circumstances in which Parent formed the subsidiary being
spun-off
• From a Securities Act perspective, a split-off transaction is a sale
of Spinco securities for consideration consisting of securities of
Parent, and accordingly it is subject to registration under the
Securities Act absent an available exemption
– Section 3(a)(9) of the Securities Act, which permits (subject to certain
conditions) unregistered exchanges of securities of an issuer with its existing
security holders, is not applicable in the split-off context because the identity-ofissuer requirement of Section 3(a)(9) is not met
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Corporate mechanics of a spin-off (continued)
– Transaction is registered under the Securities Act on Form S-4
– Also typically constitutes a tender offer by Parent for its own shares and
therefore is subject to the tender offer rules
• Generally, no stockholder approval is required, unless the spun-off
business constitutes “all or substantially all” of the assets of
Parent
• Tax considerations in restructuring corporate assets.
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Economics of a spin-off
• Corporate activists often push to break up the companies (often
through spin-offs) on the theory that the value of the parts is
greater than the value of the whole. Independent studies have
supported this theory.
• Some spin-offs have been structured to closely resemble a sale,
by having Spinco borrow substantial sums and distribute the cash,
but not the debt obligation, to Parent before the spin-off, the socalled “leveraged spin-off.” Depending on the particular
circumstances of Parent and Spinco, if carefully structured, even
though Parent receives a cash dividend before the spin-off, there
may be no taxable gain on the spin-off where a sale could
generate tax. The IRS has begun focusing more on leveraged
spin-offs.
• Simplifying a corporate structure or business can make financial
statements more transparent and, as a result, reduce borrowing
costs.
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Variations of approach
• Straight forward spin-off of Spinco
– This would be a process of dividing the assets and liabilities of the respective
businesses along business lines without any aggressive allocations, and in the
spin-off distributing 100% of Spinco stock.
• IPO 19.9% of common stock then spin-off the remaining 80.1%
– Parent is required to distribute control of Spinco in a spin-off to qualify under
section 355 of the Code. One common technique utilized by a distributing
corporation in spin-offs in order to receive some tax-free cash is to have an IPO
of Spinco stock before the spin-off, selling 19.9% of its common stock to the
public (leaving Parent with 80.1% of the stock to distribute in the spin-off). The
cash proceeds of the IPO are then distributed to Parent pursuant to a
previously declared dividend or in repayment of intercompany indebtedness.
After which, Parent spins-off Spinco by distributing to its stockholders the
80.1% of the stock of Spinco which it had retained.
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Variations of approach (continued)
• Leveraged spin
– This approach would involve Spinco borrowing significant sums from third party
lenders and using the proceeds to pay dividends to Parent or to repay
intercompany indebtedness. Spinco would continue to be liable on such
indebtedness. To the extent that Parent borrowings have been used to fund
Spinco operations, repayment of those amounts should be tax-free. To the
extent that Spinco borrows money to pay dividends to Parent, those dividends
are tax-free to Parent to the extent that Parent has tax basis in its shares of
Spinco stock. This dividend approach effectively permits Parent to recover its
investment in Spinco by receiving a cash distribution before the spin-off. To the
extent that dividends from Spinco to Parent exceed Parent’s tax basis in its
Spinco stock, that excess creates an excess loss account (essentially negative
basis) with respect to the Spinco stock. When the Spinco stock is distributed in
the spin-off, that excess loss account is triggered as income to Parent.
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Variations of approach (continued)
• Debt securities exchanges
– In addition to the structures described above, section 355 of the Code permits
debt securities of Spinco to be exchanged tax free for debt securities of Parent
when done as part of a transaction otherwise qualifying under section 355 of
the Code. This approach is logical where Parent has used the public debt
markets to finance the operations of all of its subsidiary businesses and this
type of exchange permits an allocation of that indebtedness among Parent and
Spinco. This approach is not limited to the Parent’s basis in its subsidiary
stock. The exchange of debt securities must be in the open market and would
normally involve an investment bank purchasing Parent debt securities in the
public market and exchanging those debt securities for Spinco debt securities.
The bottom line impact is that Parent’s outstanding debt securities decrease
and Spinco’s debt securities increase.
See Verizon’s spin-off of Idearc.
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Board matters
• Parent Board decisions are afforded the protection of the business
judgment rule if basic fiduciary duties are observed:
– Duty of Care: Directors must be well-informed and exercise appropriate
diligence and must take the steps a reasonably prudent director would take
about decisions facing the Board.
– Duty of Loyalty: Directors’ actions must be motivated solely by the best
interests of the company and its stockholders; they must be disinterested,
independent and act in good faith.
– If the directors have made the decision to cause the spin-off in compliance with
their fiduciary duties, acting in good faith and with the belief that the action was
taken in the best interests of the stockholders, the directors will be protected by
the business judgment rule.
– Parent does not owe fiduciary duties to Spinco.
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Board matters (continued)
– Directors must act in the best interests of a corporation’s stockholders, but
Spinco as a solvent wholly-owned subsidiary, only has the Parent as a single
stockholder. A director of Spinco need not be loyal to Spinco as against the
Parent. Directors of Spinco are obligated only to manage the affairs of Spinco
in the best interests of Parent and its stockholders. (See Anadarko Petroleum
Corp. v. Panhandle Eastern Corp. (Del. 1988)).
– Parent Board can make unilateral decisions as to the allocation of assets and
liabilities between Parent and Spinco, subject to insolvency and tax
considerations, before the spin-off is completed.
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Key Agreements
• Separation and Distribution Agreement
– Identifies assets to be transferred, liabilities to be assumed and contracts to be
assigned to Spinco and Parent to implement the separation; generally, no
representations or warranties – assets transferred as is, where is.
– Liabilities allocated and reinforced through cross-indemnities.
• Tax Sharing Agreement
– Governs rights and obligations of the Parent and Spinco after the spin-off with
respect to taxes.
• Employee Matters Agreement
– Allocates liabilities and responsibilities relating to employment matters,
employee compensation and benefit plans.
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Key Agreements (continued)
• Transition Services Agreement
– Spinco often relies on Parent for back office functions like payroll, legal, IT and
human resources
– Parent or Spinco need to negotiate which entity will retain existing services and
which entity rebuilds.
– Typically Parent and Spinco enter into a Transition Services Agreement, with
Parent continuing to provide these services for a period of time post-closing for
an arms-length fee, so that Spinco will have time post-closing to transition to its
own services.
– Duration usually not more than 24 months.
– Should be limited to support functions.
• Agreements favor Parent; Spinco management leverage
• Counsel for Spinco. (See Conoco Inc. v. Skadden, Arps.)
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Tax sharing agreement
• An agreement to allocate responsibilities relating to tax issues is
an important part of any spin-off and can be one of the most
complex agreements signed in connection with a spin-off.
Generally, Parent and Spinco join in filing a consolidated federal
income tax return for years prior to the spin-off. That joint filing
ends on the date of the spin-off, and the tax sharing agreement
will cover things like allocation of responsibility for taxes,
payments for tax benefits, tax return filing responsibility, tax audit
issues, tax controversy responsibility, and settlement of tax issues.
These agreements can be relatively straightforward (i.e., Parent
agrees to pay all pre-closing taxes) to very aggressive and
complex (Spinco pays Parent for its pre-closing taxes; all tax
benefits can be utilized by Parent without reimbursement, Parent
controls all tax audits and Spinco pays all taxes arising out of tax
audits with little or no opportunity to defend). Disputes relating to
Tax agreements may give rise to more litigation than any other in
a spin-off transaction.
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Tax sharing agreement (continued)
The more complex and/or aggressive the Tax Sharing Agreement
is, the greater the likelihood a dispute will arise. Those disputes
can go beyond just the parties and can spill over to legal counsel.
(See Conoco Inc. vs. Skadden, Arps.)
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Other spin-off tax issues (355(e) and 355(d))
• Sections 355(d) and 355(e) create exceptions to the general rule
under section 355(a) that Parent will not recognize taxable income
on the distribution of appreciated Spinco stock. These exceptions
do not affect the tax-free receipt of Parent stock by Parent
stockholders in a transaction otherwise qualifying under section
355. The focus of these two Code sections is to not permit the
avoidance of gain recognition under section 311(b) of the Code,
through a step transaction using section 355.
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Other spin-off tax issues (355(e) and 355(d)) (continued)
• Section 355(d) was aimed at overturning the result of the Esmark
case. In that situation, Mobil was interested in acquiring a specific
business owned by Esmark, but Esmark did not want to bear the
tax consequences of an asset sale. Mobil purchased from
Esmark a substantial equity interest in Esmark and subsequently,
in a split-off transaction, Esmark distributed all the stock of the
desired subsidiary to Mobil in exchange for the Esmark stock held
by Mobil. Thus, Esmark sold Esmark stock to Mobil for cash
without recognizing gain then spun off a subsidiary to Mobil, again
without recognizing gain. The IRS claimed the transaction should
be characterized as a sale of the subsidiary’s stock and taxable.
The Tax Court held that the transaction satisfied section 355 of the
Code, and Esmark did not recognize any taxable gain on the
transaction. Section 355(d) generally applies where any person
purchases a 50% interest in either Parent or Spinco during the 5year period preceding the spin-off Thus, 355(d) would effectively
reverse the holding of the Esmark case.
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Other spin-off tax issues (355(e) and 355(d)) (continued)
• Section 355(e) would apply to require Parent to recognize gain on
a transaction otherwise qualifying as a section 355 spin-off where
as part of a plan a third party acquires control (50% of vote or
value) of Parent or Spinco. A plan is presumed to exist if this
acquisition occurs within the 4-year period beginning two (2) years
before the spin-off and ending two (2) years after the spin-off;
however, the treasury regulations in section 1.355-7 provide a
number of safe harbor exceptions to the application of section
355(e).
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Other spin-off tax issues (355(e) and 355(d)) (continued)
– Section 355(e) applies whether the acquisition of the 50% interest is in a
taxable or tax-free transaction. One technique that has been used is to
structure the acquisition of the interest in Parent or Spinco as a tax-free
reorganization where the Parent stockholders continue to own in excess of 50%
of the vote and value of the entity.
– In order to apply, Section 355(e) requires that the acquisition of the 50%
interest must be part of a plan which includes the spin-off. Another approach to
avoiding the requirements of section 355(e) is reliance on the safe harbors
found in Treas. Reg. section 1.355-7. For example, the often called “Super
Safe Harbor” provides that for a post-spin-off acquisition to be considered part
of a plan, it is required that
– there was an agreement, understanding, arrangement or substantial
negotiations regarding the acquisition or a similar acquisition at some time
during the two year period ending on the date of the distribution.
– Absent the above, the acquisition should not be considered part of a plan and
as a result, section 355(e) should not be applicable to trigger gain.
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