A Tax Executive's Guide to Spin-offs: 10 Things You Won't See in Section 355; Advise board and officers to be careful about certain negotiations or public statements during pendency of the spin.

AuthorBailey, David B.

Behind the closed doors of a corporate boardroom somewhere in America, the directors of a publicly traded company are discussing the future of their business. For many years, the company has operated two major divisions that have gradually diverged over time. These divisions (having the remarkably original names Business A and Business B) are now operated by distinct groups of managers and have different operating margins, strategic priorities, and risk profiles. In due course, the directors decide that it is in the best interests of the company to spin off Business B as a separate publicly traded company. This article will use the terms "Distributing" to describe the original company, which will carry on Business A after the spin, and "Controlled" to describe the spun-off company, which will carry on Business B after the spin. After the board has made its decision, the CFO will reach out to you--the vice president of tax--to effectuate the spin. What do you do?

This article lays out a few of the key issues you will need to consider as the head of an in-house corporate tax department. It will not discuss the two most important tax deliverables: a private letter ruling (PLR) and a tax opinion. The nuances of those items have been discussed in many other great articles. Instead, it will focus on matters that tax may be handling on its own without the benefit of an outside advisor. You will not find these clearly laid out in Section 355, but they are critical considerations as you work a spin from beginning to end.

81: Speak With Directors and Officers First; Spins Are No Time for Loose Talk

The corporation's directors and officers are likely aware that a spin is an effective way to distribute an operating business to the public with no federal income tax at either the corporate or the shareholder level and that the company should obtain a PLR from the Internal Revenue Service and a tax opinion from a reputable firm confirming the spin's tax-free status. What those directors and officers may not know is that their own conduct during the run-up to the spin can impact whether the spin qualifies as a tax-free transaction. So you should reach out to the board and the officers to let them know that they should be very careful about engaging in certain negotiations or public statements during the pendency of the spin. This discussion should target three key areas.

DEVICE TEST

This test, dating back to the Gregory v. Helvering case, denies tax-free treatment for a spin that is actually a device to distribute earnings and profits to shareholders. (1) The regulations spell out a number of factors that weigh in favor of a transaction's being considered a device and a number of non-device factors weighing against it. (2) It is not necessary to educate the board and officers on all of these factors. It is simply enough to let them know that they cannot use the spin to facilitate a sale or disposition of Business B. That is, the board cannot work out a deal with a friendly acquirer to have the company package all the Business B assets into a single entity, spin it up the chain, and then have the parent sell it to the acquirer.

SECTION 355(E)

This section applies if there was a plan or arrangement in effect within two years ending on the date of the spin for either Distributing or Controlled to be acquired by a third party before or after the spin. (3) In other words, it would be perilous for your CEO to call up the CEO of Company C and ask him if he might be interested in buying Controlled after it spins off. An agreement with the purchaser or even substantial negotiations on deal terms are evidence of a plan, but other facts are also considered, including discussions with investment bankers. If there is evidence of a plan, certain exceptions and safe harbors exist, but it is far better to create a bright-line rule that none of the insiders can discuss an acquisition at all during the pre-spin period.

BUSINESS PURPOSE

The directors and officers of Distributing likely discussed a number of corporate business purposes before voting to approve the spin: the desire for each of Businesses A and B to have managers who are more focused on each business, the desire to avoid competition for capital within the company between Businesses A and B, and the desire for Business B to be able to do acquisitions using its own stock as currency. It is also likely that the directors and officers discussed the benefit to the shareholders of a likely bump in the stock price of Business B once it was spun out to the public. This is a common motivation for a spin but is not in itself a valid business purpose under Section 355. (4) Therefore, you should caution directors and officers to avoid making any public statements to the effect that the spin is being done primarily to benefit shareholders.

Tax will have to undertake a tremendous amount of due diligence in pursuit of the spin. It will need to work with many stakeholders to ensure that the spin will qualify as tax-free. It will have to work with the legal department to develop a detailed step plan for separating the relevant legal entities in the United States and perhaps in multiple foreign jurisdictions. It will need to work with management to ensure that the spin is motivated by a good corporate business...

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