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.
#1: 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.
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.
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.
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.
#2: Just Because Spin Is Tax-Free Doesn’t Mean Tax Has to Run Project, But It Might Want To
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 purpose and does not run afoul of the device prohibition. It will need to work with people in Businesses A and B to marshal the facts necessary to establish that each business has satisfied the five-year active trade or business (ATB) requirement within the meaning of the Section 355 rules. Finally, as the PLR and tax opinion begin to take form, tax will need to verify that all the representations made in those documents are valid and supportable.
Unfortunately, this is only the tip of the iceberg when it comes to the work that must be done to separate the company into two. Business B does not exist in the corporate org chart as a self-contained legal entity with its own IT systems, bank account, employees, and assets. And if Business B exists as a discrete division within the company, management may underestimate the amount of work required to separate it into a new group of entities. Many groups within the company may view the spin as a “tax” project, and assume that tax can run the show. This will be a tall order given tax’s other obligations: compliance, reporting, planning, and controversy. But tax really is the linchpin for the spin, because the failure to achieve a tax-free spin will have more severe consequences for the tax department than for any other function. So if other work streams are not focusing on the spin as seriously as they should be, you should reach out to management to ensure that sufficient resources are dedicated to the transaction. This may require engaging a full-service consulting firm and setting up a dedicated project management office (PMO) within the company, which should include company employees who can be freed up to work full-time on spin planning.
#3: Call IT Early
Early in the process of planning the spin, the company will identify all functions that need to be separated between Distributing and Controlled. Of these, IT separation is normally the most time-consuming because of the complexity of setting up Controlled’s enterprise resource planning (ERP) system and transferring the general ledger and all relevant data to Controlled. Without IT separation, Controlled will not be able to pay its employees, record intercompany transactions, or process sales to customers. Tax should reach out to IT early in the process and clearly communicate the timing of legal entity separations to IT so that IT can devote the required resources to ensure these transactions are closed on time. In most cases IT systems cannot be split down the middle and shifted over to Controlled; rather, they must be built from the ground up. As the IT separation plays out, tax should ensure that Controlled inherits not only records related to Business B but also any records related to Business A to the extent they could be relevant in determining Controlled’s tax liability. Further, due to the lengthy statutes of limitations for tax audits in various jurisdictions, tax may have longer data retention requirements than other functions and must ensure that important records are not deleted in the migration.
#4: Carve-Outs Work Stream Can Be Your Best Friend
For a public company reporting to the Securities and Exchange Commission, the company must prepare and file carve-out financial statements prior to the spin.5 The accounting group will handle this work with assistance from an outside firm. The carve-out process requires presenting the financials of Controlled on a standalone basis, as if they have been “carved out” of the financials of Distributing. This in turn requires reconstructing the P&Ls and balance sheets of Controlled for a designated look-back period. This process parallels the work of documenting the Distributing and Controlled ATBs for tax purposes. Tax can leverage off the carve-out process to obtain the detail required for the PLR or tax opinion: namely, the P&Ls and balance sheets of the Distributing and Controlled ATBs. This data is unlikely to exist within tax in any other form, because historic tax returns will have been filed on the basis of full legal entities and will not have been split between Business A and Business B.
Tax should communicate with accounting early to make sure the carve-out is available at the level of detail, and in the time frame, needed by tax. In particular, tax will need to have P&L details necessary to demonstrate the ATBs of Distributing and Controlled over a five-year look-back period. This may be a longer period than the period for which accounting is required to prepare carve-outs, in which case tax should inquire whether accounting can use the carve-out process to help tax reconstruct the full five years of results on a pro forma basis.
#5: Beware the Spiderweb of Intercompany Debts
The typical company has a spiderweb of intercompany debt in the form of a cash pooling arrangement, an in-house cash management process, and formal intercompany loans. When the company begins preparing for the spin and starts to identify what will move over to Controlled, there may be a perception that debts should be split, either by tracing them to the businesses that gave rise to them or by “splitting down the middle” so that each business takes a proportionate share of the overall debt after the spin. This is clearly a crucial point with respect to external debt, but for internal debt this belief may be a fallacy. An intercompany loan that was put in place to move cash within the group may not have any relationship to either Business A or Business B. Moreover, all intercompany debts by definition should net out to zero, so in the aggregate the web of intercompany positions is neither a net asset nor a net liability for the company. Therefore, Distributing is not typically at a disadvantage by keeping all the debts on its books.
In contrast, shifting debt to the new company will create a number of tax complications, some of which may be significant. The biggest danger would be if one leg of a large debt is moved to Controlled, with the other leg staying behind in Distributing. In this case an intercompany debt will become a debt between two unrelated parties, and this ongoing debtor-creditor relationship will cast doubt on whether there has been a true separation of the businesses. Other tax considerations include the need to ensure that moving a liability does not undermine the “control” requirement of Section 355, does not constitute a “significant modification” of the debt instrument,6 and does not create liabilities in excess of basis issue7 or a Section 385 recast8 or a “north-south” issue as positions are moved around in the group.9 The company also must ensure that the relevant Controlled entity that assumes a debt has the cash flow to service the debt.
#6: Watch Out for Landmines in Consolidated Return
You may view your company’s U.S. consolidated group as a sort of Hotel California—many entities join the group over time, but no one ever leaves. As a result, you may be aware that there are rules that apply when a member leaves the group but may not have dealt with them in practice. A spin that involves entities leaving the consolidated group puts all these rules in play. For starters, if an entity being spun out was a party to an intercompany transaction that involved a deferred gain or loss, this item may be triggered when the member leaves the group.10 Unless you have maintained a log of intercompany transactions since the dawn of time, you will need to pore over historic records to take inventory of any such items. The triggering of an excess loss account is also possible. For example, a parent company’s basis in the shares of a subsidiary may have been eroded over time through distributions up the chain to the point that the parent now has negative basis (“excess loss account”) in the shares of the subsidiary.11 When Controlled is spun up the chain, it will inherit a pro rata share of the excess loss account, which may trigger a recapture event when Controlled leaves the group.12
Similarly, if you do not have a good handle on the historic stock basis of members of the group, it will be difficult to know whether the incorporation of Controlled triggers gain under Section 357(c) (assumption of liabilities in excess of basis). Understanding the stock basis of Controlled is also important if there is a desire to have Controlled distribute cash up to Distributing immediately before the spin, because Distributing must be certain it has sufficient outside basis in the shares of Controlled for this distribution to be treated as a dividend or return of capital. Companies with a history of dividends may have kept track of the shareholders’ basis in the parent, but not the parent’s basis in its subsidiaries. Again, a distribution in excess of basis may create an excess loss account in the Controlled stock. Finally, if you have not tracked capital contributions within the consolidated group over time, you may not know whether a member of the group holds “disqualified basis” in the shares of a subsidiary in a way that would trigger gain under Section 355(d).
#7: Start Tracking Transaction Costs Early
One tax benefit of a spin is the ability to deduct certain transaction costs. Although the regulations on transaction costs do not provide detailed guidance on spins, these rules apply to spins in the same way they apply to other transactions.13 Namely, costs that “facilitate” a spin must be capitalized, but costs geared toward “integration” may be deductible. “Integration” is an odd term to use in the context of a spin, because these costs are incurred to separate two businesses rather than to integrate them. Still, the types of costs are not qualitatively different in the spin context; in both acquisitions and spins, these costs are for setting up a new operating business, with everything that entails.
In the context of a spin, classifying costs in the integration bucket takes on heightened significance, because it is not clear that any tax benefit can be obtained from “facilitative” costs. Unlike an acquisition where such costs can be capitalized into the basis of an acquired asset that can either be amortized over time (an intangible) or can generate a loss in the future (stock), it is not clear that the basis generated by facilitative costs in a spin can ever be recovered. The reason is that the asset to which the costs relate is the stock of Controlled held by Distributing, and this basis will disappear at the moment of the spin. The proper treatment of facilitative costs is beyond the scope of this article, but differences of opinion exist within the tax community. A simpler analysis applies to the treatment of banker fees—if the deal is being run by investment bankers being paid a success-based fee, you can elect to claim the seventy percent safe harbor deduction for such fees, just as in other types of merger and acquisition deals.14
#8: It May Be Worth It to Throw Back Small Fry
In a spin-off involving multiple legal entities, it is tempting to avoid all tax friction by achieving a tax-free separation of every legal entity that will become a part of the Controlled group. This may include all members of the U.S. consolidated group as well as all foreign entities that will become part of the Controlled group. However, in a case where there are many small entities (e.g., foreign limited risk distributors, or LRDs), this proposition may not survive a cost-benefit analysis. For example, for a CFC spin to be tax-free it must satisfy both the foreign law requirements (e.g., partial demerger statute) and Section 355 requirements. Even if the separation can be carried out tax-free in the local country, it may not resemble a Section 355 transaction under U.S. tax principles. Thus, to obtain tax-free treatment, rulings or opinions may need to be obtained in both the foreign jurisdiction and the United States.
If the company feels confident that its LRDs are low-value entities (for example, if it rewards them with a cost plus two percent return under its transfer pricing policy), it may be content to separate them by means of taxable asset sales rather than tax-free transactions. These transactions might value the entities according to a rule of thumb that looks to the net book value of the entity’s assets plus a few years’ worth of profits to approximate fair market value. A survey of local advisors may be helpful to determine which jurisdictions are likely to respect this approach.
#9: Be Aware of Post-Spin Entanglements
The relationship between Distributing and Controlled does not end on the day of the spin. There will be a number of entanglements between the two companies that could last for years.
Transition Services Agreements
Tax will need to monitor all work streams closely to ensure that the business can achieve the level of separation required under Section 355. The IRS provides more leeway for routine back-office functions to separate after the spin than functions that constitute an integral part of the ATB being separated.15 In the case of systems or processes that cannot separate by the spin date, or foreign entities that cannot separate, Distributing may need to operate the business on behalf of Controlled under transition services agreements (TSAs). Tax must be aware of the number and extent of TSAs so that it can disclose this information to the IRS and its advisors when seeking a PLR and a tax opinion. Tax will need to monitor TSAs to ensure they wind up on time and do not expand significantly in scope.
Tax Matters Agreement
The company will separate its assets and liabilities in the spin, including potential tax liabilities. Here there are two principal tax risks: that Distributing will incur a tax liability relating to the pre-spin period that was attributable to Business B, and that a tax liability may arise related the spin itself. It is crucial to strike a balance whereby Distributing does not remain liable for every tax risk that is attributable to the historic business of Controlled and Controlled does not assume a huge tax risk that it will be unable to handle as a newly formed, modestly capitalized company. The companies should deal with this through a tax matters agreement (TMA) governing the allocation of tax liabilities between the two companies following the spin. The TMA should be negotiated by Distributing and Controlled acting at arm’s length, and ideally should not be drafted until Controlled has its own tax leadership capable of defending the interests of the new company. The TMA should also set forth how the companies will interact with each other following the spin. The two companies will need to share information with each other about the status of ongoing audits (where indemnification obligations may exist) and calculation of tax attributes (such as earnings and profits, the research and experimentation credit, and foreign taxes). The parties should not assume that disputes under the TMA can be handled amicably and should ensure that the TMA contains adequate protections for both sides.
The timeline for the spin may have been set based on the expected time required to separate the legal entities in the United States and in other major jurisdictions, without considering the time required to separate in smaller foreign markets. In this case, many foreign separations may have to be deferred until after the closing date of the global spin. Tax will need to devote resources to completing any such deferred transactions. Ideally, these transactions can be “prewired” to some extent before the spin so they are regarded as being carried out pursuant to the “plan of reorganization” for U.S. tax purposes.16 Because these transactions probably received little attention pre-spin, they could shape up to be more complicated and demand more resources than anyone expected.
#10: Remember, End of Spin Is Only the Beginning
When a spin is complete, champagne corks will be popping and most people in the company will be ready to put the spin behind them. However, for the Controlled tax department, the day of the spin is only the beginning. The spin will cast a long shadow over the future tax operations of the business. Future transactions must be scrutinized to ensure they do not raise a Section 355(e) or device issue that implicates the bona fides of the spin (for example, if Controlled decides to merge with a company with which Distributing had discussed a transaction before the spin). If Distributing is involved in pre-spin audits that relate in part to Business B, Controlled must determine whether it is required to indemnify a portion of the tax liability to Distributing under the TMA. Controlled will also be involved in more mundane post-spin matters such as sharing information needed to compute E&P, winding down TSAs, and completing any “deferred” spins.
Controlled will have to staff up new departments after the spin, including tax. Chances are good that its tax department will not be a carbon copy of Distributing’s tax function. Controlled may be a smaller company requiring a smaller headcount. It may have a different geographical footprint requiring people with different backgrounds. For example, if Distributing operated in 100 countries but Controlled is mostly U.S.-focused, Controlled may not need international tax planners and transfer pricing experts. Creating a new department also provides an opportunity to adopt the latest technology. Just as most new cars today do not have CD players, a new tax department likely will not use the same technology that Distributing adopted years ago. It is far more likely that Controlled will opt for cloud-based data management over work papers stored on individuals’ hard drives, company-issued mobiles over landlines, and telepresence meetings over face-to-face meetings. Likewise, if the old company had adopted a patchwork quilt of different platforms to run such processes as compliance, provision, sales tax, and transfer pricing, Controlled now has the opportunity to adopt a solution that seamlessly merges all these functions.
A successful spin requires tremendous effort—particularly from tax—but creates tremendous opportunity for the new company. Working on a spin is a demanding, but rewarding, project for an in-house tax department. Tax will have to take the lead on many key tasks. To a tax executive who finds the prospect of a spin daunting, this list of other considerations may come across as cold comfort. But in a profession where knowledge is power, being armed with these additional perspectives may help you feel a little better about the tremendous task ahead of you.
David B. Bailey is tax counsel with Takeda Pharmaceuticals in the Chicago area.
Acknowledgment: The author thanks Jay Singer at Shearman & Sterling for his feedback on this article.
- 293 U.S. 465 (1935).
- Treas. Reg. Sections 1.355-2(d)(2) and (d)(3).
- Treas. Reg. Section 1.355-7(b)(2).
- Treas. Reg. Section 1.355-2(b)(2). The desire to increase the company’s share price may support another valid business purpose, however, such as to use the company’s shares as currency for an acquisition.
- 17 C.F.R. Section 210.3-05.
- Treas. Reg. Section 1.1001-3.
- Section 357(c).
- Treas. Reg. Sections 1.385-2 and -3.
- Cf. Rev. Rul. 2017-9, 2017-21 I.R.B. 1244.
- Treas. Reg. Section 1.1502-13(d).
- Treas. Reg. Section 1.1502-19.
- Treas. Reg. Section 1.1502-19(b), -19(g) example 3.
- Treas. Reg. Section 1.263(a)-5(a)(4).
- Rev. Proc. 2011-29, 2011-18 I.R.B. 746.
- See, e.g., Rev. Rul. 2003-75, 2003-2 C.B. 79.
- See, e.g., PLR 201308002 (October 25, 2012) (“Distributing Parent’s (or its subsidiaries’) transfer of the Delayed Transfer Assets to Controlled Parent (or its subsidiaries) will occur pursuant to the plan of reorganization that includes the transfer of the other Contributed Assets to Controlled Parent and the External Distribution (Treas. Reg. Section 1.368-2(g))”).