Time Warner Inc. completed the spin-off of Time Inc. earlier this month. Likewise, CBS Corp. announced that it would split off its remaining shares in CBS Outdoor Americas Inc. It’s clear that tax-free spin-offs continue to be popular transactions for media giants and other companies to divide themselves up in a tax-efficient method. But these transactions are complex, and numerous tax rules come into play in both the transaction and the after effects on shareholders. There are variants, including split-offs and split-ups, and complex versions, such as reverse-Morris Trust spin-offs and cash-rich split-offs. A full explanation, even if possible, would take volumes. But we can provide a high-level overview of the major issues involved in spin-offs.

The starting point is a parent company (we’ll call “Parent”) with a subsidiary (“Sub”) from which it would like to separate. The parent desires to do this in the most tax-efficient means, and explores doing a tax-free spin-off.

A spin-off, in its simplest and most popular version, refers to a transaction where Parent distributes the shares it holds in Sub to Parent’s shareholders. In order to be tax-free, numerous tax rules must be met – from the Internal Revenue Code, Regulations and court decisions. They can be grouped in different ways, but we like to look at them as these eight basic requirements:

• Parent must control Sub immediately prior to the distribution. Control means at least 80% of the vote and at least 80% ownership of all classes of non-voting stock.

• Parent distributes all the stock it owns in Sub, or at least enough to constitute control (and retention of any shares is not part of a plan to avoid taxes.)

• There must be a continuity of ownership interest, meaning that new shareholders cannot be brought in and take significant ownership stakes in Parent or Sub. The regulations indicate that an outside party taking a new ownership interest of 50% violates the continuity of ownership interest requirement.

• Both Parent and Sub must be engaged in an active trade or business immediately after the distribution.

• The trades or businesses being relied on in the prior requirement have been conducted for the prior five years. The business cannot have been acquired within the past five years in a transaction for which any gain or loss was recognized.

• There should be continuity of business enterprise. The regulations state “Section 355 contemplates the continued operation of the business or businesses existing prior to the separation.”

• The spin-off can be used “principally as a device for the distribution of the earnings and profits” of Parent, Sub or both. Basically, this means that the • The spin-off must have a corporate business purpose. Tax savings don’t qualify, nor due shareholder purposes, such as the typical increase in shareholder value. The strength or weakness of the corporate business purpose is typically weighed against any evidence that the spin-off might be principally a device for the distribution of earnings and profits.

Companies planning on doing a tax-free spin-off typically apply for a ruling from the Internal Revenue Service (since the consequences of doing a transaction and later finding out its taxable can be dire.)

So how is the transaction “tax-free”? In a taxable distribution, Parent would recognize any gain on the difference between its cost basis in Sub shares and the fair market value of those shares when it distributes them in a spin-off. Any gain is not recognized in a tax-free spin-off. For shareholders, in a taxable transaction receipt of the Sub shares would be a taxable dividend. A tax-free spin-off provides shareholders with more of a tax deferral, but still with significant benefits. The receipt of the shares of Sub isn’t a taxable event. The shareholders allocate their basis in the shares of Parent between the shares of Parent post-spin and the shares of Sub received, based on the respective stock’s fair market values after the distribution. The holding period of the original Parent shares becomes the holding period of the new Parent shares and Sub shares received. So any appreciation (or decrease in value) isn’t recognized for tax purposes immediately – it is deferred until the shares in Parent and Sub are sold.

Let’s put some numbers to the concept. Assume a shareholder previously bought 300 shares in Parent for $50 a share. The basis in the total position is 300 x $50 = $15,000.

Parent decides to do a tax-free spin-off of its subsidiary, Sub. For each share of Parent owned, shareholders will receive 1/6 of a share in Sub. So after the spin-off the shareholder will receive 50 shares of Sub, while retaining the 300 shares of Parent.

When the shares of Sub start trading, Parent is trading at $70 a share and Sub is trading at $25 a share. So the shareholder’s holding in Parent is worth $21,000 (300 x $70), and the holding in Sub is worth $1,250 (50 x $25), for a total of $22,250. The shareholder allocates its original basis of $15,000 between the Parent and Sub positions based on their relative values (calculated by taking the value of the Parent or Sub shares, respectively, and dividing by their combined value.)

The basis for the new position in Parent is: $15,000 x ($21,000 / $22,250) = $14,157.30. Dividing by the 300 shares of Parent owned results in a basis of $47.19 per share.

The basis for the Sub position is: $15,000 x ($1,250 / $22,250) = $842.70. Dividing by the 50 shares of Sub owned results in a basis of $16.85 per share.

So tax-free spin-offs are generally great transactions, especially since value is usually increased by the transaction (the sum of the spun-off parts usually being worth more than the prior whole), with no taxes paid. And they can be extremely useful transactions for parent corporations that feel that their business would be better conducted, and shareholders better served, by having the company split into two.

However, as with all complex transactions, investors must be careful to fully understand the transactions. Indemnifications between the parent and subsidiary should be considered, as well as transactions prior to the spin-off (such as a special dividend to the parent and/or an IPO of the subsidiary.) And, as with all investments, attention must be paid to the investment outlook for the parent and subsidiary as stand-alone companies.

 

Janet Pegg, CPA, is the Head of Accounting & Valuation at Cornerstone Capital Inc. and former Managing Director and Analyst of U.S. Accounting Research at UBS Investment Bank. Janet is an II-ranked Analyst.