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Spin Off Sales!

 
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Category : > Income Tax Filing Across The USA
Posted On : Thu Jun 10th,2010

 
Spin Off Sales!
 

SPIN-OFF SALES

 Meaning

The separation of a business unit/division from its parent company through the sale or distribution of new shares to the existing shareholders is typically known as Spin-Off. In other words, a company takes a division or part of its business and separates it from the parent company by creating a new, stand alone business.

Spin-off may be occurs in different ways but the end result is the same. In majority cases, parent company distributes the shares of new company to the existing shareholders. The spun-off companies are expected to be worth more as independent entities than as parts of a larger business.

The spin-off involves allocation of stock & securities to the existing shareholders without the surrender of any stock, which thus resembles a dividend. Internal Revenue code allows a corporation with one or more businesses that have been actively conducted for five years or more to make a tax-free distribution of the stock of a controlled subsidiary provided that the transaction is being carried out for a legitimate business purpose and is not being used principally as a device to bail out earnings and profits.

Reasons behind Spin-Offs:

Obviously, it is not an intelligent sign for any company to manage a business that is not in line with its vision and strategic goals. What if an Auto manufacturer company also owns a jewelry business? In such a case, the management might not focus on its core area of business and might not estimate the activities which need to be performed specifically for jewelry business.

The same idea prevails behind the spin-off transactions. If the Auto Company decided to sell the subsidiary, it could go to someone, who would typically buy the business for cash. But the problem is, the IRS will charge the Auto Company a capital gain tax on the sale of the business if it has appreciated in value. With most companies in the xx% tax bracket, it means that the management will only receive about xx% of what the subsidiary is “worth” on an after-tax basis.

However, if the Auto Company decided to issue a tax free spin-off to its existing stockholders, it would instead incorporate the jewelry division as a stand-alone business. Then it will have its own Board of Directors, a new CEO, corporate offices, etc. It would print up stock certificates and distribute them to the existing stockholders of the Auto Company on a pro-rata basis; in other words, if you owned 5% of the Auto Company stock, you would receive 5% of the total stock in the new jewelry store.

Sometimes, the motivation for a spin-off comes from the desire to separate a "poor" or under performing business so that an spotless "good" business can shine through to investors. A spin-off may solve a strategic, antitrust, or regulatory issue, paving the way for other transactions or objectives.

Requirements for a tax free spin off:

In order to effectively execute a spin-off, complex rules must be followed to ensure that the unit or division will be able to operate independently, that the transaction is tax-free, and the financial reporting requirements are satisfied. A corporate division will qualify as tax free spin off to the shareholders and the distributing corporation if it satisfies requirements listed below:

Control

Distribution of All Stock or Securities

Active Trade or Business Requirement

Not A “Device”

Business Purpose

Continuity of Interest

Control

According to Internal Revenue Code, Control requires ownership of 80 percent of the total combined voting power and 80 percent of the total number of shares of all other classes of stock, including nonvoting preferred stock.

Distribution

To successfully complete the Spin-Off transaction, the distributing company is bound to distribute all the stock and securities of the parent corporation that the distributing corporation holds. In other words, distributing company must distribute sufficient amount of stock to constitute control of the business.

Active Business

According to Internal Revenue Code, both the parent company and subsidiary company must be engaged immediately after the spin-off in an active trade or business in which each has actively operated for at least five years prior to the divestiture. That business must also not have been acquired within the five-year pre distribution period in a taxable transaction.

May Not Be Used As a Device To Avoid Taxation

The mission of the device limitation has been to prevent the conversion of ordinary dividend income into preferentially taxed capital gain through a bailout seeming as a corporate division. Under the code, the transaction must not be used as a device to distribute earnings of a company.  Basically, this means that the transaction may not be used simply as a means of escaping dividend taxation rules by converting ordinary income into capital gains.

Business Purpose

The regulations define a corporate business purpose as “a real and substantial non Federal tax purpose connected to the business of the distributing corporation, the controlled corporation or the affiliated group to which the distributing corporation belongs.” This is typically the most rigorous and uncertain prerequisite.

This requirement for a tax-free spin-off is that the transaction has a substantial business purpose. A corporate division lacking a business purpose can not be accomplished tax free spin off. Commonly, a spin-off must bring about material and quantifiable cost savings or other benefits to one or more of the businesses involved.

Continuity of Interest

The regulations require that the shareholders who owned an interest in the corporation prior to a corporate division must maintain a significant continuing interest in both the parent and the subsidiary company thereafter.

Tax Advantages

Spin-offs are the most tax efficient mechanism to separate a division. Spin-offs are one of three basic ways to divest a subsidiary. The other two methods are Sell-offs (usually for cash) and/or Equity Carve-Outs (also known as Initial Public Offerings-IPO). From a shareholder viewpoint, the spin-off, based on distribution of stock in a subsidiary to create a new public company is the most attractive restructuring alternative.  Because, Spin-offs that qualify under IRS Code are the only way to divest assets on a tax-free basis.  Secondly, the tax efficiency of a pure spin-off is a major reason corporations have increasingly opted to divest divisions in this manner.

If the subsidiary undergo successful tax free spin-off, this will represent significant savings to the parent company, relative to selling the division outright. Selling the division for cash, would generate a big capital gain tax.

Spinning off subsidiary corporations has become an increasingly popular way to create shareholder value while taking advantage of tax laws.   A spin-off distribution can be made tax-free to the parent corporation and the receiving shareholder.

 

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