|EDWARD J. SCHNEE, CPA, PhD, Joe Lane
Professor of Accounting, is director, MTA program, Culverhouse
School of Accountancy, at the University of Alabama, Tuscaloosa.
LEE G. KNIGHT, PhD, E. H. Sherman Professor of Accountancy, chairs the Department of Accounting and Finance at Troy State University, Troy, Alabama.
RAY A. KNIGHT, CPA, JD, is a senior manager with KPMG Peat Marwick LLP in Birmingham, Alabama.
In the corporate world, bigger is not always better. Corporate spin-offs have become a popular way for companies to release shareholder value and achieve other business purposes. A spin-off involves the pro rata distribution of a controlled corporations stock to the distributing corporations shareholders without their surrendering any distributing corporation stock. Much of the popularity of spin-offs, especially when the alternative is a simple divestiture (selling part of a corporations operations to a third party), can be traced to a companys ability to structure the transaction so it is tax-free. In fact, after the Tax Reform Act of 1986, a spin-off or other divisive reorganization is the only way a company can distribute appreciated property to shareholders without incurring a corporate-level tax. An added appeal is that corporations have considerable latitude in reporting spin-offs in their financial statements.
This article reviews the tax and financial reporting guidelines that affect corporate spin-offs. To ensure maximum tax and accounting benefits, a working knowledge of both areas is essential to CPAs who are part of a management team considering or structuring a spin-off, as well as to CPAs in public practice who may be asked to advise clients in similar circumstances.
|The Spin-Off: Coming to a Company Near You|
Many well-known companies have announced or completed spin-offs in recent years, including
ENSURING TAX-FREE TREATMENT
While IRC section 355 provides the statutory authority for tax-free treatment of corporate spin-offs, it is the regulatory hoopsparticularly the all-important business purpose requirementthat can cause a companys distribution to fail section 355. The penalty for not meeting the section requirementstax at both the corporate and shareholder levelsmakes an advance IRS ruling (or the opinion of tax counsel) a companys prudent first step to ensure tax-free treatment. In April 1996, the IRS updated and expanded its section 355 guidance by releasing revenue procedure 96-30, which retains most of the guidance in superseded revenue procedure 86-41 but also provides companies with significant new help on the business purpose requirement.
Key requirements. Section 355 includes four key requirements for tax-free treatment, and Treasury regulations section 1.355-2 adds two additional requirements: business purpose and continuity of interest.
Controlled corporation. To qualify as a tax-free
spin-off, the distributing corporation must distribute the stock of
a controlled corporation (preexisting or newly created) to its
shareholders. Provided the companies meet the active business
requirement (see below), the distributing corporation has
significant latitude in the assets it transfers to the controlled
For purposes of this requirement, control is defined as owning at least 80% of the voting power and at least 80% of the shares of each class of nonvoting stock. While this control may have existed for a long time or been obtained in exchange for the assets transferred, it must exist immediately before the distribution and must not have been obtained in a transaction in which the company recognized gain. If the distributing corporation acquires additional controlled corporation stock during the five years preceding the distribution in a taxable transaction, the shareholders treat the stock as boot.
Securities distribution. The distributing corporation
generally must distribute all its controlled corporation stock and
securities immediately before the transaction. Revenue procedure
96-30, however, allows the distributing corporation to retain a
limited amount of the stock or securities if the stock is widely
held, the retention satisfies a significant business purpose, the
controlled corporation officers and directors are officers and
directors of the distributing corporation, the retained stock and
securities are disposed of as soon as possible (but no later than
five years after the separation) and the distributing corporation
votes the retained stock in the same proportion as the stock
distributed. In all cases, stock meeting the control definition must
Active businesses. Following the distribution, both
the controlled and distributing corporations must be actively
engaged in a trade or business with a five-year history. Regulations
section 1.355-3(b) defines an active trade or business as one in
which all the necessary steps or activities take place to earn a
profit. An active business does not include ownership of investments
such as stock or land or the leasing of real or personal property
unless the corporation provides significant services related to the
While the five-year requirement does not preclude changes such as dropping old products, changing facilities or expanding the old business, it does prevent the company from creating a new business or acquiring a business in a taxable transaction during the five-year period. A distributing corporation, however, may acquire a business in a nontaxable transaction or divide its existing operation into two separate businesses. In such situations, the businesss prior history is tacked onto the current business for purposes of the five-year rule.
Exhibit 1: Device and Nondevice Factors for Distributing Earnings
- Pro rata distribution.
- Subsequent sale or exchange of the distributing or
controlled corporation stock.
- Use of distributing or controlled corporations stock in a trade or business other than the one satisfying the section 355 active business requirement.
- Existence of a business purpose for the
- Publicly traded and widely held distributing
corporation stock (not more than 5% owned directly or
indirectly by any one shareholder).
- Shareholder distributees that are domestic corporations (and thus, in the absence of section 355, would be entitled to the dividends-received deduction).
Corporation Z transfers its excess funds or liquid assets to a newly organized corporation and distributes the new corporations stock to its shareholders, who liquidate the new company to obtain its assets. By using this device, management plans for the shareholders to avoid tax on dividend income. Upon liquidation of the second company, the shareholders will be taxed on the difference between the value of the assets received in liquidation and the allocated basis of the stock. However, the tax rate applied will be the capital gains rate. Thus, the device test prevents the shareholders from obtaining the corporations liquid assets at capital gains rates while retaining the same equity interest in the company.
- Pro rata distribution.
Not a distribution device. Neither the distributing
nor the controlled corporation can use the spin-off as a device for
distributing earnings and profits. Because of its vagueness, this
requirement usually is the most troublesome. The key issue is
whether the spin-off is indistinguishable from an ordinary dividend.
Regulations section 1.355-2(d) tries to help by listing factors that
indicate when the spin-off (or other corporate division) is or is
not a device for distributing earnings. Exhibit 1 lists these
factors and provides an example illustrating the importance of the
A spin-off starts with one strike against it: The first device factor is pro rata distribution, the very essence of a spin-off. Regulations section 1.355-2(d)(5), however, discusses distributions that have no tax avoidance potential and thus may satisfy the device requirement even if one or more device factors are present. For example, a distribution ordinarily would not be a device if the distributing and controlled corporations have no accumulated earnings and profits.
Business purpose. Regulations section 1.355-2(b)
requires a spin-off to be motivated, in whole or substantial part,
by one or more corporate business purposes. The purpose(s) must be
real and substantial and germane to the distributing or controlled
corporations business or to the affiliated group of which the
distributing corporation is a member. Neither reducing federal
income taxes nor satisfying a shareholder purpose is a corporate
business purpose. However, a distribution made primarily to achieve
a corporate business purpose that also achieves a shareholder
purpose is not disqualified. A corporate business purpose also fails
the test if it could be accomplished in a nontaxable transaction
that is not impractical or unduly expensive.
The subjectivity inherent in the above rules, as well as intense IRS scrutiny, has made the business purpose requirement one of the most difficult hurdles a company must overcome to ensure tax-free treatment. Appendix A of revenue procedure 96-30 removes some of the subjectivity by discussing at length the qualifying criteria and the information companies must submit for advance rulings for each of nine business purposes that may qualify a spin-off for tax-free treatment (see exhibit 2).
Exhibit 2: Revenue Procedure 96-30Business Purposes
- Providing existing or prospective key employees with an opportunity to obtain a direct equity interest in the distributing or controlled corporation.
- Facilitating access to equity capital through a stock offering.
- Facilitating access to nonequity capital.
- Reducing the costs incurred by the distributing corporation or its affiliated group (for example, administrative, financing, insurance, state or other nonfederal taxes).
- Allowing the distributing corporation to concentrate exclusively or more intensely on its core business operations (commonly referred to as fit-and-focus purpose).
- Eliminating a business that competes with the customers or suppliers of another business of the distributing or controlled corporation.
- Facilitating an acquisition of the distributing corporation by another corporation (Morris Trust transaction).*
- Facilitating an acquisition by the distributing or controlled corporation.*
- Protecting one or more businesses of the distributing or controlled corporation from the risks of another business of the affiliated group (for example, risk of environmental claims).
*Caution: The Taxpayer Relief Act of 1997 severely limitsand probably makes obsoletethese business purposes.
Source: Adapted from revenue procedure 96-30, 1996-19 I R B 8.
The IRS says the list in exhibit 2 is not exclusive and that a spin-off undertaken to accomplish other purposes still may qualify for tax-free treatment. Other business purposes used successfully in the past include
- The desire of shareholders or shareholder groups to own and control particular businesses operated by the distributing corporation (although this now could be viewed as an offshoot of the fit-and-focus business purpose).
- A divestiture dictated by statutory, administrative or judicial law.
- A voluntary divestiture intended to separate regulated and unregulated businesses.
The Tax Court allowed the control or elimination of labor problems to serve as the business purpose in Olson (48 TC 855 , acq. 1968-2 CB 2), but few rulingsnone in recent yearshave been based on this purpose. Similarly, avoiding takeovers (by boosting the market price of the distributing corporation stock) and enhancing profitability have enjoyed only limited success in justifying section 355 treatment.
Press releases, SEC filings, investment banking reports and other spin-off-related materials frequently emphasize enhancing shareholder value more than any other business purpose. The IRS historically has characterized enhancing shareholder value as a shareholder rather than a corporate business purpose, causing some CPAs to advise their employers or clients to avoid even mentioning it in internal documents lest the IRS gain access. Including the fit-and-focus purpose in revenue procedure 96-30, however, may mix the corporate and shareholder purposes sufficiently to warrant corporate characterization. If the controlled corporations business is so incompatible with the distributing corporations that their combined growth is less than if they operated separately, the shareholder purpose (enhancing shareholder value) is accomplished with a spin-off primarily aimed at the fit-and-focus purpose.
The IRS warns companies that revenue procedure 96-30 does not remove all the subjectivity inherent in the business purpose requirement. The appendix A introduction cautions that the IRS may rule unfavorably even if a spin-off fall(s) within the literal language of these guidelines. Thus, although satisfying all the qualifying criteria and informational requirements listed in the revenue procedure does not automatically provide an acceptable business purpose, such purpose is close to automatic.
- Continuity of interest. Regulations section 1.355-2(c) says that following the distribution of the controlled corporations stock, the distributing corporation shareholders must maintain continuity of interest in both companies. Revenue procedure 96-30 further says this requirement generally is met if one or more persons who directly or indirectly own the distributing corporation before the distribution also own 50% or more of the stock in each of the modified companies after the separation.
NO PAIN, NO GAIN
If a spin-off meets the section 355 statutory and regulatory requirements, the distributing corporation generally recognizes no gain or loss on the transfer of assets to the controlled corporation or on the distribution of the controlled corporations stock and securities to shareholders. The distributing corporation, however, recognizes gain if it distributes any appreciated property other than the controlled corporation stock and securities.
If the IRS deems a spin-off to be a disqualified distribution, the distributing corporation loses part of its tax benefit and recognizes gain on the distribution of the controlled corporation stock. A disqualified distribution is one that results in a shareholder owning 50% or more of either the controlled or the distributing corporation by virtue of purchasing the distributing corporation stock within a five-year period ending on the date of distribution. This provision is designed to prevent the distributing corporation from converting a taxable disposition of a line of business into a tax-free corporate division.
Immediately following the distribution, the distributing corporations earnings and profits are allocated between the two companies. If the controlled corporation is newly formed, this allocation usually is based on the relative fair market value of the assets owned by the distributing and controlled corporations. Such an allocation prevents the controlled corporation from making nontaxable distributions to its shareholders shortly after the spin-off.
GETTING THE BOOT
Generally, the distributing corporation shareholders recognize neither gain nor loss on the distribution. However, to the extent any shareholder receives boot, gain may be recognized. Boot normally takes the form of cash or other property distributed in conjunction with the controlled corporation stock and securities; it also includes controlled corporation stock the distributing corporation acquired in a taxable transaction in the five years before the spin-off.
The gain recognized is ordinary income to the extent of the distributing corporations earnings and profits. Additional gain is capital gain. A shareholder calculates his or her basis in the new stock by allocating the basis of the distributing corporation stock between the stock he or she retains in that company and the shares in the controlled corporation held after the spin-off on a relative fair market value basis.
FINANCIAL REPORTING GUIDELINES
Reporting guidance for corporate spin-offs is in short supply when compared with tax guidance. APB Opinion no. 29, Accounting for Nonmonetary Transactions , provides the most definitive statement on accounting for spin-offs by the distributing corporation. It says spin-offs are nonreciprocal transfers to owners that should be based on the recorded amount (after reduction, if appropriate, for an indicated impairment of value) of the nonmonetary assets distributed. Thus, the distributing corporation treats the distribution as a dividend, transferred at carrying value after reduction for indicated impairment of value. Unfortunately, Opinion no. 29 does not provide companies with guidance for recognizing impairment, leading to considerable diversity in practice. While this impairment seems like it should be within the scope of FASB Statement no. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of , that statement does not amend Opinion no. 29 or include it in its list of pronouncements referring to impairment of assets.
The FASB emerging issues task force sought to clarify Statement no. 121s role in measuring Opinion no. 29 impairments, but in EITF Issue no. 96-2, Impairment Recognition When a Nonmonetary Asset Is Exchanged or Is Distributed to Owners and Is Accounted for at the Assets Recorded Amount , it could not reach a consensus on the nonreciprocal transfer issue. The EITF considered support for classifying the assets transferred in nonreciprocal transfers as assets to be held and used and assets to be disposed of, two mutually exclusive categories for recognizing and measuring impairment.
Assets to be held and used. The nonreciprocal
transfer to owners is not equivalent to a sale or abandonment. From
the stockholders perspective, the transfer does not change an assets
ownership, dictating that the measure of impairment be based on the
assets to be held and used test. If the asset passes the Statement
no.121 recoverability test before the transfer (if undiscounted
future cash flows exceed the assets carrying amount), the transfer
itself should not trigger impairment.
- Assets to be disposed of. The transfer represents a significant economic event comparable to a sale. Since the distributing corporation no longer owns the asset after the transfer, the transferred asset is one to be disposed of for purposes of determining impairment. Not to adopt this view would allow the distributing company to avoid an impairment loss on any asset by merely transferring it to owners.
Exhibit 3 shows the results of these two views. The EITF found neither set of supporting arguments conclusive and encouraged the FASB to address the issue.
|Exhibit 3: EITF 96-2: Applying FASB 121 to APB 29 Impairments|
Spin-off costs. A second accounting issue for the distributing corporation is how to treat costs related to the spin-off such as legal fees. Historically, companies treated such costs as part of the distributing corporation dividend. In the last four or five years, however, at the SECs insistence, companies have expensed those costs.
Reporting spun-off operations. If the corporation that has been spun off constitutes a segment of a business under APB Opinion no. 30, Reporting the Results of Operations , it reclassifies the results of its operations, net of tax, as discontinued operations in the income statement of the distributing corporation. Prior years operations also are reclassified as discontinued operations.
The lynchpin for reclassifying the spun-off operations as discontinued operations is whether they constitute a separate major line of business or class of customers whose assets, results of operations and activities can be clearly distinguished (physically, operationally and for financial reporting purposes) from the rest of the business. If the spun-off operations do not satisfy these Opinion no. 30 requirements, the company leaves the operations in continuing operations and discloses the planned spin-off in the footnotes to the financial statements.
Change in reporting entity. In Staff Accounting Bulletin no. 93, Accounting and Disclosures Related to Discontinued Operations , the SEC generally prohibits the distributing corporation from characterizing the spin-off as a change in reporting entity, which would allow it to restate its historical statements as though it never had an investment in the controlled corporation (APB Opinion no. 20, Accounting Changes ). Retroactive presentation is permitted, however, if the spin-off occurs in connection with the initial registration of a corporation under the Securities Act or Securities Exchange Act and the two corporations are in dissimilar businesses, have been managed and financed historically as if they were autonomous, have no more than incidental common facilities and costs, will be operated and financed autonomously after the spin-off and will not have material financial commitment, guarantees or contingent liabilities to each other after the spin-off.
Accounting and reporting by a controlled corporation. No promulgated GAAP dictates how the controlled corporation should account for the spin-off. The SEC does not treat it as a new basis transaction, and nonpromulgated GAAP has adopted this same practice. In its December 1991 Discussion Memorandum, New Basis Accounting , the FASB argued in support of the two views on this issue. However, since the FASB removed the issue from its agenda, the financial statements of the spun-off corporation probably will continue to reflect the historical costs previously consolidated.
SEPARATING THE TWO COMPANIES:
AN ECONOMIC ISSUE
Whether or not the spin-off is a new basis transaction, the parties to the transaction must address the issue of what to report in the spun-off corporations financial statements. In other words, how are the two companies to be separated? Generally, this questionparticularly the establishment of the spun-off corporations capital structureis a bargaining issue. For example, Electronic Data Services paid a large dividend to its parent, General Motors, before a spin-off. In this way, some of EDSs assets and equity were stripped out of the company before the spin-off and retained by GM.
Another common bargaining issue arising in spin-offs is the separation of debt. If the controlled corporation holds a large amount of intercompany debt, the bargaining issue is how much of that debt can be converted into equity with the spin-off. If the debt of the two companies is not primarily intercompany, the bargaining issue is how to split the debt. In most cases, large amounts of debt are shifted to the spun-off corporation. In other cases (for example, PepsiCos spin-off of its restaurant operations), the distributing corporation retains its existing debt load. This latter situation leaves the door open for the spun-off corporation to issue new debt.
MAKING INFORMED DECISIONS
To make an informed decision to spin off part of its operations, corporate management must be cognizant of the tax and accounting rules governing such transactions. Management does not need to know the intricacies of those rules, but it does need to know the boundaries within which it must operate to ensure tax-free treatment and favorable financial reporting. CPAsboth internal and externalare in a strategic position to provide this service to management.