Flexible U.S. tax laws and rules are helping to fuel a surge in U.S. corporate spinoffs, allowing companies to split apart without taking a tax hit or imposing one on investors.
This year, companies in the S&P 500 Index including Kraft Foods Inc., El Paso Corp., ConocoPhillips and L-3 Communications Holdings Inc. have announced plans for tax-free spinoffs.
The ease with which such spinoffs can be completed makes them an attractive strategy for companies, particularly when compared with the sale of a subsidiary that could trigger capital gains taxes, said Robert Willens, an independent tax consultant in New York.
“It becomes pretty simple to conclude that the spinoff is the best route, because of the tax consequences or the lack of tax consequences,” he told Bloomberg Government.
The increase in spinoffs this year follows a wave of corporate consolidation that left companies with subsidiaries they want to shed. Also, investors often prefer more narrowly focused companies that can develop expertise in particular markets.
“There’s generally greater external transparency of the business performance when the marketplace looks at the pure plays versus being accomplished” with a consolidated company, ConocoPhillips CEO James Mulva told analysts on a July 14 conference call to discuss the company’s decision to spin off its refining and marketing business from its energy-production company. “There’s more focus and attention, and greater probability of success.”
So far this year, U.S.-based public companies have announced 60 spinoffs, according to data compiled by Bloomberg. That’s more than the combined total of 46 for 2009 and 2010. The largest such deal announced in 2011 that has closed is Marathon Oil Corp.’s $13.9 billion spinoff of its refining operations, now known as Marathon Petroleum Corp.
Legal and regulatory changes over the past decade have made spinoff transactions more routine and easier to achieve without tax consequences, particularly for large U.S. public companies, said Gary Wilcox, a partner at Morgan, Lewis & Bockius LLP in Washington.
Still, completing a spinoff without triggering capital gains taxes for the parent corporation and the shareholders requires navigating a set of tax rules, which are designed in part to prevent companies from using a spinoff as a back-door way of avoiding taxes on a planned sale.
In a typical spinoff, a company turns a subsidiary into a new company, which belongs to its shareholders. The parent company doesn’t pay taxes on any difference between its investment in the subsidiary and the deal price, and the shareholders don’t face tax consequences.
Companies often view spinoffs as a way to make their operations more efficient or to unlock value in a conglomerate. In the Kraft deal, announced Aug. 4, the parent company plans to spin off its North American grocery business, putting Oscar Mayer meats together with Maxwell House coffee while keeping them separate from the global snack food business that will remain the home of Oreo cookies and Trident gum.
Several of the companies pursuing spinoffs, including Kraft and El Paso, are seeking private letter rulings from the Internal Revenue Service blessing the structure of the deals.
Those letters come with caveats. The IRS doesn’t issue opinions on whether there is a plan for a future purchase of the spun-off company, whether the spinoff is a technique for avoiding dividend taxes and whether there is an adequate business purpose for the transaction.
A 2003 decision by the IRS to include the caveats was coupled with a decision to provide clearer public guidance on how to achieve a spinoff, said Wilcox, who was deputy chief counsel at the IRS at the time.
“Too many resources at the IRS were being used to help taxpayers make these very detailed factual determinations,” he said.
That decision to limit the scope of IRS rulings hasn’t stopped companies from seeking them.
“Because the potential numbers are so great if you blow it, some folks feel better if they have the time to go get the ruling, just so they have a piece of paper in the file showing that the IRS has a piece of paper and blessed it,” Wilcox said.
Once the spinoff is completed, the tax issues don’t end for the parent or the new company. If the spun-off company is acquired, the IRS may examine whether the merger was part of a plan that was contemplated during the spinoff process.
The agreements often give a parent company the ability to limit future acquisitions to prevent unfavorable tax consequences.
The restrictions on the future purchase of a spun-off company aren’t as strict as many people think, Willens said. For example, Motorola Mobility Holdings Inc., which completed its $8.3 billion spinoff from Motorola Solutions Inc. in January 2011, is now being purchased by Google Inc.
Willens said the Google-Motorola Mobility merger will be a “watershed case” on what can happen after a spinoff even in the period when the IRS will scrutinize transactions more closely.
“Here you have very good evidence to point to when people are skeptical how quickly an acquisition can occur,” he said.
The potential tax consequences of failing to complete a spinoff can be severe. Unlike individuals, corporations don’t receive a preferential tax rate for capital gains.
That causes companies to be particularly cautious about ensuring they receive a favorable IRS ruling and an unqualified opinion from tax advisers, said Michael Wilder, a partner at McDermott, Will & Emery in Washington.
‘Betting the Company’
“You’re betting the whole company if you trip up on a spin,” said Wilder, who reviewed spinoff proposals while at the IRS.
As a result, several lawyers said they were unaware of any spinoff transaction announced by a large public company that was later invalidated by the IRS.
During the process of considering a ruling, IRS officials can identify whether a proposed financing transaction would comply with the rules, said Herb Beller, an attorney at Sutherland Asbill & Brennan LLP in Washington.
“When you’re going in for a ruling, you typically want to try to smoke out through a pre-filing conference any potential issues or problems that might arise,” said Beller, who teaches a course on spinoffs at Northwestern University Law School in Chicago. “If the service is uncomfortable about certain aspects of the proposed transactions, you often can modify the deal in ways that ultimately will permit a favorable ruling.”