SPIN-OFFS An Overview

Transcription

1 SPIN-OFFS An Overview John R. Allender, Head of Tax, US Kevin Trautner, Partner, M&A/Securities Fulbright & Jaworski LLP December 12,

2 Speaker John R. Allender Head of Tax, United States Partner Jack's practice focuses on taxation and corporate matters with an emphasis on federal income taxation. Jack is frequently involved in the planning and negotiation of mergers and acquisitions, corporate restructuring, spin-offs, tax planning for corporations and individuals and selected tax controversy matters. He has significant experience in federal tax matters relating to corporate taxation, reorganizations, incorporations, consolidated tax returns and related tax issues. 2

3 Speaker Kevin Trautner Partner Kevin Trautner has a broad-based corporate and securities practice with extensive experience in mergers and acquisitions and securities offerings. Kevin represents buyers and sellers in mergers and in stock and asset purchases. He also represents issuers, including master limited partnerships, and underwriters in a variety of public and private debt and equity securities offerings, including IPOs, debt offerings under Rule 144A, and shelf debt and equity offerings. He regularly counsels public companies on securities law compliance and corporate governance matters. 3

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5 Administrative information Today s program will be conducted in a listen-only mode. To ask an online question at any time throughout the program, click on the question mark icon located on the tool bar in the bottom right side of your screen. Time permitting, we will answer your question during the session. Everything we say today is opinion. We are not dispensing legal advice, and listening does not establish an attorney-client relationship. This discussion is off the record. You may not quote the speakers without our express written permission. If the press is listening, you may contact us, and we may be able to speak on the record. 5

6 What is a tax-free spin-off? A tax-free spin-off is a corporate transaction whereby a corporation ( Parent ) distributes to its stockholders shares of stock of a subsidiary corporation ( Spinco ) representing at least 80% of the voting power of all shares entitled to vote and 80% of the shares of each other class of stock of Spinco in a transaction described in section 355 of the Internal Revenue Code of 1986, as amended (the Code ). 6

7 The most common types of spin-offs and split-offs A classic spin-off transaction would involve a distribution of the Spinco stock by Parent, pro-rata to the Parent stockholders. A recent spin-off transaction involved ConocoPhillip s distribution of one-half share of stock of Phillips 66 with respect to each outstanding share of ConocoPhillips stock. Stockholders Parent Distribution of Spinco stock After Spin-off Stockholders Spinco Parent Spinco 7

8 The different types of spin-offs and split-offs A classic split-off is a variation of a spin-off where instead of a prorata distribution of Spinco stock to Parent stockholders, the Parent stockholders have to make a decision as to whether they keep their Parent stock or choose to exchange that stock for Spinco stock. In a split-off, Parent stockholders have the right to elect to receive Spinco stock in exchange for their Parent stock or to retain their Parent stock. Thus, a split-off involves a non pro-rata distribution of Spinco stock, while reducing the number of outstanding shares of Parent. A recent example of a split-off is Pfizer s distribution of approximately 402 million shares of Zoetis common stock in exchange for approximately 405 million shares of Pfizer common stock. 8

9 The different types of spin-offs and split-offs After Split-off Stockholders Parent Distribution of Spinco stock to electing stockholders Parent Stockholders Spinco Stockholders Spinco Parent Spinco 9

10 Why consider a spin-off? To divide the businesses into separate companies so they may operate more efficiently; the sum of the parts should be worth more than the whole. To simplify the businesses to make it easier for outsiders to evaluate and potentially to reduce financing costs. To separate disparate /conflicting businesses. To provide an opportunity to incentivize management of each respective business with ownership or stock options in the specific businesses they are managing. Hedge fund activism or competitive pressures may serve as catalyst for corporate clarity. Often a more tax-efficient and lower execution risk relative to a sale. 10

11 Overview of tax consequences of a spin-off Successful tax-free spin-off A successful tax-free spin-off under section 355 of the Code will be tax-free to Parent, Spinco and the Parent stockholders, whether structured as a spin-off or as a split-off. Failed taxable spin-off If a spin-off fails to meet the requirements of section 355, the distribution by Parent of Spinco stock to Parent stockholders will be taxable to Parent to the extent the fair market value of the Spinco stock exceeds Parent s tax basis in such stock and will be taxable to the Parent stockholders upon the receipt of the Spinco stock. If the distribution is a pro-rata failed spin-off, the distribution would generally be treated as a taxable dividend to the Parent stockholders equal to the fair market value of such stock. If the transaction is structured as a split-off, the distribution will be treated as a taxable redemption of Parent stock for Spinco stock and will be taxed to Parent stockholders as either capital gain or a dividend, depending on whether certain tests under section 302 of the Code are satisfied. 11

12 Overview of tax consequences of a spin-off (continued) As a result, a spin-off that fails to qualify under section 355 of the Code can result in double taxation, once to Parent and once to the Parent stockholders. As a result of the potential for significant tax costs of a failed spin-off, there is a lot of pressure on corporate advisors to insure that a spin-off qualifies as taxfree. IRS private letter rulings Since failure to qualify as tax-free can result in double taxation, historically many corporations have requested private letter rulings from the IRS to provide assurances that a spin-off is tax-free. Over the years, the IRS has reduced the number of spin-off related tax issues on which it would rule, but recently the IRS has changed its policy and has determined that it will not issue a private letter ruling on spin-offs under section 355 of the Code. As a result, private letter rulings are generally not available on spin-off transactions, and corporations will, in most situations, request favorable tax opinions from their advisors before proceeding with a spin-off. 12

13 Tax requirements for a spin-off Parent must distribute all of the shares of Spinco that it owns to its stockholders, and those shares must represent control of Spinco. Control consists of shares of stock representing 80% of the total combined voting power of all shares entitled to vote and 80% of the total number of all shares of other classes of stock of Spinco. Immediately after the distribution, both Parent and Spinco must be engaged in the active conduct of a trade or business which must have been actively conducted for five (5) years prior to the spinoff. The spin-off cannot be a device for the distribution of earnings and profits of either Parent or Spinco. There must be a non-tax corporate business purpose for the spinoff (not a stockholder business purpose). 13

14 Tax requirements for a spin-off (continued) After a spin-off, one or more persons who directly or indirectly were owners of Parent before the spin-off must own in the aggregate an amount of stock which would satisfy the continuity of interest in each of Parent and Spinco. Parent and Spinco must continue to operate the business existing prior to the spin-off. A 50 percent or greater interest in stock in Parent or Spinco could not have been acquired by purchase during five-year period ending on date of distribution. (355(d)) Distribution cannot be part of a plan pursuant to which one or more persons acquire directly or indirectly a 50-percent or greater interest in Parent or Spinco. (355(e)) A 50 percent or greater interest means stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or 50 percent of the total value of all classes of stock. 14

15 Corporate mechanics of a spin-off Assets and liabilities are transferred into Spinco to be spun-off In connection with a spin-off/split-off transaction, Parent often wishes to allocate a portion of its existing debt to Spinco because such debt was used to finance Spinco s businesses or because Parent wishes to extract value from Spinco Desired capital structure typically can be achieved through a combination of the following: Contributions by Parent or distributions by Spinco of cash, Assumption by Spinco of Parent debt (if permitted by the terms thereof), Debt-for-debt exchanges, and Stock-for-debt-exchanges If the value to be extracted from the business to be distributed exceeds Parent s tax basis therein, Parent is at risk of recognizing taxable income or gain 15

16 Corporate mechanics of a spin-off (continued) Under SEC interpretive guidance set forth in Staff Legal Bulletin No. 4 ( SLB 4 ), a typical spin-off may be undertaken without registration under the Securities Act SLB 4 sets forth five conditions that must be satisfied in order to qualify for this treatment: Stockholders of Parent must not provide consideration for the spun-off shares of Spinco A transfer by Parent of Spinco shares for value would constitute a sale under the Securities Act, and therefore would come within the registration requirements under Section 5 of the Securities Act absent another available exemption In a conventional spin-off, Spinco shares are distributed by dividend to Parent stockholders, and thus the stockholders do not provide any consideration in the transaction The spin-off distribution must be pro-rata to Parent stockholders In a spin-off distribution that is not pro rata, the relative interests of Parent stockholders in Spinco change and Some stockholders thereby give up value in the transaction, requiring Securities Act registration 16

17 Corporate mechanics of a spin-off (continued) Parent must provide adequate information about the spin-off and Spinco to its stockholders and to the trading markets SLB 4 guidance varies depending upon whether Spinco is a reporting entity under the Exchange Act prior to the transaction or whether it is domestic or foreign For a Spinco that is a non-reporting company, Parent gives its stockholders an information statement that describes the spin-off and complies with Regulation 14A or Regulation 14C and Spinco registers the spun-off securities under the Exchange Act Accomplished by filing with the SEC a Form 10 Registration Statement to which the 14C-compliant information statement is attached as an exhibit Content of the Form 10/information statement is substantially similar to content required for a Form S-1 Registration Statement, and SEC review process is substantially the same 17

18 Corporate mechanics of a spin-off (continued) Parent must have a valid business purpose for the spin-off If Parent is spinning off restricted securities (as defined in Rule 144), it must have held those securities for at least two years Does not apply in circumstances in which Parent formed the subsidiary being spun-off From a Securities Act perspective, a split-off transaction is a sale of Spinco securities for consideration consisting of securities of Parent, and accordingly it is subject to registration under the Securities Act absent an available exemption Section 3(a)(9) of the Securities Act, which permits (subject to certain conditions) unregistered exchanges of securities of an issuer with its existing security holders, is not applicable in the split-off context because the identity-ofissuer requirement of Section 3(a)(9) is not met 18

19 Corporate mechanics of a spin-off (continued) Transaction is registered under the Securities Act on Form S-4 Also typically constitutes a tender offer by Parent for its own shares and therefore is subject to the tender offer rules Generally, no stockholder approval is required, unless the spun-off business constitutes all or substantially all of the assets of Parent Tax considerations in restructuring corporate assets. 19

20 Economics of a spin-off Corporate activists often push to break up the companies (often through spin-offs) on the theory that the value of the parts is greater than the value of the whole. Independent studies have supported this theory. Some spin-offs have been structured to closely resemble a sale, by having Spinco borrow substantial sums and distribute the cash, but not the debt obligation, to Parent before the spin-off, the socalled leveraged spin-off. Depending on the particular circumstances of Parent and Spinco, if carefully structured, even though Parent receives a cash dividend before the spin-off, there may be no taxable gain on the spin-off where a sale could generate tax. The IRS has begun focusing more on leveraged spin-offs. Simplifying a corporate structure or business can make financial statements more transparent and, as a result, reduce borrowing costs. 20

21 Variations of approach Straight forward spin-off of Spinco This would be a process of dividing the assets and liabilities of the respective businesses along business lines without any aggressive allocations, and in the spin-off distributing 100% of Spinco stock. IPO 19.9% of common stock then spin-off the remaining 80.1% Parent is required to distribute control of Spinco in a spin-off to qualify under section 355 of the Code. One common technique utilized by a distributing corporation in spin-offs in order to receive some tax-free cash is to have an IPO of Spinco stock before the spin-off, selling 19.9% of its common stock to the public (leaving Parent with 80.1% of the stock to distribute in the spin-off). The cash proceeds of the IPO are then distributed to Parent pursuant to a previously declared dividend or in repayment of intercompany indebtedness. After which, Parent spins-off Spinco by distributing to its stockholders the 80.1% of the stock of Spinco which it had retained. 21

22 Variations of approach (continued) Leveraged spin This approach would involve Spinco borrowing significant sums from third party lenders and using the proceeds to pay dividends to Parent or to repay intercompany indebtedness. Spinco would continue to be liable on such indebtedness. To the extent that Parent borrowings have been used to fund Spinco operations, repayment of those amounts should be tax-free. To the extent that Spinco borrows money to pay dividends to Parent, those dividends are tax-free to Parent to the extent that Parent has tax basis in its shares of Spinco stock. This dividend approach effectively permits Parent to recover its investment in Spinco by receiving a cash distribution before the spin-off. To the extent that dividends from Spinco to Parent exceed Parent s tax basis in its Spinco stock, that excess creates an excess loss account (essentially negative basis) with respect to the Spinco stock. When the Spinco stock is distributed in the spin-off, that excess loss account is triggered as income to Parent. 22

23 Variations of approach (continued) Debt securities exchanges In addition to the structures described above, section 355 of the Code permits debt securities of Spinco to be exchanged tax free for debt securities of Parent when done as part of a transaction otherwise qualifying under section 355 of the Code. This approach is logical where Parent has used the public debt markets to finance the operations of all of its subsidiary businesses and this type of exchange permits an allocation of that indebtedness among Parent and Spinco. This approach is not limited to the Parent s basis in its subsidiary stock. The exchange of debt securities must be in the open market and would normally involve an investment bank purchasing Parent debt securities in the public market and exchanging those debt securities for Spinco debt securities. The bottom line impact is that Parent s outstanding debt securities decrease and Spinco s debt securities increase. See Verizon s spin-off of Idearc. 23

24 Board matters Parent Board decisions are afforded the protection of the business judgment rule if basic fiduciary duties are observed: Duty of Care: Directors must be well-informed and exercise appropriate diligence and must take the steps a reasonably prudent director would take about decisions facing the Board. Duty of Loyalty: Directors actions must be motivated solely by the best interests of the company and its stockholders; they must be disinterested, independent and act in good faith. If the directors have made the decision to cause the spin-off in compliance with their fiduciary duties, acting in good faith and with the belief that the action was taken in the best interests of the stockholders, the directors will be protected by the business judgment rule. Parent does not owe fiduciary duties to Spinco. 24

25 Board matters (continued) Directors must act in the best interests of a corporation s stockholders, but Spinco as a solvent wholly-owned subsidiary, only has the Parent as a single stockholder. A director of Spinco need not be loyal to Spinco as against the Parent. Directors of Spinco are obligated only to manage the affairs of Spinco in the best interests of Parent and its stockholders. (See Anadarko Petroleum Corp. v. Panhandle Eastern Corp. (Del. 1988)). Parent Board can make unilateral decisions as to the allocation of assets and liabilities between Parent and Spinco, subject to insolvency and tax considerations, before the spin-off is completed. 25

26 Key Agreements Separation and Distribution Agreement Identifies assets to be transferred, liabilities to be assumed and contracts to be assigned to Spinco and Parent to implement the separation; generally, no representations or warranties assets transferred as is, where is. Liabilities allocated and reinforced through cross-indemnities. Tax Sharing Agreement Governs rights and obligations of the Parent and Spinco after the spin-off with respect to taxes. Employee Matters Agreement Allocates liabilities and responsibilities relating to employment matters, employee compensation and benefit plans. 26

27 Key Agreements (continued) Transition Services Agreement Spinco often relies on Parent for back office functions like payroll, legal, IT and human resources Parent or Spinco need to negotiate which entity will retain existing services and which entity rebuilds. Typically Parent and Spinco enter into a Transition Services Agreement, with Parent continuing to provide these services for a period of time post-closing for an arms-length fee, so that Spinco will have time post-closing to transition to its own services. Duration usually not more than 24 months. Should be limited to support functions. Agreements favor Parent; Spinco management leverage Counsel for Spinco. (See Conoco Inc. v. Skadden, Arps.) 27

28 Tax sharing agreement An agreement to allocate responsibilities relating to tax issues is an important part of any spin-off and can be one of the most complex agreements signed in connection with a spin-off. Generally, Parent and Spinco join in filing a consolidated federal income tax return for years prior to the spin-off. That joint filing ends on the date of the spin-off, and the tax sharing agreement will cover things like allocation of responsibility for taxes, payments for tax benefits, tax return filing responsibility, tax audit issues, tax controversy responsibility, and settlement of tax issues. These agreements can be relatively straightforward (i.e., Parent agrees to pay all pre-closing taxes) to very aggressive and complex (Spinco pays Parent for its pre-closing taxes; all tax benefits can be utilized by Parent without reimbursement, Parent controls all tax audits and Spinco pays all taxes arising out of tax audits with little or no opportunity to defend). Disputes relating to Tax agreements may give rise to more litigation than any other in a spin-off transaction. 28

29 Tax sharing agreement (continued) The more complex and/or aggressive the Tax Sharing Agreement is, the greater the likelihood a dispute will arise. Those disputes can go beyond just the parties and can spill over to legal counsel. (See Conoco Inc. vs. Skadden, Arps.) 29

30 Other spin-off tax issues (355(e) and 355(d)) Sections 355(d) and 355(e) create exceptions to the general rule under section 355(a) that Parent will not recognize taxable income on the distribution of appreciated Spinco stock. These exceptions do not affect the tax-free receipt of Parent stock by Parent stockholders in a transaction otherwise qualifying under section 355. The focus of these two Code sections is to not permit the avoidance of gain recognition under section 311(b) of the Code, through a step transaction using section

31 Other spin-off tax issues (355(e) and 355(d)) (continued) Section 355(d) was aimed at overturning the result of the Esmark case. In that situation, Mobil was interested in acquiring a specific business owned by Esmark, but Esmark did not want to bear the tax consequences of an asset sale. Mobil purchased from Esmark a substantial equity interest in Esmark and subsequently, in a split-off transaction, Esmark distributed all the stock of the desired subsidiary to Mobil in exchange for the Esmark stock held by Mobil. Thus, Esmark sold Esmark stock to Mobil for cash without recognizing gain then spun off a subsidiary to Mobil, again without recognizing gain. The IRS claimed the transaction should be characterized as a sale of the subsidiary s stock and taxable. The Tax Court held that the transaction satisfied section 355 of the Code, and Esmark did not recognize any taxable gain on the transaction. Section 355(d) generally applies where any person purchases a 50% interest in either Parent or Spinco during the 5- year period preceding the spin-off Thus, 355(d) would effectively reverse the holding of the Esmark case. 31

32 Other spin-off tax issues (355(e) and 355(d)) (continued) Section 355(e) would apply to require Parent to recognize gain on a transaction otherwise qualifying as a section 355 spin-off where as part of a plan a third party acquires control (50% of vote or value) of Parent or Spinco. A plan is presumed to exist if this acquisition occurs within the 4-year period beginning two (2) years before the spin-off and ending two (2) years after the spin-off; however, the treasury regulations in section provide a number of safe harbor exceptions to the application of section 355(e). 32

33 Other spin-off tax issues (355(e) and 355(d)) (continued) Section 355(e) applies whether the acquisition of the 50% interest is in a taxable or tax-free transaction. One technique that has been used is to structure the acquisition of the interest in Parent or Spinco as a tax-free reorganization where the Parent stockholders continue to own in excess of 50% of the vote and value of the entity. In order to apply, Section 355(e) requires that the acquisition of the 50% interest must be part of a plan which includes the spin-off. Another approach to avoiding the requirements of section 355(e) is reliance on the safe harbors found in Treas. Reg. section For example, the often called Super Safe Harbor provides that for a post-spin-off acquisition to be considered part of a plan, it is required that there was an agreement, understanding, arrangement or substantial negotiations regarding the acquisition or a similar acquisition at some time during the two year period ending on the date of the distribution. Absent the above, the acquisition should not be considered part of a plan and as a result, section 355(e) should not be applicable to trigger gain. 33

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