Us Tax-Free Spin-Off transaction: Corporate restructuring in the US is a common occurrence. This involves selling the business of the company or simply reorganizing the management structure. Such restructuring decisions often lead to tax consequences.
A spinoff, one of the ways for corporate restructuring in the US, occurs when a corporation carves out and separates part of its business to form a new standalone entity.
Section 355 of the Internal Revenue Code provides an exemption allowing corporation to spin off the business to another company.
How Tax-Free Spin-Off Works?
- A spinoff occurs when a parent corporation separates part of its business. That corporation creates a new business subsidiary and distributes shares of the new entity to its current shareholders. Thus, after the spin-off, all the prior shareholders of the parent corporation now own stock of parent and new entity.
- Normally, if a parent corporation sells its subsidiary to an outside company, the distribution is taxable as a dividend to the shareholder. Also, the built-in gain in the stock of the subsidiary is taxed to the parent corporation.
- Section 355 of the Internal Revenue Code provides an exemption to these distribution rules. It allows a corporation to spin off or distribute shares of a subsidiary in a transaction that is tax-free to both shareholders and the parent company subject to some conditions. A company can undertake a tax-free spinoff of a business unit in 2 ways:
- A company can choose to simply distribute all the shares (or at least 80%) of the spun-off company to existing shareholders on a pro-rata basis, instead of outright selling the subsidiary to another. For example, an investor would receive 3% of the share’s issues for XYZ. If the investor-owned 3% of ABC Corporation and ABC was spinning off XYZ Corporation.
- Secondly, a company may choose to undertake the spinoff by issuing an exchange offer to current shareholders. With this strategy, present shareholders have the choice to keep their current stock positions in the parent company or exchange shares of the parent firm for stock positions that are equivalent in the spun-off company.
What Does a Tax-Free Spin-Off Under Section 355 Require?
To qualify as tax-free, there are four major requirements for a spinoff:
- Control –The ability to elect directors determines voting control. To satisfy the control requirement, the parent corporation must own stock representing at least 80% of the combined voting power of all classes of the new organisation.
- Device – The device requirement means that the spin-off cannot be used merely as a device for the distributions of earnings and profits, a review of all the circumstances surrounding the transaction, including whether the distributions are made pro rata determines, on a case-by-case basis.
- Active Trade or Business – The newly spun-off company & the pre-existing company both must qualify as “an active trade or business” immediately after the transaction goes through. Both businesses have to be actively engaged in some sort of business or commerce, for the sub-requirements to be considered an active trade or business.
- Distribution – The parent corporation must distribute all the stock or securities of the new entity. That it holds or an amount of stock sufficient to constitute control.
Furthermore, aside from the statutory requirements, there are also an array of non-statutory requirements. These are li the continuity of interest, for the spinoff to be considered non-taxable.
Tax-free spinoffs sound quite appealing but can be risky and complicated to properly pull off. We at 4i Advisory can help you to optimize taxes. We can also advise you on the pros and cons of your spin–off transactions.