The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 10, May 1999, Panel Publishers, New York, NY.
RETAINING STOCK AFTER A SPINOFF
By Robert W. Wood, San Francisco
For a spinoff to qualify for tax-free treatment the distributing corporation must distribute either all of the stock and securities it owns in the controlled corporation or an amount of stock of the controlled corporation that represents control. In the latter case, it must establish to the IRS' satisfaction that the retention of controlled corporation stock and/or securities (and options and warrants constitute securities for this purpose) is not part of a plan that has tax avoidance as one of its principal purposes.
It is generally difficult to justify such a retention of stock. Indeed, the regulations contain the ominous statement that ordinarily, the business purpose for the distribution will require the distribution of all stock and securities. See Reg. §1.355-2(e)(2).
Some Retentions OK
Nevertheless, in Rev. Rul. 75-321, the IRS permitted a retention of 5% of the controlled corporation's stock in a case in which 11 of the shareholders of the distributing corporation each owned between 1% and 5% of its stock. Collectively, these 11 shareholders owned 25% of the stock. The reason the IRS approved this was that the retention had an independent business purpose—to provide collateral for short-term financing for the distributing corporation's other businesses.
Perhaps more important, due to the dispersion in ownership of the distributing corporation's stock, the stock retention by the distributing corporation was not sufficiently large to enable the distributing corporation to maintain practical control of the controlled corporation.
The IRS has indicated in recent years, that it will entertain rulings on retentions by widely held distributing corporations. See Rev. Proc. 96-30. For example, the Service suggested rulings may be appropriate where:
There is a business purpose for the retention,
The retained stock or securities will be disposed of as soon as possible (i.e., as soon as the business purpose for such retention is accomplished) but, in any event, no later than five years after the date of the spinoff,
None of the parent's directors or officers will also serve in a similar capacity with the subsidiary, and
The retained stock is voted in the same proportions as the "public vote."
If these conditions are met, the parent would appear by definition not to be able to maintain the prohibited "practical control" of the distributed corporation.
Recent Letter Ruling
In Letter Ruling 9909027, both the parent and the subsidiary needed equity capital to fund the growth of their respective businesses. They were advised that the "most efficient means" of accomplishing that goal involved a spinoff, followed by an IPO of stock of the controlled corporation. In response to this advice, the parent distributed 80% of the subsidiary's stock to its shareholders and retained the balance of its holdings—it was further advised by its bankers that retaining such stock would lower its cost of raising equity capital.
Once the spinoff takes place, the subsidiary will consummate an initial public offering, and the parent will sell its retained stock. The parent will make the sale in the offering or shortly thereafter, but in any event, no later than five years following the distribution. The taxpayer promised to comply with the aforementioned ruling conditions. Plus, as in Rev. Rul. 75-321, the taxpayer articulated a valid business purpose for the retention. The result was a favorable ruling for a spinoff that involves a stock retention.
Jumping thorugh these hoops is not exactly easy. At the same time, with authority such as Letter Ruling 9909027, we may see more of this kind of spin with a stock retention by the distributing corporation in the future.
Retaining Stock After a Spinoff, Vol. 7, No. 10, M&A Tax Report (May 1999), p. 1.