What Is a Tax-Free Spinoff?
A tax-free spinoff is a corporate activity in which a publicly listed corporation spins out one of its business divisions as a separate entity with no tax consequences. This form of transaction is considered “tax-free” because the parent company may still sell the business unit from which it wishes to split, but the firm does not face capital gains tax on the divestment, as would be the case in an outright sale of the business unit to another company.
This can be contrasted with a taxable spinoff.
- A tax-free spinoff occurs when a corporation carves off and splits a portion of its business as a new freestanding entity without subjecting the parent company to taxation.
- The first way is for the parent firm to distribute shares in the new spinoff to current shareholders in direct proportion to their ownership holding in the parent.
- The second technique is for the parent business to give current shareholders the opportunity of exchanging their parent company shares for an equivalent amount of spinoff company shares.
How Tax-Free Spinoffs Work
A spinoff happens when a parent firm splits a portion of its operations to form a new business subsidiary and distributes shares of the new entity to its existing shareholders. If a parent business distributes shares in a subsidiary to its shareholders, the distribution is normally taxed to the shareholder as a dividend.
Furthermore, the parent firm is taxed on the built-in gain (the amount the asset has gained) in the subsidiary’s shares. Section 355 of the Internal Revenue Code (IRC) exempts corporations from these distribution requirements, enabling them to spin off or distribute shares of a subsidiary in a tax-free transaction for both shareholders and the parent business.
A tax-free spinoff of a corporate unit may normally be accomplished in two ways. In either event, the spun-off firm or subsidiary is transformed into its own publicly listed corporation, complete with its own ticker symbol, board of directors, management team, and so on.
First, instead of selling the subsidiary entirely, a corporation might simply transfer all of the shares (or at least 80%) of the spun-off firm to existing shareholders on a pro rata basis. For example, if an investor held 3% of ABC company and ABC spun off XYZ corporation, he or she would get 3% of the XYZ shares issued.
Second, a firm may decide to spin off by making an exchange offer to present shareholders. Current shareholders are offered the choice of exchanging shares of the parent firm for an equal stock position in the spun-off company or maintaining their existing stock position in the parent company under this technique. Shareholders are allowed to choose whatever firm they feel will provide the highest prospective return on investment (ROI) in the future.
To differentiate it from the previous technique, this second way of forming a tax-free spinoff is frequently referred to as a split-off.
Taxable vs. Tax-Free Spinoffs
The difference between a tax-free spinoff and a taxable spinoff is that a taxable spinoff occurs when the subsidiary firm or division of the parent company is sold entirely. The subsidiary or division might be purchased by another firm or a person, or it could be sold in an initial public offering (IPO).
The way a parent business arranges the spinoff and divests itself of a subsidiary or division impacts whether the spinoff is taxed or not. Section 355 of the Internal Revenue Code (IRC) governs the taxable status of a spinoff. Because the original firm and its shareholders do not register taxable capital gains, the majority of spinoffs are tax-free, satisfying the Section 355 conditions for tax exemption.
While a company’s first legal requirement in selecting how to perform a spinoff is to ensure its own financial sustainability, its secondary legal obligation is to operate in the best interests of its shareholders. Because the parent business and its shareholders may face significant capital gains taxes if the spinoff is deemed taxable, corporations want to arrange a spinoff such that it is tax-free.
A firm may seek to spin off a subsidiary company or division for a variety of reasons, ranging from the belief that the spinoff would be more lucrative as a distinct organization to the requirement to sell the company to avoid antitrust difficulties. IRC section 355 has comprehensive criteria that go beyond the basic spinoff structure indicated above. Spinoffs may be highly difficult, particularly when debt transfers are involved. In such circumstances, shareholders may choose to obtain legal advice on the potential tax effects of a planned spinoff.
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