IRS Cuts the Wait Between Spin-Offs and Acquisitions

A major relaxation of tax rules by the Internal Revenue Service packs the potential to stimulate increased acquisition and spin-off activity at the same time. The most significant change in new regulations sharply accelerates the timetable for a company to be involved in both types of deals while retaining tax-free treatment for the spin-off. Proposed revisions of the changes in the often complex and somewhat esoteric tax regulations covering spin-offs were unveiled in January 2001 to enthusiastic applause from deal accountants. The IRS converted the proposals to temporary regulations last August 2, meaning that they apply to all companies doing spin-offs after that. Robert Willens, a managing director and corporate tax expert at Lehman Brothers, says that it is highly likely that the temporary regulations will become permanent because they have drawn almost no dissent from the accounting profession. Under the prior rules, the spin-off was stripped of its tax shield if either the former parent or the company it cut loose by distributing shares to its own stockholders was acquired within two years after the spin-off was completed. With the temporary regulations, the freeze was cut to six months. The telescoping of the process increases the supply of acquisition targets by allowing both companies to emerge from tax limbo more quickly. It also suggests that restructuring companies may opt for more spin-offs since they won’t be penalized by long hiatuses from the m&a auction market should their long-range intention involve cashing out. If removal of the tax shackles help potential targets, there is a less appetizing flip side for firms that want to stay independent. The spin-off has lost much of its potency as a poison pill. Under the old rule, the spin-off walled off both companies from unwelcome offers for two years at a clip. Now they are untouchable by either friendly or hostile bidders for just six months. Aside from imposing a two-year moratorium on acquisitions, the old regs also created a cumbersome and costly process that discouraged acquisitions. There is nothing illegal per se about acquiring the parent or the spun-off company within the restricted period, but dealmaking within that span of time triggered an expensive tax bill. In most cases, taxes aren’t paid by either recipients or the distributing company if the spin-off is executed by issuing shares in the subsidiary business to the parent’s stockholders. But premature acquisition of either firm makes the deal taxable, with the former parent required to pay the freight. If the distributing company becomes the target, moreover, the tax bill usually is passed on to the acquirer. Indemnity agreements requiring the buyer to pay up were common features in deals involving companies that went into acquisitions before the two-year limitation expired. Many acquirers are reluctant to assume an extra tab atop the purchase price and deal fees. There are some catches to the new grants of dealmaking flexibility, chiefly in traditional spin-off requirements that were retained by the IRS. For example, the parent still must demonstrate that it has a valid business purpose in executing the spin-off. In addition, the IRS continues to demand that a spin-off and an acquisition by the same company not be part of a “plan” that makes them related transactions. Thus, while the timetable has been dramatically shortened, the IRS warns that all bets on tax protection are off if the distributing company had held discussions or negotiations or signed papers with a prospective acquirer before the six months were up or before the spin-off was announced or completed. Nevertheless, the restructuring company gains considerable maneuvering room under the tighter schedule. It could conceivably dress itself up for a future sale by using spin-offs to shed its least attractive businesses and then go through the abbreviated waiting period. As long as the firm doesn’t talk to or seek a buyer during the six months and sticks to the timetable, it probably won’t jeopardize the tax shield even if a deal is made not long after the quarantine runs out.