Bill McConnell | The Deal | July 12, 2013
The sluggish recovery is forcing companies to find any way they can to squeeze out value for shareholders. With industry consolidation and workforce productivity already heavily mined veins, corporate spinoffs of noncore or underperforming operations - either in the form of stock to be held by the parent companies' shareholders or as initial public offerings - are another increasingly popular way to excavate returns.
In 2012, public companies spun off 37 operations worth $187 billion in market capitalization, according to Spin-Off Advisors LLC, an independent equity research firm. That's an increase of more than 78% from the $105 billion in value carved out of corporations in 2011, though the raw number of spinoffs was down last year, from 47 in 2011.
Despite the dropoff in the number of transactions, Joe Cornell, principal at Spin-Off Advisors, said there were more large deals in 2012, including Abbott Laboratories $55 billion spinoff of its research-based pharmaceutical business, now named AbbVie Inc.; the $27 billion spinoff of Kraft Foods Group Inc. from Mondelez International Inc. (formerly Kraft Foods Inc.); and the $21 billion paring of Phillips 66 Co. from ConocoPhillips.
"The numbers were skewed a bit last year because there were a couple of pretty large ones but they still indicate that in terms of numbers and size, there continues to be a significant ramping up in spinoffs over the last several years," Cornell says.
The top performers among 2012 spinoffs in terms of total return for investors included Kennady Diamonds Inc., which was carved out of Mountain Province Diamonds;Phillips 66;Rouse Properties Inc. from General Growth Properties Inc. and Liberty Ventures Group out of Liberty Interactive Corp.
The pace of the past two years indicates that spinoffs might soon return to the precrash levels of 2007, when there were 41 such transactions valued at $225 billion in market cap.
In the middle of this spinoff wave, the IRS has decided to review its policies for deciding whether a spinoff is tax-free to the parent corporation and the shareholders who receive shares of the new company.
The IRS on Jan. 2 announced that it will no longer issue private letter rulings informing companies whether some key types of spinoffs are likely to be tax-free. The IRS said the policies for those types of transactions are under review and it won't issue private letters advising companies if their spinoff proposals qualify for tax-free status.
The notice affected three types of transactions. One is so-called "recapitalization into control," when a company restructures the voting and other classes of stock of the unit to be spun off so that the parent qualifies as the controlling entity of the operation being pared off. To qualify as a tax-free event, the transaction must distribute control away from the parent firm, and thus the parent must be considered in control in the first place.
The IRS defines control as holding 80% of the voting stock and 80% of all other classes of stock of the unit being spun out. Distributing companies that failed to meet that test have generally been permitted to "recapitalize into control" by establishing separate classes of high-vote/low-vote stock shortly before the spinoff in order to qualify.
The IRS also said it would stop issuing private letters regarding debt-for-debt exchanges in which the parent company retires a portion of its outstanding debt by transferring certain debt securities of the controlled operation to the shareholders.
Finally, the IRS said it won't rule on north-south transactions in which cash and other assets are moved from the parent corporation, the "north," to the distributed operation, the "south," before the spinoff. The concern in these transactions is that the transfer of properties within the corporation could create an unintended taxable event.
Tax attorneys say the stakes are high in structuring spinoffs to be tax-free. If a corporation ends up being liable for an inherent gain in value of the spun off operation, the bill could be sizeable. Likewise, shareholders would face a big bill for the receipt of new stock of the carved-out operation. By making both liable parties pay tax, the bill could be problematic because unless the spinoff is conducted as an IPO, there is no cash generated in the transaction to pay the taxes.
In the absence of IRS letter rulings, distributing companies must rely on the advice of counsel to be confident they have structured their transaction in a tax-free manner.
Jeffrey Wagner, a partner in the federal tax practice ofMcDermott Will & Emery LLP, says that issuing private letters has tended to place heavy demands on the IRS and the agency hopes that better guidance will reduce the requests for agency opinions on individual deals.
"This is an important area and lots of big names in the tax bar are expected to comment," he says. "Afterwards, they might not feel the need for private rulings and that might lighten the burden on the IRS."
Robert Clary, another MWE tax partner, says there's been little decline in the spinoff activity despite reduced clarity on the tax front. "Spinoffs are a corporate and competitive trend, separate from tax policy, that we've seen over last four or five years," he says. "That is likely to continue."
Spin-Off Advisors' Cornell agrees that the uncertainty surrounding the tax status of the transaction has not diminished demand. "We haven't seen any fall-off this year and activity has accelerated in the last two months," he says. So far this year 16 spinoffs have been completed and at least 26 are on deck.
Cornell attributes much of the interest in pursuing spinoffs to the current phase of the economic recovery. "The easy moves companies can make to create value have been done - they've cut costs; they've become efficient. The low-hanging fruit is gone," he says. "At this point you think your company has value that's not recognized in the stock market this may be a way to create shareholder value."
He also notes that activist shareholders have been much more aggressive in pressuring managements to break off pieces of their companies or restructure. "If your stock hasn't done anything in five years, they are trying to force the issue to get value unleashed," Cornell says.
The trend is paying off for investors. Cornell notes that the Bloomberg Spinoff Index as of June 24 was up 16.74% for the year versus 11.24% for theS&P 500. "It's been very good for shareholders," he says.
by Bill McConnell
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