What it means
Many spinoffs are designed to qualify as tax-free under the relevant tax rules. When they do not, for example because the business has not been actively run for long enough or the deal is mainly a way of extracting profits, the distribution is treated as a taxable event.
At company level, the parent is treated as if it had sold the subsidiary at fair market value and then handed out the proceeds. The gain is the market value minus the parent's tax basis in the subsidiary, and it can be very large if the business has grown.
At shareholder level, the shares received are generally treated as a distribution. To the extent the company has accumulated profits, this is taxed like a dividend, and anything beyond that reduces the shareholder's basis or is taxed as a capital gain.
Because of the double layer of tax, companies usually avoid taxable spinoffs unless there is a strong reason. They may still go ahead if the subsidiary holds low-basis assets and a sale is not an option, if the tax cost is small, or if the business reasons outweigh the tax.
A spinoff that begins as tax-free can turn taxable later if something breaks the rules, such as a pre-arranged acquisition shortly afterwards. For that reason, deal documents often include indemnities that make the party responsible for the trigger pay any tax.
Alternatives are worth weighing before accepting a taxable result. A company can restructure the deal to meet the tests, delay the separation until the five-year history is complete, or choose a sale, an initial public offering of part of the subsidiary or a merger.
Each route has its own tax cost, so the board should compare them on an after-tax basis.
In practice
Real-world examples.
Example
A holding company distributes a retail chain to its shareholders even though the chain has only been trading for three years. Because it fails the active business test, the deal is taxed as if the chain had been sold. The tax cost is calculated on the market value of the chain, not on what the parent originally paid for it.
Example
A pharmaceutical group considers a spinoff of a research unit but finds the tax cost is $12,000,000. It chooses a sale to a buyer, where the tax is similar but it receives cash to pay the bill. The sale gave it the cash to pay the tax, whereas a spinoff would have left it with a tax bill and no proceeds.
Example
An investor receives shares in a newly spun off logistics business and is surprised to see a tax form showing a dividend. The distribution was taxable, so she must report the value of the shares she received. The tax form reports the value of the shares on the date of distribution, and that value becomes her basis in the new shares.
Formula
Calculation
Corporate gain = Fair market value of the subsidiary - Parent's tax basis in the subsidiary
A parent distributes a subsidiary worth $50,000,000 in which its tax basis is $20,000,000. The corporate gain is $50,000,000 - $20,000,000 = $30,000,000, and at a corporate tax rate of 21% for illustration the tax would be $30,000,000 x 0.21 = $6,300,000. A shareholder who receives spinoff shares worth $3,000 may be taxed on that amount as a dividend, so at an illustrative 20% rate she would owe $3,000 x 0.20 = $600. These figures show why boards focus so heavily on the corporate-level tax: in this case it is far larger than the tax paid by any individual shareholder.Case study
Seen in the real world.
Calderon Media Group is an illustrative, fictional company with a profitable publishing arm that has grown tenfold since it was acquired. The board wants to separate the arm to focus on digital services.
The tax team finds that the publishing arm was acquired only three years earlier, so the spinoff will not meet the five-year test. The corporate gain would be $40,000,000 and the tax about $8,400,000.
The board compares this with a sale of the arm for cash and decides to sell instead. In this fictional case the sale delivers the same tax but gives the company the money to pay it, which a taxable spinoff would not.
Watch out
Common mistakes.
- Assuming every spinoff is tax-free, when many fail the conditions and are taxed.
- Overlooking the tax at the company level, which can exceed the shareholder tax.
- Ignoring the risk that a later sale or acquisition can retroactively make a tax-free spinoff taxable.
Questions
People also ask.
Why is a taxable spinoff costly?
The parent may pay tax on the gain as if it sold the business, and shareholders may also pay tax on the shares they receive.
Who pays the tax?
Both the company and the shareholders can be liable, depending on the structure and the tax rules.
Can a taxable spinoff ever make sense?
Yes, if the tax is modest, the business reasons are compelling or a tax-free structure is simply not available.
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