Why has Spin-off become significant in the post-covid world?

Why has Spin-off become significant in the post-covid world?

Most businesses, mainly large, highly diversified organizations, are continually looking for ideas to improve shareholder value by altering the composition of their assets, liabilities, equity, and operations. These activities generally are referred to as restructuring strategies. For instance, Reliance Industries had launched the process of spinning off their O2C business when the COVID-19 pandemic has created a slump in fuel demand. Post-spin-off, Reliance industry stock jumped by 5%. This column provides my insights on Spin-off and why Spin-off has become significant in the post-covid world.

A spin-off is a stock dividend paid by a firm to its current shareholders consisting of shares in an existing or newly created subsidiary. There is no need for shareholder approval since only the board of directors may decide the amount, type, and timing of dividends. Such distributions are in direct proportion to the shareholders’ current holdings of the parent’s stock. The subsidiary’s proportional ownership of shares is the same as the stockholders’ proportional ownership of shares in the parent firm. The new entity has its management and operates independently of the parent company. Unlike the divestiture or equity carve-out, the spin-off does not result in cash infusion to the parent company. Following the spin-off, the firm’s shareholders own both parent company shares and shares in the spin-off unit.

While spin-offs may be less cumbersome than divestitures, they are by no means simple to execute. The parent firm must ensure that the unit to be spun off is fully viable on a standalone basis and legally disentangled from other parent operations. The parent has no ongoing liabilities associated with the spun-off unit. If the spun-off unit goes into bankruptcy shortly after having been separated from the parent, the parent may be held responsible for the unit’s liabilities. Once the spin-off gets completed, the former parent continues to provide “transitional” services. More than one year after Baxter International completed its spin-off of biopharmaceutical business Baxalta, Inc., the parent, managed many of Baxalta’s back-office operations such as finance and IT. While receiving $100 million annually for such services, the former parent is limited in making other changes in its ongoing operations since it needs to maintain this support infrastructure.

Motives for Spin-Offs

Spin-offs provide a method of rewarding shareholders with a nontaxable dividend (if properly structured). Parent firms with a low tax basis in a business may prefer to spin off the business as a tax-free distribution to shareholders rather than sell the business and catch a substantial tax liability. Independent of the parent, the unit has its stock to use for possible acquisitions and can focus on a growth strategy without interference from the parent’s board which may not fully understand its operations. The spun-off business leadership has a greater incentive to improve the unit’s performance if they own stock. Now more focused and transparent to investors than when it was part of a more prominent diversified firm, the unit can become an attractive takeover opportunity, thereby potentially creating far more value for parent shareholders holding stock in the unit than part of the parent. Spin-offs also represent an easy alternative to divesting a difficult-to-sell business.

While there are compelling reasons for implementing spin-offs, there are significant disadvantages, including the loss of both revenue and synergies associated with the unit spun off by the parent. For publicly traded firms, eliminating a large portion of a firm through a spin-off to shareholders can result in less stock analyst coverage, removal from stock indices, and an increased likelihood of takeover of the former parent if the spin-off substantially reduces the size of the parent. Finally, the costs associated with separating a unit from the parent can become substantial if the unit gets well integrated into other parts of the firm.

Tax and Accounting Considerations for Spin-Offs

If properly structured, a corporation can make a tax-free distribution to its shareholders of stock in a subsidiary in which it holds a controlling interest (i.e., a controlled subsidiary). Neither the distributing corporation (i.e., parent) nor its shareholders recognize any taxable gain or loss on the distribution. Such distributions can involve a spin-off, a split-up (a series of corporate spin-offs often resulting in the firm’s dissolution), or a split-off (an exchange offer of subsidiary stock for parent stock). 

Spin-offs must satisfy certain conditions to be tax-free to both the parent and its shareholders like:

  1. The parent must control the subsidiary to be spun off, split up, or split off by owning at least 80% of each class of the unit’s voting and nonvoting stock; 
  2. The distributing firm must distribute all of the stock of the controlled subsidiary;
  3. Both the parent and the controlled subsidiary must remain in the same business following the distribution; 
  4. The transaction must be for a sound business purpose, such as improving profitability, increasing access to the capital markets for either the parent or the unit to be spun off, or enhancing management focus by reducing the number of business lines, and not for tax avoidance.

For example, Yahoo failed to receive IRS approval for its intended tax-free spin-off of its estimated $23 billion stakes in Alibaba in late 2015. The IRS declared it was most concerned about the “balance between investment assets such as stock and operating businesses in spin-off corporations.” Without such approval, any effort by Yahoo to distribute the Alibaba shares to Yahoo shareholders could result in as much as a $9 billion tax liability to Yahoo. Why? If it simply sold the stock and returned the cash to its shareholders as a dividend due to its low tax basis in the shares, Yahoo would get taxed at a 40% rate (35% federal corporate tax rate plus an average 5% state tax rate). Its shareholders would potentially get taxed at a capital gains tax rate as high as 20%, depending on their income tax bracket.

Yahoo intended to include its small business services division and its Alibaba shareholdings in the subsidiary called Aabaco Holdings, whose shares were to get spun off to Yahoo’s shareholders. While this structure has worked in other instances, the IRS decided the size of the operating unit included in Aabaco was too small to satisfy the requirements for a spin-off to be tax-free. As structured, the spin-off of Aabaco appeared to be primarily for tax avoidance and not for a sound business purpose. After considerable deliberation, Yahoo’s board succumbed to pressure from activist investors and decided not to spin off its investment in Alibaba.

For financial reporting objectives, the parent firm should consider the spin-off of a subsidiary’s stock to its stockholders at book value, with no gain or loss realized other than any decrease in value due to impairment. This treatment is because the ownership interests are the same before and after the spin-off.

Final Thoughts

Spin-offs as a restructuring strategy get used to redeploy assets by returning cash or noncash assets through a special dividend to shareholders or using cash proceeds to pay off debt. On average, Spin-offs create positive abnormal financial returns for shareholders around the announcement date because they tend to correct the parent’s problems. However, the longer-term performance of spin-offs is questionable.

 



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