Spin-offs and Corporate Separations: Issues and Planning

Transcription

1 Spin-offs and Corporate Separations: Issues and Planning TEI Houston Chapter February 22, 2017 Nicholas J. DeNovio & Laurence J. Stein Latham & Watkins operates worldwide as a limited liability partnership organized under the laws of the State of Delaware (USA) with affiliated limited liability partnerships conducting the practice in the United Kingdom, France, Italy and Singapore and as affiliated partnerships conducting the practice in Hong Kong and Japan. Latham & Watkins operates in Seoul as a Foreign Legal Consultant Office. The Law Office of Salman M. Al- Sudairi is Latham & Watkins associated office in the Kingdom of Saudi Arabia. Copyright 2017 Latham & Watkins. All Rights Reserved.

2 Spin-Offs The Final Frontier Last remaining way to get assets out of corporate solution without paying tax at either the corporate or shareholder level. Basic structural pattern P = parent corporation S = subsidiary that will be distributed (often newly formed) X = unrelated third party Spin-offs vs. Split-offs Spin-off P distributes stock of S to P shareholders pro rata Split-off P distributes stock of S to certain P shareholders in redemption of their stock in P 2

3 Spin-Offs Panel Agenda Basic Rules with emphasis on the remarkable number of developments over the past 12 months: Recap in/out of control Small ATB s ( Hot Dog stand rule) Rethinking of the Device Test Ruling process Spin-off structures and the issues/pitfalls Tax Matters Agreements Leveraged Spin-Offs Morris Trust/Reverse Morris Trust Transactions IPO Carve-Outs International Issues 3

4 Basic Spin-Off Structure S C/S Public P S C/S Other Subs Assets S S 4

5 Basic Split-Off Structure A S C/S B P P C/S S C/S S Other Subs Assets S 5

6 Overview of Basic Spin-Off Requirements Distribution and Control Corporate Business Purpose 5-Year Active Trade or Business Device No 50% Ownership Shift as Part of Plan (355(e) otherwise known as the Anti-Morris Trust rules) No 50% Purchased Stock within Prior 5 Years (355(d)) Limitation on Investment-Type Assets (355(g)) P Shareholders Must Maintain Requisite Continuity of Interest in both P and S 6

7 Distribution and Control Requirements P must distribute control of S = 80% of the vote plus 80% of any nonvoting classes ( 355(a)(1)). Note that control doesn t have a value element => enables use of high vote/low vote structures in which P retains more than 20% of S s value (see recap discussion). To extent P retains stock of S after the spin-off, P generally must (i) demonstrate a valid business purpose for the retention, (ii) lack overlapping directors/officers, (iii) vote retained stock in proportion to S s other stock and (iv) dispose of retained stock within 5 years (see Appendix B, Rev. Proc ). 7

8 S Recapitalizations for P to Acquire Control Historically, IRS has allowed S to recapitalize its capital structure to facilitate P acquiring control of S prior to spin-off if it results in a permanent realignment of voting control See Rev. Rul ; see also Rev. Rul , Rev. Rul Provided basis for high vote/low vote structures in a number of PLR s. How long must S retain the two classes after the spin? No plan/intent to unwind S s two classes? No legally binding obligation to collapse S s two classes? Whither the step transaction doctrine (in this and related areas in spins) as of late 2012? 8

9 S Recapitalizations for P to Acquire Control In January 2013, IRS identified the vote/value difference as an area warranting further study and will not issue further PLRs re the control requirement in this context pending issuance of guidance in the area (see Rev. Proc ). IRS issues Rev. Proc last July which deletes the no-rule on the control requirement IRS not prevented by legislative history (355(e)) and prior rulings (Rev. Rul ) from applying the step transaction doctrine to take account of all facts and circumstances (including post-spin events) to determine if a pre-spin acquisition of control has substance for purposes of satisfying the control requirement of Sec

10 S Recapitalizations for P to Acquire Control Focus is on transactions where S issues stock to allow P to obtain control of S before spin, and then after spin S effectively unwinds the prior issuance. In that context, Rev. Proc provides two safe harbors in which it will not challenge that P failed the control requirement: Safe Harbor #1 No Action Taken Within 24 Months For 24 months after spin, S takes no action (including the adoption of any plan/policy) that would result in an unwind. Safe Harbor #2 Unanticipated Third Party Transaction No agreement, etc. regarding the transaction or a similar transaction during 24 months preceding the spin-off. No more than 20% of the third party is owned by same persons that own 20% or more of S. No negative implication intended if outside the safe harbors general tax principles apply. Does not apply if P already controlled S before S stock issued. 10

11 Business Purpose Requirement The spin-off must be motivated, in whole or substantial part, by a real and substantial non-federal tax purpose germane to the business of P or S, and that purpose cannot be achievable through any other nontaxable transaction which is neither impractical nor unduly expensive. ( (b)) The spin-off must be required by business exigencies. Must be a benefit at the corporate level. Merely increasing shareholder value is not sufficient, though it may provide basis for establishing a corporate business purpose. There may be more than one business purpose, but need to meet requisite standard of proof for at least one business purpose. Typically investment bankers would provide a letter which supports the applicable business purposes being relied upon for the spin-off. In a MT/RMT, desire to acquire only a portion of P in a tax-free manner usually supplies the requisite business purpose. 11

12 Business Purpose Requirement Appendix A from Rev. Proc provides a useful list of typical business purposes as well as what the IRS generally required taxpayers to demonstrate regarding a given business purpose in a ruling context. Facilitate Debt/Equity Capital Raise (e.g., pure play ) Cost Savings Key Employee/Compensation Fit/Focus Resolve shareholder dispute (private situation split-off) Facilitate Tax-Free Acquisition of P or S (MT/RMT) Facilitate Tax-Free Acquisition by P or S Competition Risk Reduction 12

13 Business Purpose Requirement Ruling Process Prior to 2003, IRS would rule on business purpose. Starting in August 2003, IRS stated it would no longer rule on business purpose (or device or 355(e)). Starting in August 2013, IRS stated it would rule only on discrete issues generally for spins (and no longer give overall rulings on spins), though prior no rules continued. Last August, IRS reversed course (Rev. Proc ) will now rule on significant issues re business purpose and device. 13

14 Active Trade or Business Requirement ( ATB ) Each of P and S must, immediately after the spin, be engaged in an ATB, which requires: Active conduct of ATB throughout 5 years preceding spin. Neither ATB nor corporation controlling ATB acquired in taxable transaction within last 5 years preceding spin (though expansion doctrine may apply). In applying ATB test, all members of a corporation s separate affiliated group ( SAG ) treated as one corporation. Does size of ATB matter? No size requirement under current law. Prior to 2003, 5% generally required for ruling purposes (Rev. Proc ), then abandoned in 2003 (Rev. Proc ). Now, 5% rule again under proposed regulations (see subsequent discussion of 2016 proposed regulations). 14

15 Device Test Spin-off must not be used principally as a device for the distribution of E&P of either P or S ( (d)). Concern P s tax-free distribution of S presents a potential for P shareholders to avoid the dividend provisions of the Code through the post-spin sale or exchange of either P or S and the retention of the remaining corporation. Device Test determined based on all facts and circumstances, including but not limited to the presence of various device and non-device factors. Device Factors Pro rata distribution. Sale or exchange of P or S stock after the spin-off. Excessive non-business assets (e.g., cash and other liquid assets not related to reasonable needs of the business). 15

16 Device Test Non-Device Factors Corporate business purpose P is publicly traded and has no significant (5%) shareholder. Distributees are corporations entitled to a DRD. Ordinarily Not a Device No accumulated or current E&P for either P or S (taking account of the spin as if it were taxable). In absence of Sec 355, distribution would have been a redemption to which Sec 302(a) applied (i.e., exchange treatment rather than dividend treatment). 16

17 Device Test -- Developments Background Cash-rich spins. At a Spring 2015 DC bar meeting, IRS official suggested that contrary to longstanding administrative practice, S s reliance on a tiny active business where S s assets consisted largely of investment assets might be problematic. REIT spins. In effect, P is an OpCo and S is a PropCo and S elects REIT status after spin. Historically, concerns that a REIT (being a passive-type entity) couldn t satisfy the ATB requirement, but more recent IRS guidance had suggested foregoing OpCo/PropCo spin was possible and led to a number of REIT spin transactions. 17

18 Device Test -- Developments Notice Areas of Concern Excessive Investment Assets. Ownership by P or S of Investment Assets ( IA ) having substantial value in relation to (i) value of all of such corporation s assets and (ii) value of ATB assets. Differential Investment Assets. Significant difference between P s ratio of IA/non-IA to S s ratio of IA/non-IA. Tiny ATB. P s or S s ATB being small in relation to all of its assets. RIC/REIT. Either P or S (but not both) electing to be a RIC or a REIT. Notice updated the IRS 355 no-rule policy by adding certain transactions with the above characteristics. REIT spins addressed by adoption of Sec 355(h) in late Last July, IRS issued proposed regs re device and ATB which in effect adopt the no-rules as the law. 18

19 Device Test Proposed Regulations Modification of Nature/Use of Assets Device Factor Focus is on Business Assets ( BA ) rather than Investment Assets ( IA ), and comparison of BA to Nonbusiness Assets ( NBA ). IA was viewed as both overinclusive (including cash even though it may be needed for working capital) and underinclusive (excluded real estate assets even though they may be unrelated to the needs of the business). BA includes assets used in a business, which includes not only the ATB used for the spin but also ATB without regard to (i) 5 year active conduct requirement, (ii) collection of income requirement and (iii) new 5% minimum size requirement. 19

20 Device Test Proposed Regulations Focus is on both size of NBA% and relative difference between P s NBA% and S s NBA%. Ownership of NBA is evidence of device. The larger the NBA%, the stronger the evidence of device. NBA% is ordinarily not evidence of device if NBA% of each of P and S is less than 20%. Difference between P s NBA% and S s NBA% is evidence of device. The larger the difference, the stronger the evidence of device. Difference is ordinarily not evidence of device if (i) less than 10% or (ii) spin not pro rata and difference attributable to need to equalize value of S stock distributed with value of P stock exchanged. 20

21 Device Test Proposed Regulations Separation of BA from NBA Per Se Device Per Se Device if each of the following prongs is met: NBA% of either P or S is at least 66 2/3%. There is a substantial difference between P s NBA% and S s NBA%, using the following 3 bands: 66 2/3% < NBA1% < 80% and NBA2% < 30%. 80% < NBA1% < 90% and NBA2% < 40%. NBA1% > 90% and NBA2% < 50%. Two exceptions to this Per Se Device result Corporate distributee would be entitled to DRD (absent Sec 355). Transaction falls within the list of transactions not ordinarily considered a device in (d)(5) (e.g., a distribution that would be a Sec 302(a) redemption if Sec 355 did not apply). 21

22 Device Test Proposed Regulations Modification of Corporate Business Purpose Non- Device Factor Concern that taxpayers relying on a weak business purpose plus the publicly traded non-device factor to offset evidence of device caused by separation of NBA s. While ownership of NBA s or difference between P s and S s NBA% s can be outweighed by a business purpose for such ownership or difference, a business purpose that relates to a separation of NBA s from BA s is not evidence of nondevice unless it involves an exigency that requires the use of NBA s in one or more businesses of P or S or both. 22

23 Device & ATB Proposed Regulations Value of ATB for each of P and S must be at least 5% of the value of such corporation s total assets. Includes reasonable amounts of cash/cash equivalents held for working capital and assets required for business exigencies or regulatory purposes. Value Determinations P s and S s assets are determined immediately after the spin, but valuation is made at one of the following points in time: Immediately before the spin. Any date within 60-day period before the spin. Date of binding agreement for the spin. Date of public announcement or filing with the SEC regarding the spin. P and S must make consistent determinations, or else value determined immediately before the spin. 23

24 Limitations on 50% Acquisitions of P or S Stock as Part of a Plan Section 355(e) Section 355(e) Requirement -- One or more persons cannot acquire 50% or more (by vote or value) of either P or S as part of a plan with the spin-off, or else P s distribution of S becomes taxable. Any acquisition that occurs from two years before spin to two years after spin is presumed to be part of a plan, but the presumption is rebuttable, and there are several helpful safe harbors (see following slides). Each acquisition of either P or S stock is separately tested to determine if it is part of a plan with the spin (i.e., tainted ). All tainted acquisitions of P are aggregated, and the aggregate must be less than 50% of P. All tainted acquisitions of S are aggregated, and the aggregate must be less than 50% of S. Therefore, an acquisition must either (a) avoid being treated as a plan with the spin-off or (b) be part of a plan but not aggregate (together with other tainted acquisitions) to 50%+ of P or S. Note that the consequence of violating 355(e) is that the spin-off is taxable at the P corporate level only, and it remains tax-free to P stockholders. 355(e) applies to predecessors/successors of P and S (Dec 2016 regs). 24

25 Limitations on 50% Acquisitions of P or S Stock as Part of a Plan Post-Spin Safe Harbors Super Safe Harbor X s post-spin acquisition (other than pursuant to a public offering) OK if no agreement, understanding, arrangement or substantial negotiations in two years preceding the spin. Safe Harbor III X s post-spin acquisition OK if: No agreement, understanding or arrangement at time of spin. No agreement, understanding, arrangement or substantial negotiations within one year after spin. Safe Harbor II X s post-spin acquisition OK if: Business purpose was not to facilitate the acquisition. Occurs more than 6 months after spin and no agreement, understanding, arrangement or substantial negotiations from one year before spin to 6 months after spin. Acquisition (including agreement, etc. ) limited to 25%. 25

26 Limitations on 50% Acquisitions of P or S Stock as Part of a Plan Post-Spin Safe Harbors Safe Harbor I X s post-spin acquisition OK if: Business purpose was not to facilitate an acquisition. Occurs more than 6 months after spin and no agreement, understanding, arrangement or substantial negotiations from one year before spin to 6 months after spin. Similar Acquisition Foregoing safe harbors also contain the notion of a similar acquisition in applying the requirement that there be no agreement, understanding, arrangement or substantial negotiations regarding an acquisition. Safe Harbor VII Acquisitions of publicly traded stock Safe Harbor VIII & IX Certain compensatory-related acquisitions 26

27 Tax Requirements Practical Consequences Regarding Acquisitions of P or S Stock P and S should each avoid initiating a taxable sale for at least one year after the spin (absent an intervening unexpected change in circumstances). A third party may initiate an acquisition of S or P stock at any time post-spin (other than in a public offering) so long as in the two years prior to the spin, there was no agreement, understanding, arrangement or substantial negotiations between such third party and P (and facts consistent with device test; e.g., no plan/intent to sell in a taxable sale). Otherwise, such third party may need to wait until at least one year after the spin before re-engaging with S or P (and any such discussions must have ceased at the time of the spin). Discussion of significant economic terms with acquirer likely to constitute substantial negotiations. Exchange of nonpublic information or draft agreements may also potentially constitute substantial negotiations which is of particular note if P pursues a dual track process. 27

28 Remaining Spin-Off Requirements Disqualified Distributions (Sec 355(d)) In effect, to extent there has been a 50% or more purchase of P or S stock, triggers a 5 year holding period. Similar to Sec 355(e), consequence is that the spin-off is taxable at the P corporate level only. Purpose is to avoid using a high outside stock basis to (completely) avoid P s gain with respect to S. Continuity of Interest Prespin historic shareholders of P must maintain continuity of interest in both P and S. Cash-Rich Split-Offs (Sec 355(g)) not a good spin if: Immediately after spin, either P or S is a disqualified investment corporation ( 2/3 investment assets); and Any person who did not hold a 50%+ interest in the DIC immediately before spin hold such an interest immediately after. 28

29 Tax Matters Agreement Allocation of Responsibility for Taxes and Tax Returns Preclosing/Straddle Period Returns Filed Post-Closing Rights re Tax Contests Allocation of Attributes Indemnities for Blown Spin Fault concept? Split responsibility if no fault? S s Do s & Don t s for 2 Years After Spin Exception if ruling or will level opinion. Covenants are typically not symmetrical. TMA Especially Critical in RMT s 29

30 Monetization -- Extracting Value from S S assumes P debt (limited to P s basis in S) S leverages itself and distributes proceeds to P for retirement of P debt (limited to P s basis in S) P uses S securities (or S stock) to retire P debt Not limited to P s basis in S If P creditors want cash and not S securities, P can use I-Bank as an intermediary to effectively give cash to P creditors: IB acquires P debt for cash at least 2 weeks in advance (and no agreement with P for at least 5 days after debt is acquired by IB). P contributes assets to S for S stock and S securities. IB transfers P debt to P in exchange for S securities. IB sells the S securities to the public in an offering for cash. Use of (relatively) new P debt in this structure? Commercial paper? Consider limitations set forth in Rev. Proc re P debt issued in anticipation of spin (step transaction issue). 30

31 Monetization Securities Exchange Technique S secs Public P debt IB $ S secs Public P Creditors $ P debt P S C/S S C/S and S secs S Other Subs Assets S 31

32 Morris Trust Transactions Concept and Structure X wants to acquire only some of P s assets, in exchange for X stock and some cash (in a transaction that qualifies as a taxfree reorganization). P drops the wanted assets into S and spins S to the P shareholders, and then X acquires S. This is a Reverse Morris Trust transaction. If instead P drops the unwanted assets into S and spins S and X then acquires P, then it is a Regular Morris Trust transaction. The Anti-Morris Trust Rules (Sec 355(e)) P shareholders must retain 50%+ of the combined X-S entity (through ownership of X stock) after the acquisition transaction. Amount of remaining headroom will affect degree of post-spin flexibility re subsequent acquisitions of X stock. Importance of Tax Matters Agreement Potential limitations on X s ability to disturb S s ATB for 2 years following the spin. 32

33 Reverse Morris Trust Transaction Public 1 Public 2 S C/S X C/S P S S C/S X S C/S Other Subs Wanted Assets S S 33

34 IPO Carve-Out Transactions Concept P wants to take S public in an IPO transaction. S issues a portion of its stock to the public, and then P subsequently distributes the remainder of its S stock in a spinoff. Rationale Cash proceeds received by S can be distributed to P (to extent of basis). Establishes a public market valuation for S in preparation for the subsequent distribution of P s remaining interest in S. Structure Primary (S issues stock directly to public for cash) versus secondary (P sells S stock to public for cash) Secondary is taxable => usually do primary and upstream cash to the extent of basis (subject to any north/south concerns). 34

35 IPO Carve-Out Transactions Structure Size of carve-out High vote/low vote structure allows >20% offering, but also deconsolidates S from the P group. Forming and then collapsing high vote/low vote structure Ability to recapitalize S into a high vote/low vote structure, then do the offering and the spin, and then collapse the structure back into a single class of stock after the spin. Formerly, so long as no legally binding obligation to collapse the two classes. To extent Rev. Proc applies, may need to wait 2 years unless an unanticipated third party transaction occurs earlier. 35

36 IPO Carve-Out Public 80% S C/S P $ IPO Market Other Subs $ S 20% S C/S 36

37 International Issues in Spin-Offs 1. Packaging a U.S. Spinco Pre-spin International Restructuring to set the stage for spin-off of U.S. Spinco, Common international tax issues (Subpart F, FTC, Section 1248, Section 367, Host Country Issues) 2. What if Spinco subsequently combined with another company? U.S. or Foreign. 3. Inversion Issues a. Spin by U.S. Parent of Foreign Subsidiary b. Spin by Foreign Parent of Foreign Subsidiary c. Routine U.S. Spin by U.S. parent of U.S. Subsidiary 37

38 Packaging a US Spinco; Typical Pre-Spin Steps 1. Transfers of assets between CFCs. 2. Internal spin-off of one CFC by another CFC. 3. Internal spin-off of CFC by U.S. sub to another U.S. affiliate. 4. Section 351 contributions of CFC to another CFC or to a U.S. affiliate. 5. Transfer of CFC from USP Group (distributing group) to U.S. Spinco (spun off group). 38

39 Packaging a US Spinco; Typical Pre-Spin Steps Internal Spin FS2 USP 4 5 FS2 Shares 2 Internal Spin FS3 by FS1 FS1 FS3 Asset 1 Transfers D Sub1 3 Transfer FS3 Shares FS2 FS3 US Spinco Typical spin-off of US subsidiary (or US Newco) involves many pre-spin steps. Essentially "Packaging" US Spinco for overall deal by separating business lines. Might involve dozens of subsidiaries and steps. Note: FS3 might or might not be Newco. 39

40 Packaging a US Spinco; Typical International Issues Issues 1. Asset transfers from FS1 to FS3 to separate business line. Subpart F? Transfer taxable or tax free? Section 351 typically applies but could be issues. Certainly Host Country issues (de-merger) See slide Internal spin of FS3 by FS1. Need to look at Section 1248 amounts embedded in FS1 and FS3. Does spin off cause a reduction in Section 1248 amount? See Reg Section 1.367(b)-5. Basis D Sub 1 has in FS1 shares Allocation of that basis between FS1 and FS3 E&P of FS1 and FS3 Result may be basis reduction or Section 1248 inclusion See slide

41 Packaging a US Spinco; Typical International Issues Transfers between CFC s or separation of business in CFC. D. Sub 1 FS1 Assets FS3 Local steps via de-merger or actual asset sale with cash Round Tripped Cash : IRS liberal view in rulings. Section 355 qualification 41

42 Internal Spin of CFC by another CFC 40% USP Basis 80 What would USP s Section 1248 amount be if it sold FD? 100% FD FMV 500 E&P 0 Assume FD distributes FC to USP. FC FMV 250 E&P 300 Treas. Reg (b)-5 examples. Sale of FD would have resulted in: Amount realized 200 (40% X 500) Basis 80 Gain 120 (All 1248) 42

43 Section 367(b): Internal Spin of CFC by another CFC Basis 40 USP 40% 40 Basis What would USP s Section 1248 amount be if it sold FD and FC? FMV 250 E&P 0 FMV 250 E&P 0 FD FC FMV 250 E&P 300 Sale of FC would now result in: Amount realized 100 (40% X 250) Basis 40 Gain 60 (All 1248) USP must reduce basis in FC to 0, and include 20 dividend. USP can increase basis in FD by Preservation of Section 1248 Amount is goal. 43

44 Packaging a US Spinco; Typical International Issues 3. D Sub 1 transfers FS3 to FS2. This is outbound transfer of CFC to CFC. Gain Recognition Issues, Reg (a)-3. GRA required under Ref (a)-8 Basis and Holding Period Rules under Section 358. See also Reg (b)-13. Can arise in merger where results in higher basis in FS2 (due to BIL in FS3 shares). 4. Internal spin of FS2 by D Sub 1 to USP. Distribution of CFC by one U.S. affiliate to another U.S. affiliate. Section See Section 1248(f). General rule is Section 1248 inclusion by D Sub 1. But see Reg (f)-2. No inclusion if certain basis, holding period and compliance met. Again Preservation of 1248 Amount key. See Slide Contribution of FS2 to U.S. Spinco. Section Note: U.S. Spinco to leave group; now owns the hot potato. See Slide 46 44

45 Packaging a US Spinco: Internal Domestic Spin of CFC Internal Spin FS2 USP 4 5 FS2 Shares 2 Internal Spin FS3 by FS1 FS1 Asset 1 Transfers D Sub1 3 Transfer FS3 Shares FS2 US Spinco When D Sub 1 distributes FS2 to USP, this is domestic spin of CFC. CFC status is preserved, but rules under section 1248(f) apply. FS3 FS3 45

46 Post-Spin: Who owns the CFC on day 365? Public Public USP US Spinco Combination U.S. Company Issue D Sub 1 FS1 FS2 FS3 USP has just spun US Spinco US Spinco to combine with unrelated U.S. Company US Spinco holds FS2, FS3, etc. Tax years of FS2, FS3 have not closed. Subpart F based on last day of CFC ownership. U.S. Company may be liable for pre-spin subpart F income. Tax Sharing Agreement. 46

47 Post-Spin: Post Spin actions impacting 1248? Public Public USP US Spinco U.S. Company Issue D Sub 1 FS1 FS2 FS3 USP has just spun US Spinco US Spinco to combine with unrelated U.S. Company US Spinco holds FS2, FS3, etc. following spin. Section 1248 calculations based on full year earnings and profits pro rated by days. U.S. Company actions may impact USP s expectations from steps on slide

48 Packaging a US Spinco; Summary Summary on Packaging up a U.S. Spinco where various lower tier International Subs and Steps: 1. Do transfers within CFC group or by CFCs trigger Subpart F income? Host country issues in De-Merger or asset sales. 2. Does internal spin of CFC by another CFC trigger basis reductions or Section 1248 inclusion under Reg (b) When CFC is transferred to another CFC or a U.S. sub? GRA Issues (outbound transfers only) Section 1248 Basis adjustments 4. Internal spin of CFC by U.S. sub to USP Section 1248(f) 5. Tax sharing agreement especially in post Spin combination. 48

49 Inversion Issues in Spins: Background First US Co. (DT) and Foreign Co. (FT) seek to combine under existing FT or a new foreign holding company. DT Shareholders FT Shareholders DT (US) FT Foreign Subs (CFCs) FT Subs (non-cfcs) 49

50 Inversion Issues in Spins: Background First Legacy DT Shareholders Legacy FT Shareholders New Foreign Topco DT (US) FT Foreign Subs (CFCs) FT Subs (non-cfcs) 50

51 Inversion Issues in Spins: Background First The key corporate level issue is whether Foreign Topco is respected as a foreign corporation for US tax purposes under section 7874 The key shareholder level issue is whether the transfer of USP stock to FA otherwise nontaxable under the subchapter C rules is respected as a tax-free exchange under section 367 Note: Fair to say that although there has been increase in inversion activity in recent years, part of recent focus is due to greatly expanded rules, thus requiring "Inversion" analysis on transactions which five years ago would not have been relevant. 51

52 Inversion Issues in Spins: Background First If Legacy DT Shareholders own 80% or more of New Foreign Topco, New Foreign Topco is treated as a US corporation for purposes of the Internal Revenue Code If Legacy DT Shareholders own 60% but less than 80% of New Foreign Topco, and New Foreign Topco is in same jurisdiction as FT, New Foreign Topco is respected as a foreign corporation under the Internal Revenue Code however: Restrictions apply to US tax attributes, such as net operating losses and foreign tax credits A 15% excise tax applies to certain executive compensation of the US senior management Limits apply to intercompany cash transfers, post-closing restructuring options and depending on future regulations, related party interest expense Key is determining ratio of (i) New Foreign Topco shares held by DT shareholders, divided by (ii) total number of Topco shares. But a number of special rules apply to increase numerator and reduce denominator. 52

53 Section 7874 Generally Adjusts Numerator and Denominator Rules are subject to several regulatory and statutory rules of application that may modify the application of the statute: Disregard of EAG-owned stock (Code Sec. 7874(c)(2)(A)) Internal group restructuring and loss of control rules (Reg. Sec (c)(2) and (3)) Disregard of transfers of properties or liabilities to avoid purposes of section 7874 (Code Sec. 7874(c)(4)) Aggregation of acquisition of domestic entity by multiple foreign corporations (Reg. Sec (d)) Aggregation of acquisitions of multiple domestic entities by foreign acquiring corporation (Reg. Sec (e)) Disregard of stock of foreign acquiring corporation issued in related public offerings or private placements (Reg. Sec ) Disregard of disproportionate distributions (Temp. Reg. Sec T) Disregard of stock of foreign acquiring corporation if foreign acquiring group has significant passive assets (Temp. Reg. Sec T) 53

54 Can a U.S. group spin a foreign sub? Temp Reg T: "Spinversions" Using a Spin to Achieve an Inversion Legacy DT Shareholders Legacy DT Shareholders Legacy DT Shareholders Spin-off DT DT DT FA Contribute FA DSub1 FA DSub1 DSub1 Spin structurally achieves the inversion of DSub1 underneath FA. Note: But since FA acquired sub all of DT, likely an inversion. 54

55 Temp. Reg t: Subsequent Transfers Of Foreign Acquiring Stock in foreign acquiring that is held by a former corporate shareholder or partner of the domestic entity and is subsequently transferred in a transaction related to the inversion is not treated as held by a member of the expanded affiliated group (EAG) for purposes of applying the EAG rules Thus, this stock will be included in both the numerator and the denominator of the 7874 ownership fraction. E.g., if USP contributes US Sub to FA and then distributes FA in a 355, this is an inversion of US Sub (assuming no substantial business activities) notwithstanding the internal group restructuring exception. Two exceptions to the subsequent transfers rule 1 US-parented group exception, which applies if: i. both before and after the acquisition, the transferor corporation (or its successor) is a member of a ii. US-parented group; and after all related transactions, both foreign acquiring and the person who holds foreign acquiring stock are members of a US-parented group 2 Foreign-parented group exception, which applies if: i. before the acquisition, both the transferring corporation and the domestic entity are members of the same foreign-parented group; and ii. after the acquisition, the transferring corporation is a member of the EAG or would be a member of the EAG absent the subsequent transfer of any stock of the foreign acquiring by a member of the foreign-parented group in a transaction related to the acquisition (but taking into account all other transactions related to the acquisition). 55

56 Navigating the 7874 Issues in a Spinversion with the EAG Exception Shut Off Must carefully examine the various internal restructurings and Packaging that are inevitably part of spin-offs Need to make sure there is not a sub all acquisition (directly or indirectly) of a US corporation by a foreign corporation that potentially creates a 7874 taint If there is a sub all acquisition, consider whether there is another means to avoid 7874 taint (e.g., by not meeting the "by reason of" prong) 56

57 Navigating the 7874 Issues in a Spinversion with the EAG Exception Shut Off DT's contribution of DSub1 to FA FA is acquiring 100% of the stock of a US corp (DSub1) => flunks "sub all" prong However, if FA is old/cold and sufficiently large in value relative to DSub1, then DSub1's former shareholder (DT) does not hold 80% of the stock of FA by reason of holding stock in DSub1 DT's distribution of FA to DT shareholders DT shareholders clearly acquire 100% of FA "by reason of" holding stock in DT However, if DSub1 is not a relatively large portion of DT's overall assets, then FA has not acquired "sub all" of DT If need to restructure FA to make it "public ready" (e.g., corporate changes that would constitute an "F"), consider whether that could be treated as New FA acquiring the assets of Old FA so as to create another potential sub all acquisition of a US company that implicates

58 Additional Issues in Spinversions: Corporate Level Tax Even if DT's distribution of the stock of FA navigates the inversion rules and qualifies as a good spin-off under Section 355, DT may nonetheless be taxed on gain realized on the distribution. Section 1248(f) causes DT to recognize such gain as a dividend to the extent of FA's earnings and profits. CFC status lost. Excess gain (above FA's E&P) may be taxed to DT under Sections 367(b) and (e). This can be huge. 58

59 Cross-Border M&A Market Spin-offs and other corporate separations setting stage for subsequent strategic merger? When that merger is under discussion, what are diligence issues which look back at spin? Did the structure of the spin contemplate a strategic partner waiting out there? 59

60 Inversion Diligence - Large Foreign-Based Multinational Group Spins Off Division, which then Combines with Unrelated US Company (USP) FP Shareholders USP Shareholders FP Shareholders USP Shareholders FP FP spins FS2 to Shareholders USP Unrelated US Company New Foreign Holdco FS1 FS2 US Operations [Retained] Foreign Operations US Operations [Spinoff] Foreign Operations FS2 Issues: Was FS2 artificially stuffed ; Did it issue shares for non-qualified property? Did it acquire a U.S. affiliate before spin? USP FS2 has a history: very relevant to USP. 60

61 Inversion Diligence: What if US Spin; and either USP or US Spinco to combine with FC? Public Public USP US Spinco Foreign Co. D Sub 1 FS1 FS2 FS3 USP has just spun US Spinco US Spinco to combine with unrelated Foreign Company (FC) Or, USP to combine with FC. Issues Must consider whether any calibrations of the size of USP or Spinco (debt allocation, cash extraction etc.); also distributions by US Spinco in dieting rules. 61