The IRS said last week it will no longer issue broad rulings about whether such deals qualify for tax-free treatment. It will still offer rulings on “significant issues” that aren’t a matter of settled law, but for by-the-book transactions that don’t raise red flags, companies will have to rely on their lawyers.
The change, which becomes effective in August, is the IRS' latest effort to curb the time it spends telling specific companies whether their transactions are kosher. The agency says the move is meant to cut costs and use in-house attorneys more effectively.
In theory, the impact should be minimal, said Steve Gordon, who heads the tax practice at Cravath Swaine & Moore LLP. Companies whose spinoffs use newfangled tax structures or touch on genuinely unsettled questions of law should still be able to get IRS rulings on those issues.
But “in practice, it may make companies a little bit more cautious,” he said. “Getting those comfort rulings is nice. It's a security blanket. At the margin, we could see companies hesitating more before engaging in these transactions.”
Spinoffs are particularly complex, and much of their value comes from their tax-free status. Stockholders don’t pay taxes until they sell the shares of the spun-off entity. And companies pay no taxes on their proceeds, which gives spinoffs a key perk over the sale of those same assets to a third party.
“Section 355 [of the IRS Code] is really the only way left to remove assets from a corporation on a tax-free basis,” says Thomas May, who chairs Baker & McKenzie’s global tax planning group.
So they have drawn scrutiny from the IRS, which requires a good reason for doing the spinoff — the so-called business purpose test — and proof that it isn’t an attempt to avoid taxes on distributions, or to use shareholders as a fence to sell assets to a third party tax-free.
To preempt a problem, many companies seek the agency's blessing beforehand. This approval can take up to six months to get, but gives companies the security of knowing they won’t face a surprise audit down the road.
But as the IRS has dealt with budget cuts in recent years, it has sought to limit the scope of its letter rulings.
Starting in 2003, the IRS stopped issuing private letter rulings on three of the most important tax aspects of spinoffs, including the business purpose test. The change left companies more reliant on lawyers’ judgment, rather than the blessing of regulators, when structuring deals as spinoffs.
Now, it is dropping the blanket rulings altogether.
“The IRS has gradually restricted the areas in which they will rule, and this is a fairly dramatic step,” said Gregory Kidder, a tax partner with Steptoe & Johnson LLP’s Washington D.C. office. “Opinion letters [from counsel] only get you so far, especially in an environment where companies are afraid of finding themselves on the front page of the Wall Street Journal for having a deal that’s challenged.”
The question going forward, Gordon said, is how serious the IRS is about its promise to continue to give rulings on unsettled issues. Debt-for-debt swaps are one such issue, as are “north-south” transfers, where a parent and subsidiary want to trade assets in the course of a spinoff.
“If people can still get answers to legitimate questions where there is widespread uncertainty, I think the effect of the ruling will be minimal,” Gordon said.
It’s worth noting that the IRS long ago stopped issuing similar blanket rulings for mergers and acquisitions, Gordon said. Parties adjusted, tax counsel started to play a bigger role, and deals continued to get done.
But the change may echo especially loudly in the current environment of enhanced shareholder activism, where companies are fielding calls from hedge funds to sell or spin off noncore businesses. Greenlight Capital LLC’s Dan Loeb is pushing Sony Corp. to spin off part of its entertainment business. Shareholders of metals manufacturer Timken Co. in May passed a nonbinding proposal to spin out the company’s steel arm.
Even without needling from activists, some companies are proactively taking the “fit and focus” motto to heart. Pfizer Inc. recently spun off its animal health unit, Zoetis Inc., and ConocoPhillips Co. and Marathon Oil Corp. have both jettisoned downstream operations into new traded companies.
Spinoffs are also the preferred tool of a slew of companies looking to unlock the value of their real estate. Penn National got IRS approval late last year to separate its racetracks and casinos from its operations and convert the former into a real estate investment trust, a tax-advantaged structure. Prison landlord Corrections Corp. of America and cellphone tower owner American Tower Corp. have both received similar rulings since 2011.
Others are pushing the definition of real estate further. Outdoor billboard owner Lamar Outdoor Co. and data storage companies Equinix Inc. and Iron Mountain Inc. are still awaiting approval, which may not be forthcoming, the agency suggested earlier this month.
Independent tax expert Robert Willens said their efforts likely won’t be affected by the IRS’ recent move because the question of exactly what counts as real estate is far from answered.
“A REIT ruling cannot be characterized as a ‘comfort ruling’ in light of the difficult issues that have to be resolved,” he said. “This new pronouncement tells us nothing about the fate of REIT rulings.”
The ruling is IRS Revenue Procedure 2013-32.
--Editing by Kat Laskowski and Chris Yates.