How Tax Insurance is Key to Unlocking Post-Spinoff Transactions

Summary:

Following a tax-free spinoff, the distributed corporation often needs to raise additional capital, incentivize key employees, invite significant new investment, and grow inorganically using equity as acquisition currency. However, these transactions are highly restricted by the Tax Matters Agreement drafted by the company that made the distribution. In most cases, these TMAs effectively prevent equity transactions if they would cause a 50% or greater change in the ownership of the distributed company. Tax insurance is the key to unlocking these transactions, by allowing the distributed company to price an insurance program to fully protect its former corporate parent from any negative economic impact from the equity transactions. The underwriting limits for tax insurance policies addressing post-spinoff transactions have been steadily increasing, while the premiums for such policies are at historic low prices. Taxpayers considering spinoff transactions, and their legal and tax advisors, will benefit going forward from a broader view of permitted post-spinoff equity transactions that includes the potential use of tax insurance where traditional tax advisory services and private letter ruling requests provide inadequate protection.

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Aon is not a law firm or an accounting firm and does not provide legal or tax advice. Commentary provided is based solely on Aon’s experience as insurance practitioners. We recommend you consult with your legal counsel and tax and financial advisors to address your specific situation.

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¹ If certain of these rules are violated, Parent’s shareholders are also taxed on the distribution.

² A post-spinoff transaction could jeopardize the entire tax-free nature of the spinoff if the initial spinoff was determined to be an impermissible “device” as a result of the post-spinoff transaction. Alternatively, if a change of control transaction is treated as part of a plan with the distribution, but did not constitute a “device”, the spinoff would result in taxation to Parent but not its shareholders. The “device” rules are contained in Section 355(a)(1)(B) and Treas. Reg. 1.355-2(d). The “change of control” restrictions are found in Section 355(e) and Treas. Reg. 1.355-7. All references to “Section” are to the Internal Revenue Code of 1986, as amended, and all references to “Treas. Reg.” are to the Treasury regulations promulgated thereunder.

³ Section 355(e)(2)(B).

⁴ See Treas. Reg. 1.355-7.

⁵ Treas. Reg. 1.355-7(b)(2).

⁶ An “unqualified opinion” is typically defined as a “will” opinion of a tax advisor on which Parent may rely to the effect that a transaction will not affect the tax-free status of the distribution.

⁷ See, e.g., TMA for Pfizer Inc.’s distribution of Zoetis Inc., Section 6.01(c) (PLR or unqualified tax opinion required in advance of “change of control” transaction); TMA for Smith and Wesson Brand Inc.’s distribution of American Outdoor Brands, Inc., dated August 21, 2020, Section 3.02(f) (same); TMA for United Technologies’ distribution of Otis Worldwide Corporation and Carrier Global Corporation, April 2, 2020 Section 7.02(d) (same).

⁸ See Rev. Proc. 2017-52, Section 2.03(2) (confirming no change in IRS no-rule policy on Section 355(e)), Rev. Proc. 2017-3, Section 3.01(54) (Section 355(e) no rule policy). See also, IRS, “Statement on Private Letter Ruling Pilot Program Extension” (March 12, 2019) (extending Section 355 PLR pilot ruling practice indefinitely).

⁹ In general, if a spinoff is determined to constitute an impermissible “device” to convert what would otherwise be a distribution treated as ordinary income into a transaction for which capital gain treatment applies, the spinoff is treated as taxable to the Parent company and its shareholders.

¹⁰ See https://www.irs.gov/pub/irs-utl/statements_on_standards_for_tax_services.pdf (AICPA standards published on IRS website that indicates a “’Should’ level opinion denotes 70-80% probability of success if challenged by the IRS.)