Split-offs Get a Bright-line Test

Will the rumored sale of the Atlanta Braves baseball team be the first deal to take advantage of a new tax rule for cash-rich split-offs?
Marie LeoneJune 30, 2006

The new tax law signed by President Bush on May 17 received a lot of press attention, mostly because it provided a $70-billion tax cut. But the law also set limits for the first time on the amount of cash a company can pile on a subsidiary and still split it off tax-free. That change is likely to prompt many companies to complete a corporate asset swap before the more stringent limits take place next May.

The new rule, contained within the Tax Increase Prevention and Reconciliation Act (TIPRA), modifies Section 355 of the tax code by limiting the amount of cash that can be used in split-off deals. Before TIPRA, there was no official cap on the amount of cash a company could use to form a subsidiary destined to be split off. To keep the swap from looking like an outright taxable sale in the eyes of the Internal Revenue Service, it was common practice to keep the cash component of deals below 75 percent.

In recent years, however, split-off have been structured using more than 75 percent cash, points out Grant Thornton tax specialist Andy Cordonnier. For example, he says the deal between Janus Capital and DST Systems, completed in 2003, used 89.6 percent cash, while a deal involving Keyspan and Houston Exploration, which closed in 2004, used 86.6 percent cash.

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TIPRA puts an end to such deals. Under the new law, the cash component of the transactions will be limited to 75 percent. After May 17, 2007, it will be capped at 66.33 percent.

A split-off works like this: A parent company loads up an unwanted subsidiary with cash and distributes stock in the “new” company to existing shareholders in exchange for a block of its own stock. It’s a sort of a stock buyback, explains Lehman Brothers tax expert Robert Willens, in which the stock of the new subsidiary is used to buy back the parent company’s shares.

For these deals to be tax-free, the new subsidiary must be formed from “an active business” of the parent company — in practice, a unit that has been affiliated with the parent for at least five years, says Cordonnier. More important, the market value of the parent shares and the new subsidiary shares must be roughly equal to constitute a swap.

The parent also contributes enough cash to the new subsidiary to make up the difference between the value of new subsidiary and the block of stock being traded. That cash component is what TIPRA now limits to 75 percent of the total market value of the new subsidiary.

TIPRA’s second-phase deadline, which drops the transaction’s cash component to two-thirds, will likely encourage companies to complete deals sooner, than later, says Willens. For one thing, stockholders prefer to receive more cash for their shares, than be saddled with less-liquid assets, such as stock in a new subsidiary. Cordonnier also expects to see more deals going forward because the bright-line test gives companies more confidence in their tax-free status. Indeed, the rules are spelled out, and companies won’t have to worry that the IRS may reject a deal’s validity based on a nebulous cash component criteria.

One of the first deals to take advantage of the TIPRA’s bright line rules will likely be a transaction involving Major League Baseball’s Atlanta Braves, its current owner, Time Warner, and potential new owner, Liberty Media. If consummated, the widely-rumored deal — mentioned in articles in the Wall Street Journal and other press outlets — would send the Braves to Liberty Media, and about $1.8 billion worth of Time Warner stock back to the team’s former parent.

Some sources say that the deal is imminent, and is being held up by MLB officials, who insist that a baseball executive remain general manager of the team. If true, that may be a wise move: Once Liberty exchanges Time Warner stock for the subsidiary, it can do what it likes with the the Braves and the cash, including reselling or even liquidating the team. Still, that’s not likely: If the IRS interpreted a quick turnaround sale as evidence that the swap was orchestrated solely to avoid paying taxes, then Liberty, which has interests in the team already, could be taxed for the split-off.

It is usually a large shareholder that initiates a cash-rich split-off as a way of liquidating stock without paying taxes on the gains. But both the stockholder and parent company benefit from the loophole. According to Willens, Janus avoided a $400 million dollar tax bill on a $1 billion deal using a cash-rich split-off. He reckons that Germany’s Henkel saved even more on its enormous $2.8 billion deal with Clorox Co. in 2004.

Willens also says Liberty Media is likely to save a bundle on its deal, if it’s completed, because most of the 100 million shares Liberty is selling back to Time Warner were purchased in the 1980s, when Liberty bought shares in Turner Broadcasting, before Time Warner gobbled up that company.

It’s probable that Time Warner — like Clorox and DST — will also benefit from the split-off. Instead of selling the Braves, a team estimated to be worth $450 million, and paying tax on the sale, Time Warner would slip by the tax man by swapping shares with Liberty Media. That’s certainly a home run in any board room.