A 1995 study by J. P. Morgan reported that spin-offs increased from 10 per cent to 26 per cent of all US divestitures between 1988 and 1994. There were 23 spin-offs in 1992 valued at $5.7bn. By 1995, there were 31 spin-offs valued at $45.8bn and estimated volume for 1996 more than doubled to $100bn. The increase in non-taxable spin-offs presumably indicates an increase in tax efficient (that is, non-taxable) restructurings; however, most divisive restructurings remain tax inefficient (that is, taxable) sales. Thus it appears that divestitures, at least those in the US, are not structured to achieve maximum tax savings. To explore the reasons for this apparent anomaly, we
Spin-offs: tax comparison with an asset sale
analyzed 221 large subsidiary sales and 53 large spin-offs made by US public companies during 1987-1995 (all transactions exceeded $100m in market value).
We computed the tax costs or benefits for each of the 274 transactions under both the chosen divestiture method and the alternative method. We approximated the tax costs of sales using the taxable gains from the units that were sold and the tax benefits of spin-offs by estimating the ‘as if taxable gains assuming the units had been sold instead of being spun off. The taxable gain was multiplied by the divesting organization’s estimated marginal tax rate to obtain the tax cost to the divesting unit in a sale transaction. The spin-offs were all non-taxable. The market value of a subsidiary may be higher in a sale than in a spin-off because of the tax benefits received by the buyer. A taxable sale provides for a basis step up (hence, increased tax depreciation deductions) while a non-taxable spin-off does not.
During negotiations, the seller attempts to capture these tax benefits from basis step up by increasing the sale price. Therefore, for spin-offs, we calculate the ‘as if sales proceeds incorporating this higher price due to the buyer’s tax benefits. This adjustment assumes that a buyer would have had to pay this extra premium to close the sale, a reasonable assumption since a sale at the spin-off market value would make the parent worse off (relative to a non-taxable spin-off) by the taxes due on the gain.
We consider a transaction to be tax efficient or inefficient based on the sign of the ‘net tax cost’, which includes both the taxes due (or avoided) because of the choice of divestiture method and the higher price paid in a sale due to the buyer’s tax benefit. A tax-inefficient sale results in avoidable tax payments, even after factoring in the increase in sales price enjoyed by the seller due to the buyer’s tax benefits. Likewise, a tax-efficient spin-off avoids the payment of taxes, even after factoring in the increased sales price that could be obtained in excess of the spin-off market value, due to the buyer’s tax benefits. Conversely, a tax-efficient sale generates a net tax loss (to be applied against other taxable income) and a tax-inefficient spin-off foregoes net tax benefits that would have been available to shelter other income had a taxable sale been undertaken with tax deductible losses.
Why so few spin-offs?
If a divestiture could qualify as either a spin-off or an asset sale, we would expect that, in the absence of non-tax factors, a company facing a positive tax rate would choose a non-taxable spin-off when the assets to be divested have an unrealized taxable gain and a taxable sale when these assets have an unrealized tax deductible loss. However, we find that non-tax considerations must play a considerable role in divestiture decisions. Of the 221 sales transactions in our sample, only 29 were tax efficient and 192 were tax inefficient. Of the 53 spin-offs, 47 were tax efficient and only six were tax inefficient.
The preponderance of tax-inefficient sales is not due to negligible tax costs. For our sample, the average net tax cost of the tax-inefficient sales is $38m or 2.4 per cent of the market value of equity of the parent. The tax-efficient spin-offs generate a mean $180m in tax savings (about 6.7 per cent of the parent’s equity at market value). In more extreme cases, such as the 1996 non-taxable spin-off by Viacom of the US of its cable business, tax savings can be as much as $500m to $600m. The only way for managers to justify an avoidable tax cost of $38m is to point to at least $38m of non-tax benefits gained by the parent because the transaction was structured as a taxable sale rather than a non-taxable spin-off. (In our sample, we know the tax cost is avoidable
because we included only divestitures that meet the criteria for a tax-free spin-off and thus could have been undertaken as either a non-taxable spin-off or a taxable sale.)
It is also possible that the real tax cost to the seller is immaterial because a buyer offers a premium (perhaps based on anticipated synergies) that exceeds the tax costs. In our sample, however, the acquisition premium paid by buyers, measured as the purchase price less the book value of the subsidiary, is not significantly different from the market premium afforded spun-off subsidiaries, measured as the initial traded share price less book value. Even if the tax costs are considerable, some companies may use tax dollars to buy accounting earnings. In its financial statements the parent recognizes gain (or loss) equal to the sale’s proceeds minus the net asset book value of the subsidiary. In a spin-off there is no income effect since a spin-off is treated as a dividend and all accounting is done using book values.
By structuring divestitures as sales to increase accounting earnings, companies may end up paying higher taxes. While we find that financial reporting concerns are important to organizations in choosing a divestiture, we also find that managers do not maximize reported net income regardless of the cost. Not surprisingly, there is a limit to what they will pay for earnings.