The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 6, January 2000, Panel Publishers, New York, NY.


By Robert W. Wood

In order for a distribution of the stock of a controlled subsidiary to qualify as a tax-free spin-off, it must be proven that the distribution is undertaken for reasons germane to the business of the distributing corporation, the controlled corporation, or both. Usually a ruling request can't enumerate many business purposes. It just doesn't sound credible. In Revenue Procedure 96-30, the IRS provided a non-exclusive list of business purposes, any of which may be relied upon to secure a ruling on a spin-off.

Among the purposes listed, is facilitating a stock offering (where an equity offering is planned to raise capital for expansion, and the issuer's investment bankers attest to the fact that the offering will raise more funds per share if the separation is accomplished through the spin-off). A second notable purpose is what is popularly known as "fit and focus." The separation will enhance success, so the argument goes, by enabling the corporations to resolve problems — systemic or managerial — that arise by operation of different businesses within a single corporation or group.

In Letter Ruling 199948022, a taxpayer secured a ruling primarily on the basis of the equity offering business purpose. The taxpayer was unable to complete the offering, presumably due to poor market conditions within the timing limits generally imposed by the IRS. (According to the IRS, the offering should be completed within the 12 month period following the distribution.) The taxpayer, nevertheless, petitioned the IRS to uphold its 355 ruling on the theory that the taxpayer had also established in its ruling request that the distribution was motivated by fit and focus concerns. The IRS conceded that the failure to issue equity within the twelve months would not adversely affect the original ruling. Fortunately, the taxpayer had the prescience to back up its primary business purpose with an equally acceptable one.

Second Purpose Salve

Sometimes, the use of a backup business purpose can, well, backfire. In elevating fit and focus to its perch as the business purpose supporting the ruling in Letter Ruling 199948022, the taxpayer had to address a potential problem. It had two greater than five percent shareholders at the time of the spin-off. The IRS will not issue fit and focus rulings in cases where the corporation has one or more significant shareholders, unless the distribution is structured as a nonpro-rata spin-off. After all, a nonpro-rata spin would enable the significant shareholders to focus their attention on only some of the corporation's diverse businesses. A significant shareholder is one who owns five percent or more of any class of stock, and who actively participates in the management and operations of the corporation.

Here, the large shareholders proved they were not significant shareholders (because each had filed a Schedule 13G attesting to the fact that each was a passive investor). Despite the presence of these large shareholders, the taxpayer was able to structure the separation as a pro-rata distribution, even though the combination of large shareholders and the use of fit and focus as the (second round) business purpose normally calls for a non pro-rata format.

This is more than just an academic inquiry. For example, Allegheny Teledyne may be relying on the equity offering business purpose with respect to its spin-off of Teledyne Technologies. If there is difficulty in the offering, Allegheny Teledyne and Teledyne Technologies might be well advised to consider using fit and focus as a backup business purpose. One can lay the groundwork (if it becomes necessary) for that purpose to ultimately emerge as the activating business purpose for the separation.

Spinoff Business Purpose: Two is Better Than One, Vol. 8, No. 6, The M&A Tax Report (January 2000), p. 7.