The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 9, April 1999, Panel Publishers, New York, NY.
SPINOFFS OF CAPTIVE COMPANIES
By Robert W. Wood, San Francisco
Okay, so we do cover spinoffs a lot here at The M&A Tax Report. But it's still an important hole in the dike that is General Utilities repeal. And trends are continually developing in this important field.
For example, General Motors, in the wake of an offering of 100 million shares of its subsidiary, Delphi Automotive Systems Corporation, has announced its intention to distribute its residual stock in Delphi to its shareholders (via a spinoff or a splitoff). General Motors' decision to reduce the extent to which it employs vertical integration with respect to its manufacturing operations may or may not make industrial or market sense. But ah, the taxes. From a commercial point of view and, collaterally, from a tax perspective, it seems to make eminent sense to allow captive subsidiaries to expand their business opportunities by granting such subsidiaries their independence.
The business objective that this kind of distribution would inevitably seem to accomplish is to allow these captive entities to respond to the needs of actual and potential customers who object to their supplier being associated with a business that competes with customers. As stated in the Delphi prospectus, such customers are fearful that the captive will share sensitive information, which they provide to the supplier, with the parent/competitor. In addition, and more basically, if they do business with the captive, in its capacity as such, they will enhance the captive's profitability and, derivatively, the financial strength of their competitor.
Good Business Purpose
From a tax viewpoint, this business purpose is compelling and well-accepted. All spinoffs or splitoffs must, if they are to attain tax-free status, be undertaken for reasons germane to the business of the parent, the subsidiary or the affiliated group to which the parent belongs. This business purpose was initially recognized as a valid business purpose in Rev. Rul. 56-450 (where the distribution took the form of a splitoff) and is cited in Rev. Proc. 96-30, which contains the IRS's nonexclusive list of business purposes for which it will issue a ruling. The recognition of this business purpose is a pretty big deal.
Indeed, in the distant past, the IRS occasionally took the position that a corporation that did business exclusively or primarily with an affiliate, could not (by definition) be engaged in the active conduct of a business. This issue has now been conclusively resolved in favor of taxpayers (even with Section 355 in play we occasionally win one). Such a corporation can be "active" so long as it performs, via its own employees, significant services and has substantial management and operational functions. (See, generally, King v. Commissioner, 458 F.2d 245 (6th Cir. 1972), in which a functional division was upheld.)
Recently, a number of high-profile spinoffs have employed the customer/competitor conundrum as the business justification for the separation. They include PepsiCo's spinoff of Tricon. PepsiCo was viewed as a competitor by other restaurant companies and was disadvantaged in its efforts to market its beverages to these restaurants. Similarly, AT&T's spinoff of Lucent, and General Motors' splitoff of EDS were facilitated by this same type of customer relations problem.
For investors who seek to predict situations that are ripe for a separation, it may be fruitful to be on the lookout for parent/subsidiary relationships that feature a captive supplier, particularly a captive supplier that is desirous of expanding its business opportunities with nonaffiliated customers.
Spinoffs of Captive Companies, Vol. 7, No. 9, M&A Tax Report (April 1999), p. 1.