McDonald's Corp. recently completed an innovative transaction in which it disposed of its Class B stock in Chipotle Mexican Grill Inc. The divestiture took the form of a split-off, rather than a more conventional spinoff.
In a spinoff, the parent simply distributes its stock in a controlled subsidiary to its shareholders on a pro-rata basis. In a split-off, by contrast, the parent offers stock in the subsidiary in exchange for a specified number of its own shares. A split-off is thus, of necessity, a non-pro-rata transaction. But like a spinoff, it will be tax-free if the parties follow the rules in Sec. 355(a) of the tax code.
How does one structure a split-off? Let's look at the McDonald's transaction. Immediately before the split-off, the parent owned all of Chipotle's Class B stock, with each Class B share possessing 10 votes. Chipotle's Class A stock, entitling the holder to only one vote per share, had been previously sold in a public offering.
So on the eve of the divestiture, McDonald's owned Chipotle's stock that carried 82.2% of the total combined voting power of all classes of Chipotle's stock -- even though that stock comprised only 50.8% of the total value of CMG's outstanding stock. Yet this disparity did not prevent a split-off.
As the rules demand, McDonald's was in control of Chipotle's immediately before the split-off, because control is defined as the ownership of stock possessing at least 80% of the total combined voting power of all classes. There is, oddly, no requirement to own any particular percentage of the value of the subsidiary's outstanding stock.
To ensure that the offer would be fully subscribed, McDonald's offered its shareholders an attractive premium. It promised them $1.11 worth of Chipotle's Class B stock for each $1.00 worth of McDonald's stock tendered in the exchange. However, in no event would a tendering shareholder be entitled to receive more than 91.57% of a Chipotle's share for each share of McDonald's surrendered.
The premium served its purpose, since the offer was substantially oversubscribed. McDonald's accepted 18,628,187 of its own shares in exchange for all 16,539,467 shares of the Chipotle's Class B stock it possessed. Accordingly, each tendering shareholder received 88.79% of a Class B share for each McDonald's share accepted for exchange. The values used to compute the exchange ratio, $49.95 for the Class B stock and $39.92 for the McDonald's stock, enabled the company to accomplish its goal. Each tendering shareholder received, for each dollar of McDonald's stock surrendered, Chipotle's Class B stock with a value of $1.11.
Unfortunately, the demand for the Class B stock, taking the premium into account, far outstripped the supply, and the proration factor was a miserly 7.01%. Each tendering shareholder, therefore, putting aside holders of odd lots, received only 7.01% of the Class B shares she had subscribed for.
There are some unique advantages to doing a split-off rather than a spinoff. In a split-off, the parent retires a portion of its stock, which has the effect of minimizing the earnings-per-share dilution created by removing the earnings of the split-off unit from the consolidated earnings figure. What's more, the parent gets to retire such stock using the pretax value of the subsidiary's stock as the buyback currency. Although normally a corporation's distribution of appreciated property to shareholders in retirement of its stock is a taxable transaction, Sec. 355(c) provides that a distribution that qualifies as a spinoff or split-off avoids tax consequences.
And a split-off permits the shareholders of the parent to rearrange their holdings on a tax-free basis. In a spinoff, a shareholder who likes the subsidiary's business prospects, but not the parent's, must sell his parent stock and pay a tax on the resulting gain, to raise the funds to invest in the subsidiary's stock. In a split-off, a shareholder can achieve the same goal without the tax liability by simply tendering aggressively into the exchange offer.
A split-off also offers freedom from one of Sec. 355's tests, the so-called device test. Ordinarily, a distribution cannot qualify for tax-free treatment if it is found to be used principally as a device for the distribution of earnings and profits. The purpose of the device test is to prevent the use of Sec. 355 to avoid the Tax Code's dividend provisions.
In the case of a split-off, however, those provisions cannot be avoided because, if the distribution was taxable, it would qualify (under Sec. 302[a]) as a payment "in exchange" for the surrendered stock rather than as a dividend. Accordingly, a split-off need not, in the first instance, confront the device test; and this means that even if the transaction exhibits "device factors" (such as later stock buybacks by either party), it cannot be rendered taxable by the device test.
Some investors have inquired as to whether the premium is taxable. Even though offering a premium is a common tactic in split-offs, the IRS has never officially commented on its tax character. The authorities suggest, however, that the premium ought to be tax-free. There was a ruling in which the IRS concluded otherwise, but in that case the parent happened to be indebted to the exchanging shareholder for rent on a building; the premium was seen as a method for paying that debt.
Here, of course, the premium was not offered for the purpose of defraying any discernible obligation owed by McDonald's to its shareholders; arguably, the primary beneficiary of the premium was McDonald's itself. The premium was offered to ensure that the separation would proceed without a hitch, which it certainly did. It advanced the business purposes of both McDonald's and Chipotle's, and also delivered a tax-free windfall for the exchanging shareholders. - Robert Willens
Robert Willens is a managing director and tax and accounting specialist at Lehman Brothers Inc. He is also an adjunct professor of finance at Columbia Business School.
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