Time Warner Inc. announced last week that its board of directors has authorized management to proceed with plans to complete the “legal and structural separation” of AOL from Time Warner. The spin-off, according to Time Warner, will help both companies to focus on their core businesses and pursue separate growth strategies.
The separation will be structured as a spin-off or split-off in which Time Warner distributes the AOL shares to its shareholders in exchange for a portion of the shareholder’s Time Warner stock.
The proposed transaction, according to the press release, “will be structured as tax-free to Time Warner shareholders.” As a result, Time Warner intends to take the steps necessary to insure that the separation meets all of the requirements of Section 355 of the Internal Revenue Code: The transaction can only be tax-free “to the Time Warner shareholders” if these requirements are complied with.
Presumably, the deal will be structured to be tax-free to the Time Warner corporation as well. This outcome can be achieved if the same requirements necessary to insulate the shareholders from taxation are satisfied, and additional steps are taken to insure that the separation is not part of a plan in which one or more persons acquire stock representing a 50 percent or greater interest in either Time Warner or AOL. If, in fact, the separation is part of such a plan, the separation would remain tax-free to the Time Warner shareholders, but be taxable at the corporate level.
In that case, Time Warner’s gain with respect to the AOL stock (the amount by which the fair value of AOL stock exceeds its basis in Time Warner’s hands) would be recognized. That’s because under that scenario, the AOL stock would not constitute “qualified property” – the only kind of property that can be distributed tax-free in a reorganization. (See Section 361(c)(2)(A).)
Hot Stock Time Warner currently owns 95% of the stock of AOL and Google holds the remaining 5%. Time Warner ”expects to purchase” Google’s stake in AOL in the third quarter of 2009. Accordingly, when the distribution is completed, the recipient Time Warner shareholders will own 100 percent of AOL’s stock.
In the past, this sort of activity would have put a crimp in Time Warner’s plans to structure the distribution as tax-free in its entirety. Under Section 355(a)(3)(B) of the tax code, stock of the controlled corporation (AOL) acquired by the distributing corporation (Time Warner) by reason of any transaction which occurs within five years of the distribution of such stock – and in which gain or loss was recognized in whole or in part, shall not be treated as stock of such controlled corporation but as other property.
Thus, this so-called “hot stock”- the stock of the controlled corporation acquired within the five year pre-distribution period in a taxable transaction – could be neither distributed nor received on a tax-free basis. Instead, both the distributing corporation and the distributee shareholders would be taxed on the distribution and receipt, respectively, of the stock. (See Revenue Ruling 65-286.)
However, as luck would have it, the hot stock rules were recently relaxed with the result that the ordinary consequences of distributing hot stock should not arise (see Internal Revenue Service bulletin T.R. 9435) . Therefore, new regulations provide that stock that would otherwise be characterized as hot stock will not be so characterized when, as here, the controlled corporation is a member of the distributing corporation’s separate affiliated group at any time after the acquisition of such stock, but before the distribution of the stock.
AOL is a member of Time Warner’s separate affiliated group, and will remain such after the Google stake is acquired. In fact, AOL will continue to be an affiliate group member until the separation is consummated. This same ameliorative rule will apply even if the Google stake is redeemed by AOL – rather than purchased by Time Warner – regardless of whether the redemption is financed with funds supplied directly or indirectly by Time Warner. Accordingly, in this case, the hot stock rules should not be an impediment to the separation’s qualification for full tax-free treatment.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com