Section 355

Section 355 is a provision within the U.S. Internal Revenue Code that acts as a magical key for corporations, unlocking a special type of transaction: the tax-free separation. In essence, it allows a parent company to distribute the stock or securities of a subsidiary it controls (think of it as a corporate child) to its own shareholders without triggering an immediate tax bill for either the company or the shareholders. These separations, known as a spin-off, split-off, or split-up, are powerful tools for restructuring. Instead of selling a business unit and paying hefty corporate taxes on the gain, a company can use Section 355 to set the unit free as an independent, publicly-traded entity. This process is designed to allow for genuine corporate rearrangements that have a real business purpose, rather than just being a clever way to dodge taxes on what would otherwise be a taxable dividend or sale. For European investors, it's crucial to understand this U.S. tax concept as it frequently creates unique investment opportunities in American markets.

For the savvy value investor, a Section 355 transaction is like a flashing neon sign that says, Potential Bargain Ahead! Why? Because these corporate separations create classic “special situations” where good businesses can often be bought on the cheap. Famed investor Joel Greenblatt detailed this phenomenon in his book You Can Be a Stock Market Genius. The newly independent company (the 'SpinCo') is often misunderstood and ignored by the market. Large institutional investors who owned the parent company might automatically sell their new SpinCo shares because it's too small for their portfolio, doesn't fit their investment mandate, or they simply haven't done the research. This indiscriminate selling can push the stock price well below its intrinsic value. Furthermore, the newly freed management team is often highly motivated, with their compensation tied directly to the new company's success. This combination of temporary selling pressure and improved corporate focus can create a launchpad for spectacular returns for investors who do their homework.

While the concept is powerful, the execution is highly technical. A Section 355 transaction generally takes one of three forms.

• Spin-Off: This is the most common form. Imagine a large conglomerate (ParentCo) that also owns a small, successful software division (SubCo). In a spin-off, ParentCo simply distributes a proportional number of SubCo shares to all of its existing shareholders. After the transaction, a shareholder owns stock in both the original ParentCo and the newly independent SubCo. No exchange is made; the new shares just appear in their account.
• Split-Off: This works more like an exchange offer. Using the same example, ParentCo would offer its shareholders the choice to trade in some or all of their ParentCo stock in exchange for shares of SubCo. This is often used to resolve disagreements among shareholders or to consolidate the ownership of a particular business line. It effectively functions like a share buyback, where the parent company uses the subsidiary's stock as currency.
• Split-Up: This is the most drastic and least common of the three. Here, the parent company distributes the stock of two or more subsidiaries to its shareholders and then completely liquidates itself. The original parent company ceases to exist, leaving two or more new, independent companies in its place.

Getting the Internal Revenue Service (IRS) to bless a transaction as tax-free isn't a walk in the park. Companies must jump through several significant legal and financial hoops to qualify under Section 355.

1. Control: The parent company must own at least 80% of the voting power and 80% of all other classes of stock of the subsidiary right before the distribution.
2. Active Trade or Business (ATB): This is a big one. Both the parent and the spun-off subsidiary must be engaged in a legitimate business that has been actively running for at least the last five years. This prevents companies from just parking passive assets in a new entity and spinning it off tax-free.
3. Not a 'Device': The transaction cannot be used principally as a 'device' to distribute earnings and profits to shareholders while avoiding dividend taxes. The IRS looks for signs of a bailout, such as pre-arranged sales of the spun-off stock, which would make the whole thing look more like a disguised cash distribution.
4. Valid Business Purpose: There must be a real, non-tax reason for the split. Common reasons include separating a risky business from a stable one, improving management focus, unlocking better access to capital markets, or resolving a dispute among shareholders.
5. Distribution of Control: The parent company has to give away the farm—or at least, all the stock and securities it holds in the subsidiary. A small carve-out is allowed, but only if the company can prove to the IRS that retaining some shares isn't part of a tax-avoidance plan.