Spinoffs and Reverse Spinoffs

A spinoff or a spinout is a type of divestment. Large entities create a new entity by selling new stocks of their existing business. This arrangement results in a legal new entity.

In some cases, the newly established entity may fulfill certain criteria that can be termed as a reverse spinoff. In that situation, the resulting legal spinnee should be compared against certain guidelines to determine whether it resulted in a reverse spinoff or not.

Let us understand the concept of spinoffs and see which cases may result in reverse spinoffs.

What is a Spinoff?

A spinoff results when a parent company (spinnor) issues new shares to create a separate legal entity (spinnee). The process involves the transfer of assets such as human resources and intellectual property to the new entity.

New shares are issued to existing shareholders of the parent company. Thus, the existing shareholders keep the legal ownership of the new entity. The shareholders do not need to surrender any previously held shares in the parent company.

Under the ASC 845-10-30-10, a pro-rata share distribution to existing shareholders of the parent company or an investor should be considered as an equivalent of the spinoff. Further, if the shareholders of the subsidiary sell the shares, they avoid the double taxation that would incur in an otherwise direct sale of the company.

What is a Reverse Spinoff?

When large entities create a separate legal entity by issuing new shares to their existing shareholders, it may form a new entity on a continuation basis. It means the new entity would continue to use the assets and human resources of the parent company. The special case is referred to as a reverse spinoff.

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It happens when the newly established entity differs in its legal form and economic substance. There are no straightforward rules to determine whether a spinoff should be classified as a reverse spinoff.

Determination Basis of a Reverse Spinoff

A spinoff can result or can be judged as a reverse spinoff. However, there are no set definitions to determine whether the transaction resulted in this spinoff or not. The GAAP rules offer guidelines that need to be judged professionally to distinguish a spinoff from a reverse spinoff. (ASC 505-60-05-04)

The ASC 505-60-25-8 provides a few guiding points to apply to determine whether a reverse spinoff happened or not. These principles points should be applied coherently and no one point should be considered presumptive or determinative.

In a reverse spinoff, the size of the legal spinnee will be larger than that of the legal spinnor. The comparison can be made on the comparison of assets, revenue, and earnings of both entities. However, there shouldn’t be any comparative specifications that favor one as compared to other entity.

The Fair Value of Both Entities

The market value or the fair value of both entities can be compared to judge a reverse spinoff. The fair value of the legal spinnee will be larger than the fair value of the legal spinnor in a reverse spinoff. However, careful consideration should typically be taken when comparing both entities immediately after the transaction completes.

Transfer of Senior Management

In a reverse spinoff, all other factors being equal, the legal spinnee will be headed by the senior management of the legal spinnor. It means the senior management from the board takes charge of the newly formed entity as well.

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The senior management can include:

  • Chairman of the Board
  • Chief Executive Officer
  • Chief Financial Officer
  • Executive Committee
  • Divisional Heads if applicable, and so on.

Length of the Holding Period

A spinoff may take place to make a division or segment of the company profitable and sell it afterward. Hence, the length of the holding period can also be used to determine whether it resulted in a reverse spinoff or not.

If the length of the holding period for the legal spinnee is greater than that of the legal spinnor, it should be accounted for as a reverse spinoff.

As mentioned earlier, there is no single criterion to determine whether the newly established entity resulted in reverse spinoff. It is a matter of professional judgment for analysts to determine by evaluating different guiding principles stated above.

Understanding Spinoff and Reverse Spinoffs

Large entities often create a separate legal entity through spinoff so that the new entity performs well. The shares of the newly established entity are offered to the existing shareholders in the form of dividend stocks.

The distribution of these dividend stocks can affect the accounting treatment of the net book values of the shares and retained earnings of both entities. Further, the spinoff may result in a discontinued operation under the ASC 360 rule. The accounting spinnee can remain a part of the accounting spinnor as a result of a spinoff. If it meets other criteria under the ASC 360, it should be treated as a discontinued operation, which further complicates the spinoffs and reverse spinoffs.

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