A New Spin On Spin-Offs
Posted by Lori Ehleben on May 15, 2020 5:39:50 PM
Are registered funds recording taxable spin-off transactions correctly?
A spin-off is the creation of an independent company through the distribution of new shares of an existing business or division of a parent company. The business rationale for these transactions is the belief that the spun-off companies will be worth more as independent companies than as parts of a larger business. In a spin-off transaction, shares of the newly created company are distributed, or spun off, to the shareholders of the parent. In most cases, the cost basis of the new security is calculated as a pro rata allocation of the cost of the original investment in the parent company based upon the values of both stock of the spun-off company and the stock of the parent company at the time of the spin-off transaction. If no cash is remitted along with the shares of the new company, no realized gain or loss will be recognized.
While the majority of spin-offs are non-taxable transactions, there are some that are considered taxable mergers, usually resulting from investments in securities of foreign corporations. Often, these taxable spin-offs are recorded as dividend income in a fund’s accounting records to align accounting and tax records. However, the AICPA Audit and Accounting Guide for Investment Companies contains guidance for spin-offs that does not differentiate the accounting treatment for spin-offs that are taxable from spin-offs that are non-taxable. Therefore, the same cost allocation to the new security from the original investment should be applied in all spin-off transactions, whether taxable or non-taxable.
One of the difficulties encountered when recording a taxable spin-off transaction using the cost allocation method instead of booking dividend income is that it will create a difference between book and tax cost basis that will need to be tracked until both the original investment and the shares of the new investment received in the spin-off are disposed. For this reason, a fund’s management may decide to follow the tax treatment for book purposes if the amounts are not considered material.
Bottom Line: During our audit procedures, we often see taxable spin-off transactions recorded in the same manner for both book and tax purposes. We understand and agree that this may be appropriate as an administrative ease, especially if the amounts are not material. If the amounts are material, management should develop a process to track the differences between the accounting and tax treatment of these transactions and make adjustments to the accounting records on financial reporting dates.