You may have read that Warren Buffett (through Berkshire Hathaway) is acquiring the Duracell battery line of business from Procter & Gamble in a deal worth approximately $4.7 billion. The transaction will be stock-for-stock, although P&G is stuffing approximately $1.7 billion of cash into Duracell before Berkshire takes over. Berkshire will exchange all its P&G stock in the deal. Even better, there should be minimal or no income tax, either to P&G or to Berkshire Hathaway.
Do you wonder how?
The tax technique being used is called a “cash rich split off.” Believe it or not, it is fairly well-trod ground, which may seem amazing given the dollars at play.
Let’s talk about it.
To start off, there is virtually no way for a corporation to distribute money to an individual shareholder and yet keep it from being taxable. This deal is between corporations, not individuals, albeit the corporations contain cash. Lots of cash.
How is Buffett going to get the money out?
- Buffet has no intention of “getting the money out.” The money will stay inside a corporation. Of course, it helps to be as wealthy as Warren Buffett, as he truly does not need the money.
- What Buffett will do is use the money to operate and fund ongoing corporate activities. This likely means eventually buying another business.
Therefore we can restrict ourselves to corporate taxation when reviewing the tax consequences to P&G and Berkshire Hathaway.
How would P&G have a tax consequence?
P&G is distributing assets (the Duracell division) to a shareholder (Berkshire owns 1.9% of P&G stock). Duracell is worth a lot of money, much more money than P&G has invested in it. Another way of saying this is that Duracell has “appreciated,” the same way you would buy a stock and watch it go up (“appreciate”) in value.
And there is the trip wire. Since the repeal of General Utilities in 1986, a corporation recognizes gain when it distributes appreciated assets to a shareholder. P&G would have tax on its appreciation when it distributes Duracell. There are extremely few ways left to avoid this result.
But one way remaining is a corporate reorganization.
And the reorganization that P&G is using is a “split-off.” The idea is that a corporation distributes assets to a shareholder, who in turn returns corporate stock owned by that shareholder. After the deed, the shareholder owns no more stock in the corporation, hence the “split.” You go your way and I go mine.
Berkshire owns 1.9% of P&G. P&G is distributing Duracell, and Berkshire will in turn return all its stock in P&G. P&G has one less shareholder, and Berkshire walks away with Duracell under its arm.
When structured this way, P&G has no taxable gain on the transaction, although it transferred an appreciated asset – Duracell. The reason is that the Code sections addressing the corporate reorganization (Sections 368 and 355) trump the Code section (Section 311) that would otherwise force P&G to recognize gain.
P&G gets to buy back its stock (via the split-off) and divest itself of an asset/line of business that does not interest it anymore - without paying any tax.
What about Berkshire Hathaway?
The tax Code generally wants the shareholder to pay tax when it receives a redemption distribution from a corporation (Code section 302). The shareholder will have gain to the extent that the distribution received exceeds his/her “basis” in the stock.
Berkshire receives Duracell, estimated to have a value of approximately $4.7 billion. Berkshire’s tax basis in P&G stock is approximately $336 million. Now, $336 million is a big number, but $4.7 billion is much bigger. Can you imagine what the tax would be on that gain?
Which Berkshire has no intention of paying.
As long as the spin-off meets the necessary tax requirements, IRC Section 355 will override Section 302, shielding Berkshire from recognizing any gain.
Berkshire gets a successful business stuffed with cash – without paying any tax.
Buffett likes this type of deals. I believe he has made three of them over the last two or so years. I cannot blame him. I would too. Except I would take the cash. I would pay that tax with a smile.
There are limits to a cash-rich split off, by the way.
There can be only so much cash stuffed into a corporation and still get the tax magic to happen. How much? The cash and securities cannot equal or exceed two-thirds of the value of the company being distributed. In a $4.7 billion deal, that means a threshold of $3.1 billion. P&G and Berkshire are well within that limit.
As happens with so much of tax law, somebody somewhere pushed the envelope too far, and Congress pushed back. That somebody is a well-known mutual fund company from Denver. You may even own some of their funds in your 401(k). They brought us IRC Section 355(g), also known as the two-thirds rule. We will talk about them in another article.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.