Transforming tax for two: Spin-offs and the tax function

Companies that have thought about the tax implications of a spin-off should also consider the implications for the tax function itself. Otherwise, they may be missing a significant opportunity to derive more value from the deal for transformation.

Spin-offs have increased dramatically in volume in recent years. In 2021 we saw some of the biggest spin-off deals ever announced, and there are more such transactions on the horizon.

GE announced it’s spinning out its health care, renewable energy and power divisions over the next few years. Johnson & Johnson blueprints to spin out its consumer health business from its pharmaceutical business. GSK, General Motors, Royal Dutch Shell and Intel are among the long list of corporate giants who have publicly stated they are exploring spin-off opportunities in the near future.

Yet spin-offs are complex transactions. They take significant time to plan. They call for specialized capabilities and resources. They necessitate a keen focus on operational continuity in the face of often drastically different corporate footprints. And they require some very strategic thinking about tax operations.

What about tax?

The good news is that tax is rarely an afterthought when executives start planning a spin-off. Right from the start, important tax implications should be considered. Will the deal be structured as a tax-free transaction? How should legal entities be structured in order to achieve tax efficiency? What tax filings must the organizations complete in the run-up to the spin-off? Big questions inform big decisions.

What executives may forget to ask, however, is how the spin-off should impact the tax function and what tax knowledge, capabilities and talent will each company need moving forward. It’s not as easy as dividing the tax function in two. That may work for other parts of the business. But for the tax department, when you start separating things, you quickly run into capacity challenges, operational complexities and new considerations.

It’s important to leave each entity with intelligent, centralized and efficient finance, tax and legal operations. The challenge is to design, implement and then stand up those separate functions while maintaining continuity of operations. That often requires new technologies, talent and resources. It’s not easy.

Today and tomorrow

The planning phase is where most of the heavy lifting for the tax function takes place. Indeed, by the time a new spin-off company has a head of tax or even a CFO in place, most of the major tax operating model, technology and capability decisions will already have been made. In some cases, budgets will already be in place and service agreements will have been signed.

That means, ultimately, the success of the spin-off for tax will often depend on the planning team’s ability to balance the short-term demands of the transaction and the transition against the long-term strategic goals for both the remaining company (let’s call it RemainCo), and the new company, NewCo.

Copy and paste?

In the short term, the pragmatic approach to ensuring the lights stay on in the tax department on day one may be to “lift and shift.” With few resources available to develop new processes and tools, tax leaders will naturally look at what can be replicated, shared or borrowed from past practice. Transition service agreements, service level agreements and data-sharing agreements will be key to keeping these processes going in the immediate months following the spin-off.

However, these operating models, processes and agreements must be developed with a long-term view in mind. Many organizations may find their tax operating model for the NewCo should be substantially different from that of the RemainCo. (One could imagine that a spun-off health care division would have a different tax operating model than a remaining jet engine business, for example.)

Direct and indirect tax processes and requirements may differ. Regulatory, compliance and reporting requirements may vary. The tax footprint and operating model for NewCo may ultimately be radically different from that of RemainCo. That makes finding that balance between short-term pragmatism and long-term strategy critically important.

New models for a new company

While data and processes can sometimes be shared, people cannot — at least not past the term of the transition service agreement. While people and roles can simply be moved over to the new entity, that can create two mirrored tax departments, neither of which may be at the right scale for the post-spin enterprise. Even if the separated entity only represents a small portion of the original company’s activities, it may still have the same global footprint and global compliance requirements that the bigger company had. Hollowing out the old tax function is not usually a sustainable option, and yet operational budgets for both sides may shrink as the size of the business supported by tax declines due to the separation.

Many tax leaders will quickly recognize their NewCo tax organization may require different skills and capabilities. Depending on which activities are outsourced and which are kept in-house, tax functions may require different technology skill sets as well. The new organization may face different materiality thresholds, requiring focus in different areas. It may ultimately operate in different markets, requiring different structures and operating models.

Over the long term, many of the initial decisions will need to be revisited and new structures created. But the reality is that — on day one as a separate entity — the NewCo needs to have a functioning tax department. More often than not, however, our experience suggests executives expect most of that work to fall on the shoulders of the existing tax function who — arguably — are already strapped for time and resources.

Transformation for two

Many companies’ first priority is to stand up an efficient and effective NewCo tax function leveraging the right technologies and sourcing models. In many instances, the second priority is how the RemainCo tax leaders can capture the same efficiencies as the organization they are spinning off.

However, and perhaps not surprisingly, many tax leaders are starting to see spin-offs as not only an opportunity to launch a more efficient NewCo tax function, but also to transform their RemainCo’s tax operating models. They are aligning their tax strategy with the long-term business and technology strategy. That is helping them discover opportunities to leverage new tools and operating models such as outsourcing and co-sourcing to help enhance compliance, improve efficiency and streamline processes.

It’s clear a spin-off can present an opportunity to enhance the tax operating model. Many organizations are evaluating the smart use of co-sourcing or outsourcing as a key lever to help reduce the disruption of transformation, better manage costs and create a more flexible, effective tax operating model. Those planning (or in the midst of) a spin-off may want to consider broadening their perspective to evaluate all of the available options for both the NewCo and RemainCo.

Over the coming two years, some of the world’s largest organizations will likely conduct some sort of separation transaction. Some leaders will use the life event as a way to help both companies leap ahead of their competition with more effective and efficient tax functions.

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