Spin-offs have become increasingly popular with innovative companies as a method of unlocking shareholder value, but the transaction is not always tax-free, particularly for international employees holding equity awards or shares.

The ability to obtain tax-free treatment in the United States for both the company and shareholders in a spin-off is often attractive. However, the transaction is not always tax-free for shareholders located outside the US. When local country criteria are not met, the distribution of spin-co shares is taxable for shareholders.

Significantly, employees holding equity awards and company shares can be negatively affected by a spin-off, which can have a significant impact on morale at a very sensitive time in a spin-co’s evolution.

Companies generally take one of two approaches when adjusting equity awards in a spin-off: either a basket approach, where employees hold equity awards from both companies; or a concentration approach, where employees only retain equity awards from their post-spin employer. The basket approach raises more local tax and securities compliance issues than the concentration approach as the employee is holding awards from a company that is not their employer.

“Long” shares held by employees in an employer’s plan raise additional issues. The applicable tax analysis mirrors the analysis applicable to shareholders generally, which may or may not be taxable upon distribution, depending on the country. However, the tax result may differ when the shares are held in a trust or where the employee does not yet have full ownership of the shares. In certain cases, a local tax ruling should be submitted, potentially providing the employees with more favorable tax treatment than regular shareholders.

Tax-qualified equity awards also require consideration as the tax-advantaged treatment may be lost for the employees in many countries. For example, in the United Kingdom, Share Incentive Plans (SIPs) and Company Share Option Plans (CSOPs) are common equity awards and a spin-off impacts them differently.

When an employee holds shares in a SIP for five years, the employee may sell the shares without paying income tax or national insurance contributions. However, when a spin-off transaction does not meet the UK “demerger” rules for a tax-free spin-off, the SIP participants will be subject to taxation on the value of the distributed spin-co shares when they are distributed.

If an employee exercises CSOP options three or more years after grant, that employee doesn’t pay income tax at exercise for the difference between the exercise price and the current fair market value of the shares. Any adjustment of the CSOP awards results in the loss of tax-qualified treatment, subjecting the employee to income taxation when the options are exercised. Employees who have already met the three year requirement may therefore prefer to exercise the awards prior to the spin-off.

In most cases, particularly if the communication occurs shortly before the spin-off, employees do not fully understand the ramifications until it is too late to mitigate the tax impact. To avoid this, companies should communicate the tax implications to employees well before the spin-off, taking into [...]

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