Eli Lilly & Co. is positioning itself to avoid up to roughly $2 billion in taxes by splitting off—rather than selling—its stake in a former subsidiary.

The pharmaceutical giant held on to just over 80 percent of Elanco Animal Health Inc. after selling a minority stake in the pet health company when the latter went public in September. Now Lilly is asking shareholders to exchange their Lilly stock for shares of Elanco, sparing both shareholders and itself from any tax liability, as long as the transaction adheres to certain tax code requirements.

The “split-off” under tax code Sections 355 and 368 could save Lilly up to roughly $2.1 billion in tax payments it might have faced if it were to sell its 80.2 percent stake in Elanco, which has a market value of about $10.7 billion, at applicable federal and state rates.

The amount of the tax would have depended on how much basis—or capital investment for tax purposes—Lilly has in Elanco, with lower basis corresponding to a higher would-be tax bill. Lilly likely holds little, if any, basis in Elanco, tax professionals said, because it sucked hundreds of millions of dollars in cash out of the former subsidiary—as detailed in a Feb. 8 regulatory filing—after the initial public offering.

That means the tax Lilly likely avoided would amount to about a 25 percent rate, combining federal and state rates, applied to the 80.2 percent stake in Elanco, tax professionals said. Lilly’s basis in Elanco may reduce that, they said, but the tax bill easily could hit $1 or $2 billion.

“Lilly received a substantial cash distribution in connection with the IPO and related financings, and could have received even more cash had they just sold Elanco rather than distributed it, but Lilly would likely have had a significant taxable gain,” said Gary Friedman, a partner at Debevoise & Plimpton in New York. “My guess is—and this is just a guess—that Lilly’s basis in Elanco is pretty low because they extracted significant cash in connection with the IPO.”

The tax-free nature of the exchange, in which only shareholders who take cash would be subject to capital gains tax, depends on an opinion from the law firm Skadden, Arps, Slate, Meagher & Flom LLP, the companies said in the regulatory filing.

“Lilly could’ve sold its shares of Elanco to someone and paid tax on the gain from the sale,” said Robert Willens, a New York-based tax consultant. Compared with that option, he added, “the split-off is obviously superior due to the absence of tax leakage.”

Strategic Moves

The transaction is a indicator of the company’s strategy when it held onto more than 80 percent of Elanco after the former subsidiary’s IPO, Willens said. To qualify for tax-free treatment of a split- or spin-off under Section 355, the remaining corporation has to distribute at least 80 percent of the shares of the spun- or split-off entity. Lilly kept 80.2 percent after the IPO.

A spokesperson for Lilly declined to comment on the transaction or its intentions.

The company is offering shareholders a discount on Elanco shares, allowing them to receive $107.53 worth of Elanco stock for every $100 of Eli Lilly shares they hand back. That trade is subject to a limit of just over 4.5 Elanco shares per share of Eli Lilly, according to the regulatory filing. The animal health company’s share price closed at $29.30 Feb. 12, while Eli Lilly’s stood at $119.49 at market close.

The pharma multinational can still engage in a “clean up” spin-off under Section 355, even if shareholders don’t take the deal to help Lilly ditch its 80.2 percent stake, according to tax professionals.

Better Option

The economic gain from the exchange with shareholders should be a negative for Lilly, but the split-off of Elanco is far superior to a sale, the tax professionals said.

Under the alternative, Lilly would pay tax on its gains from selling all of its Elanco stock, then use the after-tax proceeds to buy back some of its own shares. Through the split-off exchange, Lilly can both avoid the tax on the gain and use the pre-tax value of Elanco’s stock to retire the Lilly shares—which will yield yet another benefit.

“Lilly is essentially repurchasing its shares with Elanco shares,” Friedman said. He added that it’s unclear whether the increase in value of Lilly shares that will likely result from that retirement will cover the cost of the discount offered to shareholders as part of the exchange.

The deal is likely to get a green light from Lilly’s lawyers at Skadden, too, the tax practitioners said.

“I don’t view this as highly controversial,” said Don Lonczak, a partner at Baker Botts LLP in Washington who focuses on tax treatment of spin-offs and other transactions.