INSIGHT: Eli Lilly Completes Highly Successful Split-Off

Eli Lilly & Co. owned 80.2 percent of the stock of Elanco Animal Health, Inc. For good and valid business reasons, Eli Lilly decided to separate Elanco from the Eli Lilly Group and determined that a “split-off” was the best way to accomplish this goal.

Accordingly, Eli Lilly offered its shareholders, for each $100 of Eli Lilly common stock accepted in the exchange offer, approximately $107.53 in value of Elanco common stock, subject to an upper limit of 4.5262 shares of Elanco common stock per share of Eli Lilly common stock. It is standard operating procedure, in the case of split-offs, in order to reduce the “execution risk” that split-offs are necessarily subject to, for the distributing corporation to offer its shareholders an “inducement” to tender enthusiastically into the exchange offer.

This inducement almost always leads to “oversubscription,” and the Eli Lilly split-off of Elanco was, as expected, heavily oversubscribed. Eli Lilly accepted for exchange 65 million shares of Eli Lilly common stock, over six percent of its outstanding stock, in exchange for its 293 million shares of Elanco common stock. Each share of Eli Lilly common stock accepted for exchange by Eli Lilly was exchanged for 4.5121 shares of Elanco common stock. Because the exchange offer was so heavily oversubscribed, Eli Lilly wound up accepting only a small portion of the shares of Eli Lilly tendered into the exchange offer. The final proration “factor” was only 13.597 percent. The tendered shares not accepted for exchange were returned to the tendering shareholders. Thus, Eli Lilly will not have to undertake the “clean up spin-off” it would have effected had the offer not been fully subscribed.

The transaction was quite beneficial to Eli Lilly. In exchange for the transfer to Elanco of the animal health business and assets, Eli Lilly received all of the net proceeds that Elanco had received from the sale of 19.8 percent of its stock in last fall’s initial public offering; and the net proceeds received by Elanco in the senior notes offering; and the proceeds garnered by Elanco in the term loan facility. Eli Lilly will not be taxed on these funds so long it uses them to defray its own indebtedness and/or distributes the funds to its shareholders, either as dividends or in redemption of its stock. See tax code Section 361(b)(1)(A): “If the corporation receiving such other property or money distributes it in pursuance of the plan of reorganization (the creation and distribution of the stock of Elanco constitutes a ’D’ reorganization), no gain to the corporation shall be recognized from the exchange.”

Neither Eli Lilly nor the distributee shareholders will recognize gain (nor include any amounts in income) as a result of the split-off. See Section 361(c). The shareholders are able to receive the stock of Elanco on a tax-free basis because the distribution meets the requirements of Section 355(a). Each exchanging shareholder will take a basis in the Elanco stock received that is equal to the basis of the Eli Lilly stock exchanged therefor. The holding period of the Elanco stock will include the period during which the exchanging shareholder held the Eli Lilly stock surrendered in the transaction.

While Eli Lilly will not recognize gain or loss on the exchange for federal income tax purposes, it will record a massive gain for financial accounting purposes. The amount of such gain will be determined by reference to the value of the Eli Lilly shares accepted for exchange and the carrying amount of Eli Lilly’s investment in Elanco. Here, it appears that the fair market value of the Eli Lilly shares accepted in the exchange offer is nearly $8 billion and that Eli Lilly’s carrying value for the Elanco shares distributed in the split-off was approximately $4.2 billion. Thus, before expenses are reflected, Eli Lilly will be reporting a (non-taxable) gain of approximately $3.8 billion in connection with the “deemed sale” of its Elanco stake.

Can Elanco Be Acquired?

The agreement between Eli Lilly and Elanco imposes certain restrictions on Elanco’s freedom of action, ostensibly for the purpose of insuring that the split-off remains a tax-free transaction. Thus, Elanco may take certain actions only if Elanco obtains a ruling from the Internal Revenue Service (highly unlikely, since the IRS does not rule on the tantalizing question of whether a spin-off or split-off and a subsequent acquisition of either spinco or remainco are part of a plan or series of related transactions) or an opinion of counsel, acceptable to Eli Lilly in its sole and absolute discretion, “to the effect that such action will not jeopardize the tax-free status of the transaction.” During the period ending two years after the date of completion of the exchange offer, Elanco is precluded from issuing or selling stock or securities, selling assets, and engaging in any transaction which would cause a 40 percent or more change in its ownership, absent the receipt of the requisite opinion that such action will not imperil the tax-free status of the split-off.

For those investors who are counting on a takeover of Elanco, it seems highly likely that, even if such a takeover occurred well within the two-year period following the date of the exchange offer, an opinion that such action will not jeopardize the split-off would be forthcoming, provided that such acquisition was neither agreed to nor substantially negotiated during the two-year ending on the date of the split-off. Treasury Regulation Section 1.355-7(b)(2) makes it abundantly clear that a prohibited plan, for purposes of Section 355(e), can exist only if there was an agreement, understanding, arrangement, or substantial negotiations, regarding the acquisition or a similar acquisition, at some time during the two-year period ending on the date of the distribution.

Moreover, such a prompt acquisition will not cause the distribution to be seen as used principally as a device for the distribution of earnings and profits because the device test simply does not apply to split-offs. The device test does not apply to split-offs because a split-off cannot be used to accomplish the “evil” at which the device test is directed, i.e., the conversion of dividend income into capital gains. A split-off cannot be used to achieve this purpose because, if the split-off were taxable, it would qualify under Section 302(a) as a distribution “in part or full payment in exchange for stock,” rather than as a distribution of property to which Section 301 applies, i.e., a dividend. See Revenue Ruling 71-383.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.