Madison Square Garden Inc. split into companies on April 17 in a tax-free transaction when it spun off Madison Square Garden and Radio City Music Hall into a new corporation while retaining the New York Knicks and New York Rangers and development league teams along with some esports interests.
The original corporation became Madison Square Garden Sports Corp. (MSGS), and the new corporation became Madison Square Garden Entertainment Corp. (MSGE).
On March 31, the board of directors of Madison Square Garden Inc. (MSG) approved the distribution to its shareholders of the common stock of a newly-created subsidiary, Madison Square Garden Entertainment Spinco, Inc. (Spinco), which became MSGE.
The distribution took the form of a distribution by MSG of (a) one share of MSGE’s Class A common stock, for each one share of MSG’s Class A common stock, and (b) one share of MSGE’s Class B common stock for each one share of MSG’s Class B common stock. MSGE received, immediately prior to the distribution, “the businesses and other assets…that formerly comprised [MSG’s] Madison Square Garden Entertainment business segment,” including Madison Square Garden itself and Radio City Music Hall, according to an SEC filing. MSG (now MSGS), therefore, was left with the New York Knicks and the New York Rangers and became, along with the Atlanta Braves, the only public “pure play” sports franchise corporations of which we are aware. It should be noted that the distribution, a “straight” pro rata spin-off, differs quite dramatically from the original separation plan.
At the outset, it was envisioned that Spinco would be capitalized with two classes of stock, a high vote class and a lower vote class; and that MSG would distribute the high vote (lower equity value) class to its shareholders and retain for itself the lower vote (higher equity value) class of stock. The retained stock would be disposed at a later date, in accordance with Internal Revenue Service guidelines regarding “retentions,” and would have provided the MSG with an opportunity to retire (using the retained stock as the currency) a portion of its indebtedness and/or a portion of its stock on a tax-efficient basis. The eventual transaction didn’t feature a retention of Spinco (MSGE) stock on the part of MSG (MSS). Instead, 100% of the stock of Spinco (MSGE) was distributed to the shareholders of MSG (MSGS).
In order for a spin-off that features a retention to pass tax-free muster, it must be established that the retention, on the part of the distributing corporation of stock and/or securities of the controlled corporation, is not “pursuant to a plan having, as one of its principal purposes, the avoidance of federal income taxes.” See tax code Section 355(a)(1)(D)(ii). To do so, among other conditions the IRS imposes, the corporations must refrain from having any overlapping directors and/or officers. Perhaps Mr. James Dolan did not want to be bound by this restriction and, therefore, MSG (MSGS) chose to engage in a “retention-less” separation. Moreover, unlike most “modern” separation transactions, the instant spin-off does not appear to be a “leveraged” spin-off.
Ordinarily, almost to the point of becoming standard operating procedure, the controlled corporation in a spin-off will engage in a preliminary borrowing transaction in connection with which the loan proceeds are immediately conveyed to the distributing corporation. The distributing corporation then “uses” the proceeds to retire a portion of its indebtedness, or to repurchase its stock, and/or to fund ordinary dividends to its shareholders. If this use of proceeds occurs “in pursuance of the plan of reorganization,” the distributing corporation will not recognize any gain or income on the receipt of such proceeds. This is the first separation transaction we have seen in quite some time that does not feature an element of “monetization.”
It is, of course, intended that the transfer of assets by MSG (MSGS) to Spinco (MSGE) qualify as a ’D’ reorganization (of the divisive variety); and that the distribution of Spinco’s (MSGE) stock qualify under Section 355. There is every reason to believe that the transfer and distribution so qualified. Clearly, each of MSG (MSGS) and Spinco (MSGE) will be engaged in the active conduct of a trade or business following the spin-off; and each such trade or business will have been actively conducted throughout the five year period ending on the date of the distribution.
The distribution does not exhibit any obvious “device” factors and, therefore, there is no reason to think the IRS will contend that the separation was used principally as a device for the distribution of earnings and profits. Most notably, the distribution is certainly being carried out for a valid corporate business purpose(s), including the ubiquitous “fit and focus,” and, to the company’s credit, the reasonable expectation that the stocks of the two corporations, MSGS and MSGE, in the aggregate, will be valued by the market more richly than would the stock of MSG had it continued to represent each of the businesses now housed separately in MSGS and in MSGE. This is a good business purpose for a spin-off, even though the increase in the stock price appears to be a “shareholder purpose” for the spin-off rather than a corporate business purpose.
The IRS has ruled that the desire to increase the stock price is a valid corporate business purpose for a separation where, as here, the more richly valued stock is intended to enhance the corporation’s equity based compensation programs and also permit the corporation to make acquisitions (using its stock as the acquisition currency) “in a manner that preserves capital with significantly less dilution of the existing shareholders’ interests.” See Revenue Ruling 2004-23.
One thing that is uppermost in investors’ minds is the potential for an acquisition of either or both of MSGS and MSGE and whether such an acquisition would, because it might jeopardize the tax-free nature of the spin-off, have to be held in abeyance for a considerable period of time.
In the instant case, the disaffiliation agreement provides, as they almost always do, that, for the two-year period following the distribution, MSGS and MSGE may not engage in certain actions that might jeopardize the tax-free treatment of the distribution to MSG and its shareholders, the largest of whom is the Dolan family. However, this prohibition is by no means absolute. An otherwise prohibited transaction, involving Spinco (MSGE), can in fact be carried out if either (a) MSG (MSGS) consents to the transaction; or (b) Spinco (MSGE) obtains a “legal opinion” that the action will not adversely affect the tax-free status of the distribution to MSG and its shareholders.
It is our view that such an opinion would be rather easy to come by. If, for example, the prohibited action is an acquisition of MSGE (or for that matter MSGS), the opinion the parties would be looking for would be, as a matter of law, that the distribution and the acquisition were not, within the meaning of Section 355(e), part of a plan (or series of related transactions).
Since the regulations (see Treasury Regulation 1.355-7(b)(2)) unreservedly provide that “a plan can exist” only if there was an agreement, understanding, arrangement, or substantial negotiations, regarding the acquisition a similar acquisition, at some time during the two-year period ending on the date of the distribution, counsel should have no difficulty opining (assuming no such agreement or negotiations actually took place) that the acquisition should have no adverse effect on the spin-off. This is true, moreover, even if the acquisition occurs well within the two-year period beginning on the date of the distribution.
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.