Handicapping A Callaway–Topgolf Tax-Free Spin-Off

By Stuart E. Leblang, Michael J. Kliegman and Amy S. Elliott

On September 4, Topgolf Callaway Brands Corp. (NYSE:  MODG) (Topgolf Callaway or the Company) announced that its Board of Directors intends to pursue a separation into two independent companies:  golf equipment and related product company Callaway and Topgolf, which focuses on driving ranges.^[1] In addition to laying out a coherent rationale for the separation, the announcement states that the most likely scenario will be a tax-free spin-off to shareholders of at least 80.1 percent of Topgolf, with a possible retention of a “limited ownership in Topgolf for a period of time.”^[2] Expected timing for the spin-off is the second half of 2025.  Management also indicated in the press release and analyst call that it will be evaluating other options, including an M&A transaction, as possible alternatives to a spin-off.

There are a few issues presented as to qualification of the transaction for tax-free treatment under Section 355 of the Internal Revenue Code.  The first question is whether the fact that the Company did not acquire control of Topgolf until March 2021^[3]presents a problem with respect to the active trade or business (ATB) requirement.  Other concerns involve pending changes in attitude on the part of the Internal Revenue Service’s corporate tax ruling division toward some of the gray areas of the spin-off rules, which have been the subject of much consternation by tax practitioners.^[4]

The ATB rules would require, among other things, that immediately after the spin-off, Callaway and Topgolf each be engaged in an ATB that has been continuously carried on during the preceding 5 years and was not acquired by the Company during the 5-year period other than in a fully tax-free^{transaction.[5]} The relationship between the two companies began in 2006,^[6]and during the next several years, Callaway made equity investments (both common and preferred) in the privately held Topgolf culminating in a 14 percent position in 2018.^[7]Callaway acquired 100 percent of Topgolf in a 2021 merger, and a review of this transaction indicates it qualified as a tax-free reorganization in which the sole consideration was Callaway stock, with the exception of cash in lieu of fractional shares.^[8] As such, the fact that this acquisition of control occurred within the 5-year pre-spin period should not present an ATB problem.

It looks like the transaction will involve the Company’s distribution of the Topgolf subsidiary that it acquired in 2021, although management has stated that TopTracer, a relatively small portion of the Topgolf segment that is associated with its proprietary ball-tracking technology, will remain with Callaway.  It is unclear whether this resides within the parent or the Topgolf subsidiary, in which case it would have to be distributed out in connection with the spin-off.

The Callaway Remainco intends to retain all term and convertible debt, leaving the Topgolf Spinco substantially free of debt except for venue financing, and Topgolf will also have a significant cash balance.  At the same time, the Company plans to de-lever Callaway in part by using some or all of the retained (up to 19.9 percent) Topgolf stake not distributed to shareholders.^[9] Generally, the Company can make use of undistributed Topgolf stock to pay down debt in two ways:  one would be to sell shares in taxable transactions and use the cash to pay down debt, and the other is to fit within tax rules allowing the tax-free distribution of shares in Topgolf to creditors.

Under the tax-free spin-off rules, a Parent corporation can distribute stock in the Spinco tax-free to Parent’s creditors if it is pursuant to a reorganization involving Parent’s transfer of assets to Spinco in exchange for Spinco stock.^[10] If there is no asset-transfer reorganization, but only a distribution of stock of a preexisting Spinco subsidiary, then in order to use Spinco stock to pay down debt, additional technical hurdles must be overcome.  Section 355 grants tax-free status to Parent’s distribution of Spinco stock to Parent’s shareholders and security holders.^[11]In this context “security” refers to a debt instrument with a longer term deemed to represent a deeper interest in the issuer corporation than shorter term debt instruments.  Not defined anywhere in a statute or regulation, in practice securities are commonly acknowledged to exist where a term debt instrument has a maturity of longer than five years.^[12]

Separate from the above nonrecognition rules that tie the “monetization” of Spinco stock to the spin-off/reorganization transaction, the spin-off rules require that the Parent distribute all of its shares in the Spinco, but provide that it may retain a portion of the Spinco stock (though in any case, 80-percent control must be distributed^[13]) provided it establishes to the Internal Revenue Service (IRS) that the retention is not for tax avoidance purposes.  Over the years, the IRS has developed a ruling approach in which it will permit retention based on information confirming nontax business reasons for the retention (usually these are financial), confirming no continuing influence over Spinco, and a disposition of any retained shares no later than five years after the spin-off.^[14]

One complex area of planning that arises in many spin-offs that should not be presented here involves the push-down of a portion of the Parent company’s debt to the Spinco to achieve a desired leverage level for the two companies.  There are mechanisms in the tax law that enable this to occur, but the changing of the guard at the helm of the corporate division of the IRS Chief Counsel’s office has created some flux and uncertainty in this area that it appears can be avoided in this case.

Those changes have made it a bit more difficult than in the past for a Parent company to retain a portion of the Spinco stock.  In the past, the IRS allowed a flexible approach for the Parent as to whether it would ultimately distribute the retained shares to creditors or debt security holders pursuant to the spin-off plan or retain them for an indefinite period of time under the official “retention” rules referred to above.  In the latter case, an eventual disposition of the retained shares would be a taxable event, giving rise to taxable gain or loss.

In the IRS’s recently announced guidance, it is requiring a parent company to “pick a lane” in connection with a ruling request, in any case prior to consummating the proposed spin-off, i.e., to commit with respect to the undistributed stock whether it will be “retaining” it for an indefinite period, or will be distributing it to security holders, other creditors or even shareholders pursuant to the spin-off plan.^[15]On the September 4 investor call about the intended separation, the Chief Financial Officer stated that the Company will seek to obtain a private letter ruling from the relevant tax authorities and/or an opinion of tax counsel regarding the intended federal tax treatment of the spin-off.^[16]It is likely that even if the Company proceeds based solely on opinion of counsel, before the spin-off is to be completed, the Company will need to decide how much stock will be distributed to shareholders and whether and how any shares not immediately distributed are to be disposed of, whether tax-free as part of the spin-off plan or taxable over a longer time period.

Assuming a portion of the Topgolf stock is to be distributed tax-free to creditors holding longer- term debt treated as securities for tax purposes, there are well-trodden paths for executing this strategy that coordinate the tax requirement for an exchange of stock for the debt and the practicalities of executing such transactions.  Most common is a general approach where a banker purchases the requisite amount of debt instruments from current holders and thereafter engages in an exchange with the Company of the debt instruments for stock of the Spinco, which, in turn, it sells to investors.  Substantively, it is important that the banker’s purchase of the debt instruments and subsequent sale of Spinco stock be viewed as being for its own account as a principal and not as an agent for the Company.  This requires that the banker bear the benefits and burdens of holding the positions for a period of time.  While there has been flux about the formalities, including the number of days of ownership, this should not present a problem for the Company.

Finally, the Company’s announcement of the spin-off states that “the two companies are also expected to enter into ongoing, value-creating commercial agreements with one another.  As an example, Callaway will continue to be the exclusive golf equipment partner for Topgolf.”^[17] The topic of continuing business relationships and overlapping board positions has been a source of concern and uncertainty for several years.  The new Revenue Procedure only directly raises this as a potential problem in connection with a ruling that a retention of stock of the Spinco (as opposed to a delayed distribution that is part of the spin-off plan) does not have a tax avoidance purpose.  It lists continuing relationships between the two companies as indicative of a tax avoidance purpose.^[18]

Ostensibly, if the Company does not have a “retention” (indefinite retention rather than delayed distribution) of Topgolf stock, then continuing commercial relationships would not be a problem.  However, in Notice 2024-38, which was issued along with the new Revenue Procedure, the IRS invited comments about issues raised in the Revenue Procedure and also explained some areas of concern and interest that it would be considering for future guidance.  In the Notice, the IRS states:

The Treasury Department and the IRS are considering the degree to which connections between Distributing and Controlled . . . would prevent a transaction from qualifying under § 355.  In particular, the Treasury Department and the IRS are considering the impact of (i) overlapping key employees . . . , (ii) overlapping directors or officers . . . , (and (iii) the existence of continuing contractual agreements . . . that include provisions that are not arm’s-length. . . .

In addition, it is the view of the Treasury Department and the IRS that . . . the existence continuing contractual agreements . . . that include provisions that are not arm’s-length, weigh against a determination of §355 qualification”^[19]

This is strong language, although it is contained in sub-regulatory guidance so it does not yet represent an official IRS interpretation of the law.  It is also the subject of strong opposition by the organized tax bar, and, if it is implemented in regulations, it could have potentially disruptive commercial impacts in the spin-off area.  But even on its own terms, reference to non- arm’s-length terms suggest that continuing commercial arrangements that are on arm’s-length terms may be less problematic.

^{[1] Press Release, Topgolf Callaway Brands, Topgolf Callaway Brands Announces Intent to Separate into Two Independent Companies (Sept. 4, 2024) (https://www.topgolfcallawaybrands.com/news-releases/news-release-details/topgolf-callaway- brands-announces-intent-separate-two).}

^{[2] Id.}

^{[3] In March 2021, the Company completed its merger with Topgolf International, Inc. in an all-stock transaction.}

^{[4] On May 1, the Corporate Division of the IRS Chief Counsel’s office issued Rev. Proc. 2024-24, which updated the procedures and associated substantive approaches to be taken in connection with issuance of spin-off rulings.  This was accompanied by Notice 2024-38, indicating the IRS was continuing to study the best approach to addressing various issues and soliciting input from taxpayers and their advisors.  These pronouncements indicate changes from previous approaches by the IRS in this area, presumably following a change in leadership of the corporate division in June 2023. These changes were not greeted warmly by the tax bar, especially from the standpoint of the apparent abruptness of the changes.  This is indicated in two lengthy reports issued by the New York State Bar Association on March 4, 2024 (Report No. 1491 on Procedural Guidance for Private Letter Rulings on Divisive Reorganizations) and July 30, 2024 (Report No. 1497 on Changes to Spin-Off Standards).}

^{[5] IRC §355(b)(2)(B) and (C).}

^{[6] “Callaway established a business relationship with Topgolf in 2006 as Topgolf began to expand in the United States,” from Callaway Golf Company Amendment No. 1 to Form S-4 Registration Statement filed Jan. 5, 2021, numbered page 83 (https://www.sec.gov/Archives/edgar/data/837465/000119312521002056/d54680ds4a.htm).  “During the fourth quarter of 2006, the Company made an investment in Golf Entertainment International Limited (‘GEI’), the owner and operator of TopGolf entertainment centers.  In connection with the investment, the Company acquired Preferred Shares of GEI for approximately $9,630,000 and provided GEI with debt financing of $378,000,” from Callaway Golf Company’s Form 10-K filed March 1, 2007 (https://www.sec.gov/Archives/edgar/data/837465/000119312507044062/d10k.htm).}

^{[7] See numbered pages F-26 and F-27 in Callaway Golf Company’s Form 10-K filed March 1, 2019 (https://www.sec.gov/Archives/edgar/data/837465/000083746519000002/ely-20181231x10k.htm).}

^{[8] “It is intended that, for U.S. federal income tax purposes, the Merger will qualify as a ‘reorganization’ within the meaning of Section 368(a) of the Code,” according to the Form 424B3 Prospectus filed Jan. 28, 2021 (https://www.sec.gov/Archives/edgar/data/837465/000119312521020870/d54680d424b3.htm).  See also Rev. Rul. 66-365, holding that cash in lieu of a fractional share does not violate the “solely for voting stock” requirement for a “B” reorganization.}

^{[9] “From a leverage perspective, at the time of the spin, Topgolf with no financial debt would not have any financial leverage. . . . [With respect to Callaway’s leverage ratio,] we would expect to get to three times or less within twelve months of the spin and we’ll essentially be using the cash from operations as well as any retained stake . . . ,” said Brian Lynch, Executive Vice President and Chief Financial Officer of the Company.  “Topgolf in particular will retain its venue financing obligations but will have no financial debt, be funded with a strong cash balance of approximately $200 million and is expected to be free cashflow positive in 2025 just as it was in 2023 and it is forecast to be in 2024,” said Oliver “Chip” Brewer III, the President and Chief Executive Officer of the Company.  Topgolf Callaway Brands Separation Announcement Conference Call (Sept. 4, 2024) (https://www.topgolfcallawaybrands.com/news-and-events/presentations).}

^{[10] IRC §361(c). Other rules allow Parent to receive cash from Spinco and use the cash to pay down debt, limited to the amount of Parent’s basis in Spinco.  Given the financial characteristics of this transaction, that seems to be inapplicable.}

^{[11] IRC §355(a)(1).}

^{[12] See Bittker & Eustice, Federal Income Taxation of Corporations & Shareholders para. 12.11[13] (Warren Gorham & Lamont).  For discussion of the criteria for qualification as a security, albeit without setting forth even a rule of thumb as to length of maturity, see Camp Wolters Enterprises, Inc. v. Commissioner, 230 F.2d 555 (5thCir. 1956); Rev. Rul. 59-98.}

^{[13] IRC §355(a)(1)(D) and §368(c).}

^{[14] See Rev. Proc. 96-30, Appendix B.  The information and criteria for rulings on retentions and other spin-off issues were significantly modified in Rev. Proc. 2004-24, with much controversy surrounding many changes, some of which will be referred to later in this report.}

^{[15] See Rev. Proc. 2024-24, Section 3.01(1)(b).}

^{[16] See https://www.topgolfcallawaybrands.com/news-and-events/presentations and https://www.topgolfcallawaybrands.com/static-files/6cf26527-d05f-4fff-9eb8-f164ac6653ea.}

^{[17] Supra, Note 1.}

^{[18] Specifically, according to Rev. Proc. 2024-24, “the degree of continuing relationships between Distributing and Controlled will significantly inform a determination of whether a Retention would be in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax.” Further, Notice 2024-38 provides that “the existence of continuing contractual agreements between the DSAG and CSAG that include provisions that are not arm’s-length, weigh against a determination of §355 qualification — particularly, for example, if the purported business purpose for the Section 355 Transaction is to achieve a fit-and-focus business purpose.”}

^{[19] Notice 2024-38, Section 2.02(2).}