If Macy’s Follows Saks E-Commerce Separation, Is Subsequent Spin to Shareholders a Possibility?

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

It was recently reported that Saks Fifth Avenue is moving ahead with plans for a public offering of shares in its recently separated e-commerce business.¹ News reports indicate timing of the IPO could be during the first half of 2022, targeting a valuation of the e-commerce unit of approximately $6 billion.  Following Saks’ majority owner, Canada-based HBC (which wholly owns Hudson’s Bay), being taken private in early 2020, in March 2021, the e-commerce unit was placed in a separate subsidiary with a minority interest sold to venture capital firm Insight Partners.  Insight Partners invested $500 million based on a $2 billion valuation, meaning that presumably HBC presently holds 80 percent and Insight Partners holds 20 percent. ² 

If HBC were a public company, we would be looking at how a post-IPO tax-free spin-off to its shareholders could be done.  A tax-free spin-off under Internal Revenue Code (IRC) Section 355 requires that the parent company distribute at least 80 percent “control” of the subsidiary to the shareholders. ³  Assuming the entity housing the e-commerce business (they are calling the e-commerce unit simply Saks) is a corporation with a single class of stock, then today HBC holds 80 percent and Insight Partners holds 20 percent, and an IPO of any amount would dilute HBC to less than 80 percent.

Post-IPO Saks will apparently be majority-owned by privately-owned HBC and a more complete separation is unlikely to occur.  But as plans for a Saks IPO move ahead, Macy’s, Inc. (NYSE:  M) (Macy’s) announced November 18 that it has hired a third-party firm to analyze whether it should separate off its e-commerce operations. ⁴  The move comes just weeks after activist investor JANA Partners LLC (Jana Partners) sent a letter to Macy’s management suggesting it pursue a strategy to separate its online unit from its bricks-and-mortar stores. ⁵ It has been noted that, unlike in the Saks case, a separation for Macy’s may be more problematic due to its strategy of integrating the online business with the stores.⁶

Nevertheless, pressure to showcase e-commerce on a separate basis and establish a public-market valuation may change the calculus for a possible Macy’s separation.  Right now Macy’s presents itself as a “multichannel” business, with no differentiation between the in-store and online channels.  The first step would be to create a separate online division, determine how the elements of a separate income statement would be determined, all without undermining a successfully integrated approach to serving customers.

Assuming those formidable operational and financial hurdles can be overcome, the company could proceed to a spin-off to shareholders or first do an IPO of the online subsidiary.  In lieu of or prior to an IPO, Macy’s could, as is suggested by some investors, bring in a private equity investor for a minority interest.  In order to be able to qualify a subsequent distribution of stock to Macy’s shareholders for tax-free treatment under Section 355, the company would need to retain at least 80 percent of the stock of the post-IPO online subsidiary. ⁷  In any case, what challenges do we see a spin-off of a Macy’s online subsidiary presenting from a tax standpoint?

Since we are positing that the online channel may only be broken out as a separate line of business relatively soon before a spin-off, can it satisfy the active trade or business (ATB) requirement if not carried on as a separate division for at least five years as required by Section 355(b)?  This should not be a problem.  Aside from the fact that the underlying online sales activities will have at least a five-year history, the Internal Revenue Service (IRS) actually ruled on breaking out an online channel as an active business back in 2003.  Revenue Ruling 2003-38 ^[8] was a delayed response to the dotcom boom in the late 1990s, when it literally seemed to be the case that adding “dot-com” after any business name would add a much higher market valuation.  The ruling involved a retail shoe business that sought to spin off an online shoe distribution business without having the requisite five-year history.  The ruling held that the online business was a permissible expansion of the conventional retail shoe business, allowing it to tack onto the core business’s five-year history.

Establishing a compelling non-tax business purpose is a central requirement for tax-free treatment.  Discussions of public company spin-offs often gloss over this essential requirement, perhaps because of focusing on other structural aspects of the transaction and perhaps because, ultimately, a business purpose is established in nearly all cases.  The most common business purpose for public-company separations is the so-called “fit and focus” problem, broadly requiring demonstration that one or both businesses are suffering from being under a single corporate parent.  The more happily integrated two businesses are, the more challenging it may be to develop the requisite business purpose.

At this point in the conversation, tax lawyers reveal the seemingly bizarre fact that merely enhancing shareholder value is not an adequate business purpose for a spin-off.  The fact that the market will attribute a significantly higher multiple in valuing the separated online business is nice, but insufficient in its own right.  Linking this to an acquisition strategy, or better focusing management equity incentives, are examples of connecting the corporate finance aspects to a business purpose.  Any such separation would involve important debt-and capital-structure considerations, and perhaps the separation could tie to that in a favorable way.

The interrelationship between Macy’s online channel and its stores presents both operational challenges and a potential tax concern with respect to a tax-free spin-off.  As noted above, if it is hard work to disentangle the two operationally and from an accounting standpoint, then the business-purpose case may be harder.  All the more reason to test the proposition by following the Saks approach and either bringing in a private equity investor or doing an IPO for up to 20 percent of the stock of a newly-created online subsidiary.  This phase would need to successfully carve out the online business and establish an ongoing working relationship that retains the benefits of an omnichannel strategy while providing a separate investment vehicle for the online business.

Assuming that is accomplished and a spin-off of the online subsidiary to shareholders is desired, one issue the IRS would likely raise is the ongoing relationship between Spinco and Remainco following the spin-off.  The closest thing to an explicit admonition about this comes up with respect to the requirement that a spin-off not be “used principally as a device for the distribution of . . . earnings and profits. . . .” ⁹  The regulations list several factors indicating evidence that a transaction is or is not a device, and one “device factor” involves what the regulations refer to as a related function.  Specifically, there is evidence of device if a business of either post-spin company is a “secondary business” that continues as a secondary business for a significant period after the separation, and that secondary business can be sold without adversely affecting the main business.  One example of such a secondary business is a coal mine providing coal for a steel manufacturing business, and another example involves the sales operation connected to a primary business of meat processing. ¹⁰ 

We do not think that either the online or the in-store business could be viewed as secondary to the other, at least not in the sense contemplated in the regulations, especially considering the focus being on the ancillary, commodity-like aspect of the secondary business such that it could be sold without significant strategic implications.

That said, it is the case that the IRS generally views with some reluctance situations where there will be ongoing commercial relationships between the post-spin companies.  This really pertains primarily to a notion that if there is a sufficiently-compelling business purpose to separate, then having non-transitory significant commercial relationships between the two corporations presumptively belies that business purpose.  This presumption can be rebutted, however, and—as is often the case—it comes back to the business purpose.

A current, public example of where there is clearly an ongoing, strategic interrelationship between post-spin companies is the spin-off history of the Madison Square Garden companies.  In 2015, the company formerly known as The Madison Square Garden Company became MSG Networks Inc. (NYSE: MSGN) when it separated off its sports and entertainment businesses (which became The Madison Square Garden Company (NYSE: MSG)) from its media business in a tax-free spin-off under Section 355. ¹¹   Then in 2020, The Madison Square Garden Company divided again, with its sports business becoming Madison Square Garden Sports Corp. (NYSE: MSGS) and its entertainment business becoming Madison Square Garden Entertainment Corp. (NYSE: MSGE) in a tax-free spin-off.  These were done on the basis of opinions of counsel rather than private letter rulings, but all indications are that the strength of those opinions was not diminished by the close post-spin relationships between the companies.

^{[1] Cara Lombardo, Saks E-Commerce Unit Begins IPO Preparations, WALL ST. J., Oct. 17, 2021 (https://www.wsj.com/articles/saks-e-commerce-unit-begins-ipo-preparations-11634508756).}

^{[2] Press Release, HBC, HBC and Insight Partners Launch Saks as a Standalone Ecommerce Company Set to Rapidly Expand Customer Base in Growing Online Luxury Fashion Market (March 5, 2021) (https://www.hbc.com/news/article/hbc-and-insight-partners-launch-saks-as-a-standalone-ecommerce-company-set-to-rapidly-expand-customer-base-in-growing-online-luxury-fashion-market/).}

^{[3] IRC §355(a)(1)(D). Control is defined under IRC §368(c) as ownership of stock possessing at least 80% of the voting power and at least 80% of each class of nonvoting stock.}

^{[4] Charity L. Scott, Macy’s Hires Adviser to Study Separation of E-Commerce Business, Wall St. J., Nov. 18, 2021 (https://www.wsj.com/articles/macys-sales-and-profit-jump-ahead-of-holiday-period-11637243283?st=vjg64n55v1rena2&reflink=article_email_share); see also Macy’s Q3 2021 Nov. 18, 2021 Earnings Call transcript (provided by Motley Fool), in which Macy’s Chairman and CEO Jeff Gennette said:  “I think the omnichannel behavior is irrefutable and we need to respect that.  But we’re looking at a range of things including the net of costs.  That’s an execution that’s associated with operating as a one integrated business versus operating two separate businesses.  And ultimately, we just need to see that the additional shareholder value can be unlocked beyond the potential of our current approach with our digitally led omnichannel Polaris strategy.  So we’re working with our board, and our advisors for some time on this.  But based on how the market is assigning value e-commerce businesses, we just added AlixPartners, which we announced this morning as an objective third-party firm to really pressure test all of our analyses.  And so, we’re in the middle of that work, we need to complete our analysis, and we plan to provide an update after the work is complete.” (https://www.fool.com/earnings/call-transcripts/2021/11/18/macys-inc-m-q3-2021-earnings-call-transcript/)}

^{[5] Dana Cimilluca and Cara Lombardo, Jana Partners Takes Stake in Macy’s, Urges E-Commerce Spinoff, Wall St.  J., Oct. 14, 2021 (https://www.wsj.com/articles/jana-partners-takes-stake-in-macys-urges-spin-off-of-e-commerce-business-11634234298).}

^{[6] Nikitha Sattiraju and Ronald Orol, The Deal Macy’s E-Comm Spinoff May Not Be Perfect Fit, The Deal, Oct. 19, 2021 (https://pipeline.thedeal.com/article/296vu7ka3s54x1n9iplog/deal-news/activism/macys-e-comm-spin-off-may-not-be-perfect-fit).}

^{[7] See supra note 3. Using a two-class voting stock structure, it is possible to take more than 20% of the subsidiary public from an economic standpoint, but—absent important nontax considerations (such as maintaining control in a single shareholder or group of shareholders)—such an arrangement is ordinarily problematic.}

^{[8] https://www.irs.gov/pub/irs-drop/rr-03-38.pdf}

^{[9] IRC §355(a)(1)(B).}

^{[10] Treas. Reg. § 1.355-2(d)(2)(iv)(C). We have to note that most of the examples in these regulations involve commercial fact patterns more common in the 1950s than in our current economy.}

^{[11] Press Release, MSG Networks, The Madison Square Garden Company Becomes New Public Sports and Entertainment Company (Oct. 1, 2015) (https://s23.q4cdn.com/910947899/files/doc_downloads/spin-off_information/MSGN_News_2015_10_1_General_Releases.pdf); Press Release, The Madison Square Garden Company, The madison Square Garden Company Baoidr Approves Spin-Off of Emtertainment Businesses from Sports Businesses (March 31, 2020) (https://s23.q4cdn.com/910947899/files/doc_downloads/Press_Release.pdf).}