The Internal Revenue Service is considering relaxing the rules for companies to qualify for tax-free spinoffs — a shift that could benefit drugmakers and tech firms with promising early-stage products.

The agency said Tuesday it’s looking into whether units should still be required to generate revenue before a spinoff from a larger company can be deemed tax-free. Current rules generally require units to have been engaged in a trade or business involving income collection and payment of expenses for at least five years. The change could be a way for the U.S. government to promote research and development within the country by giving companies a tax break on the spinoff transaction.

The IRS “has observed a significant rise in entrepreneurial ventures” where the development can be subject to regulatory review “that can span multiple years and cost millions of dollars,” the agency said in a statement announcing it would be studying the issue.

“It seems to me that this is intended to foster more innovation in the U.S. by making it more profitable to investors,” said Andrew Silverman, an analyst with Bloomberg Intelligence.

Allowing companies that aren’t yet generating revenue to qualify for tax-free spinoffs would be a boon for startups, typically backed by private equity and venture capital funds. Those investors tend to prefer spinoffs and initial public offerings as a way to recoup their money. Large tech and pharmaceutical companies, such as Alphabet Inc.’s Google and Johnson Johnson that have internal incubators, could also benefit.

‘Off its books’

President Donald Trump’s 2017 tax law included several provisions that reward U.S. companies that develop and manufacture products domestically — while attempting to punish those that shift assets and operations overseas.

If the IRS moved ahead with the proposal, it would expand tax-favored spinoffs — a favorite strategy of corporate shareholders looking to bolster the value of their investment — after several years of policies that made it more difficult for companies to execute these types of deals.

“If you’re investing in a big, new product that takes seven or 10 years to develop, you can spend a whole lot of money and employ a whole lot of people and clearly be running a real business for a very long time before you ever have a dollar of revenue to show for it,” said Jay Singer, a partner at law firm McDermott Will Emery in Washington.

The agency is considering whether to soften its current definition of active trade or business with respect to tax-free spinoffs to include units that aren’t yet producing income. That could include units of a pharmaceutical company that are in the development stage of a drug.

“It may be that such a spinoff is desirable because while the project is still in the development phase it is incurring expenses (without accompanying revenues) and these expenses are depressing the parent’s earnings such that it makes sense for the parent to get the activity ‘off of its books’ as soon as possible,” Robert Willens, an independent tax consultant, said in an email.

Yahoo! spinoff blocked

Companies with underperforming stocks, including Dell Inc. or International Business Machines Corp., could face shareholder pressure to spin off units in an attempt to boost the value, said Mandeep Singh, a senior technology analyst at Bloomberg Intelligence.

Tax-free spinoffs have been a source of tension between the IRS and corporate America in recent years as the agency has sought to rein in what it considered to be overly aggressive deal-making. The IRS effectively blocked Yahoo! Inc.’s effort to spin off its stake in Alibaba Group Holding Ltd. in 2015 after declining to give the deal tax-free treatment.

The IRS is “showing open mindedness” with regard to admitting non-income producing companies into the group that can be spun off tax-free, said Gary Friedman, a tax partner at law firm Debevoise Plimpton.

The IRS said pending completion of its study, it will accept requests to review deals before closing to determine whether they qualify for tax-free treatment. Investors typically ask for such rulings to ensure the IRS won’t later decide the transaction should be taxed.

‘Game changer’

The invitation for companies to have their deals reviewed represents a shift at the IRS. The agency has greatly restricted the deals it’s approved since 2015, citing cuts in agency staff and concerns that companies were pursuing the deals for the tax benefits rather than business reasons.

If the IRS moves forward with the change, Singer said it will have to consider anti-abuse measures to prevent taxpayers who aren’t engaged in real businesses from exploiting the rules. For example, the agency may want to look at the number of people a business employs or the amount of money and time it invests in R and D, he said.

Singer called Tuesday’s announcement a potential “game changer.”

“Historically, you’ve seen pharma companies do spinoffs in certain situations but usually not to split up individual lines of pharmaceuticals,” Singer said. The type of guidance the IRS is talking about “would make those sorts of transactions more feasible and practical.”

It would also “enable more tech-oriented companies out West to do spinoffs more regularly,” he said.

Bloomberg News