Can a Spin-Off Get Spotify Back to the Garden?

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

Neil Young needed to be separated from Joe Rogan.  As did Joni Mitchell.  And Nils Lofgren, who, despite pulling his solo work, can presumably still be faintly heard superfluously strumming an acoustic guitar as part of Bruce Springsteen’s E Street Band.  These and some other musicians are abandoning Spotify Technology S.A.’s (NYSE:  SPOT) (Spotify’s) music streaming business because of their objections to at least one of the more visible manifestations of the company’s burgeoning podcast streaming business.  Are there more pervasive and enduring conflicts between Spotify’s music and podcast businesses, with sufficiently different constituencies on both the talent and customer sides (and perhaps sufficiently different business strategies) to warrant a separation of the two businesses?

We do not purport to offer an answer to that larger question, but having seen so many instances of irreconcilable “fit and focus” difficulties resulting in public company separations, we think it is worth considering what such a transaction might look like.

From a tax and legal standpoint, note that Spotify is a Luxembourg corporation doing business primarily through Swedish (Spotify AB) and U.S. (Spotify USA) operating subsidiaries. ¹ Its shareholders are global, with many in the United States, and a large block of stock (nearly 27 percent) owned by Swedish cofounders Daniel Ek and Martin Lorentzon. ² 

It is likely that in order for a separation into two separate public companies to occur, Spotify would need to satisfy requirements for tax-free treatment in the United States, Sweden and Luxembourg.  For purposes of this report, we note that demerger transactions are generally permitted under Luxembourg and EU corporate law, with particular requirements that would have to be met to qualify for tax-free treatment to the corporation and shareholders.  Similarly, both from the standpoint of avoiding corporate level tax to the Swedish subsidiary and to Swedish shareholders, the separation would have to meet requirements of Swedish tax law.  For purposes of this report, we will focus primarily on U.S. requirements for a tax-free spin-off, both from the standpoint of avoiding corporate-level tax to Spotify USA and to the company’s U.S. shareholders.

Structurally, separating off either the podcast operations or the music streaming operations into a Spinco and distributing it to shareholders would meet the structural requirements of Section 355 of the Internal Revenue Code (IRC).  We can comfortably proceed on the basis that regardless of the formal steps required under Luxembourg law, we would expect that any such steps could be incorporated into a separation that meets the structural requirements of Section 355.  We turn our attention, then, to the “softer” Section 355 requirements of business purpose and active trade or business (ATB).

“Fit and focus” is a fairly generic business purpose category, broadly described by the Internal Revenue Service (IRS) as involving a spin-off to “enhance the success of the businesses by enabling the corporations to resolve management, systemic, or other problems that arise (or are exacerbated) by the taxpayer’s operation of different businesses within a single corporation or affiliated group.” ³ There are numerous instances of the IRS ruling that a public company spin¬off satisfies the criteria for a fit and focus business purpose, with each particular set of circumstances fairly unique.

As it happens, the Spotify situation also brings to mind another business purpose with a longer history, referred to in shorthand as “competition.” The IRS describes a spin-off as being motivated by competition when the separation is done “to resolve the taxpayer’s problems with customers or suppliers who object to [one business] being associated with a business that competes with the customer or supplier . . . .” ⁴ We think it very likely the IRS would agree that, while not strictly a competition issue, the element of outside pressure from “suppliers” to Spotify’s music streaming business could justify separating it from Spotify’s podcast business.

The ATB rules require that, following the spin-off, Parent and Spinco each be engaged in an active trade or business that has been carried on for at least the preceding five years by Parent’s affiliated group or, if not carried on by Parent, the ATB was acquired in an entirely tax-free transaction during that period. ⁵ We are not sure when Spotify first entered the business of distributing podcasts ⁶ (it went public on April 3, 2018 and was incorporated on December 27, 2006), but its 2018 Q1 report refers to “partnerships with several major podcast networks and aggregators” that significantly increased “the size of our catalog compared to Q4 2017.” ⁷ On October 3, 2018, it launched Spotify for Podcasters, a platform enabling “podcast creators who are hosting their podcasts elsewhere [to] be able to make their show available to Spotify users by providing us with their podcast feed.” ⁸ And on February 14 and 15, 2019, it acquired U.S. companies Anchor FM Inc. and Gimlet Media, Inc., respectively—one a podcast software company and the other a producer of podcast content.  Other acquisitions occurred in that year and subsequently.

We could conservatively assume that the podcast business goes back to at least January 2018 and likely at least some time before then.  That means that, conservatively, a spin-off could be announced at any time and be consummated at the end of 2022 without presenting ATB concerns.  This would eliminate the need to explore the strong prospect that Spotify’s movement from music to spoken-word content would be treated as an expansion of the company’s historical business, and therefore not require an independent five-year history.

Any spin-off involving a multinational company involves a great deal of country-by-country work that goes on behind the scenes, often resulting in some amount of tax leakage.  Here, the primary demerger/spin-off of the public Luxembourg company would likely need to be preceded by intra-group separations of the two businesses in Sweden and the United States.  The degree to which either the Swedish or U.S. subsidiary needs to engage in a tax-free intra-group separation depends on details of where the primarily intangible assets associated with the music and podcast businesses reside.  To the extent technology necessary to operate one business may be owned by the other, licensing arrangements may be put in place that could avoid having to separate ownership of the technology intellectual property (IP).  We do not know where the IP, contracts and other assets reside, though it appears from the acquisitions history that the podcast business may be largely centered in the United States.  At the same time, it seems likely that as a non-U.S.-based multinational company, Spotify would have historically sought to plan to situate its IP outside the United States.

Generally, we do not think that Spotify should have a problem qualifying such a music streaming-podcast separation for tax-free treatment under Section 355.  Where the matter could be more problematic is if the company wished to combine a spin-off with a merger of either business with another company in a so-called Morris Trust transaction. ⁹ It is not difficult to imagine that one or more much larger companies—Apple Inc. (NASDAQ:  AAPL) (Apple) and Amazon.com, Inc. (NASDAQ:  AMZN) are a couple that come to mind—for whom acquisition of Spotify’s music streaming business could be attractive.  Under the so-called anti-Morris Trust rules of Section 355(e), a spin-off followed by a prearranged stock-for-stock merger will give rise to corporate level gain tax even though it is tax-free to the shareholders unless the Parent company shareholders will own a majority of the post-merger company (which would not be the case with these market colossus acquirers).

As noted above, a corporate-level tax in the United States would only be a cost to the extent it is necessary to separate music streaming (or podcast) business assets from Spotify’s U.S. group.  This could be a manageable cost.  Another possibility might be for an acquirer—Apple, for example—to contribute assets to a subsidiary that would merge with a Spotify Music Streaming Spinco in a Reverse Morris Trust (RMT) transaction.  This would require that Apple own less than 50 percent of the vote and value of the resulting music streaming subsidiary, with the public shareholders holding more than 50 percent.  Whether this would be sufficient practical control to allow Apple to consolidate the music subsidiary in its financial statements (and whether consolidation would be essential for a deal) are open questions.

Certainly, the Section 355(e) restrictions could be avoided by consummating a straight spin-off, and, after some period of time, potential acquirors could then initiate discussions about a possible acquisition.  In addition to avoiding those restrictions, another advantage of this approach is that the acquisition can be for cash, whereas in a Morris Trust or RMT transaction the consideration must be all stock.  On the other hand, what may be most helpful about arranging a merger to coincide with the spin-off is that it can eliminate the need to engage in the difficult work of establishing two separate stand-alone public companies, negotiating not only the financial terms but also the commercial foundation for the post-spin merged company prior to the separation.

^{[1] Per Spotify’s Form 20-F filed Feb. 3, 2022, which lists its principal subsidiaries, the main operating company is Spotify AB, incorporated in Sweden, and the U.S. operating company is Spotify USA Inc. (https://www.sec.gov/ix?doc=/Archives/edgar/data/0001639920/000163992022000004/ck0001639920-20211231.htm).}

^{[2] Also according to the Form 20-F, Ek’s approximate percentage ownership of outstanding ordinary Spotify shares is about 16.0% and Lorentzon’s is approximately 10.9%.}

^{[3] Rev. Proc. 96-30, Appendix A, section 2.05.}

^{[4] Rev. Proc. 96-30, Appendix A, section 2.06.}

^{[5] IRC §355(b).}

^{[6] Spotify’s first Form 20-F (for the fiscal year that ended Dec. 31, 2018, filed Feb. 12, 2019) mentions its podcast business (https://www.sec.gov/Archives/edgar/data/1639920/000156459019002688/ck0001639920-20f_20181231.htm).}

^{[7] https://s22.q4cdn.com/540910603/files/doc_financials/quarterly/2018/Q1/Shareholder-Letter-Q1-2018.pdf}

^{[8] https://newsroom.spotify.com/2018-10-03/introducing-spotify-for-podcasters-in-beta/}

^{[9] A spin-off followed by a prearranged merger is referred to as a Morris Trust transaction because of Comm’r v. Morris Trust, 367 F.2d 794 (4th Cir. 1966), a court case that first found such a transaction could qualify for tax-free treatment.}