Dell Announces Spin of VMware Stake, Special Dividend

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

In a late-day filing April 14, Dell Technologies Inc. (NYSE:  DELL) (Dell) announced that it plans to spin off its 80.6-percent stake in VMware Inc. (NYSE:  VMW) (VMware) in the fourth quarter of 2021, assuming, among other conditions,^[1]that it can obtain a favorable private letter ruling from the Internal Revenue Service (IRS) that the spin-off will be tax-free to Dell’s shareholders.^[2]

Before the spin-off, VMware will pay a special dividend of as much $28.62[3] in cash per share to its shareholders, including Dell (such that Dell would receive as much as $9.7 billion in cash, enabling it to use the proceeds to pay down its debt).  As part of the transaction, VMware’s dual-class stock structure will be unwound, eliminating the high-vote Class B held by Dell and making VMware stock eligible to be included on indices where such structures are banned.^[4]

We have written more than a dozen reports detailing tax and corporate law issues raised by Dell’s VMware stake.^[5]In our first Dell report—from January 2018—we noted that Dell must generally wait five years (until September 2021) from the time of its transaction with EMC Corporation (how Dell obtained its controlling stake in VMware^[6]) before distributing the VMware stock to shareholders in a tax-free split or spin-off under Internal Revenue Code (IRC) Section 355 so that it can clearly satisfy the active trade or business test.^[7]

Why even consider such a separation and deconsolidation of Dell’s VMware stake? To address the ongoing relative discount at which Dell trades to VMware.^[8]While our more recent reports addressed other options for achieving a similar goal (including application of the so-called expansion doctrine, the success of which was speculative^[9]), Dell never pursued the less straightforward options.  This announcement makes clear that it has chosen instead to wait out the five years.  (Two of our more recent Dell reports addressing such a separation are appended.)

The Mechanics of the Separation

The distribution of the VMware stock out to Dell shareholders will be preceded by some internal restructuring (distributions that, with one exception,^[10]should also qualify as tax-free spin-offs).  These internal distributions are necessary in order get Dell’s VMware stock (which is currently housed in three wholly owned Dell subsidiaries, including EMC Corporation, that appear to be at least three tiers down the chain of Dell subsidiaries) up to the Dell parent company.^[11]

While the five-year wait all but ensures that Dell and VMware will be able to satisfy the active trade or business rule,^[12]there are other important requirements to a tax-free spin-off.  The so- called control requirement states that the distributing corporation (in this case, Dell) must distribute as part of the spin-off an amount of stock in the controlled corporation (in this case, VMware) constituting control.^[13]Control for this purpose is generally defined as the ownership of stock possessing an 80-percent or greater voting interest.^[14]

As of April 14, 2021, Dell controlled 80.6 percent of the total outstanding shares of common stock of VMware and about 97.4 percent of the combined voting power of both classes of common stock.  Specifically, Dell owned 30,678,605 shares of VMware’s low-vote (one vote per share) Class A common stock (about 27 percent of the Class A shares outstanding as of March 16, 2021) and 307,221,836 shares of VMware’s high-vote (10 votes per share) Class B common stock (Dell owns 100 percent of the Class B), which is convertible into an equal number of shares of Class A at any time.^[15] Because of this, Dell controls the election of all of VMware’s directors and controls the vote with respect to all other matters submitted to VMware stockholders for a vote.^[16]

So while Dell currently has more than enough voting control (97.4 percent) of VMware to satisfy the control requirement for tax-free spin-offs, it also has just enough voting control (80.6 percent) if it were to convert its high-vote Class B into low-vote Class A before the spin-off.  But the transaction contemplates that the conversion will occur after the shares leave Dell.

Specifically, immediately after Dell receives its portion of the VMware special dividend, Dell will distribute all of its VMware stock (both its low-vote Class A and high-vote Class B) to the transfer agent.  Before the transfer agent distributes the VMware shares out to Dell’s shareholders, there will be an automatic conversion of each VMware Class B share into one VMware Class A share such that Class A will become the sole outstanding common stock of VMware.  This conversion will result in a shift of voting power and will constitute a recapitalization that should be tax- free.^[17]

We think it likely that the intended tax treatment is that Dell would be treated as distributing its Class A and B shares to shareholders, followed by a post-spin recapitalization exchange of the Class B for Class A (receipt of shares by the transfer agent is treated as completion of the spin- off distribution).  Given that Dell’s shareholders will, in any case, end up receiving just over 80 percent of the voting power in VMware after the recapitalization, the conversion should not threaten the control analysis.  We suspect an IRS private letter ruling is being sought to confirm this point.  The Separation and Distribution Agreement supports this suspicion, as it states that “the effect of any such recapitalization . . . of shares shall take into account any applicable IRS private letter ruling received by VMware.”^[18]

Once a company has decided to go to the IRS for a private letter ruling on a spin-off, it can take several months (oftentimes more than six months) to actually obtain one.  That said, we suspect that Dell has already started the process and took that into account when announcing its expected fourth quarter closing.  However, if there is a hiccup in the ruling process, the agreement provides that the Separation and Distribution Agreement may be terminated if the transactions are not completed on or before January 28, 2022.

VMware has indicated that it plans to fund the $11.5 billion to $12 billion special dividend with between $2.5 billion and $3.5 billion in cash (the bulk of its $4.7 billion in cash and investments at the end of fiscal year 2021), with the remainder funded by “incremental debt.”^[19]However, VMware says that the debt will not be around for long, as it expects “to use free cash flow primarily to de-lever for two years following the transaction.”^[20]

Tax Treatment of the Special Dividend

It is intended that the VMware special dividend will be treated as a Section 301 distribution.  This means that—for VMware shareholders other than Dell—the distribution of cash will be treated as a taxable dividend to the extent of VMware’s current and accumulated earnings and profits (E&P) and then will be treated as a tax-free return of capital (until the shareholder’s basis is zeroed out).  Any excess will be treated as capital gain.

So how much E&P does VMware have? We do not know for sure, but financial statement retained earnings may provide a high-level approximation.  According to VMware’s most recent annual report, as of January 29, 2021, the company had $7.067 billion in retained earnings.^[21]That is nearly 60 percent of the (as high as) $12 billion planned special dividend, which means that the bulk of the distribution will be taxable (to VMware shareholders other than Dell).

But because VMware is part of Dell’s consolidated tax group, the special dividend should be tax- free to Dell.^[22]It will reduce Dell’s tax basis in its VMware stock, but presumably Dell has enough basis to avoid the creation of an excess loss account (ELA).  It is even possible that the size of the special distribution was capped not only by considerations of debt ratios of the two companies, but also so that Dell could come close to zeroing out the tax basis it has in its VMware stock, without creating an ELA that would be triggered by the spin-off.

^{[1] A shareholder vote is not required.  Spin-offs are ordinarily state law dividends to shareholders that only require board approval.}

^{[2] Press Release, Dell, Dell Technologies Announces Planned VMware Spin-Off (April 14, 2021) (https://www.sec.gov/Archives/edgar/data/1571996/000119312521116271/d142017dex991.htm).}

^{[3] Based on outstanding shares as of March 16, 2021.}

^{[4] Including, for example, S&P, which determined in 2019 that companies with multiple share class structures would be ineligible for inclusion in the S&P Composite 1500 index.(https://www.spglobal.com/spdji/en/documents/indexnews/announcements/20191220- 1059762/1059762_US%20Indices%20methodology%20clarifications%20Dec%202019.pdf)}

^{[5] They are:  “Review of Dell’s Options for Its VMware Holding” (June 26, 2020); “Tax Impact of VMware’s $2.7 Billion Acquisition of Pivotal” (August 29, 2019); “Buzz Regarding Possible Spin-Off of VMware by Dell” (February 26, 2019); “Reducing Risk of Withholding from Cash Election in Dell’s Class V Transaction” (December 20, 2018); “As Dell’s Friday Deadline Looms, Dividend vs. Capital Gain Is a Focus for Many Investors” (December 19, 2018); “Does Dell Ownership Impede VMware’s Acquisition Strategy? Can Dell Separate VMware Before 2021?” and “Dell Sweetens DVMT Exchange Terms by About $2.2B” (November 27, 2018); “Have Dell’s IPO Discussions Created an Entire Fairness Issue (aka:  Is Carl Icahn Right)?” (October 15, 2018); “If Dell Ups the Equity in Its Tracking Stock Elimination Deal, Does That Put Undue Pressure on the Redemption Analysis?” (July 31, 2018); “Elimination of Dell Tracking Stock—Treatment of the Cash” (July 23, 2018); “Dell Will Take Class C Public and Eliminate Tracking Stock in Deal That Gives Tracker a Vote” (July 2, 2018); “What Could Happen If a Dell IPO and Anticipated Tracking Stock Conversion Reduces the Value of the Tracking Stock” (February 9, 2018); “Dell Tracking Stock Holders Likely to Get Class Vote to Protect Their Interests In the Event of a Dell IPO/Merger” (February 8, 2018); and “Dell May Go Public Again—How the Transaction Is Structured Could Impact Tracking Stock Holders” (January 31, 2018).}

^{[6] Specifically, the acquisition of all of the shares of EMC by Dell, which closed on Sept. 7, 2016, generally resulted in the exchange of each EMC share for both cash and stock such that the receipt of the cash was a taxable transaction for U.S. federal income tax purposes (https://www.sec.gov/Archives/edgar/data/1124610/000112461016000063/a8‐k09x01x16.htm; https://www.sec.gov/Archives/edgar/data/790070/000119312516614138/d59207ddefm14a.htm).}

^{[7] September 2021 is the five-year anniversary of Dell’s purchase of EMC Corporation in a partly taxable transaction.  The Internal Revenue Code requires that each company involved in the tax-free spin-off—both Parent and Spinco—be engaged in an active trade or business (ATB) that was not purchased in a transaction in which gain or loss was recognized in whole or in part during the preceding five years (§355(b)(2)(C)).}

^{[8] According to Michael Dell, speaking on a Dell conference call April 14, 2021, the discount has persisted.  Specifically, he said:  “[A]s much as we grew the revenues of VMware tremendously and we had great revenue synergies across VMware and Dell Technologies over the last – almost five years, the market does not appear to appreciate a hardware-software combination, given the discount in the current structure.” See the transcript available here:  https://investors.delltechnologies.com/static- files/9eb97e87-1b79-4d22-87dd-821c0aea3372.}

^{[9] As we wrote about in our Nov. 27, 2018 report “Does Dell Ownership Impede VMware’s Acquisition Strategy? Can Dell Separate VMware Before 2021?”, if the expansion doctrine applied to Dell’s facts, the 2016 EMC transaction would not be treated as the acquisition of a new trade or business, requiring a new five‐year waiting period, but rather the purchase of business operations that merely represented an organic expansion of one of Dell’s preexisting trades or businesses.  We left as an open question—albeit one we later characterized as “a challenging judgment call”—whether Dell had facts that could convince the IRS that the expansion doctrine should apply in its case.}

^{[10] According to the Separation and Distribution Agreement between Dell and VMware dated as of April 14, 2021, the one internal distribution that will not be a Section 355 is the distribution of VMware Common Stock owned by VMC Holdco LLC and EMC Equity Assets LLC to EMC Corporation.  We suspect that this distribution—while not a spin-off—is likely nevertheless nontaxable, because it is from LLCs most likely treated as partnerships or disregarded entities for federal tax purposes.  (https://www.sec.gov/Archives/edgar/data/1571996/000119312521116271/d142017dex21.htm}

^{[11] Dell Form 8-K filed April 14, 2021 (https://www.sec.gov/ix?doc=/Archives/edgar/data/1571996/000119312521116271/d142017d8k.htm).}

^{[12] IRC §355(b)(1)(A) provides, among other things, that “the distributing corporation, and the controlled corporation . . . , is engaged immediately after the distribution in the active conduct of a trade or business,” which is defined in §355(b)(2) as, among other things, a trade or business that “has been actively conducted throughout the 5-year period ending on the date of the distribution” and a trade or business that was not acquired during that 5-year period in a taxable transaction.}

^{[13] IRC §355(a)(1)(D)(ii).}

^{[14] IRC §368(c).}

^{[15] VMware Schedule 13D disclosing Dell’s ownership, filed April 14, 2021 (https://www.sec.gov/Archives/edgar/data/1124610/000119312521116320/d143335dsc13da.htm).}

^{[16] VMware’s Annual Report (Form 10-K) at 29, filed March 26, 2021.  (https://www.sec.gov/ix?doc=/Archives/edgar/data/1124610/000112461021000015/vmw-20210129.htm)}

^{[17] §368(a)(1)(E).}

^{[18] See the Separation and Distribution Agreement between Dell and VMware dated as of April 14, 2021, at 6 (https://www.sec.gov/Archives/edgar/data/1571996/000119312521116271/d142017dex21.htm).}

^{[19] VMware slide deck April 14, 2021 (https://ir.vmware.com/download/companies/vmware/Presentations/VMware%20Spin- off%20Slide%20Deck.pdf).}

^{[20] Id.}

^{[21] VMware’s Annual Report (Form 10-K) at 62, filed March 26, 2021 (https://www.sec.gov/ix?doc=/Archives/edgar/data/1124610/000112461021000015/vmw-20210129.htm).}

^{[22] According to Treas. Reg. §1.1502-13(f)(2), which provides rules for intercompany transactions to which §301 applies.}