Reviving the Reverse Morris Trust for Mergers

Reverse Morris Trust transactions gain popularity on the IRS's declaration that Revenue Ruling 70-225 is obsolete and the relaxation of the 'D' reo...
Robert WillensJuly 3, 2002

Before the 1997 alteration of the law, the ground rules for structuring a Morris Trust transaction with respect to an acquisition were well understood—albeit somewhat illogical.

In most cases, the trust used to work like this: First, assume that the target corporation engaged in two different businesses. From the acquirer’s perspective, one is a wanted business, and the other an unwanted business.

Next, the target company would “drop” the unwanted business into a Newco, and distribute the latter’s stock to its shareholders. The acquirer would then obtain the target—which contained only the wanted business—in a merger or in a stock swap qualifying as a ‘B’ reorganization. See Rev. Rul. 70-434.

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Note that the business combination had to take the form of a two-party merger—qualifying as an ‘A’ reorganization—or as a stock swap—qualifying as a ‘B’ reorganization. The ability to consummate a triangular, or “three party,” reorganization—of either the forward or reverse variety—was circumscribed because the triangular reorganization provisions each contain a “substantially all” of the assets requirement.

Furthermore, because the plan called for a preliminary extraction of the unwanted business from the target, the target would, as a result, be unable to convey the requisite quantum of its assets to the acquirer in the case of an attempted forward triangular merger. Similarly, the target would not be able to hold substantially all of its assets in the case of an attempted reverse triangular merger.

The transaction was tax-free in its entirety. Indeed, the target’s transfer of the unwanted business to Newco was tax-free, as was its distribution of Newco’s stock to its shareholders. Why? Because the transaction qualified as a ‘D’ reorganization. Recall that the unwanted business was transferred to a corporation and the shareholders of the transferor (the target) were in control of the unwanted business immediately after the transfer.

The fact that the shareholders, as part of the plan, surrendered control of the target (in the merger or stock swap) was not relevant because the post-distribution control requirement only applied to the corporation (Newco) to which the assets were transferred. See Rev. Rul. 68-603

Conversely, if the identical economic result was sought through a different format (popularly known as a reverse Morris Trust transaction), the tax results would be markedly different.

So, when Rev. Rul. 70-225 is applied, the target dropped the wanted company (not the unwanted one) into Newco, and as part of a prearranged plan, distributed Newco’s stock to its shareholders. Then, the acquirer obtained the Newco stock (from it’s own shareholders) solely in exchange for voting stock.

Important here is that the IRS ruled that the transaction did not qualify as a ‘D’ reorganization because of the prompt and prearranged loss of control of the corporation to which the assets were transferred. Control here meaning the ownership of at least 80 percent of the total combined voting power of all classes of stock entitled to vote and 80 percent or more of the total number of shares of each class, if any, of nonvoting stock—See Sec. 368(c).

In other words, the transaction was treated as if the target had directly transferred the wanted business to the acquirer in exchange for stock—in a fully taxable exchange—and as if, immediately thereafter, the target had distributed the acquirer stock (constructively received) to its shareholders in a distribution to which Sec. 301 applied. Such distribution, assuming there was sufficient earnings and profits, was taxable as a dividend.

Thus, the same economic transaction, improvidently structured, yielded two levels of taxation: The target was taxed on the appreciation (in excess of its basis) inherent in the wanted business; and the target’s shareholders were taxed, at dividend rates, on the value of wanted business.

This issue has now been alleviated. The definition of a ‘D’ reorganization has been substantially relaxed. More specifically, the post-distribution “maintenance of control” requirement has been summarily eliminated. The determination of whether a transaction constitutes a ‘D’ reorganization is now made without regard to whether the shareholders who receive the distributed stock dispose of such stock, or whether the corporation whose stock is distributed issues additional stock. Moreover, to insure that Congress’ intent—with respect to the relaxation of the ‘D’ reorganization requirements—is fully implemented, the IRS, in Rev. Rul. 98-44, expressly declared that Rev. Rul. 70-225 is obsolete.

This concession, in turn, has sparked a renaissance with respect to the reverse Morris Trust pattern. In fact, some high-profile reverse Morris Trust transactions have recently been announced, including the Heinz/Del Monte deal, the Proctor & Gamble/JM Smucker arrangement, the AT&T/Comcast transaction as well as the troubled General Motors/Echo Star transaction.

In each case, the target is distributing, to its shareholders, the stock of a corporation to which wanted assets had been transferred. Additionally, the distribution is promptly followed by a prearranged business combination in which such shareholders receive in excess of 50 percent, but less than 80 percent of the stock of the acquirer.

The transactions, in each case, qualify as a ‘D’ reorganization because there is no longer, for that purpose, a post-distribution maintenance of control requirement. Accordingly, the “asset movement” (from target to Newco) is tax-free. Moreover, the Newco stock is received by the target’s shareholders on a tax-free basis. That is because the requirements of Sec. 355 are satisfied, and finally, because the target shareholders obtain in excess of 50 percent of the value and voting power of the acquirer’s stock.

The distribution (of Newco’s stock by the target) is also tax-free because the transaction does not run afoul of Sec. 355(e). That section, which as Congress intended when it enacted the 1997 changes, now has hegemony with respect to the taxability of Morris Trust transactions—either of the reverse or forward variety.

To be sure, Sec 355(e) operates where, in connection with an otherwise qualifying spin-off, the former shareholders of the distributing corporation (target) cede 50 percent or more of the stock of such corporation (to outsiders) as part of a “plan or series of related transactions.” What’s more, the above-cited reverse Morris Trust transactions do not violate Sec. 355(e) because in each instance, the shareholders of the target succeed well in excess of 50 percent of the acquirer’s outstanding stock.

However, the reason why the latest generation of spin-off/acquisition transactions are structured as reverse Morris Trust transactions can be directly traced to the relaxation of the ‘D’ reorganization requirements—the beneficial elimination of the post-distribution maintenance of control condition. That is why these deals can now be structured in the most direct manner; as a drop down of the wanted business to Newco, a spin-off of Newco, and a business combination involving Newco and the acquirer.

That is, of course, as long as the shareholders of the target obtain a greater than 50 percent interest in the acquirer, so the entire transaction can be accomplished on a fully tax-free basis.