Kraft Cereal Deal Avoids Tax Crunch

Using a reverse Morris Trust to split off its Post cereal division, Kraft nabs tax-free treatment.
Robert WillensAugust 4, 2008

Filling breakfast bowls with everything from Shredded Wheat to Cocoa Pebbles, the Post cereal company claims that “everyone’s taste is a little different.” So when its parent company, Kraft Foods, split off the division today, it seemed fitting to use a unique flavor of divestiture — a “reverse Morris Trust.”

As a result, Kraft closes the transaction with Ralcorp Holdings for its Post cereals business in a tax efficient manner. In fact, by using the pre-tax value of Post as the retirement currency, Kraft should be able to retire approximately $662 million of its existing indebtedness, and generate some $300 million in cash, all without experiencing any tax consequences. This favorable result is possible because of by using the reverse Morris Trust, all of the requirements for a tax-free transaciton will be satisfied.

Stripped to its essentials, the transaction worked like this:
• Kraft borrowed $300 million from outside lenders.
• Kraft transfered the Post assets, subject to the liabilities associated with those assets, to “Splitco,” a new corporation formed for purposes of the transaction. Splitco assumed the liability incurred by Kraft to raise the $300 million. Splitco issued to Kraft all of its stock, and issued some $662 million in debt “securities” to Kraft. These instruments have a term of at least 10 years and be non-callable for a period of five years. Essentially, the Post business was conveyed by Kraft to Splitco in exchange for: (1) Splitco assuming Kraft liabilities; (2) 100 percent of Splitco’s stock; and (3) Splitco’s debt securities in the principal amount of $662 million.
• Kraft then offered its Splitco stock to its shareholders in exchange for the appropriate amount of Kraft stock. To the extent that Kraft is unable to divest itself of all of its Splitco stock in the “split-off” phase of the transaction, Kraft will distribute — in a “spin-off” — the unsubscribed shares of Splitco. In the end, Kraft will have distributed all of its Splitco stock to its shareholders, either in a split-off, or in a combination of a split-off and a “back end” spin-off distributed on a pro-rata basis;
• Kraft then conveyed the debt securities it received from Splitco to a group of financial institutions who purchased an equivalent amount of Kraft securities on the open market. The securities Kraft received from these financial institutions (in exchange for the conveyance of its Splitco debt securities) will be retired;
• Splitco, now owned by the Kraft shareholders who elected to participate in the transaction, will be merged with and into a limited liability company (Holdco) created by Ralcorp for purposes of this transaction. The Kraft shareholders, as is crucial to the favorable tax outcome of the Morris Trust, received some 54 percent of Ralcorp stock in the merger. Thus, the historic Ralcorp shareholders will see their ownership of Ralcorp reduced from 100 percent to approximately 46 percent;
• Holdco will be merged, upstream, with and into Ralcorp. Then, Ralcorp will assume the liabilities of Splitco and become the issuer of the securities that were used by Kraft to retire some $662 of its own indebtedness.

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The transaction should qualify as a ‘D’ reorganization because the distribution of the Spiltco stock by Kraft seems to meet the requirements imposed by Section 355 of the Internal Revenue Code. Therefore, the “movement” of the Post assets (from Kraft to Splitco) should be tax-free because Kraft will receive solely “non-recognition” property. For example, each element of consideration that Kraft receives — the debt assumption, the debt securities, and the Splitco stock — can be received by the transferor in a reorganization (a description that fits Kraft) without tax consequences. (See Section 362(a) and Section 357(a).)

Moreover, the distribution by Kraft of the Splitco stock to its shareholders — and the distribution by Kraft of the Splitco debt securities to the financial institutions that recently purchased Kraft securities &#8212 should not entail any tax consequences either. To be sure, as a transferor in a reorganization, Kraft does not recognize gain or loss on the distribution “to its shareholders” of property involved in the plan of reorganization.

A gain would have been recognized if the appreciated property being distributed was something other than so-called “qualified property.” But in this case, Kraft is distributing only qualified property, defined by two main characteristics. First, qualified property includes any stock in another corporation (Splitco) which is a party to the reorganization, or the obligations (the Splitco debt securities) of another corporation that were “received in the exchange.” In addition, a transfer of qualified property by a corporation to its creditors “in connection with” the reorganization is treated as a distribution to its shareholders under the plan of reorganization. To be sure, the distributions will be made, as Section 361(c) requires, “to its shareholders.”

The split-off/spin-off will not be adversely affected by the so-called “anti-Morris Trust” rules found in Section 355(e)(1). Here, as in any reverse Morris Trust transaction, the separation and the “acquisition” will be considered parts of a plan (or series of related transactions).

In such a case, the separation becomes taxable at the distributing corporation (Kraft) level, but only if the acquisition step produces a specific result referred to in Section 355(e)(2)(A). That result is an acquisition “by one or more persons” that is directly or indirectly made up of stock possessing a 50 percent or greater interest in the distributing corporation (Kraft) or in any controlled corporation (Splitco).

In the Kraft reorganization plan, however, persons referred to in the Section 355 provision will not be acquiring the requisite amount of stock in Splitco’s successor. This is so because the former Ralcorp shareholders — the persons referred to in Section 355(e)(2)(A) — will only “acquire” stock representing a 46 percent interest in Splitco’s successor. Accordingly, even though the separation and acquisition are clearly part and parcel of a plan, the separation should not run afoul of the anti-Morris Trust rules.

Finally, for accounting purposes, Ralcorp and Kraft are taking the position that Ralcorp is the “acquiring” entity. This is true even though the exchanging Splitco shareholders will, as a result of the Splitco/Ralcorp merger, wind up with a majority of the voting stock of Ralcorp. Nevertheless, Ralcorp will be viewed, properly in my estimation, as the acquiring entity. That’s because the “composition of the governing body” and “composition of senior management” factors each point, conclusively, towards Ralcorp’s designation as the acquiring entity. (Such factors are taken into consideration in assessing a business combination effected through an exchange of equity interests.) Accordingly, it will be Splitco’s assets and liabilities that will be, in the purchase accounting process, awarded a new basis and carrying amount, respectively.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for


1The fact that Splitco, as part of the plan, will cease to exist does not mean that its transitory existence will be disregarded with the disastrous result that the transaction will be treated as a taxable sale of assets by Kraft to Ralcorp. Revenue Ruling 2003-79, I.R.B. 2003-29 (July 1, 2003) provides that a corporation formed in connection with a distribution that qualifies under Section 355 (a description which fits Splitco) will be respected as a separate corporation for purposes of determining whether a pre-distribution transfer (of assets) satisfies the requirements of a ‘D’ reorganization even if (as here) a post-distribution restructuring causes the controlled corporation (Splitco) to cease to exist. In addition, the ruling concedes that the controlled corporation (whose existence is terminated as part of the plan) will also be considered independently in determining whether the acquisition of the controlled corporation qualifies as a reorganization. This ruling, and the concessions it makes, serves to explain the recent surge in popularity of reverse Morris Trusts.