Can Warrants Be Used to Complete a Spin-Off?

A handful of older tax cases lay the groundwork for such a move, but there are caveats.
Robert WillensJune 7, 2010

As corporate finance executives begin to review new merger and acquisition deals, it is interesting to consider what a handful of older tax court cases have to say about warrants and spin-off deals. Indeed, it appears that the use of warrants to complete a spin-off is a difficult, but not impossible, task.

To begin, take a closer look at a case decided in 1980 in which a water company owned all of the stock of another company, in this case, Shorewood Corp. The board of directors of the water company decided to distribute to its shareholders warrants to purchase Shorewood stock. The warrants afforded the holder the right to receive one share of Shorewood stock upon the surrender of two warrants and the payment of $5.

Also, the warrants were transferable. In fact, 1,019,537 shares, representing 76.26% of Shorewood’s outstanding stock, were distributed to the warrant holders, and 50,000 shares, representing approximately 4% of Shorewood’s outstanding stock, were conveyed to the underwriters. The water company retained slightly less than 20% of Shorewood’s outstanding stock.

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Taxpayers, known collectively as Redding, were shareholders of the water company. They received warrants and exercised them. Redding contended that both the receipt and exercise of the warrants were tax-free under the Internal Revenue Code, specifically Section 355, which addresses distribution of stock and securities of a controlled corporation. What’s more, the U.S. Tax Court agreed with Redding. However, the decision was reversed by the Seventh Circuit Court of Appeals, which concluded that the distribution of the warrants was taxable as a dividend.1

Step Transaction Doctrine

The appeals court noted that to qualify under Section 355, a distribution must consist solely of stock or securities which does not include stock rights. Further, the tax court sought to keep the transactions within the ambit of Section 355 by integrating, via the step transaction doctrine, the distribution of the warrants and the subsequent exercise of the instruments. Using that technique, the overall transaction can be viewed as a distribution of stock.

But in the case of the water company, the distribution of the warrants was not made for the purpose of reaching the “end result” of distributing stock to the water company shareholders. Rather it was a matter of relative indifference to the water company whether Shorewood’s stock was transferred to the utility’s shareholders, their assignees, or the underwriters.

The appeals court noted that the reason for using transferable warrants was to arrange for the water company shareholders to be excluded as recipients of Shorewood stock in favor of new investors prepared to make a capital contribution. So, to the extent the rights distribution was a “step,” it was not a necessary step in the sort of corporate division contemplated by Section 355. Accordingly, the court concluded that the issuance of transferable warrants “added nothing” to the “essential purpose” of completing a spin-off.

Willens quote June 7-10

Distribution with Respect to Stock

The appeals court went on to say that “even were we to agree that the step transaction doctrine permits these transactions to be viewed as a distribution of Shorewood stock, the requirement of Section 355(a)(1)(A), that the stock be distributed with respect to stock of [the water company], has not been met.” In the Redding case, the warrants were distributed with respect to the stock of the water company, and the stock of Shorewood was distributed with respect to the warrants. As a result, it was the warrant distribution, and only the warrant distribution, that conformed to the statutory test.

Moreover, Section 355(a)(1)(D) requires a distribution of “control” to shareholders of the distributing corporation. However, the water company retained slightly less than 20% of Shorewood’s stock and distributed slightly more than 80% of the stock. In addition, 50,000 shares were acquired by the underwriters.

The transfer of shares to the underwriters reduced the percentage of stock distributed to the water company shareholders to, at most, 76.26%. Therefore, there was no distribution of control of Shorewood to the water company shareholders. (Control is defined as holding stock representing at least 80% of the total combined voting power of all classes of stock entitled to vote.)

The appeals court stated that “given our conclusion that the step transaction doctrine does not require the transaction to be seen as a distribution of Shorewood stock, and our further finding that, even if it could be so viewed, there has been a failure to comply with the requirements of Section 355, we must turn to a determination of what constitutes the taxable event.”

Palmer Distinguished

Under Section 316(a) of the Internal Revenue Code, a distribution of property by a corporation to its shareholders out of earnings and profits is a dividend. The exclusion of rights to acquire stock of the distributing corporation — from the definition of property contained in Section 317(a) — implies that rights to acquire stock of another corporation are included in the term property.2 Therefore, Redding received a dividend upon receipt of the warrants, and the amount of such dividend was the fair-market value of the warrants.

But what about the findings that relate to the Redding decision in the case known as Palmer v. Commissioner, 302 US 63 (1937)? In Palmer, “at the money” rights were distributed entitling shareholders to purchase from the distributing corporation shares in another corporation. The Supreme Court found no dividend. It held that the “mere issuance of rights” was not a dividend.

But, in Commissioner v. Gordon, 391 US 83 (1968), the Supreme Court observed that “it has not, however, been authoritatively settled whether an issuance of rights to purchase at less than fair market value itself constitutes a dividend, or the dividend occurs only upon the actual purchase.”

The Seventh Circuit, in reconciling these conflicting thoughts, looked to the 1954 Code. Under the provisions of the code — in a case of stock rights in which the subscription price is less than the fair-market value of the property to which the rights pertain — there is a dividend at the time of the issuance of the rights. The amount of the dividend is measured by the market value of the rights at the time of issuance. In short, the court concluded that a “fair reading of Palmer be limited to its facts.” Therefore, in the water company case, Redding was in receipt of dividend income at the time of the issuance of the rights.

Therefore, it seems that the use of warrants to complete a spin-off, although difficult, is not impossible. At a minimum, however, it seems that the warrants would have to be nontransferable. Only then would a court be inclined to apply the step-transaction doctrine — so that the issuance and exercise of the warrants could be telescoped into a single transaction — to find that the substance of the transaction was a distribution of the stock of the subsidiary to the shareholders of the distributing corporation with respect to its stock.

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


1 See Redding v. Commissioner, 630 F.2d 1169 (7th Cir. 1980).
2 See Revenue Ruling 70-521, 1970-2 C.B. 72.