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Corporateupdate Corporateupdate CorporateUpdate VOLUME 231—NO. 37 THURSDAY, FEBRUARY 26, 2004 DISTRESSED MERGERS & ACQUISITIONS Fallen Angels, Spin-Offs And Tax Attributes corporation with fundamen- would reap the benefits of holding stock in tally sound businesses a financially stronger (better-focused and nevertheless may find itself deleveraged) company, they would have facing the disapproval of its lost any benefits of the potential upside of A the misfit business. capital markets because of problems with one or more of its businesses. Whether the disapproval reaches the point of a debt Divesting Misfit Business downgrade,1 or simply manifests itself If AngelCo were instead to divest its in falling stock and debt prices, the misfit business through a tax-free spin-off, it company’s management will feel pressure might be able to alleviate some or all of to take action. CORINNE BALL these value-reducing problems while A frequent management response to achieving substantially the same goals. The correct the problem and restore the compa- requirements for a tax-free spin-off are ny to the markets’ good graces is to attempt accomplishing this goal would be for many, complex and stringent, but if they to divest the problematic, generally AngelCo to sell the misfit business, either can be satisfied the benefits can be “non-core,” business(es) and reduce the to the public in an initial public offering substantial. In addition, while the rules leverage of the “fallen [or falling] angel.” As (IPO), or to a single acquiror in a negotiated governing tax-free spin-offs are demanding discussd in the previous column, these sale, and use the proceeds to pay down its they also provide considerable, sometimes efforts present opportunities to potential debt. Such a transaction would be a taxable surprising, flexibility. acquirors; they also present both opportunities disposition, so if AngelCo realizes a gain it For example, depending on the misfit and potential pitfalls to the angels — and generally must pay tax on the disposition, business’s appropriate level of leverage, it their shareholders — from the point of view reducing the proceeds available for debt could assume a substantial portion of the of maximizing shareholder value, especially reduction. Or it might use its tax attributes AngelCo debt prior to being spun-off. It when one factors in the potential tax effects — net operating losses (NOLs) or other could also issue its own bank and/or public of the divestiture efforts. losses or credits available to it — to offset debt and distribute the proceeds to Suppose the “AngelCo” owns a business the gains. The use of the attributes to AngelCo prior to the spin-off, and or affiliate that is not actually worthless, but shelter the gains would prevent tax leakage AngelCo could then use those proceeds to the markets disapprove of AngelCo’s in the short-run, but could result in higher pay down its own debt.2 Alternatively, the ownership of the business — because, for tax bills in the future. misfit business corporation (MisfitCo) instance, it is not profitable, it devours more In addition, if AngelCo were to could issue a small percentage — less than than its fair share of cash flow, it is a repurchase its debt at a discount it may 20 percent — of its stock to the public or to slow-growth business, it typically requires recognize cancellation of debt (COD) a financial intermediary to fund its higher leverage than AngelCo’s other income, which would also require either indebtedness assumed from (or cash or debt businesses, or it is a bad “fit” for other current tax payments or additional distributed to) AngelCo before the spin-off.3 reasons. AngelCo therefore decides to attribute-usage. Or if AngelCo has actually The misfit business could also issue its divest the misfit business, and hopes to do it sought bankruptcy protection or is own securities to AngelCo, and AngelCo in a way that reduces its leverage (especially insolvent, the COD income would result could exchange those securities for its own the leverage that supports the misfit in attribute reduction under §108 of the securities, either through an open market business and is thus doubly disapproved). Internal Revenue Code (IRC). Further, if offering or through a financial intermediary.4 One relatively straightforward way of the misfit business has its own tax Finally, AngelCo could retain a portion — attributes which it takes with it in its less than 20 percent — of the misfit business stock, and either sell it and use the Corinne Ball is a partner at Jones Day. divestiture, its use of these attributes would Candace A. Ridgway, also a partner at the be subject to limitation under §382 of the proceeds to pay debt (a taxable transaction) firm, assisted in preparing this article. IRC. Finally, while AngelCo’s shareholders or exchange the stock for its own debt NEW YORK LAW JOURNAL THURSDAY, FEBRUARY 26, 2004 (non-taxable if part of the spin-off).5 MisfitCo) and/or the separated MisfitCo to along with it in its spin-off, its acquisition In general, neither AngelCo nor MisfitCo combine with other businesses more could cause AngelCo to use those NOLs to would incur tax liability on the distribution compatible with their own after the shelter taxable gain, so that only any NOLs to AngelCo of cash or MisfitCo securities, so spin-off or split-off. AngelCo or MisfitCo surviving that usage would go to MisfitCo long as, if AngelCo is transferring misfit could achieve such a combination tax-free and then be subject to limitation use.) business assets to MisfitCo in connection — and, critically, without impairing the On the other hand, if either AngelCo or with the spin-off, AngelCo distributes the tax-free nature of the spin-off itself — if the MisfitCo engages in a reverse Morris Trust cash to creditors and any MisfitCo debt former AngelCo shareholders own more acquisition in connection with the spin-off securities to its own security holders. If than half of the value and voting power of — that is, if former AngelCo shareholders MisfitCo is a pre-existing subsidiary to the combined entity: a so-called “reverse own more than 50 percent of the vote and which AngelCo does not transfer assets in Morris Trust” transaction. The title is value of the combined entity after the connection with the spin-off, AngelCo may acquisition — then the tax-free nature of xxxxxxxxxxxxxx receive dividends from MisfitCo tax-free the spin-off will remain intact, as will the tax before the spin-off — that is, it may fully Acquisitions in which the attributes of AngelCo and MisfitCo and recoup its investment in MisfitCo tax-free. distributing company’s their ability to use those attributes. In that In these types of transactions, AngelCo is shareholders lose control of case, not only could AngelCo achieve not taxed on its disposition of MisfitCo, thus the combined entity became its divestiture and deleveraging while preserving its capital and/or its tax attributes. known as “Morris Trust” preserving its capital and tax attributes, as If MisfitCo (or any subsidiaries that are well as those of MisfitCo, from the ravages of spun-off with it) is a preexisting company, transactions in connection the tax code, it may also give its shareholders however, it will take its tax attributes — with the statutory attack on the ongoing potential upside of reinforced including consolidated tax attributes if such transactions under and strengthened core and/or misfit AngelCo and MisfitCo are members of a §355(e) of the IRC. business, tax-free to them.8 consolidated tax group — with it when it ------------------------------------------------ The “bottom line” in evaluating divesti- departs. MisfitCo also will not incur any tax ture options, then, is just that: the well-advised liability on any acquisition of business assets actually a misnomer; in the original Morris company will take careful stock of the from AngelCo, any distributions of its stock, Trust transaction, which was litigated in bottom-line results of a divestiture plan to cash or debt to AngelCo, or on its spin-off Comr. v. Morris Trust,6 the shareholders of its shareholders, taking into account any by AngelCo. It will also not become subject the distributing company did hold more tax effects — including both immediate to limitation on the use of any tax attributes than 50 percent of the stock of the costs and effects on its tax attributes — that it takes with it in the spin-off. Thus, company that survived the merger with the can affect the value of the total package its AngelCo’s shareholders will have the benefit “acquiror.” Nevertheless, acquisitions in shareholders end up with. In a number of not only of a substantially deleveraged which the distributing company’s situations it will find the best value is pro- AngelCo but will also retain any potential shareholders lose control of the combined duced by a spin-off, and potentially a reverse upside inherent in MisfitCo, which they entity became known as “Morris Trust” Morris Trust spin-off and acquisition. may “cash in” (taxably) to a limited extent, transactions in connection with the or they may hold for future realization. statutory attack on such transactions under ••••••••••••••••••••••••••••••• (1) As described by Corinne Ball and John Kane in “Fallen If AngelCo’s business and MisfitCo’s §355(e) of the IRC. Thus, true “Morris Angels: An Acquisition Opportunity,” NYLJ Oct. 29, 2003, business have such completely different Trust” transactions are now referred to as page 4. 7 (2) See, e.g., IRS Priv. Ltr. Rul. (“PLR”) 200129029 (Apr. market profiles that investors in one are “reverse Morris Trust” transactions. 20, 2001); PLR 200139009 (June 27, 2001); PLR 200252058 unlikely to want an investment in the other, If either AngelCo or MisfitCo undergoes (Sep.
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