M&A Report – Reverse Morris Trusts Revisited

May 31, 2016

Over the last twelve months, over fifty US publicly traded companies with a market capitalization of over $1 billion have announced plans to spin-off lines of business into independent companies.  During that period, companies such as Starwood Hotels, ConAgra Foods, and Citrix Systems have announced spin-offs of one or more businesses.  

Spin-offs are motivated by various reasons, but the common theme in these transactions is that the spun-off entity and the remaining corporation should perform better and achieve better market valuation on a stand-alone basis.   

A spin-off is effected by reorganizing a line of business, contributing its assets and liabilities to a separate subsidiary, and distributing the shares of the subsidiary to the shareholders of the corporation either pro-rata or through an exchange offer.  If properly structured, the distribution and receipt of subsidiary shares will be tax-free to the corporation and its shareholders.  

A spin-off can be combined with a strategic combination or merger of either the corporation or the spun-off subsidiary with a merger-partner that is a separate corporation.  These transactions are referred as Morris Trust or Reverse Morris Trust, depending on whether the remaining corporation or the spun-off subsidiary merges with the merger-partner.   

Spin-off/merger transactions have proven to be an efficient and effective tool to divide a company in order to effect a combination of a particular line of business that has strategic and synergistic value to a merger-partner.  This is evidenced by the number of spin-off/merger transaction that have occurred in the last several years and continue to occur.  Last week, Gibson Dunn’s client Hewlett Packard Enterprise announced a Reverse Morris Trust transaction with Computer Sciences Corporation (CSC).  HPE will organize its Enterprise Services business into a separate subsidiary and effect a spin-off of the subsidiary to HPE shareholders.  Immediately after the spin-off, the spun-off subsidiary will merge into CSC in a tax-free merger. 

For a spin-off/merger transaction to be tax free, the tax law adds a requirement that the shareholders of the corporation have to own more than 50% of the stock of (1) the combined merger-partner/spun-off subsidiary or (2) the combined corporation/merger-partner and the spun-off subsidiary, as the case may be.  This requirement means that the merged entity, be it the corporation or the spun-off subsidiary, must have a larger market value that the merger-partner.  If the values are close, sometimes pre-merger dividends or similar transactions could shrink the market value of the merger-partner, though tax issues become paramount in a shrinking transaction.  If the 50% test is not satisfied, the receipt of spun-off subsidiary shares by the shareholders will still be tax-free.  However, the distribution of the spun-off subsidiary shares will trigger taxable gain to the corporation, measured by reference to the market value and the tax basis of the spun-off assets.  In the case of a historical line of business, the tax basis of the assets are likely to be very low; hence the tax on the gain could prohibit the transaction.  

If the merger-partner itself has effected a spin-off prior to and in close proximity to the merger, the 50% test applies on both sides.  This means the shareholders of the merger-partner and the shareholders of the spinning corporation have to each own more than 50% of the merged entity.  This tests can only be satisfied if the spinning corporation and the merger-partner have an overlapping shareholder base. This requires additional tax and corporate planning and diligence, but is likely to become a more frequent issue for practitioners and transaction planners as the use of the Morris Trust/Reverse Morris Trust structure continues to accelerate.