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.

Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Mergers and Acquisitions or Tax practice groups, or the authors:

Eduardo Gallardo – New York (+1 212-351-3847, [email protected])
Hatef Behnia – Los Angeles (+1 213-229-7534, [email protected])

Please also feel free to contact any of the following practiceleaders and members:   

Mergers and Acquisitions Group:
Barbara L. Becker – Co-Chair, New York (+1 212-351-4062, [email protected])
Jeffrey A. Chapman – Co-Chair, Dallas (+1 214-698-3120, [email protected])
Stephen I. Glover – Co-Chair, Washington, D.C. (+1 202-955-8593, [email protected])
Dennis J. Friedman – New York (+1 212-351-3900, [email protected])
Jonathan K. Layne – Los Angeles (+1 310-552-8641, [email protected])
Eduardo Gallardo – New York (+1 212-351-3847, [email protected])
Russell C. Hansen – Palo Alto (+1 650-849-5383, [email protected])

Tax Group:
Art Pasternak - Co-Chair, Washington, D.C. (+1 202-955-8582, [email protected])
Jeffrey M. Trinklein - Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
David B. Rosenauer - New York (+1 212-351-3853, [email protected])
Eric B. Sloan – New York (+1 212-351-2340, [email protected])
Romina Weiss - New York (+1 212-351-3929, [email protected])
Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, [email protected])
Hatef Behnia – Los Angeles (+1 213-229-7534, [email protected])
Paul S. Issler – Los Angeles (+1 213-229-7763, [email protected])
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Scott Knutson – Orange County (+1 949-451-3961, [email protected])
David Sinak – Dallas (+1 214-698-3107, [email protected])   

© 2016 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.