In some cases, spin-offs have a dual character. They can be tax-free at the shareholder level, but taxable at the distributing corporation level.
General Electric Co. and Wabtec Corp. had structured such a transaction, and it is the subject of a recent Internal Revenue Service private letter ruling, PLR 201919008, dated Nov. 16, 2018, and released May 10, 2019. (Note, the Twenty-First Century Fox spin-off of New Fox occurring as part of a “Morris Trust” transaction in which Fox was acquired by New Disney also fits that profile).
I was puzzled as to why the spin-off GE was engineering ran afoul of tax code Section 355(e) in light of the fact that once the spin-off and merger were completed, GE and its shareholders were scheduled to own 50.1% of the stock of Wabtec. The PLR makes it clear that such ownership was not determinative of the results of the spin-off, because GE was required to sell down a portion of its Wabtec stock, thus reducing the ownership of GE and its shareholders, with respect to Wabtec, to well below 50%.
These sales were taken into account in determining the relevant ownership of GE and its shareholders. While GE has revised its deal with Wabtec, such that the spin-off will now be taxable at both the GE and GE shareholder levels, the PLR issued in connection with the original transaction provides a blueprint for structuring a “partially taxable” Morris Trust or “Reverse Morris Trust” transaction. See The Willens Report, GE’s Distribution Of Spinco’s Stock Will Now Be Taxable, Bulletin, Jan. 25, 2019.
In the PLR, “Distributing” (GE) is the common parent of a worldwide group of affiliated entities, the “Distributing Worldwide Group.” The GE group was engaged in multiple businesses including the businesses in “Segment A” (i.e., GE’s transportation business). These businesses were referred to in the ruling as the “Separated Businesses.” “Controlled” (GE Transportation) was formed for the sole purpose of facilitating the spin-off and merger with Wabtec. Wabtec is itself the common parent of a worldwide group of affiliated entities.
Members of the GE group would first sell to members of the Wabtec group certain assets associated with the GE separated businesses in exchange for cash and the assumption of liabilities associated with the GE separated businesses. Next, GE would contribute certain assets and liabilities to GE Transportation. Members of the GE group would sell other assets related to the separated businesses directly to GE Transportation or its subsidiaries.
GE would then distribute at least “a%” (more than 80%) of GE Transportation common stock to GE’s shareholders (the “distribution”). GE would retain any shares of GE Transportation common stock not distributed in the distribution. The transfer of assets to GE Transportation by GE and the distribution of GE Transportation’s stock by GE, taken together, were intended to (and certainly would) qualify as a “D” reorganization under tax code Section 368(a)(1)(D).
The distribution was also intended to qualify as both a distribution described in tax code Section 355(a) (i.e., a distribution that is tax-free to the recipient shareholders) to which tax code Section 355(e) applies and a “qualified stock disposition” within the meaning of Treasury Regulation Section 1.336-1(b)(6) by reason of the application of Treas. Reg. Section 1.336-1(b)(5)(ii). GE would make, and cause GE Transportation to make, an election under tax code Section 336(e) with respect to the distribution. (The “consolation prize” for a taxable spin-off is a stepped-up basis for the assets conveyed to the controlled corporation, by virtue of the tax code Section 336(e) election that the “failed” spin-off makes possible).
Next, the final essential leg of the Reverse Morris Trust transaction—Merger Sub, a newly formed, wholly owned subsidiary of Wabtec would merge with and into GE Transportation, with GE Transportation surviving such merger. Shares of GE Transportation common stock would be converted into shares of Wabtec common stock in the merger, including the retained shares held by GE
Immediately after the merger, and subject to GE’s obligation to sell retained Wabtec shares, GE and its shareholders would hold, collectively, “b%” (i.e., 50% or less) of the voting power and value of the common stock of Wabtec. Contractual arrangements between GE and Wabtec would require GE to sell, within “x” years of the distribution, a number of retained Wabtec shares intended to result in the application of tax code Section 355(e) to the distribution.
GE’s retention of GE Transportation shares would be “integral to its widely communicated near-term strategy of raising cash to reduce its liabilities and strengthen its overall balance sheet” (the “retention business purpose”). None of GE’s directors or officers would serve as a director or officer of GE Transportation as long as GE retained the Wabtec shares. The retained Wabtec shares would be disposed of as soon as “disposition is warranted” (consistent with the retention business purpose) but in any event not later than “y” (i.e., five) years after the distribution; and GE would vote the retained Wabtec shares in strict proportion to the votes cast by Wabtec’s other shareholders.
As a result of these representations, the IRS issued to GE the ruling it was looking for. The agency ruled in PLR 201919008 that the retention by GE of the GE Transportation shares would not be in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax within the meaning of tax code Section 355(a)(1)(D)(ii) and Treas. Reg. Section 1.355-2(e). This PLR was necessary to insure that the distribution would, as the parties then intended, qualify under tax code Section 355(a).
The IRS issued a PLR in this situation because the regulations under tax code Section 355 provide that the business purpose for the distribution will, ordinarily, require the distribution of all of the stock and securities in the controlled corporation held by the distributing corporation. However, the IRS will rule on the retention of stock (and/or securities) by a public parent where:
- there is a business for the retention;
- none of the parent’s directors or officers will serve in a similar capacity with respect to the spun-off corporation so long as the distributing parent retains such stock and/or securities;
- the retained stock or securities will be disposed of as soon as disposition is warranted (consistent with the business purpose for the retention) but in any event not later than the fifth anniversary of the distribution; and
- the distributing parent votes the retained stock in strict proportion to the votes that are cast by the other shareholders of spun-off corporation.
These requirements must be met in order to insure that there has been a “genuine separation” of the spun-off corporation from the distributing parent; and that distributing parent is unable to maintain any “practical control” of the spun-off corporation. See Revenue Ruling 75-321.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.