United States: Of Fallen Angels, Spin-Offs, and Tax Attributes

A corporation with fundamentally sound businesses nevertheless may find itself facing the disapproval of its capital markets because of problems with one or more of its businesses. Whether the disapproval reaches the point of a debt downgrade, as described by Corinne Ball and John Kane in "Fallen Angels: An Acquisition Opportunity," or simply manifests itself in falling stock and debt prices, the company’s management will feel pressure to take action. A frequent management response to correct the problem and restore the company to the markets’ good graces is to attempt to divest the problematic, generally "non-core," business(es) and reduce the leverage of the "fallen [or falling] angel." As discussed by Ms. Ball and Mr. Kane, these efforts present opportunities to potential acquirors; they also present both opportunities and potential pitfalls to the angels — and their shareholders — from the point of view of maximizing shareholder value, especially when one factors in the potential tax effects of the divestiture efforts.

Suppose the "AngelCo" owns a business or affiliate that is not actually worthless, but the markets disapprove of AngelCo’s ownership of the business — because, for instance, it is not profitable, it devours more than its fair share of cash flow, it is a slow-growth business, it typically requires higher leverage than AngelCo’s other businesses, or it is a bad fit for other reasons. AngelCo therefore decides to divest the misfit business and hopes to do it in a way that reduces its leverage. (Especially the leverage that supports the misfit business and is thus doubly disapproved.)

One relatively straightforward way of accomplishing this goal would be for AngelCo to sell the misfit business, either to the public in an IPO, or to a single acquiror in a negotiated sale, and use the proceeds to pay down its debt. Such a transaction would be a taxable disposition, so if AngelCo realizes a gain, it generally must pay tax on the disposition, reducing the proceeds available for debt reduction, or it might use its tax attributes — net operating losses (NOLs) or other losses or credits available to it — to offset the gains. The use of the attributes to shelter the gains would prevent tax leakage in the short run but could result in higher tax bills in the future. In addition, if AngelCo were to repurchase its debt at a discount, it may recognize cancellation of debt (COD) income, which would also require either current tax payments or additional attribute-usage. If AngelCo has actually sought bankruptcy protection or is insolvent, the COD income would result in attribute reduction under section 108 of the Internal Revenue Code (IRC). Further, if the misfit business has its own tax attributes that it takes with it in its divestiture, its use of these attributes would be subject to limitation under section 382 of the IRC. Finally, while AngelCo’s shareholders would reap the benefits of holding stock in a financially stronger (better-focused and deleveraged) company, they would have lost any benefits of the potential upside of the misfit business.

If AngelCo were instead to divest its misfit business through a tax-free spin-off, it might be able to alleviate some or all of these value-reducing problems while achieving substantially the same goals. The requirements for a tax-free spin-off are many, complex, and stringent, but if they can be satisfied, the benefits can be substantial. In addition, while the rules governing tax-free spin-offs are demanding, they also provide considerable, sometimes surprising, flexibility.

For example, depending on the misfit business’s appropriate level of leverage, it could assume a substantial portion of the AngelCo debt prior to being spun off. It could also issue its own bank and/or public debt and distribute the proceeds to AngelCo prior to the spin-off, and AngelCo could then use those proceeds to pay down its own debt. Alternatively, the misfit business corporation (MisfitCo) could issue a small percentage — less than 20 percent — of its stock to the public or to a financial intermediary to fund its indebtedness assumed from (or cash or debt distributed to) AngelCo before the spin-off. The misfit business could also issue its own securities to AngelCo, and AngelCo could exchange those securities for its own securities, either through an open market offering or through a financial intermediary. Finally, AngelCo could retain a portion — less than 20 percent — of the misfit business stock, and either sell it and use the proceeds to pay debt (a taxable transaction) or exchange the stock for its own debt (non-taxable if part of the spin-off).

In general, neither AngelCo nor MisfitCo would incur tax liability on the distribution to AngelCo of cash or MisfitCo securities, so long as, if AngelCo is transferring misfit business assets to MisfitCo in connection with the spin-off, AngelCo distributes the cash to creditors and any MisfitCo debt securities to its own security-holders. If MisfitCo is a pre-existing subsidiary to which AngelCo does not transfer assets in connection with the spin-off, AngelCo may receive dividends from MisfitCo tax-free before the spin-off — that is, it may fully recoup its investment in MisfitCo tax-free.

In these types of transactions, AngelCo is not taxed on its disposition of MisfitCo, thus preserving its capital and/or its tax attributes. If MisfitCo (or any subsidiaries that are spun off with it) is a preexisting company, however, it will take its tax attributes — including consolidated tax attributes if AngelCo and MisfitCo are members of a consolidated tax group — with it when it departs. MisfitCo also will not incur any tax liability on any acquisition of business assets from AngelCo, any distributions of its stock, cash, or debt to AngelCo, or on its spin-off by AngelCo. It will also not become subject to limitation on the use of any tax attributes it takes with it in the spin-off. Thus, AngelCo’s shareholders will have the benefit not only of a substantially deleveraged AngelCo but will also retain any potential upside inherent in MisfitCo, which they may "cash in" (taxably) to a limited extent, or they may hold for future realization.

If AngelCo’s business and MisfitCo’s business have such completely different market profiles that investors in one are unlikely to want an investment in the other, AngelCo might offer its shareholders the choice of exchanging their AngelCo stock for MisfitCo stock in a split-off. In a split-off exchange, its shareholders generally could shift their investment into MisfitCo in lieu of AngelCo, tax-free. Furthermore, if AngelCo splits off MisfitCo instead of spinning it off, a subsequent combination with another company might include some cash consideration to the AngelCo or MisfitCo shareholders without endangering the tax-free nature of the split-off.

The benefits of a divestiture of the misfit business may be further enhanced by the opportunity for AngelCo (without MisfitCo) and/or the separated MisfitCo to combine with other businesses more compatible with their own after the spin-off or split-off. AngelCo or MisfitCo could achieve such a combination tax-free — and, critically, without impairing the tax-free nature of the spin-off itself — if the former AngelCo shareholders own more than half of the value and voting power of the combined entity: a so-called "reverse Morris Trust" transaction. The title is actually a misnomer; in the original Morris Trust transaction, which was litigated in Comr. v. Morris Trust, the shareholders of the distributing company did hold more than 50 percent of the stock of the company that survived the merger with the "acquiror." Nevertheless, acquisitions in which the distributing company’s shareholders lose control of the combined entity became known as "Morris Trust" transactions in connection with the statutory attack on such transactions under section 355(e) of the IRC; thus, true "Morris Trust" transactions are now referred to as "reverse Morris Trust" transactions.

If either AngelCo or MisfitCo undergoes a so-called Morris Trust acquisition in connection with the spin-off, the spin-off will become retroactively taxable to AngelCo under section 355(e) of the IRC as if it sold the stock of MisfitCo (assuming such a sale would result in taxable gain to AngelCo), although the spin-off would not also become taxable to AngelCo’s shareholders. In addition, the survivor of the AngelCo or MisfitCo acquisition would generally become subject to limitation on the use of any surviving tax attributes of AngelCo or MisfitCo under section 382 of the IRC. (If MisfitCo would have been entitled to bring its share of consolidated NOLs along with it in its spin-off, its acquisition could cause AngelCo to use those NOLs to shelter taxable gain, so that only any NOLs surviving that usage would go to MisfitCo and then be subject to limitation use.)

On the other hand, if either AngelCo or MisfitCo engages in a "reverse Morris Trust" acquisition in connection with the spin-off — that is, if former AngelCo shareholders own more than 50 percent of the vote and value of the combined entity after the acquisition — then the tax-free nature of the spin-off will remain intact, as will the tax attributes of AngelCo and MisfitCo and their ability to use those attributes. In that case, not only could AngelCo achieve its divestiture and deleveraging while preserving its capital and tax attributes, as well as those of MisfitCo, from the ravages of the tax code, it may also give its shareholders the ongoing potential upside of reinforced and strengthened core and/or misfit business, tax-free to them.

The "bottom line" in evaluating divestiture options, then, is just that: the well-advised company will take careful stock of the bottom-line results of a divestiture plan to its shareholders, taking into account any tax effects — including both immediate costs and effects on its tax attributes — that can affect the value of the total package with which its shareholders end up. In a number of situations, it will find the best value is produced by a spin-off, and potentially a "reverse Morris Trust" spin-off and acquisition.