5. BackgroundVerizon had two main
businesses:1.Wireline2.Wireless
6. Background Wireline business declining, wireless growing
Operating Profit of Verizons
Segments$16,000MM$14,000MM$12,000MM$10,000MM$8,000MM$6,000MM$4,000MM$2,000MM$0MM200120022003
200420052006 2007 2008 Wireline Wireless
7. Objective: Sell off wirelines Verizon wanted to dump sell
its wirelinebusiness, via Reverse Morris Trust Trans. Needed to
find a smaller firm willing to buy
8. Target: Fairpoint Comm.
9. Fairpoint Communications Small telecommunications firm
Mostly focused on rural areas Merger would make Fairpoint eighth
largesttelecommunications firm
10. What is a Reverse Morris Trust?A loophole firms can exploit
to sell a part of its businessTax freeMade up of two components
Dougiesad1)A tax free spinoff2)A tax free merger
11. Part 1: Tax Free spinoff
12. Whats a spinoff? A parent company distributing shares of
asubsidiary to shareholders, i.e A dividend Subsidiary becomes a
separate, independentcompany Commonly done to separate unrelated
and/orunwanted parts of business
13. Example: Altria spins-off Kraft
14. Whats a spinoff?Animation here
15. Taxable spinoffs Normally (uh-oh), spinoffs are taxed, just
like anyother dividend
16. Taxable spinoffsExample: ParentCo gives all of its shares
in SubCo toParentCo shareholders Shareholders get dividend taxed
But ParentCo must also recognize a gain
17. Taxable spinoffs Why is ParentCo taxed as well? Because
they would have been taxed if they soldthe subsidiary and gave a
cash dividend instead
18. Double taxation How many layers of tax? Regular stock sale
(and dividend): Two Taxable spinoff: Two Normally
19. The tax-free* spinoff If a company meets a number of
requirements (per 355) the spin-off can be tax-free* *Technically
tax deferred. The basis in the sub. stockis carried over to
shareholders What are the requirements?
20. Requirements
21. The tax-free spinoff We wont cover them all, but the big
one: Must have a business purpose (i.e., non-taxpurpose) for the
spinoff E.g. To focus on our core competencies So if a firm wanted
to separate a subsidiary forstrategic reasons (rather than selling
it) it could do ittax free Non-tax purpose. Righttt
22. Morris Trust Transactions Many firms took advantage of the
tax-free spinoffin order to sell subsidiariesThe old school Morris
Trust Transaction: Conduct a tax-free spinoff Buyer then purchases
the spunoff sub.s stock fromthe shareholders and acquires
subsidiary
23. Morris Trust Transactions How many layers of tax? Regular
stock sale (and dividend): Two Taxable spinoff: Two Tax-free
spinoff (followed by sale): One The shareholders would recognize a
capitalgain, but the parent would recognize nothing We beat
Dougie!
24. Dougie Strikes Back Dougie didnt think that was funny
25. Retroactive tax In response, tax law was changed so that:
If a tax-free spinoff is followed by S beingacquired within two
years IRS will retroactively tax the original spinoff
26. Back to square oneRecap: How many layers of tax? Regular
stock sale (and dividend): Two Taxable spinoff: Two Tax-free
spinoff (followed by sale): One Two So after all that, Dougie will
tax us twice Normally (aww huh? Yay!)
27. Part 1: Tax-Free Spinoff
28. Part 2: Tax-Free Merger
29. Re-visit: Retroactive Tax Rule A tax-free spinoff is
retroactively taxable to theparent company, if: The subsidiary is
acquired within two years So then what if The subsidiary is the
acquirer?
30. Definition of BuyerWhos the buyer? If a A pays cash for Bs
stock? Company A If a A pays cash for Bs assets? Company A If
company A exchanges company A stock forcompany B stock?
Depends
31. Buyer If stock is exchanged for stock, then the buyer
isdefined as the company whose shareholders obtainmajority control
(>50%) i.e. The company thats bigger
32. Reverse Morris Trust If a tax-free spinoff is followed by
the spun offsubsidiary merging with a smaller firm And stock is
given for stock (a tax-free merger) Then the subsidiary is
considered the buyer The parent avoids the retroactive taxation And
the shareholders defer tax on the sale! We beat Dougie!!!
33. Take thatIRS!
34. Drawback: Majority ControlThe main drawback is that the
spunoff subsidiary has to be bigger than the buyerAs a
consequence:1.Limits pool of potential buyers for sub.2.Buyer and
its shareholders may not likebecoming minority interest
35. Tax Free Sale! But aside from that, a Reverse Morris
Trusttransaction, i.e.Atax free spinoff A tax free merger (with a
smaller company) Allows a company to sell a subsidiary tax
free
38. Taxable spinoffs ParentCo shareholders are now the proud
owners ofSubCo, and They recognize a $1000K dividend Ouch. But
thats not too bad Dougie aint done
39. Taxable spinoffs In addition to ParentCo shareholders
recognizing a$1000k dividend ParentCo itself also recognizes a gain
Double ouch, baby
40. Taxable spinoffs Gain = FMV of Sub. Basis in Sub. ParentCos
gain = $1000k-500k=$500k So in total: ParentCo shareholders: $1000k
dividend ParentCo: $500k gain
41. Morris Trust Transaction Example ParentCo spins off SubCo
tax free Shareholders have a basis of $500K in SubCo BuyerCo buys
all the stock from shareholders for $1000K Shareholders recognize
capital gains of $500K Parent CompanyParentTotal
TaxableShareholdersIncomeSell Sub. + Dividend $500K$1000K
$1500KSpinoff Sub. $500K$1000K $1500KMorris Trust Trans.-$500K
$500K
42. Example revisited In the last example: ParentCo made a tax
free spinoff Shareholders recognized $500K capital gains Since the
acquisition happened within 2 yearsParentCo will be retroactively
taxed on spinoff Shareholders not taxed on dividend