Reverse Morris Trust

A Reverse Morris Trust deal combines a tax-free spin-off with a pre-arranged merger.

What is Reverse Morris Trust?

The Reverse Morris Trust is a tax-avoidance technique that allows a parent company to dispose of unwanted assets without having to pay taxes on any gains from those particular assets. It is a transaction that basically combines each major deal structure type in a sequence: an asset sale to a new subsidiary, followed by a stock transfer to public shareholders, followed by a merger with the buyer.

First, the parent company must create a subsidiary to merge with a smaller external company. Next, the company created from the merger must hand over more than 50% of the economic value and voting rights back to the parent company. The overall result is transferred assets to a smaller external company (tax-free).

A spin-off offers an opportunity to the parent company to raise capital, monetize its interest in the segment being spun off, and thereby reduce debt. Companies resort to Reverse Morris Trust deals as it offers the combined benefits of mergers and spin-offs.

 

History

Often, the sole or primary business purpose for a spin-off is to shed an unwanted business and thereby facilitate the planned acquisition of the “wanted” business.

In Commissioner v. Mary Archer W. Morris Trust, 697 F.2d 794 (4th Cir. 1966) (“Morris Trust”), the distributing corporation (“Distributing”) was engaged in two businesses: banking and insurance. Distributing transferred the insurance business to a new corporation and spun off the stock of the new corporation to its shareholders. Distributing then merged, for valid, non-tax business reasons, with another bank. The court determined that the continuity of stockholder interest requirement was satisfied because the historic shareholders of Distributing received 54% of the stock of the merged corporation, and, as a result, the transfer was a nontaxable spin-off. The perception became that, due to the lack of a continuing interest by the historic shareholders, the Morris Trust rule was being used as a device to transfer unwanted corporate assets without incurring a tax at the corporate level.

 

Anti-Morris Trust Rules

For a while after that, companies kept implementing this type of tax-dodging transaction, but Congress did fix it in 1997, by passing the so-called “anti-Morris Trust” regulations that specifically closed the loophole. The rules are outlined in Internal Revenue Code Section 355(e) and Treasure Regulations 1.355-7.

The Anti-Morris Trust Rules enacted in 1997 have further curtailed the ability to use this type of structure in a tax-free spinoff. Under these rules, a spin-off will be taxable at the corporate level (but potentially not at the shareholder level) if the distribution is part of a plan (or series of related transactions) pursuant to which one or more persons acquire 50% or more of the stock of either the distributing company or the spun-off company.

As a result, while it is still possible to effect a Morris Trust transaction (distributing) or Reverse Morris Trust transaction (spin-off), the shareholders of the merger partner must receive less than 50% of the stock of the combined company (meaning that the merger partner must be smaller than the company with which it combines).

 

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