Playing It Safe In Morris Trust Deals

Structuring a Morris Trust-type deal to avoid taxes through execution of a contemporaneous acquisition and spin-off is always a tricky proposition. Yet, says Lehman Brothers managing director and corporate tax expert Robert Willens, dealmakers rarely take the safe approach – which has been blessed by the Internal Revenue Service – in handling the second-step spin-off. An exception, Willens notes, is the deal involving Johnson & Johnson and Inverness Medical Technology Inc. J&J has agreed to buy the Inverness diabetes care business for $1.3 billion in stock and leave behind the Inverness women’s health, nutritional supplements, and clinical diagnostics operations, which will be spun off as a new company. J&J and Inverness are not seeking an IRS ruling on whether the spin-off is tax-free. But with the safe approach, Willens says, Inverness will handle the second- step spin-off through a redemption, with Inverness holders trading their existing stock for shares in the new company. That method, he notes, was authorized as virtually tax-free by the IRS in a 1979 revenue ruling. “The worst case is that Inverness shareholders may have to pay capital gains taxes, which is far less than having their new shares taxed as dividend income,” he says. “But even that seems unlikely.” Willens says he does not understand why more companies engaged in Morris Trust arrangements didn’t use redemptions. He notes that they could be useful if second-step spin-offs added a cash payment to shareholders, because the cash would be taxable only at the capital gains rate. Cash rarely, if ever, finds its way into spin-offs because of tax consequences, but that could change as dealmakers look for innovative ways to enhance the attractiveness of transactions to shareholders. Rather than guess at whether a spin-off is tax-free, Willens says, “The better approach, by far, is to employ the procedure adopted by Inverness; a company should structure the separate transaction as an exchange in which the target shareholders actually swap a portion of their stock for stock on the unwanted assets corporation.”