Restructuring: Tougher to Keep Tax Shields

There’s no such thing as an easy reverse Morris Trust transaction. Yet, architects of the format are being required to finesse added complications as the unique combination of a spin-off and merger increasingly moves into uncharted territories. Their key challenge remains to keep the deal tax-free for shareholders of both partner companies by finding ways to tiptoe around the stiff rules governing tax avoidance. Two recently announced deals demonstrate the lengths to which restructuring companies have to go each time a new wrinkle is appended to the basic approach. In one transaction, forest products giant Weyerhaeuser Co. plans to combine its fine-paper business with Canada’s Domtar Inc. to create the largest fine-paper operation in North America. In the second, AmerisourceBergen Corp. and Kindred Healthcare Inc. will merge their institutional pharmacy units, forming the second-largest player in a field that provides pharmaceuticals to nursing homes, retirement facilities, and other institutions. Despite their wide differences, both industries are marked by extensive restructuring toward development of specialized channels served by large, focused companies, which is reflected in the two transactions. On the tax front, the Weyerhaeuser/Domtar linkup is problematic because it’s the first cross-border project under the reverse Morris Trust banner. The threat to the tax shield in formation of the new pharmaceutical supplier is that stockholders of each sponsor company will own a 50% slice. Had Weyerhaeuser and Domtar executed their deal in the typical reverse Morris Trust format, it would have triggered capital gains taxes on Weyerhaeuser’s shareholders. Even if a cross-border merger is done via a normally nontaxable stock swap, the shares received by American stockholders are subject to taxes if the buyer is a foreign concern. To avert that, Weyerhaeuser is creating a newly formed American firm to hold the fine-paper business (a Newco), which will be spun off and subsequently will acquire Domtar. The resulting firm will be 55% owned by Weyerhaeuser’s stockholders, thus meeting the key requirement for tax avoidance – that a majority be owned by holders of the company doing the spin-off. “They had to change the direction of the deal in a case like this,” says Robert Willens, a Managing Director and tax expert at Lehman Brothers. “They had to walk a bit of a tightrope to ensure that the deal was tax-free. The merger exchange would have been taxable had they not changed the direction of the deal. If you’re going to do a reverse Morris Trust with a foreign company, this is the blueprint.” With AmeriSource and Kindred, the issue was achieving a majority for stockholders of one company. Although strictly speaking that wasn’t achieved quantitatively, the partners pulled out an old, little-known IRS rule that allowed them to back into compliance by “taking into account overlapping stockholders” and essentially allowing both companies to claim a majority. “It’s a very obscure rule and it’s never been used before,” Willens says. But it could become a cornerstone for future Morris Trust arrangements in which a majority stake for holders of the spun-off company may be elusive. The strategic stakes suggest that combining the businesses was worth navigating the backwaters of the tax rules. Institutional pharmacy distribution is a highly fragmented business with one clear giant – the highly acquisitive Omnicare Inc. The newly emerging company, with sales of more than $900 million a year, will be the second-largest player, and in a much stronger position than its constituents – currently smallish arms within pharmaceuticals distributor AmerisourceBergen and hospitals operator Kindred. Jamie Hintlian, a Partner in the health and life science group at Accenture, says that the institutional pharmacy space is a growing market within the distribution sector, which is basically composed of supply chain professionals. But he notes that the institutional business differs from other niches because it’s based on providing custom dosages for patients who often are chronically ill or elderly, taking that job off the care facility’s hands. Bigger companies are increasingly important because they can reduce costs through synergies and economies of scale and assemble the resources needed for supply chain technologies and distribution efficiencies. “Distributors can add value by providing services such as packaging and dosage delivery and they have the know-how to get to these places because that’s what they’re good at doing,” Hintlian says. “They are all about distribution, transportation, and access to many points of distribution.” Many distributors already are in packaging so “this is really an extension of that,” he adds (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com