The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 3, October 1999, Panel Publishers, New York, NY.

MORRIS TRUST REGULATIONS AT LAST

By Robert W. Wood

The so-called "anti-Morris Trust provision." Sec. 355(e) was enacted back in 1997. It applies to a spinoff that otherwise qualifies for tax-free treatment, rendering it taxable (at the distributing corporation level), if the spinoff is part of a plan (or series of related transactions) pursuant to which one or more persons acquire stock representing a 50% or greater interest (measured by ownership of stock possessing either voting power or value) in the distributing corporation or any controlled corporation.

This statute contains a presumption that any such acquisition that occurs within the four-year period beginning two years prior to the date of distribution is part of a plan or series of related transactions. Proposed Regulation Section 1.355-7 defines the circumstances under which this presumption can be rebutted so that the mere presence of an acquisition will not serve to render the spinoff taxable.

Acquisitions After Spinoffs

The proposed regulations reiterate the proposition that where a distribution occurs within two years of an acquisition, the events are presumed part of the bad plan or series of related transactions. If the acquisition occurs after the distribution, the presumption can be rebutted if:

The definition of an "agreement" is intentionally left vague. An agreement can exist even though all its terms have not been finalized. More unsettling is the possibility that merely contacting an investment banker during the relevant six-month period, or having a banker contact potential acquirers on behalf of the distributing or controlled corporation during the six-month period, might itself constitute the requisite agreement. The IRS is soliciting comments on whether contacts, in and of themselves, should rise to the level of an agreement. Let's just say no!

Alternative Rebuttal

If the presumption cannot be rebutted under this rule, the taxpayer can turn to an alternative which will be substantially more difficult to satisfy. This alternative is satisfied only if, at the time of the distribution, it can be established that: (a) the distributing corporation did not intend that one or more persons would acquire the requisite 50% or greater interest during the two-year period or (b) the distribution was not motivated by an intention to facilitate such an acquisition and (c) at the time of the distribution, the distribution corporation would not have reasonably anticipated that it was more likely than not that one or more persons would acquire a 50% interest in the distributing corporation or the controlled corporation within two years, who would not have acquired such interests if the distribution had not occurred and the distribution is not motivated by an intention to decrease the likelihood of the acquisition of one or more businesses, by separating these businesses from other businesses that are themselves likely to be acquired.

That's a mouthful. Basically, it seeks to identify acquisitions that would not have occurred but for the distribution. It seems to sanctify the notion that a plan can exist on the strength of mere expectations regarding the likelihood of an acquisition. Plus, it seems to reject the theory that a plan can only be found to exist where negotiations have been conducted.

The importance of rebutting the Sec. 355(e) presumption using the general rebuttal apparatus can be seen in Example 4 in the proposed regulations. A spinoff was undertaken for a valid business purpose but, within six months thereafter, the controlled corporation was acquired. Thus, the general rebuttal rule could not be satisfied. The example concludes that the taxpayer cannot rely on the alternative rebuttal rule either.

Why? At the time of the distribution, the taxpayer would reasonably anticipate that if the controlled corporation is separated, an acquisition of an interest in such corporation is more likely than not to occur by persons who would not have acquired a proportionate interest in the distributing corporation if the distribution had not occurred. Yuck!

Basically, this alternative rebuttal test cannot be met unless you can show that the spinoff does not make an acquisition of either party more likely to occur compared to the potential for such an acquisition absent the spinoff. This may be an impossible hurdle to surmount. In most cases, taxpayers will surely rely on the general rebuttal rule. Once the regulations are finalized and effective, a six-month embargo on acquisitions following spinoffs may evolve. Moreover, during that same six-month period, it may be imprudent to initiate all but the most innocuous of contacts with the distributing or controlled corporation.

Take Example 5 in the proposed regulations. There, a parent effected a spinoff for a valid business purpose. At the same time, it believed it would become a more attractive acquisition candidate if the spinoff was undertaken. The hoped-for acquisition occurred about a year after the spinoff, and it was not undertaken pursuant to an agreement in place during the six-month period following the spinoff. The example concludes that the presumption can be rebutted, under the general rebuttal rule, if the spinoff was in substantial part motivated by the non-acquisition business purpose. However, the transaction cannot satisfy the alternative rebuttal rule because the distributing corporation cannot establish that, at the time of the spinoff, it did not intend that one or more persons would acquire the requisite 50% interest during the two-year period referred to in Sec. 355(e). Yuck again!

Acquisitions Before Spinoffs

Where an acquisition precedes a spinoff, the presumption can be rebutted only if it can be established that, at the time of the acquisition, the distributing corporation and its controlling shareholders did not intend to effectuate a distribution. A controlling shareholder is a person who possesses voting power representing a "meaningful voice" in corporate governance. For a publicly-traded corporation, a controlling shareholder is a person who owns 5% or more of any class of stock and who actively participates in the management or operation of the corporation.

Alternatively, the presumption can be rebutted if it can be established that the distribution would have occurred at approximately the same time and under substantially the same terms (regardless of the acquisition), provided no person acquiring an interest in that acquisition becomes a controlling shareholder before the end of the two year period beginning on the date of distribution. If a new controlling shareholder arises from the acquisition (preceding the distribution) the alternative rebuttal mechanism thus provides no solace.

Safe Harbors?

Suppose an acquisition occurs more than two years after a distribution. The distribution and acquisition are presumed part of a plan only if there was an agreement, understanding or arrangement concerning the acquisition at the time of the distribution, or within the two years thereafter. On the other hand, if an acquisition occurs more than two years before the distribution, the acquisition and distribution are not presumed part of a plan unless the IRS establishes that a person acquiring an interest in that acquisition becomes a controlling shareholder before the end of the two year period beginning on the date of distribution.

Note the burden shift! If an acquisition creates a new controlling shareholder, it is not clear that a subsequent spinoff will ever be safely seen as not undertaken pursuant to the requisite plan or series of related transactions.

The regulations confirm that if the distributing corporation is acquired in a manner that invokes Sec. 355(e) it will be taxed on the distribution of all controlled corporations involved in the transaction. However, if several corporations are distributed in a spinoff, and fewer than all are so acquired, the distributing corporation is not taxed on the distribution of those corporations that remain sufficiently independent. These regulations will only affect distributions that occur subsequent to the time the regulations (now in proposed form), are finalized.

The state of the law during the interim is unclear. Most taxpayers believe that no "plan" can be found to exist if at the time of the spinoff, the parties to the business combination did not contemplate such a transaction and there were no negotiations or discussions regarding a business combination until some time after the spinoff had been consummated. See Rev. Rul. 96-30. What, me worry? If you read the proposed regulations, you'll worry.

Morris Trust Regulations at Last, Vol. 8, No. 3, M&A Tax Report (October 1999), p. 7.