On May 7, 2008, Rainbow Media Holdings LLC, a programming subsidiary of Cablevision Systems Corp., announced that it had reached an agreement to acquire the Sundance Channel from General Electric Co.’s NBC Universal, CBS Corp.’s Showtime Networks, and entities controlled by none other than Robert Redford.
The structure of this $496 million deal is rather unusual. Under the terms of the transaction, the total consideration will be paid through a tax-free exchange of approximately 12.7 million shares of common stock of GE held by Rainbow Media, with a “cash adjustment” at closing based upon the value of the GE shares in relation to the total purchase price. Under the transaction structure, GE will receive the GE shares held by Cablevision, and CBS and Redford will receive cash in exchange for their interests in the Sundance Channel.
There is only one way to make sure the deal, which involves a swap of Cablevision’s GE shares for GE’s shares in the Sundance channel, would qualify as a tax-free exchange — configure it as a “split-off” that meets the requirements of Section 355 of the Internal Revenue Code. The exchange constitutes a split-off only if, among other things, GE is in control of the Sundance Channel immediately before the stock distribution.
For this purpose, control is defined by Section 368(c) , and means ownership of stock possessing at least 80 percent of the total combined voting power of all share classes entitled to vote, and 80 percent of the total number of shares of each class, if any, of the non-voting stock. (See Revenue Ruling 59-259, 1959-2 C.B. 115.)
Accordingly, we can surmise that GE, which only owns 57 percent of the value of the Sundance Channel’s stock, must own stock possessing at least 80 percent of the total combined voting power of Sundance’s outstanding stock. Presumably, the Sundance Channel is capitalized with two classes of stock — a high-vote class and a low-vote class. Further, we can also assume GE possesses a sufficient number of shares of the high vote class to provide it with the requisite percentage of the total combined voting power of all classes of Sundance stock entitled to vote.
In addition, it’s likely that the distribution of stock will not be characterized as a disqualified distribution within the meaning of Section 355(d). A disqualified distribution is one in which after distribution any person (Cablevision) holds a 50 percent or greater interest in either corporation (GE or the Sundance Channel) and the interest is attributable to disqualified stock. Disqualified stock are shared acquired by “purchase” within the five year period ending on the date of the distribution.
In the case of this most recent transaction, Cablevision acquired its GE stock in a tax-free exchange when it sold the Bravo Channel to NBC Universal. So long as five years have elapsed from the time Cablevision acquired the Bravo (by purchase or otherwise), Cablevision’s stock in GE will not constitute disqualified stock. As a result, the stock distribution by GE of the Sundance Channel to Cablevision will not be characterized as a disqualified distribution and, therefore, such distribution will remain eligible for tax-free treatment with respect to GE.
There is, however, one potential roadblock to tax-free treatment — the fact that the arrangement may feature a cash payment from Cablevision to GE which will be, “based on the value of the GE shares in relation to the total purchase price.”* For the exchange to qualify for tax-free treatment it must be classified as “a distribution (by GE) with respect to its stock.” This is a fundamental requirement for tax-free exchange status.
However, in a case entitled Owens Machinery Co., Inc. v. Commissioner, 54 T.C. 877 (1970), a parent corporation, Omega Co., owned 85 percent of the stock of a subsidiary Lambda Inc. To separate the interests of the company’s dominant shareholders, Mr. L and Mr. O, Omega Co. transferred its stock in Lambda Inc. (to Mr. L) in exchange for Mr. L’s shares in Omega, plus $25,000 in cash. Omega sustained a loss of $134,710 with respect to this exchange which it sought to deduct.
However, the IRS took the position that the transaction should be “fragmented” into two separate transactions for tax purposes, and accordingly sought to invoke the non-recognition (of gain or loss) provisions of Section 311of the tax code. By invoking Section 311, a portion of the Lambda Inc. stock was exchanged by Omega Corp. for its own stock. And the exchange allowed Omega Corp. a loss on the remainder of the Lambda Inc. stock, which the IRS would treat as sold for $25,000.
But the tax court rejected the IRS approach with the following rebuke “…we know of no rule which would warrant fragmenting such transaction to treat it as an exchange for stock of part of the stock and a sale for cash of the balance…” Here, the court noted that the cash payment was a “significant element” of the total consideration received by Omega. Unless the transaction is fragmented — and the court concluded that it should not be — the transaction cannot be characterized as a distribution with respect to stock.
The court cited, for this damaging proposition (from the IRS perspective), the Ninth Circuit’s decision in Commissioner v. Baan, 382 F.2d 485 (9th Cir. 1967), aff’d, 391 US 83 (1968). In that case, the court held that in considering the provisions of Section 355, “…the phrase, distributes with respect to stock is a term of art with a consistent meaning throughout the Code…it is used to refer only to distributions without consideration and not to sales for a cash consideration…” (See also Johnson-McReynolds Chevrolet Corp. v. Commissioner, 27 T.C. 300 (1956)).
As a result, the cash adjustment in this current case, if it flows from Cablevision to GE, can arguably render the exchange taxable. If such a cash adjustment is made, the transaction might not be characterized as “a distribution with respect to stock” and, absent that characterization, it will be difficult — in fact impossible — to conclude that the exchange is governed by the non-recognition provisions of Section 355.**
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
If the payment flows from GE to Cablevision, the transaction’s status as a tax-free split-off will not be imperiled. In that case, the transaction simply will be a split-off “with boot.” Accordingly, Cablevision’s gain from the exchange will be recognized, but in an amount not in excess of the boot. Such recognized gain should be a capital gain with respect to Cablevision because the exchange will not have the “effect of the distribution of a dividend” within the meaning of Section 356(a)(2). (See Reg. Sec. 1.356-1(a)(1) and Rev. Rul. 93-62, 1993-2 C.B. 118.)
The tax court is not entirely convinced that the presence of cash will “spoil” a distribution to which Section 355 otherwise applies. Thus, in Owens Machinery Co., the court said, admittedly in dicta, that “…it is not necessary to decide here whether we follow this logic in the case of a spin-off (or split-off)…it is sufficient, here, to decide, simply, that there was no distribution (with respect to stock) under Sec. 311…”