Why Sprint Can Spin Nextel Off, Tax-Free

The authorities support the proposition that the deal wouldn't run afoul of the "active-business test."

Sprint Corp. is evaluating its options concerning Nextel Communications, its wholly-owned subsidiary. Apparently, one of those options is a spin-off of Nextel’s stock to Sprint’s shareholders. Can such a spin-off be accomplished on a tax-free basis?

Although it’s far from clear, such a tax-free spin-off could very likely occur.

Let’s consider the facts. Spring acquired Nextel on August 12, 2005. The transaction was structured as a “forward triangular merger” in which Nextel was merged with and into a newly-created subsidiary of Sprint. In the merger, the Nextel shareholders were compensated with a combination of cash and shares of voting and non-voting Sprint common stock.

The amount of cash issued in the merger was about $969 million. But the vast majority of the consideration was in the form of Sprint common stock, which was valued, as of the date of closing, at approximately $35.6 billion. The merger qualified as a reorganization under Sec. 368(a)(1)(A) and Sec. 368(a)(2)(D) of the Internal Revenue Code.

Accordingly, those shareholders of Nextel who realized a gain on the exchange were required to recognize that gain but in an amount not more than the cash received. Further, since the transaction qualified as a reorganization, Sprint’s basis in the stock of the subsidiary that houses Nextel’s business was, at the start, equal only to Nextel’s “net basis” in its assets.

Thus, although Sprint “spent” nearly $37 billion in acquiring Nextel, its basis in the stock of the corporation conducting Nextel’s business is, undoubtedly, only a fraction of that amount. Thus, if Sprint were to dispose of Nextel via a distribution of its stock to its shareholders, Sprint would almost certainly realize a gain on the distribution. If the spin-off met the requirements for tax-free treatment, Sprint would avoid having to recognize the distribution.

The merger consideration included cash in order to insure that Nextel’s shareholders would not own as much as 50 percent of Sprint’s stock immediately after the merger. (Had Sprint issued just stock in the merger, the Nextel shareholders would have emerged with a majority of S’s stock).

Sprint thought it was important to keep the Nextel shareholders’ ownership to less than 50 percent to insure that the spin-off by Sprint of its ILEC business, which occurred shortly after the merger, qualified for tax-free treatment. Had the Nextel shareholders emerged with a majority of S’s stock, the spin-off might well have been taxable (at the Sprint level) because the spin-off would have been regarded under the tax code as part of a plan or series of related transactions pursuant to which “one or more persons” (the former Nextel shareholders) acquired stock representing a 50 percent (or greater) interest in either or both of the distributing corporation, Sprint, and the controlled corporation (the subsidiary to which the ILEC assets were conveyed and whose stock was distributed).

Is the “Five-Year Rule” Violated?

In order for a spin-off to qualify for tax-free treatment, the requirements set forth in Sec. 355 of the Internal Revenue Code must each be met. One such requirement is known as the “active business” requirement. Thus, both the distributing corporation, Sprint, and the controlled corporation, Nextel, must be engaged, immediately after the distribution, in the active conduct of at least one trade or business.

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