Kraft Cereal Deal Avoids Tax Crunch

Using a reverse Morris Trust to split off its Post cereal division, Kraft nabs tax-free treatment.

Filling breakfast bowls with everything from Shredded Wheat to Cocoa Pebbles, the Post cereal company claims that “everyone’s taste is a little different.” So when its parent company, Kraft Foods, split off the division today, it seemed fitting to use a unique flavor of divestiture — a “reverse Morris Trust.”

As a result, Kraft closes the transaction with Ralcorp Holdings for its Post cereals business in a tax efficient manner. In fact, by using the pre-tax value of Post as the retirement currency, Kraft should be able to retire approximately $662 million of its existing indebtedness, and generate some $300 million in cash, all without experiencing any tax consequences. This favorable result is possible because of by using the reverse Morris Trust, all of the requirements for a tax-free transaciton will be satisfied.

Stripped to its essentials, the transaction worked like this:
• Kraft borrowed $300 million from outside lenders.
• Kraft transfered the Post assets, subject to the liabilities associated with those assets, to “Splitco,” a new corporation formed for purposes of the transaction. Splitco assumed the liability incurred by Kraft to raise the $300 million. Splitco issued to Kraft all of its stock, and issued some $662 million in debt “securities” to Kraft. These instruments have a term of at least 10 years and be non-callable for a period of five years. Essentially, the Post business was conveyed by Kraft to Splitco in exchange for: (1) Splitco assuming Kraft liabilities; (2) 100 percent of Splitco’s stock; and (3) Splitco’s debt securities in the principal amount of $662 million.
• Kraft then offered its Splitco stock to its shareholders in exchange for the appropriate amount of Kraft stock. To the extent that Kraft is unable to divest itself of all of its Splitco stock in the “split-off” phase of the transaction, Kraft will distribute — in a “spin-off” — the unsubscribed shares of Splitco. In the end, Kraft will have distributed all of its Splitco stock to its shareholders, either in a split-off, or in a combination of a split-off and a “back end” spin-off distributed on a pro-rata basis;
• Kraft then conveyed the debt securities it received from Splitco to a group of financial institutions who purchased an equivalent amount of Kraft securities on the open market. The securities Kraft received from these financial institutions (in exchange for the conveyance of its Splitco debt securities) will be retired;
• Splitco, now owned by the Kraft shareholders who elected to participate in the transaction, will be merged with and into a limited liability company (Holdco) created by Ralcorp for purposes of this transaction. The Kraft shareholders, as is crucial to the favorable tax outcome of the Morris Trust, received some 54 percent of Ralcorp stock in the merger. Thus, the historic Ralcorp shareholders will see their ownership of Ralcorp reduced from 100 percent to approximately 46 percent;
• Holdco will be merged, upstream, with and into Ralcorp. Then, Ralcorp will assume the liabilities of Splitco and become the issuer of the securities that were used by Kraft to retire some $662 of its own indebtedness.

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