Ready for Prime Time: Discovery’s Tax-Free Spinoff

In a tax-free -- albeit complex -- spin-off Discovery Holdings reworks its subsidiary structure to become a pure play programmer.

In 2005, Discovery Holding Company (DHC) was spun-off from Liberty Media. Now, Discovery Holding is undertaking its own spin-off in conjunction with a series of restructuring steps that will culminate in its becoming a pure play programming entity. The hope is that the stock of Discovery Holding’s successor will be accorded a higher valuation by the market than is currently the case.

To reach its ultimate goal, the company has put forth a multi-step plan, carefully devised to be free from tax consequences. We believe the parties have succeeded — although the transaction is complex.

Discovery Holdings currently owns a two-thirds capital and profits interest in Discovery Communications LLC, the programming arm of the holding company family. The remaining one-third interest in Discovery Communications is owned by a partnership known as the A/N (for Advance Newhouse) partnership. Discovery Holding also owns 100 percent of the stock of Ascent Media.

The presence of Ascent in the prior separation of Discovery Holding from Liberty Media enabled the first spin-off to be completed on a tax-free basis. Discovery Holdings’ active business status, with respect to the prior spin-off, was premised on its ownership of a controlling interest in Ascent. It was, therefore, Ascent’s active business on which the parties had relied to satisfy the active business test.

The new transaction on which Discovery Holding is embarking entails the following steps:
• Discovery Holdings will distribute its stock in Ascent Media to its shareholders;
• A new company, named Discovery Communications Inc. (DCI), will be organized, and DCI will form a transitory subsidiary (MergerSub) which will merge with and into Discovery Holdings. In the merger, the shareholders of Discovery Holding will have their stock converted into various classes of voting and non-voting common stock of DCI, and the stock of MergerSub owned by DCI will be converted into stock of Discovery Holding. Thus, Discovery Holding will become a wholly-owned subsidiary of DCI, and the former shareholders of the holding company will become shareholders of DCI;
• As part of the overall plan, the A/N partnership will transfer its interest in Discovery Communications to DCI in exchange solely for Series A and Series C convertible preferred shares of DCI.

Global Section 351 Exchange

There is every reason to believe that the spin-off of Ascent Media will be tax-free to both Discovery Holdings and its shareholders. The spin-off, which is clearly being undertaken for one or more valid corporate business purposes, seems to meet the active business test. As a result, the spun-off corporation, Ascent, will be engaged in the active conduct of a trade or business immediately after the spin-off and clearly, Discovery Holdings will also be so engaged.

The Internal Revenue Service has ruled that a partner is deemed to be conducting the business of a partnership in which it has an interest so long as that interest represents a “significant” interest in the partnership. (See Rev. Rul. 2007-42, I.R.B. 2007-28, June 21, 2007.) A one-third interest in partnership capital and profits should suffice. Also, Discovery Holdings is in possession of a two-thirds capital and profits interest with respect to Discovery Communications. So Discovery Holdings would be viewed as conducting the trade or business in which Discovery Communications is engaged, even if it does not have active and substantial management functions with respect to Discovery Communication’s business.

Further, the tax-free nature of the spin-off should not be adversely affected by the second-step merger and contribution by A/N of its partnership interest (in Discovery Communications) to DCI. That is because a spin-off is rendered taxable at the corporate level under Section 355(e) if the jettisoned company is part of a plan — or series of related transactions — that involves one of three situations. That is, that the plan is one in which one or more persons acquire stock representing a 50 percent or greater interest in either the distributing corporation (Discovery Holdings), a successor of the distributing corporation (DCI), or any controlled corporation (Ascent Media).

In this case, the A/N partnership will be acquiring an interest in DCI, but not nearly enough of an interest to trigger the application of the foregoing rule. The A/N partnership will be acquiring by value no more than one-third of the stock of DCI — the successor to Discovery Holdings, and therefore the distributing corporation. Accordingly, the spin-off should not be seen as running afoul of the so-called “anti-Morris Trust” rule found in Section 355(e).

It is a condition of the deal that the exchange by the A/N partnership of its interest in Discovery Communications for stock in DCI be eligible for tax-free treatment. And as we noted early, we think that goal will be met.

The contribution by the A/N partnership in conjunction with the merger, and the merger in conjunction with the contribution, ought to together constitute a so-called “global Section 351 exchange.” Recall that Section 351 of the tax code provides that no gain or loss shall be recognized when one or more persons (here, the A/N partnership and the former shareholders of Discovery Holdings) transfer property (the partnership interest and the stock in Discovery Holdings, respectively) to a corporation (DCI) solely in exchange for stock in such corporation, as long as one important caveat is met. That is, no gain or loss is recognized only if, immediately after the exchange, the transferors of the property are collectively in control (within the meaning of Section 368(c)) of the transferee.

We believe this requirement will be met here principally because DCI should not be viewed as a “mere continuation” of Discovery Holdings. (See in this regard Revenue Ruling 76-123, 1976-1 C.B. 94. Compare Revenue Ruling 68-349, 1968-2 C.B. 143.) That means that the transferor group in this instance should consist of not only the A/N partnership but, also the former shareholders of Discovery Holdings. As a result, the group of property transferors will be — within the meaning of Section 351 and Section 368(c) — in control of the transferee immediately after the exchange.

In our view, the formation of DCI should meet the conditions for Section 351 treatment with the result that the contribution by the A/N partnership of its interest in Discovery Communications to DCI should be tax-free. We are confident the A/N partnership will be able to easily secure an opinion of counsel to that effect.1 What’s more, we see no tax related impediments to this deal which ought to achieve its goal of freedom from taxation.

Footnotes

1The convertible preferred stock, which will be issued by DCI to the A/N partnership, should not be classified as “non-qualified preferred stock”, the receipt of which, in a transaction otherwise qualifying under Section 351, gives rise to gain recognition. The convertible preferred stock is not, for this purpose, “preferred stock” (and, hence, cannot be non-qualified preferred stock) because the conversion feature provides the holders with a ‘real and meaningful likelihood” of actually participating in the earnings and growth of the issuer. See Section 351(g)(3).

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