The Upside to a Downstairs Merger

Can Retail Ventures Inc., the parent of shoe retailer DSW, be eliminated in a tax-efficient way?

Retail Ventures Inc. (RVI) is a holding company whose principal asset is 62% of the stock of DSW Inc., a footwear retailer. From an organizational perspective, DSW has a “high vote/low vote” stock structure — with RVI holding all of the high-vote, Class B stock. In fact, RVI’s 62% equity interest translates into 93% of the voting power of all of DSW’s stock entitled to vote.

There are several other key structural facts to note, including that about 53% of RVI stock is owned by Schottenstein Stores Corporation (SSC), a closely-held company; RVI has accumulated approximately $320 million in federal net operating loss (NOL) carryovers; and RVI holds outstanding premium income exchangeable securities (PIES) — which are mandatory convertible securities. In this case, the PIES convert to a portion of RVI’s stock in DSW. That means that RVI has the option to “settle” the PIES in cash, or in a combination of cash and DSW stock. So if RVI were to “deliver” shares of DSW in satisfaction of these instruments, RVI would recognize a gain for tax purposes measured by the excess of the liability defrayed with the stock over RVI’s adjusted basis in such stock.

Downstairs Merger

If the overall business objective was to eliminate RVI as the corporation standing between its shareholders and its DSW stake, at least two avenues exist for accomplishing this goal. The first would be a complete liquidation of RVI. In that event, the corporation would adopt a plan of liquidation and distribute its assets to its shareholders in complete cancellation of its stock. However, this approach would be anything but tax-efficient.

Indeed, the Internal Revenue Code — specifically Section 336(a) — states that a gain or loss is recognized by a liquidating corporation on the distribution of property in complete liquidation as if such property were sold to the distributee at its fair market value. Therefore, in a liquidation, the gain inherent in the DSW’s stock that RVI holds would be recognized. What’s more, a second level of tax would be assessed under the tax code’s Section 331(a).

Under Section 331(a), amounts received by a shareholder in a distribution resulting from a complete liquidation of a corporation are treated as in full payment in exchange for the stock. So, with respect to the stock surrendered in the liquidation, each shareholder of RVI would recognize a gain in the amount by which the value of the property he or she received in the liquidation that exceeded the shareholder’s adjusted basis. Based on the tax treatment alone, an outright liquidation of RVI will not, we are confident, be pursued.

Fortunately, the same economic outcome (eliminating RVI) that a liquidation delivers can be achieved via a “downstairs” or downstream merger. Unlike a liquidation, a downstairs merger does not have current tax consequences. To be sure, such a merger should constitute a reorganization within the meaning of Section 368(a)(1)(A), with the result that RVI will not recognize gain or loss on the “movement” of its assets to DSW. Further, RVI’s shareholders will not recognize gain or loss on the exchange of their RVI stock for shares in DSW.

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