As corporate finance executives begin to review new merger and acquisition deals, it is interesting to consider what a handful of older tax court cases have to say about warrants and spin-off deals. Indeed, it appears that the use of warrants to complete a spin-off is a difficult, but not impossible, task.
To begin, take a closer look at a case decided in 1980 in which a water company owned all of the stock of another company, in this case, Shorewood Corp. The board of directors of the water company decided to distribute to its shareholders warrants to purchase Shorewood stock. The warrants afforded the holder the right to receive one share of Shorewood stock upon the surrender of two warrants and the payment of $5.
Also, the warrants were transferable. In fact, 1,019,537 shares, representing 76.26% of Shorewood’s outstanding stock, were distributed to the warrant holders, and 50,000 shares, representing approximately 4% of Shorewood’s outstanding stock, were conveyed to the underwriters. The water company retained slightly less than 20% of Shorewood’s outstanding stock.
Taxpayers, known collectively as Redding, were shareholders of the water company. They received warrants and exercised them. Redding contended that both the receipt and exercise of the warrants were tax-free under the Internal Revenue Code, specifically Section 355, which addresses distribution of stock and securities of a controlled corporation. What’s more, the U.S. Tax Court agreed with Redding. However, the decision was reversed by the Seventh Circuit Court of Appeals, which concluded that the distribution of the warrants was taxable as a dividend.1
Step Transaction Doctrine
The appeals court noted that to qualify under Section 355, a distribution must consist solely of stock or securities which does not include stock rights. Further, the tax court sought to keep the transactions within the ambit of Section 355 by integrating, via the step transaction doctrine, the distribution of the warrants and the subsequent exercise of the instruments. Using that technique, the overall transaction can be viewed as a distribution of stock.
But in the case of the water company, the distribution of the warrants was not made for the purpose of reaching the “end result” of distributing stock to the water company shareholders. Rather it was a matter of relative indifference to the water company whether Shorewood’s stock was transferred to the utility’s shareholders, their assignees, or the underwriters.
The appeals court noted that the reason for using transferable warrants was to arrange for the water company shareholders to be excluded as recipients of Shorewood stock in favor of new investors prepared to make a capital contribution. So, to the extent the rights distribution was a “step,” it was not a necessary step in the sort of corporate division contemplated by Section 355. Accordingly, the court concluded that the issuance of transferable warrants “added nothing” to the “essential purpose” of completing a spin-off.