Can Warrants Be Used to Complete a Spin-Off?

A handful of older tax cases lay the groundwork for such a move, but there are caveats.

Distribution with Respect to Stock

The appeals court went on to say that “even were we to agree that the step transaction doctrine permits these transactions to be viewed as a distribution of Shorewood stock, the requirement of Section 355(a)(1)(A), that the stock be distributed with respect to stock of [the water company], has not been met.” In the Redding case, the warrants were distributed with respect to the stock of the water company, and the stock of Shorewood was distributed with respect to the warrants. As a result, it was the warrant distribution, and only the warrant distribution, that conformed to the statutory test.

Moreover, Section 355(a)(1)(D) requires a distribution of “control” to shareholders of the distributing corporation. However, the water company retained slightly less than 20% of Shorewood’s stock and distributed slightly more than 80% of the stock. In addition, 50,000 shares were acquired by the underwriters.

The transfer of shares to the underwriters reduced the percentage of stock distributed to the water company shareholders to, at most, 76.26%. Therefore, there was no distribution of control of Shorewood to the water company shareholders. (Control is defined as holding stock representing at least 80% of the total combined voting power of all classes of stock entitled to vote.)

The appeals court stated that “given our conclusion that the step transaction doctrine does not require the transaction to be seen as a distribution of Shorewood stock, and our further finding that, even if it could be so viewed, there has been a failure to comply with the requirements of Section 355, we must turn to a determination of what constitutes the taxable event.”

Palmer Distinguished

Under Section 316(a) of the Internal Revenue Code, a distribution of property by a corporation to its shareholders out of earnings and profits is a dividend. The exclusion of rights to acquire stock of the distributing corporation — from the definition of property contained in Section 317(a) — implies that rights to acquire stock of another corporation are included in the term property.2 Therefore, Redding received a dividend upon receipt of the warrants, and the amount of such dividend was the fair-market value of the warrants.

But what about the findings that relate to the Redding decision in the case known as Palmer v. Commissioner, 302 US 63 (1937)? In Palmer, “at the money” rights were distributed entitling shareholders to purchase from the distributing corporation shares in another corporation. The Supreme Court found no dividend. It held that the “mere issuance of rights” was not a dividend.

But, in Commissioner v. Gordon, 391 US 83 (1968), the Supreme Court observed that “it has not, however, been authoritatively settled whether an issuance of rights to purchase at less than fair market value itself constitutes a dividend, or the dividend occurs only upon the actual purchase.”

The Seventh Circuit, in reconciling these conflicting thoughts, looked to the 1954 Code. Under the provisions of the code — in a case of stock rights in which the subscription price is less than the fair-market value of the property to which the rights pertain — there is a dividend at the time of the issuance of the rights. The amount of the dividend is measured by the market value of the rights at the time of issuance. In short, the court concluded that a “fair reading of Palmer be limited to its facts.” Therefore, in the water company case, Redding was in receipt of dividend income at the time of the issuance of the rights.

Therefore, it seems that the use of warrants to complete a spin-off, although difficult, is not impossible. At a minimum, however, it seems that the warrants would have to be nontransferable. Only then would a court be inclined to apply the step-transaction doctrine — so that the issuance and exercise of the warrants could be telescoped into a single transaction — to find that the substance of the transaction was a distribution of the stock of the subsidiary to the shareholders of the distributing corporation with respect to its stock.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for


1 See Redding v. Commissioner, 630 F.2d 1169 (7th Cir. 1980).
2 See Revenue Ruling 70-521, 1970-2 C.B. 72.


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