The Best Part of Breaking Up Is Folgers’s Tax-Free Spinoff

Despite running into a potential deal-breaker, Folgers parent Proctor & Gamble successfully uses a reverse Morris Trust transaction in its latest pact with Smucker.

The regulations state that an acquisition of the stock of the distributing or controlled corporation that is listed on an “established market” is not part of a plan (or series of related transactions) which includes the distribution as long as neither the transferor nor transferee of such stock falls within certain specified categories. (See Regulation Section 1.355-7(d)(7)(i).) Thus, here, since the transferors and transferees of the Smucker stock will not fall within any of those categories, the post-merger acquisitions of Smucker stock (by the parties to whom the short-term holders convey their stock) should not be taken into account in determining whether the anti-Morris Trust rule has been breached.

However, the regulations go on to say that if a transfer of stock to which this otherwise “safe harbor” applies results in an indirect acquisition of voting power by a person other than the transferee of such stock, the safe harbor does not prevent an acquisition of stock by such other person (with the voting power such stock represents after the transfer) from being part of a plan. (See Regulation Section 1.355-7(d)(7)(ii)(B) and Regulation Section 1.355-7(j), Example 5.)

Therefore, consider that the transfer of the Smucker stock issued in the merger causes the voting power of Smucker to shift to the former shareholders. Such a shift in voting power will be treated as attributable to the stock acquired by the former Smucker shareholders (in Folgers’s successor) as part of a plan that includes the distribution by P&G of Folgers. That outcome would render Section 355(e) applicable and, undoubtedly, cause the deal to be unceremoniously abandoned.

Voting powerNevertheless, P&G’s counsel was able to render an opinion so the transaction does not trigger the provisions of Section 355(e), despite the shift in voting rights caused by the prompt disposal of Smucker stock issued in the merger. This is so because the post-merger transfers of Smucker stock — which would otherwise be eligible for the benefits of the safe harbor — will not result in an indirect acquisition of voting power by a person other than the transferee of such stock.

For tax purposes, voting power means the power to participate in the election of the entity’s board of directors. In short, participation in management through the election of directors is the sole criterion of voting power. (See Revenue Ruling 69-126, 1969-1 C.B. 218.) In this case, each share of Smucker carries with it one vote with respect to the election of directors. Moreover, this is true regardless of how long the holder has owned the stock.

Transfers of Smucker’s stock in connection with the merger will produce an indirect acquisition of voting rights (with respect to the enumerated matters) by a person other than the transferee of such stock. However, that outcome is not barred by Section 355(e). Instead, that section focuses solely on ownership of stock possessing voting power.

As a result, the shift in voting rights that will occur when short-term holders of Smucker’s stock promptly sell the stock will have no impact on the transaction’s claim to exemption from the anti-Morris Trust rules. Indeed, the stock will be sold to holders whose voting privileges will be impaired for four years. Thus, it appears that no tax impediment should exist with respect to the scheduled completion of this innovative deal.

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

Footnotes

1If all of the shares of Folgers held by P&G are not ᰬ notwithstanding the inducement — subscribed for, the balance of the Folger’s shares held by P&G will be distributed, as promptly as practicable, to the remaining holders of P&G shares.

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