1. 1. REVERSE MORRIS TRUSTTRANSACTIONVerizon Fairpoint MergerClaire Cui, Lychee He, Junichi Hara, Ronald Klein, Christina Ko, AlexanderBurtka, Claire Zhang
2. 2. Agenda Verizon/Fairpoint Background Verizons options Solution: Reverse Morris Trust Result/Opinions
3. 3. Its 2008 iPhone 3G came out (only for AT&T)
4. 4. Verizon Fairpoint Transaction
5. 5. BackgroundVerizon had two main businesses:1.Wireline2.Wireless
6. 6. Background Wireline business declining, wireless growing Operating Profit of Verizons Segments$16,000MM$14,000MM$12,000MM$10,000MM$8,000MM$6,000MM$4,000MM$2,000MM$0MM200120022003 200420052006 2007 2008 Wireline Wireless
7. 7. Objective: Sell off wirelines Verizon wanted to dump sell its wirelinebusiness, via Reverse Morris Trust Trans. Needed to find a smaller firm willing to buy
8. 8. Target: Fairpoint Comm.
9. 9. Fairpoint Communications Small telecommunications firm Mostly focused on rural areas Merger would make Fairpoint eighth largesttelecommunications firm
10. 10. What is a Reverse Morris Trust?A loophole firms can exploit to sell a part of its businessTax freeMade up of two components Dougiesad1)A tax free spinoff2)A tax free merger
11. 11. Part 1: Tax Free spinoff
12. 12. Whats a spinoff? A parent company distributing shares of asubsidiary to shareholders, i.e A dividend Subsidiary becomes a separate, independentcompany Commonly done to separate unrelated and/orunwanted parts of business
13. 13. Example: Altria spins-off Kraft
14. 14. Whats a spinoff?Animation here
15. 15. Taxable spinoffs Normally (uh-oh), spinoffs are taxed, just like anyother dividend
16. 16. Taxable spinoffsExample: ParentCo gives all of its shares in SubCo toParentCo shareholders Shareholders get dividend taxed But ParentCo must also recognize a gain
17. 17. Taxable spinoffs Why is ParentCo taxed as well? Because they would have been taxed if they soldthe subsidiary and gave a cash dividend instead
18. 18. Double taxation How many layers of tax? Regular stock sale (and dividend): Two Taxable spinoff: Two Normally
19. 19. The tax-free* spinoff If a company meets a number of requirements (per 355) the spin-off can be tax-free* *Technically tax deferred. The basis in the sub. stockis carried over to shareholders What are the requirements?
20. 20. Requirements
21. 21. The tax-free spinoff We wont cover them all, but the big one: Must have a business purpose (i.e., non-taxpurpose) for the spinoff E.g. To focus on our core competencies So if a firm wanted to separate a subsidiary forstrategic reasons (rather than selling it) it could do ittax free Non-tax purpose. Righttt
22. 22. Morris Trust Transactions Many firms took advantage of the tax-free spinoffin order to sell subsidiariesThe old school Morris Trust Transaction: Conduct a tax-free spinoff Buyer then purchases the spunoff sub.s stock fromthe shareholders and acquires subsidiary
23. 23. Morris Trust Transactions How many layers of tax? Regular stock sale (and dividend): Two Taxable spinoff: Two Tax-free spinoff (followed by sale): One The shareholders would recognize a capitalgain, but the parent would recognize nothing We beat Dougie!
24. 24. Dougie Strikes Back Dougie didnt think that was funny
25. 25. Retroactive tax In response, tax law was changed so that: If a tax-free spinoff is followed by S beingacquired within two years IRS will retroactively tax the original spinoff
26. 26. Back to square oneRecap: How many layers of tax? Regular stock sale (and dividend): Two Taxable spinoff: Two Tax-free spinoff (followed by sale): One Two So after all that, Dougie will tax us twice Normally (aww huh? Yay!)
27. 27. Part 1: Tax-Free Spinoff
28. 28. Part 2: Tax-Free Merger
29. 29. Re-visit: Retroactive Tax Rule A tax-free spinoff is retroactively taxable to theparent company, if: The subsidiary is acquired within two years So then what if The subsidiary is the acquirer?
30. 30. Definition of BuyerWhos the buyer? If a A pays cash for Bs stock? Company A If a A pays cash for Bs assets? Company A If company A exchanges company A stock forcompany B stock? Depends
31. 31. Buyer If stock is exchanged for stock, then the buyer isdefined as the company whose shareholders obtainmajority control (>50%) i.e. The company thats bigger
32. 32. Reverse Morris Trust If a tax-free spinoff is followed by the spun offsubsidiary merging with a smaller firm And stock is given for stock (a tax-free merger) Then the subsidiary is considered the buyer The parent avoids the retroactive taxation And the shareholders defer tax on the sale! We beat Dougie!!!
33. 33. Take thatIRS!
34. 34. Drawback: Majority ControlThe main drawback is that the spunoff subsidiary has to be bigger than the buyerAs a consequence:1.Limits pool of potential buyers for sub.2.Buyer and its shareholders may not likebecoming minority interest
35. 35. Tax Free Sale! But aside from that, a Reverse Morris Trusttransaction, i.e.Atax free spinoff A tax free merger (with a smaller company) Allows a company to sell a subsidiary tax free
36. 36. The graveyard
37. 37. AnimationSpinoff SHs Parent SHsSubsidiary Parent Subsidiary
38. 38. Taxable spinoffs ParentCo shareholders are now the proud owners ofSubCo, and They recognize a $1000K dividend Ouch. But thats not too bad Dougie aint done
39. 39. Taxable spinoffs In addition to ParentCo shareholders recognizing a$1000k dividend ParentCo itself also recognizes a gain Double ouch, baby
40. 40. Taxable spinoffs Gain = FMV of Sub. Basis in Sub. ParentCos gain = $1000k-500k=$500k So in total: ParentCo shareholders: $1000k dividend ParentCo: $500k gain
41. 41. Morris Trust Transaction Example ParentCo spins off SubCo tax free Shareholders have a basis of $500K in SubCo BuyerCo buys all the stock from shareholders for $1000K Shareholders recognize capital gains of $500K Parent CompanyParentTotal TaxableShareholdersIncomeSell Sub. + Dividend $500K$1000K $1500KSpinoff Sub. $500K$1000K $1500KMorris Trust Trans.-$500K $500K
42. 42. Example revisited In the last example: ParentCo made a tax free spinoff Shareholders recognized $500K capital gains Since the acquisition happened within 2 yearsParentCo will be retroactively taxed on spinoff Shareholders not taxed on dividend