1. REVERSE MORRIS TRUST
TRANSACTION
Verizon Fairpoint Merger
Claire Cui, Lychee He, Junichi Hara, Ronald Klein, Christina Ko, Alexander
Burtka, Claire Zhang

2. Agenda
 Verizon/Fairpoint Background
 Verizon’s options
 Solution: Reverse Morris Trust
 Result/Opinions

3. It’s 2008…
 iPhone 3G came out (only for AT&T)…

4. Verizon Fairpoint Transaction

5. Background
 Verizon had two main businesses:
1. Wireline
2. Wireless

6. Background
 Wireline business declining, wireless growing
Operating Profit of Verizon's Segments
$16,000MM
$14,000MM
$12,000MM
$10,000MM
$8,000MM
$6,000MM
$4,000MM
$2,000MM
$0MM
2001 2002 2003 2004 2005 2006 2007 2008
Wireline Wireless

7. Objective: Sell off wirelines
 Verizon wanted to dump sell its wireline
business, via Reverse Morris Trust Trans.
 Needed to find a smaller firm willing to buy…

8. Target: Fairpoint Comm.

9. Fairpoint Communications
 Small telecommunications firm
 Mostly focused on rural areas
 Merger would make Fairpoint eighth largest
telecommunications firm

10. What is a Reverse Morris Trust?
 A loophole firms can exploit to sell a part of its
business…
 Tax free
 Made up of two components
Dougie
sad…
1) A tax free spinoff
2) A tax free merger

11. Part 1: Tax Free spinoff

12. What’s a spinoff?
 A parent company distributing shares of a
subsidiary to shareholders, i.e…
 A dividend
 Subsidiary becomes a separate, independent
company
 Commonly done to separate unrelated and/or
unwanted parts of business

13. Example: Altria spins-off Kraft

14. What’s a spinoff?
Animation here

15. Taxable spinoffs
 Normally (uh-oh), spinoffs are taxed, just like any
other dividend

16. Taxable spinoffs
Example:
 ParentCo gives all of its shares in SubCo to
ParentCo shareholders
 Shareholders get dividend taxed
 But ParentCo must also recognize a gain

17. Taxable spinoffs
 Why is ParentCo taxed as well?
 Because they would have been taxed if they sold
the subsidiary and gave a cash dividend instead

18. Double taxation
 How many layers of tax?
 Regular stock sale (and dividend): Two
 Taxable spinoff: Two
 …Normally

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. stock
is carried over to shareholders
 What are the requirements?

20. Requirements

21. The tax-free spinoff
 We won’t cover them all, but the big one:
 Must have a business purpose (i.e., non-tax
purpose) for the spinoff
 E.g. “To focus on our core competencies…”
 So if a firm wanted to separate a subsidiary for
strategic reasons (rather than selling it) it could do it
tax free
 “Non-tax purpose”. Righttt…

22. Morris Trust Transactions
 Many firms took advantage of the tax-free spinoff
in order to sell subsidiaries
The “old school” Morris Trust Transaction:
 Conduct a tax-free spinoff
 Buyer then purchases the spunoff sub.’s stock from
the shareholders and acquires subsidiary

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 capital
gain, but the parent would recognize nothing
 We beat Dougie!

24. Dougie Strikes Back
 Dougie didn’t think that was funny

25. Retroactive tax
 In response, tax law was changed so that:
 If a tax-free spinoff is followed by S being
acquired within two years…
 IRS will retroactively tax the original spinoff

26. Back to square one…
Recap: 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. Part 1: Tax-Free Spinoff

28. Part 2: Tax-Free Merger

29. Re-visit: Retroactive Tax Rule
 A tax-free spinoff is retroactively taxable to the
parent company, if:
 The subsidiary is acquired within two years
 So then what if…
 The subsidiary is the acquirer?

30. Definition of “Buyer”
Who’s the buyer?
 If a A pays cash for B’s stock?
 Company A
 If a A pays cash for B’s assets?
 Company A
 If company A exchanges company A stock for
company B stock?
 Depends…

31. Buyer
 If stock is exchanged for stock, then the buyer is
defined as the company whose shareholders obtain
majority control (>50%)
 i.e. The company that’s bigger

32. Reverse Morris Trust
 If a tax-free spinoff is followed by the spun off
subsidiary 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. Take that
IRS!

34. Drawback: Majority Control
 The main drawback is that the spunoff subsidiary
has to be bigger than the “buyer”
 As a consequence:
1. Limits pool of potential buyers for sub.
2. “Buyer” and its shareholders may not like
becoming minority interest

35. Tax Free Sale!
 But aside from that, a Reverse Morris Trust
transaction, i.e.
A tax free spinoff
 A tax free merger (with a smaller company)
 Allows a company to sell a subsidiary tax free

36. The graveyard…

37. Animation
Spinoff SH’s Parent SH’s
Subsidiary Parent
Subsidiary

38. Taxable spinoffs
 ParentCo shareholders are now the proud owners of
SubCo, and…
 They recognize a $1000K dividend
 Ouch. But that’s not too bad…
 Dougie ain’t done

39. Taxable spinoffs
 In addition to ParentCo shareholders recognizing a
$1000k dividend
 ParentCo itself also recognizes a gain
 Double ouch, baby

40. Taxable spinoffs
 Gain = FMV of Sub. – Basis in Sub.
 ParentCo’s gain = $1000k-500k=$500k
 So in total:
 ParentCo shareholder’s: $1000k dividend
 ParentCo: $500k gain

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 Company Parent Total Taxable
Shareholders Income
Sell Sub. + Dividend $500K $1000K $1500K
Spinoff Sub. $500K $1000K $1500K
Morris Trust Trans. - $500K $500K

42. Example revisited
 In the last example:
 ParentCo made a tax free spinoff
 Shareholders recognized $500K capital gains
 Since the acquisition happened within 2 years
ParentCo will be retroactively taxed on spinoff
 Shareholders not taxed on dividend