Defective and Reverse Morris Trust Transactions in the Wild

When one corporation (“Parent”) distributes the stock of a subsidiary (“Sub”), normally both Parent and its shareholders are taxed: Parent on the gain (fair value minus basis) in the Sub shares distributed, and the shareholders for receiving a dividend.  But, if Parent (1) controls (defined technically) Sub before the transaction, (2) distributes a controlling interest in the transaction, (3) has a corporate business purpose for the transaction, (4) both Parent and Sub have an active trade or business, (5) those businesses continue after the transaction (the “continuity of business enterprise” requirement), and (6) and the transaction is not a “device for the distribution of … earnings and profits,” then neither Parent nor the shareholders are taxed on the transaction (except to the extent of non-stock “boot” property distributed).  This is, for example, what eBay has announced they intend to do with PayPal later this year.

Where Parent or Sub are sold in a related transaction after the spin off, does the spin off meet the continuity of business enterprise requirement?  This is expected to be the problem for Safeway Inc.’s spin off last April of Blackhawk Network Holdings, Inc.  Because Safeway is expected to be acquired for cash by Albertsons in a related, pre-planned transaction closing any day now, the distribution of Blackhawk will have been taxable.

In 1965, the Mary Archer W. Morris Trust answered this question when it defeated the Commissioner of Internal Revenue in a holding that would give its name to a new class of transactions.  The trust held stock in a bank (Parent), which spun off a Sub immediately before the bank was itself acquired.  In the end, because the acquisition was itself a non-taxable merger, the continuity of business enterprise requirement was met despite the parent’s ceasing to exist in the merger.  So, a “Morris Trust” transaction is a spin off followed by an acquisition of Parent that satisfies the continuity requirement, while a “Reverse Morris Trust” transaction is a spin off followed by an acquisition of Sub.

To qualify as a Morris Trust or Reverse Morris Trust transaction, the Parent shareholders must hold a majority of the stock in the merger.  If not (or the acquisition is taxable as is expected to be the case for Safeway), then the distribution of Sub is taxable to Parent (although not to Parent’s shareholders).  This majority ownership requirement was enacted after Mary Archer W. Morris Trust case, and would have changed the result in that case, as the distributing Parent shareholders only received 46% of the stock of the acquirer.

The recently announced acquisition of Hawaiian Electric Industries by NextEra Energy, Inc. is an example of a defective Morris Trust transaction.  NextEra Energy, Inc. will be acquiring in a stock merger all of the stock of Hawaiian Electric.  So far, this follows the pattern of a Morris Trust (Parent spins off Sub and then is acquired).  But first, Hawaiian Electric will spin off its subsidiary American Savings Bank, and pay a dividend of $0.50 per share.  Unfortunately, Hawaiian Electric’s shareholders will not hold the required majority of NextEra stock after the merger, so the transaction will fail to qualify as a Morris Trust transaction and is taxable to Hawaiian Electric (with that tax bill to be shouldered by NextEra following the transaction).

Carl Icahn, a significant and vocal shareholder of eBay (so soon to be of PayPal as well), has called for PayPal to try to get acquired by a larger player in the online payment processing marketplace.  If PayPal does so in a transaction arranged before the spin off, the terms of that transaction will determine if the PayPal spin off is taxable to eBay or not.  With Mr. Icahn’s call for merger coming before the spin off is completed, it will be interesting to see if and how PayPal works around the requirements for a Reverse Morris Trust transaction or if it follows Safeway and Hawaiian Electric into corporate level tax.