AT&T Inc. (AT&T) and Discovery, Inc. (Discovery) recently announced an agreement to combine WarnerMedia’s entertainment, sports, and news business (WarnerMedia), which is part of AT&T, and Discovery’s nonfiction and international entertainment and sports businesses into a new company. Pursuant to the agreement, structured as a “Reverse Morris Trust” transaction, WarnerMedia will be spun or split off to AT&T shareholders via dividend or an exchange offer and simultaneously combined with Discovery’s business. The transaction is expected to be tax-free both to AT&T and its shareholders.1
AT&T itself will receive approximately $43 billion in cash, debt securities, and debt retention by WarnerMedia. AT&T shareholders will receive stock representing 71% of the new company, and Discovery shareholders will own 29% of the new company. AT&T expects to significantly reduce its debt as a result of the transaction.2
Section 355 in general
Section 355 distributions, which can occur as a “spin off” or “split off” (or both), allow a corporation (Distributing) to distribute the stock of a controlled corporation (Controlled) to shareholders in a tax-free manner.3 Congress established a strong set of requirements needed to qualify for tax-free treatment for the shareholders as well as Distributing and Controlled. A more comprehensive outline of the section 355 requirements can be found in a prior RSM article, Want to split up with your business partner?
A section 355 distribution often occurs as part of a divisive tax-free reorganization (D/355 Reorganization).4 In a D/355 Reorganization, Distributing transfers assets to Controlled in exchange for Controlled stock or securities and (possibly), cash, other property, and/or liability assumption. As part of the reorganization, Distributing distributes the Controlled stock to its shareholders.5
Distributing cannot obtain tax-free treatment on its distribution of Controlled stock if the distribution is part of a plan in which one or more persons acquire 50% or more of the stock of either Distributing or Controlled.6 Put differently, neither Distributing nor Controlled can undergo a change in control (within the meaning of section 355(e)) as a result of transactions that are part of the same plan as the distribution of Controlled stock. A plan is presumed to exist if 1 or more persons acquire (directly or indirectly) stock representing a 50-percent or greater interest in Distributing or Controlled during the 4-year period beginning 2 years before the date of distribution.7
Reverse Morris Trust transactions
It is common to undertake a section 355 distribution to facilitate the acquisition of a business (Merger) of either Distributing or Controlled by an unrelated third party (Acquiring). One possible way taxpayers can structure the tax-free acquisition of a business is through a Reverse Morris Trust transaction. Broadly speaking, Distributing retains the business that Acquiring does not want to obtain and separates the targeted business in a section 355 distribution.8 Controlled then merges into Acquiring tax-free, and Controlled shareholders receive Acquiring stock.9
There is a major trap for the unwary in Reverse Morris Trust transactions. The post-distribution Merger likely causes the Acquiring shareholders to obtain an indirect equity interest in Controlled through their equity interests in Acquiring. To avoid violating section 355(e), the Merger must be structured so that Controlled shareholders receive over 50% of the Acquiring stock. Accordingly, Controlled must have a higher value than Acquiring at the time of the Merger. Notably, this may limit Distributing’s ability to shift debt to Controlled (see discussion below).
As discussed above, AT&T’s combination of WarnerMedia with Discovery will be structured as a Reverse Morris Trust transaction. AT&T will transfer WarnerMedia to Magallanes, Inc. (Magallanes), a wholly owned subsidiary, in exchange for Magallanes stock, assumption of WarnerMedia liabilities, cash, and Magallanes securities. As part of the same plan, AT&T will distribute the Magallanes common stock to its shareholders. Subsequently, a wholly owned subsidiary of Discovery (MergerSub) will merge into Magallanes. Magallanes will survive as a subsidiary of Discovery, and Magallanes shareholders will receive 71% of Discovery stock. Significantly, it appears that the Magallanes shareholders, who are historic AT&T shareholders, will indirectly control Magallanes through their ownership interest in Discovery.10
Structuring a section 355 transaction to reduce debt
Distributing can often reduce its overall debt in a tax-free manner by shifting its liabilities to Controlled or transferring cash or Controlled stock or securities to its creditors in satisfaction of debt. Companies have found the ability to reduce overall debt levels tax-free in an otherwise tax-free D/355 Reorganization is a potent and effective corporate planning tool. One precedential example of this is Lucent’s 2002 spin-off of Agere. Lucent effectively monetized a portion of its Agere stock by issuing short-term debt shortly before the spin-off and then using Agere stock to satisfy that short-term debt tax-free as part of the spin-off.11
Consider the conventional ways Distributing can shift its debt to Controlled tax-free as part of a D/355 Reorganization:
- Controlled Equity Satisfies Distributing Debt. Distributing contributes assets to Controlled in exchange for a combination of Controlled stock and Controlled securities. Distributing then distributes a controlling amount of Controlled stock and securities to its shareholders. Next, Distributing transfers the remaining Controlled stock and securities to creditors in repayment of Distributing debt. Distributing can reduce its debt in this manner tax-free and is unconstrained by its basis in the assets it transferred to Controlled.12 Distributing is limited by the section 355 requirement that it distribute a controlling equity interest in Controlled to its shareholders (and not its creditors).13
- Controlled Assumes Distributing Debt: Distributing contributes assets to Controlled in exchange for Controlled stock, and Controlled also assumes Distributing debt. Distributing distributes a controlling amount of Controlled stock and securities to its shareholders. This liability assumption can be tax-free to Distributing as long as the assumed debt does not exceed the adjusted basis of the property Distributing transferred to Controlled.14 If Distributing transfers assets to Controlled that have a low adjusted basis, Controlled’s ability to assume Distributing debt tax-free is limited.
- Leveraged Distribution of Cash to Distributing. Distributing contributes assets to Controlled in exchange for both Controlled stock and cash that Controlled borrowed from a third party. Distributing then distributes a controlling amount of Controlled stock and securities to its shareholders. Distributing can receive the cash tax-free provided it is distributed to creditors in repayment of its debt. However, Distributing’s ability to reduce its debt through a leveraged distribution from Controlled also is limited to the adjusted basis of the assets transferred to Controlled, reduced by debt assumed by Controlled.15
A noteworthy aspect of the AT&T/Discovery transaction is that AT&T will receive about $43 billion in the form Magallanes securities, cash, and assumed debt as part of the contribution of WarnerMedia to Magallanes. As such, the transaction apparently utilizes each of the three conventional ways of shifting debt to the separated business. Significantly, AT&T may be able to reduce its debt tax-free--and unconstrained by the adjusted basis of Warner Media assets--by transferring a portion of Magallanes securities to its creditors. The anticipated cash flow from the merger with Discovery appears to enhance AT&T’s ability to shift debt to WarnerMedia.
The proposed combination of WarnerMedia and Discovery illustrates that Reverse Morris Trust transactions continue to be a viable way for taxpayers to facilitate the tax-free acquisition of a business by a third party, even in the context of a divisive reorganization governed by section 355. Such transactions can also be an occasion for highly-leveraged taxpayers to pay off a significant amount of debt. Given the limitation placed on business interest deductions by the Tax Cuts and Jobs Act of 2017, taxpayers may have greater incentive to reduce their reliance on debt financing.