Friday, August 14, 2015

P&G, Coty And A Unicorn Named Morris



You may know that P&G is streamlining, selling off non-core lines of business. It just concluded a deal to sell 43 beauty brands, including Clairol and Max Factor, to Coty, Inc. The deal appears to be good for Coty, as it will double sales and transform Coty into one of the largest cosmetic companies in the world. P&G in turn receives $12.5 billion.

What makes it interesting to the tax planners is the structure of the deal: P&G is using a “reverse-Morris” structure. It combines a carve-out of unwanted assets (unwanted, in this case, by P&G) with a prearranged merger. The carve-out is nontaxable, but if you err with the merger the carve-out becomes taxable. This is a high stakes game, and woe unto you if the IRS determines that the merger was prearranged. The reverse Morris is designed to directly address a prearranged merger.

Let’s walk through it.

First, what is a “regular” Morris?

Let’s say that you own a successful and publicly-traded company (say Jeb). You have a line of business, which we shall call Lindsey. Someone (“Donald”) wants to buy Lindsey. Jeb could flat-out sell Lindsey, but the corporate taxes might be outrageous. Jeb could alternatively spinoff Lindsey to you, and you in turn could sell to Donald. That would probably be preferable.

Why?

Front and center is the classic tax issue with C corporations: double taxation. If Jeb sells, then Jeb would have corporate taxes. Granted, Jeb would distribute the after-tax proceeds to you, but then you would have individual taxes. The government might wind up being the biggest winner on the deal.

Forget that. Let’s spinoff Lindsey tax-free to you, and you sell to Donald. There would be one tax hit (yours), which is a big improvement over where we were a moment ago.

But you cannot do that.

You see, under regular corporate tax rules a tax-free merger with Donald within two years of a spinoff would trigger BAD tax consequences. We are talking about the spinoff being retroactively taxable to Jeb. Jeb will have to amend its tax return and write a big check. That is BAD.

I suppose you could tell Donald to take a hike for a couple of years while you reset the clock. Good luck with that.

You talk to your accountant (“Hillary”). She recommends that you have Jeb borrow a lot of money. You then drop Lindsey into a new subsidiary and spinoff new Lindsey to you. You leave the debt in Jeb. You then sell Jeb to Donald. Donald takes over the debt. He doesn’t care. Donald just offsets whatever he was going to pay you by that debt.

This is a Morris deal and Congress did not like it. It looked very much like a payday.

  • The cash is in Lindsey
  • The debt is in Jeb
  • You sell Jeb
  • You keep Lindsey
  • You keep the money that is in Lindsey
  • The government doesn’t get any money from anybody

The government was not getting its vig. Congress in response wrote a new section into the tax Code (Section 355(e)) which triggers gain if more than 50% control of either the parent or subsidiary changes hands. 

Yep, that pretty much will shut down a Morris deal. Donald wants more than 50% control. Donald is like that.

Now, Section 355(e) presented a challenge to the tax attorneys and CPAs. Think of it as an epic confrontation between a chromatic Great Wyrm and your 28th level paladin at the weekly Saturday night D&D game. The players were not backing down. No way.



So someone said “the deal will work if the buyer will accept less than 50% control.”

Eureka!

Let’s take our example above and introduce a different buyer (let’s call him Bernie). Bernie wants to buy Lindsey. Bernie is willing to accept less than 50%, as contrasted to that meanie Donald. Same as before, let’s drop Lindsey into a new subsidiary. New Lindsey borrows a lot of money and ships it to Jeb. New Lindsey, now laden with debt, is sold to Bernie. Bernie takes over the debt as part of the deal. When the dust settles, Bernie will own less than 50% of new Lindsey, which gets us out of the Section 355(e) dilemma.

You in turn keep Jeb and the cash.

And that is the reverse Morris. We sidestep Section 355(e) by not allowing more than 50% of either Jeb or Lindsey to change hands.


Why do we not see reverse Morris deals more often? There are three key reasons:

  1. It requires a buyer that is smaller than the target, but not so small that it cannot do the deal. 
  2. There will be new debt, likely significant. This raises the business risk associated with the deal, as the bank is going to want its money back.
  3. The new company’s management and board may be an issue. After all, the buyer BOUGHT the company. It is not unreasonable that Bernie wants to control what he just bought. I would want to drive the new car I just bought and paid for.
The Reimann family of Germany owns approximately two-thirds of Coty. Even though Coty is acquiring less than 50% of the P&G subsidiary, the Reimann’s will own a large enough block of stock to have effective control. That must have helped make the reverse Morris attractive to Coty.

Reverse Morris deals are not unicorns, but there have been less than 40 of them to-date. That makes them rare enough that the tax specialists look up from their shoes when one trots out. P&G by itself has had three of them over the last ten or so years. Someone at P&G likes this technique.

No comments:

Post a Comment