What is Reverse Morris Trust (RMT) ?

A Reverse Morris Trust is a form of tax-avoidance strategy in which a company wants to spin-off and later sell unwanted assets, they can do so without paying taxes on any gains made from the sale.

The Reverse Morris Trust is a type of organization that allows a business to merge or acquire a business that was spin-off with another business free of taxes, provided that all legal requirements for a spinoff are met. The technique works in the following manner, a parent company first spins off a subsidiary to which it wants to sell off the unwanted asset than a new, unrelated company is formed by a merger or combined with a business that is interested in acquiring the assets; the new business issues minimum 50.1% of its voting stocks to the shareholder of the parent company. It all starts with a parent company seeking to sell assets to a third-party company and it also result in reorganization and transfer of assets and liability in a tax-efficient manner. RMT is most prevalent in the US.

The subsidiary spin-off provides an opportunity for the parent company to raise capital, monetize its interest in the segment being spun off and then reduce debt.  The difference between Reverse Morris Trust and Morris Trust is that in a Morris trust the parent company gets consolidated with the target company without forming a subsidiary company.

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History of the Reverse Morris Trust

The primary aim of spin-off is to sell off unwanted business or assets and thereby facilitate the planned acquisition of a wanted assets or business.

Reverse Morris Trust is a result of loopholes in a ruling by US court of appeals in 1966 in case of Commissioner v. Mary Archer W. Morris Trust 697 F.2d 794, where the distributing corporation was engaged in two businesses that included insurance and banking. The distributing company transferred the insurance company to new corporation and spun off the stock of the new corporation to its shareholders. It is then merged, for valid, non-tax business reasons, with another bank.

The companies started taking advantages of the loophole and as a result in 1977 internal revenue survey formulated Section 355 for the Reverse Morris Trust giving various requirements that need to be fulfilled to get the tax benefits.   

How a Reverse Morris Trust Works

The Reverse Morris Trust was implemented because of a 1966 ruling in a lawsuit against the Internal Revenue Service, which created a tax inconsistency to avoid taxes when selling unwanted business or assets.

The Reverse Morris Trust starts with a parent company seeking to sell assets or unwanted business to third-party Company. The parent company creates a subsidiary, and the third-party company consolidates to create new entity. The new entity then issues at least 50.1% controlling shares to original parent company’s shareholders.

After its formation the key feature to preserve the tax-free status of a Reverse Morris Trust is shareholders of the parent company holds minimum 50.1% of the value and voting rights of the consolidated entity.  This makes it appealing for third-party businesses that are of same size or smaller than the spun-off subsidiary. Despite a non-controlling stake in the trust, the third-party company has more flexibility in gaining control of its board of directors and appointed senior management.

Why do companies choose a Reverse Morris Trust?

Companies choose Reverse Morris Trust if they are looking to focus on its principal operations and want to sell assets or business in a tax-efficient manner as this enables parent company to raise money and reduce their debt. This type of transactions can help companies that are highly indebted.

Are Reverse Morris Trusts commonly used?

Reverse Morris Trust is not that common as only a few takes place each year. However, dozens of conventional spin-offs are announced in a year. The reason is certain requirements need to be fulfilled before Reverse Morris Trust can be applied. Companies must have produced profits in five years prior to the transaction, among other things.

Advantages

• Avoid corporate taxes on gains

Reverse Morris Trust allows tax planning within the legal boundaries of tax laws.

• Consideration paid is the acquirer’s stock

It makes it attractive for businesses as buyers can give the consideration even in equity shares as well.

• Net Book Value of the Transmission assets remain same

All assets are transferred to third company book value in reverse Morris trust. As a result, it does not result in extraneous rise in the overvaluation of the assets.

• Silent movement of assets

Immediately after selling the shares to the shareholders spin-off of the assets will occur. It will allow the free movements of assets as no further approvals are needed to be taken.

• No change in management

The Reverse Morris Trust will have no impact in the day-to-day operations of the business as there will be no change in management, employees, and assets. So, it is considered as a silent transfer of subsidiaries.

Disadvantage

• Limited scope for issue of consideration in cash

As the threshold of the equity is required to be maintained, consideration will be restricted to equity. So, there will be less scope of monetary issuance of consideration. 

• Limited scope for issue of equity post merger

Even during the post-merger, the original shareholders of the parent company needs to maintain 5% of the ownership.