As a tax-avoidance strategy, the Reverse Morris Trust allows a corporation to spin off property, corporate divisions, and other assets without having the profits from the sale taxed. The Reverse Morris Trust is a variation of the Morris Trust. For a tax-free spinoff like the Morris Trust to work, there must be a parent company selling assets, a subsidiary, and an external buyer unrelated to the parent company; financial legislation regarding such deals must also be adhered to. In a Morris Trust, the parent company places all assets not involved in the transaction in a new publicly traded company and allows the purchasing company to merge with the remaining assets. A Reverse Morris Trust differs because the subsidiary of the parent company is created using the assets being dealt and is subsequently merged with the buyer.
The Reverse Morris Trust is favored over the Morris Trust because it provides a less convoluted way for the transaction to be completed. Such a deal must be structured a certain way and satisfy certain regulations before being approved by mergers and acquisitions regulators, however. These policies exist to prevent tax evasion and ensure that shareholders in the parent company are not defrauded.
The 50% Test is the biggest determinant of a Reverse Morris Trust’s legality. Under this test, the shareholders of the parent company must have more than 50% ownership in the merged company. When an individual purchases stock in a publicly traded company, she effectively becomes part owner of the business and has a claim on all assets and earnings. She may even be issued a share certificate or paid a dividend, however most shareholders do not have the right to regular income payments and cannot influence managerial decisions like the Reverse Morris Trust. Government regulators enacted the 50% rule to ensure that shareholders' claims to such assets are recognized despite the merger.
For example, assume Company A signs a contract with Company B to sell assets. Rather than pay taxes on the gains, Company A can include a closing condition that allows it to spin off the assets into a new company known as Company C. Since the shareholders have a claim to such assets, they have a 100% vested interest in Company C. To ensure fairness and prevent fraud, when Company B merges with Company C, the shareholders of Company A need more than a 50% stake in the merged company. Without such rules, there is nothing stopping the management of Company A from spinning off the company’s most valued assets and pocketing the profits at the expense of shareholder’s equity.
