INSIGHT: Overlapping Ownership Rule Protects EchoStar From Gain Recognition

EchoStar Corp. intends to spin off its broadcast satellite services business to its parent, DISH Network Corp. in a “Reverse Morris Trust” transaction to avoid any tax on the gain.

Pursuant to the Master Transaction Agreement, EchoStar will first carry out an “internal reorganization” in which what is referred to as the “BSS Business” will be transferred to Newco in exchange for all of the stock of Newco. EchoStar will then distribute all outstanding shares of common stock of Newco, on a pro rata basis, to the holders of record of its Class A and Class B common stock. Immediately thereafter BSS Merger Sub Inc. will merge with and into Newco, such that, upon completion of this “reverse triangular merger,” BSS Merger Sub will cease its separate legal existence and Newco will continue as a direct wholly-owned subsidiary of DISH.

As consideration for the merger, shares of Newco common stock will be automatically converted into the right to receive, and will be exchangeable for, newly issued shares of Class A common stock of DISH. In particular, DISH will be issuing an additional 22.9 million shares of its Class A common stock to EchoStar’s shareholders (to whom the stock of Newco was distributed in the distribution). The transactions are intended to be structured as a tax-free spin-off and merger. It certainly appears that this goal will be realized.

Part of a Plan

Assuming the distribution qualifies as a transaction that is tax-free for U.S. federal income tax purposes under tax code Sections 355 and 368(a)(1)(D)—(i) the distribution will not result in the recognition of income, gain or loss to EchoStar or Newco; and (ii) U.S. holders of EchoStar common stock will not recognize income, gain, or loss upon the receipt of Newco common stock in the distribution. Assuming the merger qualifies as a reorganization within the meaning of Section 368(a), no gain or loss will be recognized by DISH, EchoStar, or Newco as a result of the merger; and no gain or loss will be recognized by a Newco shareholder as a result of the merger.

There is no doubt that the merger qualifies as a reorganization. In fact, since the sole consideration to be issued in the merger is voting stock of DISH, the merger should qualify, simultaneously, as an ‘A’ reorganization (by reason of Section 368(a)(2)(E)) and, once the transitory existence of BSS Merger Sub is disregarded, as a ‘B’ reorganization.

The tax-free nature of the distribution—at least at the EchoStar level—is not quite so obvious. The SEC Form S-4 points out that: “Even if the Distribution otherwise qualifies for the Intended Tax Treatment, the Distribution would be taxable to EchoStar pursuant to Sec. 355(e) of the Code if one or more persons acquire a 50% or greater interest (measured by vote or value) in the stock of EchoStar or Newco, directly or indirectly…as part of a plan or series of related transactions that includes the Distribution.” (Emphasis added.)

As is the case with all Reverse Morris Trust transactions, in the instant case it is conceded that, for purposes of this test, “the merger will be treated as part of a plan,” that includes the distribution. That concession would appear to be problematic, as regards the application of Section 355(e), since DISH is only issuing about 5% of its stock in the merger, with the result that “one or more persons,” i.e., the shareholders of DISH, will be acquiring (as part of the plan which includes the distribution) stock representing an approximate 95% interest in Newco.

In determining the DISH shareholders’ ownership of Newco stock, the attribution rules of Section 318(a) apply—in particular, Section 318(a)(2) attributes to those shareholders DISH’s ownership of Newco’s stock in proportion to their ownership of DISH stock, since Section 318(a)(2)(C) shall be applied, for this purpose, without regard to the phrase, “50 percent or more in value”.

Overlapping Ownership

It appears, however, that the so-called “overlapping ownership” rule will enable EchoStar to avoid gain recognition with respect to its distribution of Newco’s stock. The S-4 states that the merger will be treated as part of a plan (which includes the distribution), but because the EchoStar shareholders will collectively own more than 50% of DISH’s common stock following the transactions, the merger, standing alone, will not cause the distribution to be taxable to EchoStar under Section 355(e).

There is, of course, a substantial amount of common ownership, most notably on the part of the Ergen family, with respect to DISH and EchoStar. That, in turn, depending on the extent of the common ownership, can eliminate what appears to be an insuperable Section 355(e) problem. Thus, Section 355(e) provides that “if there is a distribution to which this subsection applies, any stock or securities in the controlled corporation [i.e., Newco] shall not be treated as qualified property for purposes” of Section 361(c)(2). That means that the distributing corporation will recognize gain on the distribution of the controlled corporation’s stock as if such stock had been sold to the shareholders of the distributing corporation for its fair market value. This subsection applies to any distribution—to which Section 355 otherwise applies—and which is part of a plan (or series of related transactions) pursuant to which one or more persons acquire directly or indirectly stock representing a 50% or greater interest in the distributing corporation or in any controlled corporation.

Here, it appears that the requisite one or more persons, i.e., the shareholders of DISH, are acquiring, indirectly, through their ownership of DISH stock, an approximate 95% interest in Newco, the controlled corporation in the distribution. Moreover, this “acquisition” is occurring as part of the plan which includes the distribution.

However, certain acquisitions are not taken into account in determining whether a sufficient amount of stock of the controlled corporation to activate Section 355(e) has been acquired. In particular, Section 355(e)(3)(A)(iv) provides that the following acquisitions shall not be taken into account—"...the acquisition of stock in the distributing corporation or any controlled corporation to the extent that the percentage of stock owned directly or indirectly in such by each person owning stock in such corporation immediately before the distribution does not decrease....” (Emphasis added.) Thus, in determining the application of Section 355(e), the increase in ownership of Newco on the part of the DISH shareholders is determined after subtracting therefrom the decrease in such ownership on the part of those DISH shareholders who are also shareholders of EchoStar.

On the one hand, these overlapping owners are increasing their ownership of Newco stock, as a result of their ownership of DISH stock, but, on the other hand, their ownership of Newco stock immediately before the distribution (via their ownership of C stock) is decreasing. To implement the overlapping ownership rule, the Internal Revenue Service requires that the decreases be netted against the increases in assessing whether one or more persons have acquired, indirectly, the requisite interest in the stock of the controlled corporation. See IRS Private Letter Ruling 201740015, Feb. 14, 2017, addressing the application of the overlapping ownership rule with respect to the spin-offs accomplished by DowDuPont following the merger of Dow Chemical and DuPont.

Thus, the overlapping ownership rule can certainly cure what appears to be an incurable Section 355(e) problem. It should be noted, however, that such overlapping ownership, if it is to render Section 355(e) inapplicable, must be “old and cold.” The flush language of Section 355(e)(3) admonishes that “this subparagraph shall not apply to any acquisition if the stock held before the acquisition was acquired pursuant to a plan (or series of related transactions) described in paragraph (2)(A)(ii).” In other words, the overlapping ownership cannot be created on the eve of the transaction for the principal purpose of exempting the transaction from the rigors of Section 355(e).

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.