Recent publicity in Newsweek magazine (The Double Dummy Can Be Very Smart, March 2007) about the 2007 sale by McClatchy Newspapers of its Minneapolis newspaper business has drawn attention to an acquisition model that originated in the ’70s. The tax advantage realized by McClatchy on the sale has led several commentators to ask why the old acquisition model is not more widely used. By one account, fewer? than one percent of acquisitions since 1996 have utilized this model.

The model in question goes by the esoteric name of “horizontal double dummy.” It has its roots in the 1978 acquisition of National Starch by Unilever. This acquisition is better known as INDOPCO, the name of the tax controversy decided by the Supreme Court in 1992. Interestingly, the Supreme Court case had nothing to do with the acquisition model, but dealt with the treatment of $2.75 million of investment banking fees incurred by National Starch in putting together the deal. Later, the eponymous INDOPCO regs dealt with the treatment of intangible expenses globally. T.D. 9107 (1/5/04). See my previous article on the INDOPCO regulations.

As with many acquisition models, the National Starch deal was a creature of necessity. The elderly principal shareholder in National Starch refused to accept cash for his stock, the deal of choice for more than 80 percent of National Starch shareholders. The reluctance of the senior citizen was completely understandable: His 14 percent stake was founder’s stock with a very low basis, so a cash-for-stock deal would have saddled him with a big tax bill. But, if tax-free, a stock-for-stock deal might soon morph into a new basis for his stock upon his not-too-distant death. The challenge for the tax advisers was to craft a deal that satisfied the diverse interests of the National Starch shareholders.

A traditional reorganization, such as a merger, of National Starch into Unilever was a non-starter because of the amount of dollars needed to satisfy the National Starch shareholders who wanted to cash out. At the time, the maximum amount of cash permitted in a merger (according to IRS, and thus to conservative tax advisers also) was 50 percent of the total cap value of a target. Today, the max has been raised to 60 percent. View my past article on this topic.

If the reorganization route is closed off, where can tax advisers find safe passage? How about the hoariest of Code sections in Subchapter C, the starting point for any introductory corporate tax course, section 351? The parameters of section 351 are well-known to even baby tax students: a transfer of property to a corporation, either new or existing, is tax-free for the stock received by the transferors if they are in “control” (80% of the transferee) immediately after the transfer. Any cash (“boot”) received by the transferors would be taxable but the amount of cash used in the deal is not limited to 50 percent, etc., as it was in a merger back then. (Note: At one point during the 80s IRS asserted that the same 50 percent limit on boot applied to section 351 transactions but that position was short-lived — see Rev. Rul. 80-284, revoked by Rev. Rul. 84-71.).

If more than 80 percent of the consideration for National Starch stock could consist of cash, the way was open to use section 351 as an acquisition vehicle, not exactly what Congress had in mind when the predecessor of section 351 was enacted to accommodate routine incorporations of sole proprietorships. But seeing the possibility of using one Code section for a totally different purpose is what separates the creative tax adviser from the rest of us drones.

The 1978 section 351 transaction used by Unilever involved a joint transfer to a new holding company by Unilever and the National Starch shareholders, 86 percent of whom took cash; while the senior citizen received holding company stock. In the 1998 section 351 transaction used by McClatchy to acquire Cowles Publishing, the shareholders of McClatchy and Cowles Publishing transferred their respective stock interests to a new holding company. The McClatchy shareholders all got holding company stock. Fifteen percent of Cowles shareholders took holding company stock; the majority 85 percent took cash, almost $1 billion.

Importance of McClatchy Deal

If you’ve gotten this far, you might be thinking all this fancy footwork is devilishly fascinating to M&A types, but where’s the sizzle? Why all the buzz about the McClatchy deal? The answer lies below the shareholder level, at the link between the holding company and its subsidiary, Cowles.

What basis did the holding company obtain in Cowles? That basis consists of two pieces. The first is a carryover piece, the basis that the Cowles shareholders had in their stock, probably not a box car number. The second piece is the big enchilada: The “boot” distributed to the Cowles shareholders who cashed out for a total of $1 billion. Section 362(a). Including $1 billion in the basis of Cowles stock came in awfully handy this year when the holding company sold Cowles. The increased basis enabled McClatchy to recognize a reported $500 million capital loss which, not coincidentally, was used to shelter a comparable amount of capital gains. That’s the reason why the McClatchy deal garnered the pub in the financial press. Sort of the tax equivalent of making a silk purse, etc.

A final note: Some may wonder, what’s the magic in using section 351 (as opposed to a merger) as an acquisition vehicle? The answer is BASIS. While it’s true that boot is allowed in a merger (up to 60 percent), the acquiring corporation in a merger does not obtain basis for the boot. That’s because the gain recognized on the boot distributed in a merger is not recognized by the transferor, i.e., the target transferring its assets to the acquiring corporation. Instead, the boot is recognized by the shareholders of target. Their gain recognition is ignored by section 362(b).

Some Closing Observations

• It’s axiomatic in our tax system that taxpayers obtain basis for the cost of acquiring property. Clearly, the boot distributed by McClatchy was the major cost of acquiring Cowles in 1998. So why shouldn’t McClatchy get a basis “bump” for the boot? Yet that would not have been the result in a garden-variety reorganization (assuming the amount of boot could be reduced to a tolerable level). Rather it took the ingenuity of McClatchy’s tax advisers to craft a deal that produced basis for McClatchy, while also yielding tax-free treatment for those receiving McClatchy stock.

• Was it likely that a basis “bump” was paramount to McClatchy in 1998? Probably not. How many acquiring corporations go into a deal, contemplating a later sale at a loss? Surely not many, but what’s the downside to constructing a deal that produces basis, just in case. It’s sort of like a pre-nuptial agreement; it can’t hurt (unless, of course, you’re on the wrong end of the agreement, like K-Fed).

• Is McClatchy’s reported $500 million-plus capital loss the tax equivalent of turning base metals into gold? Hasn’t McClatchy suffered a genuine economic loss that should be recognizable under our system? As Wall Street knows only too well, the newspaper business today sucks.

• And yet … the media accounts of the McClatchy sell-off make no mention of a possible application of the consolidated return regulations to McClatchy’s capital loss on Cowles stock, an application that might bar recognition of part (or all) of the loss. Perhaps, McClatchy does not file a consolidated return. But, if it does, claiming a loss on the sale of subsidiary stock is the tax equivalent of the proverbial camel passing through the eye of a needle. It requires running the gauntlet of the loss disallowance rules (LDR). It’s well to keep in the mind that the tax advisers who devised the Black & Decker contingent liability tax shelter made sure that the B&D consolidated return did not include the sub whose stock was sold (to produce the would-be capital loss of $560 million). The stock ownership of the B&D sub was carefully crafted to insure its exclusion (“include me out,” in the words of the great Hollywood philosopher, Sam Goldwyn). There was no way for B&D to justify the loss on the sub stock as a genuine economic loss (à la Rite Aid v. US, 255 F.3d 1357 (2001)), when the stock was underwater from the moment of inception, with an asserted basis of $561 million and a fair market value (FMV) of $1 million.

George L. White, a CPA and attorney, is with the AICPA Tax Division, Washington, D.C. office. His duties include acting as liaison to the Tax Accounting Technical Resource Panel and Corporations and Shareholders Technical Resource Panel. He is a retired tax partner from Ernst & Young, and a prolific author and editor. He holds a B.A. from Holy Cross College, an M.B.A. from the University of Pennsylvania, and an LL.B. from Harvard University.