JetBlue-Spirit Deal Includes Pre-Closing Cash

By Stuart E. Leblang, Michael J. Kliegman, and Amy S. Elliott

The long-running battle between rival suitors Frontier Group Holdings, Inc. (NASDAQ:  ULCC)) (Frontier) and JetBlue Airways Corporation (NASDAQ:  JBLU) (JetBlue) to acquire Spirit Airlines, Inc. (NYSE:  SAVE) (Spirit) ended on July 27 with Spirit’s announcement that it and Frontier had terminated their merger agreement and that Spirit had entered into an agreement to be acquired by JetBlue. ¹ The headline price for the JetBlue deal is $3.8 billion, with base consideration of $33.50 per share in cash, to be effected via a reverse subsidiary merger. ² But the deal calls for certain cash payments that will present a good measure of tax uncertainty.

The parties expect to obtain approval of the Spirit shareholders this coming fall, obtain regulatory approval in the fourth quarter of 2023 or the first quarter of 2024 and close no later than the first half of 2024.  Although the Merger Agreement ³ calls for earlier outside closing dates, an outside closing date is set as late as July 24, 2024 if regulatory approvals have not been obtained before then. ^4]

The Merger Agreement calls for certain interim payments to be made to the Spirit shareholders.  Specifically, JetBlue will make the following advance payments:

• $2.50 in cash per share payable immediately upon Spirit shareholder approval of the deal (Approval Prepayment);^[5]and
• assuming the merger is approved by the shareholders, an additional $0.10 in cash per month per share between January 2023 and closing of the deal (Additional Prepayment).

Most of the advance payments (the initial $2.50 and the $0.10 per month) would be prepayments that reduce the $33.50 total consideration.  But the reduction associated with the $0.10 per month payments is capped at $1.15.^[6]Any excess (which would occur if the transaction is consummated after December 2023) would increase the total consideration to as much as $34.15.^[7]

If the parties are not able to consummate the transaction due to antitrust objections, JetBlue will pay a reverse break-up fee of $70 million to Spirit as well as $400 million (less any prepayments to stockholders and equivalent prepayments with respect to restricted stock units) to the Spirit shareholders.^[8]

Tax Treatment of Prepayments

The prepayments in this deal are rather unusual and the associated U.S. federal income tax consequences are unclear.  We expect to see that fact emphasized when Spirit eventually files a proxy statement soliciting a vote on the merger in the fall.  We also expect that the company will at least indicate its view of the matter and include some mild recommendation to its shareholders.

There is a threshold question as to whether the direct payments from JetBlue to the Spirit shareholders before, and irrespective of whether, the merger is consummated will be respected as such or rerouted by the Internal Revenue Service (IRS) as deemed payments made to Spirit followed by distributions by Spirit to its shareholders.  While the parties agree to treat these as direct payments from JetBlue to the Spirit shareholders,^[9]a clear indication that the parties are concerned about an IRS recharacterization is found in Section 5.18(e) of the Merger Agreement.  That provision calls for JetBlue to indemnify Spirit for any adverse corporate tax consequences resulting from the Approval Prepayment or Additional Prepayments being treated as taxable income to the Spirit corporate group.

From a corporate tax standpoint, if the IRS were to successfully argue that any of the prepayments should be treated as first paid to Spirit and then out to its shareholders, the deemed receipt of the payments would be taxable income to Spirit.  Though the immediate cash-tax impact be minimal due to a significant net operating loss (NOL), the above indemnity would kick in at such time in the future when a cash-tax impact would be felt (mainly, by Spirit having to pay income tax because it used NOLs to offset IRS’s recharacterization of the prepayments). ^10]Assuming such an IRS recast, the resulting payments to the shareholders would most likely be treated as dividends.  For U.S. investors, this constructive distribution by Spirit would be taxable as an ordinary dividend to the extent of its current and accumulated earnings and profits (E&P). ¹¹ It should be considered qualified dividend income eligible for the long-term capital gain rate for individuals, assuming they meet the holding period requirements. ¹² For foreign investors, the dividend would be subject to 30 percent withholding tax (unless reduced by an applicable tax treaty).

Bear in mind, however, that any such redetermination by the IRS of the proper tax treatment of the prepayments would presumably not occur until one or more years after the payments have been made.  For domestic taxpayers, their tax years (e.g., 2022 for the Approval Prepayment and 2023 and 2024 for the Additional Prepayments) could still be open to adjusting their tax treatment (which could be better or worse than the treatment of direct payments, discussed below).  But for foreign investors, assuming there has not already been withholding tax taken out of the direct prepayments (discussed below), it is unclear how this would affect the foreign investors or Spirit, which could be liable for uncollected withholding tax.

Clearly, counsel for Spirit was sufficiently troubled by a possible IRS recast of the prepayments to make sure that an indemnity was added to the Merger Agreement.  It was willing to add to that risk by fairly explicitly identifying the risk in the document.  We think the risk is fairly low that the IRS would argue for such a recharacterization of the prepayments, and if they did argue for it, we think it is unlikely that a court would agree.  Without going deeply into the matter in this report, the IRS and courts generally do not recharacterize legal steps in a transaction unless it is clear that the form chosen lacks economic substance and smacks of tax avoidance.  To say that direct payments by JetBlue to the Spirit shareholders should more appropriately be treated as paid to Spirit (which then remitted the money to the shareholders) hardly seems like the true substance of the transaction.  Beyond that, the main transaction at the closing—the reverse subsidiary merger of a JetBlue subsidiary into Spirit—is incontrovertibly treated for tax purposes as a purchase by JetBlue of 100 percent of the outstanding Spirit stock from the shareholders.  Spirit itself, though a party to the Merger Agreement, is ultimately a passive participant— essentially the chattel in the sale transaction. ¹³ 

Now let’s get to the tax treatment of the prepayments on the assumption that they are respected as direct payments from JetBlue to the Spirit shareholders.  We want to flag one point with respect to the monthly $0.10 payments, which are referred to as a “ticking fee” in the companies’ press release and slide presentation but not in the Merger Agreement.¹⁴While these seem to be in the nature of compensation for delays in the receipt of the merger consideration, because they are payments prior to (and irrespective of) closing of the transaction, they should not be treated as interest to the company or to the investors.

Accepting that the prepayments are respected as direct payments from JetBlue to the Spirit shareholders, the IRS could argue that the payment is not a prepayment for the purchase of the company but rather ordinary income.  Specifically, the Approval Prepayment could be viewed as compensation to the shareholders as a group for approving the merger and accordingly taxed as ordinary income.  If so, there would also be a significant risk that, where the payment is made to a foreign investor, it would be subject to 30 percent withholding tax (unless reduced by an applicable treaty).

Moving on, it would generally be desirable, and seemingly appropriate, to treat the Approval Prepayment and Additional Prepayments as in fact prepayments for the sale of Spirit stock, and accordingly, such prepayments should give rise to capital gain treatment.  In the context of a private sale, this would be a strong possibility, where there is no doubt about whether the recipient of the prepayment is the same person who holds and is obligated to sell the property that is the subject of the prepayment.  But a Spirit shareholder will receive the Approval Prepayment provided only that it holds Spirit stock on the record date for the stockholder meeting to vote on the merger.  Similarly, a monthly Additional Prepayment will be paid to each shareholder that holds Spirit stock on the designated record date no more than five business days before the last business day of the month.  In neither case is it necessary that the recipient of the payment be a shareholder at the time the merger closes.

In the context of a private transaction with a prepayment/nonrefundable deposit paid by the buyer to the seller, there is reasonable support to tie receipt of the deposit to the ultimate sale transaction and leave the tax treatment of the up-front payment open until the main transaction closes out, one way or the other.¹⁵ Assuming the sale closes, the deposit/ prepayment is included in the seller’s amount realized in computing its gain or loss.  If the transaction does not go through and the seller retains the deposit and the underlying property, then only at that time is the deposit amount treated as taxable income (and under general tax rules, it would not give rise to capital gain).  This is because capital gain or loss requires a sale or exchange of a capital asset.¹⁶ 

However, Section 1234A of the Internal Revenue Code overrides the general tax rule, providing capital gain treatment for certain transactions involving a capital asset (such as corporate stock) that fail to meet the “sale or exchange” requirement.  It treats as capital the gain or loss attributable to the “cancellation, lapse, expiration, or other termination” of a right or obligation with respect to a capital asset.  Our hypothetical seller that retained a nonrefundable deposit for an agreement to purchase a capital asset after the agreement is terminated should obtain capital gain treatment for the amount of the deposit.

Returning to our situation, the fact that it is a public company situation should not in itself prevent a Spirit shareholder from obtaining open transaction (and, ultimately, capital gain) treatment with respect to the prepayments.  In principle, a stockholder that holds Spirit shares on the record date for the shareholder vote approving the merger and continuously through to closing should be able to include all prepayments along with the merger consideration in computing capital gain or loss from the merger.  Similarly, a stockholder holding Spirit shares on the shareholder vote record date and continuously through to termination of the transaction— for example, due to failure to obtain antitrust approval—should in principle be able to claim capital gain treatment for the prepayments under Section 1234A.

But what of the stockholder that holds Spirit shares on the record date to receive the Approval Prepayment and subsequently sells the shares prior to the merger being either consummated or terminated? While logic may suggest simply adding the prepayment amount to the shareholder’s amount realized in computing its capital gain on the sale of its shares in the market, it is difficult to find authority supporting such an approach.  One might argue that the sale of the Spirit shares has the effect of “terminating” the stockholder’s rights with respect to those shares, triggering Section 1234A treatment for the prepayment that was received.

Given the dynamic nature of public trading in Spirit stock, it will be difficult to comfortably sustain an approach that does not currently tax Spirit shareholders as they receive prepayments.  The prospect of ordinary versus capital gain treatment is a real concern as well, particularly given the likelihood that the Approval Prepayment will be received in 2022 and the sale of the Spirit shares won’t occur until 2023.

For domestic shareholders, this dilemma is foisted primarily on the investors themselves and their tax advisors.  However, for foreign investors facing potential 30-percent withholding tax, there is little or no room for independent judgment, as the withholding agent will withhold from each prepayment absent near certainty.  Accepting that the prepayments are respected as made directly from JetBlue to the Spirit stockholders, absent clear authority to treat the payments as capital gains, there is a significant risk that these would be treated as U.S.-sourced “fixed or determinable annual or periodical” (FDAP) income subject to withholding tax. ¹⁷ 

Tax Treatment of Reverse Break-up Fee

As noted above, if the transaction is terminated as a result of the parties’ inability to obtain antitrust approvals, in addition to a payment to Spirit, JetBlue is to pay a reverse breakup fee to the Spirit shareholders, equal to $400 million less prior prepayments, with the record date for such payment no more than five business days following termination of the transaction.  We think the tax treatment of this payment as capital gain under Section 1234A is more clear than with respect to the prepayments discussed above. ¹⁸ Accordingly, it is reasonably likely that JetBlue and its payment agent will not withhold from this payment to foreign investors.

We think that regardless of whether the transaction is consummated or terminated, prepayments and the reverse breakup fee would be capitalized by JetBlue, rather than deducted as an ordinary business expense.  Assuming the transaction closes, the prepayments would be added to its tax basis in the Spirit shares acquired; if the transaction is terminated, these payments and the reverse breakup fee would give rise to a capital loss, which generally may only be used to offset capital gains.

^{[1] Press Release, Spirit, Spirit Announces Termination of Merger Agreement with Frontier (July 27, 2022) (https://www.sec.gov/Archives/edgar/data/0001498710/000119312522204192/d368049dex991.htm).}

^{[2] Joint Press Release, Spirit and JetBlue, JetBlue and Spirit to Create a National Low-Fare Challenger to the Dominant Big Four Airlines (July 28, 2022) (https://www.sec.gov/Archives/edgar/data/0001498710/000119312522204192/d368049dex992.htm).}

^{[3] Agreement and Plan of Merger among JetBlue, Spirit and Sundown Acquisition Corp. dated as of July 28, 2022 (Merger Agreement) (https://www.sec.gov/Archives/edgar/data/0001498710/000119312522204192/d368049dex21.htm).}

^{[4] See Section 7.1(e) of the Merger Agreement.}

^{[5] Sections 2.1(a) and 5.18(a) of the Merger Agreement.}

^{[6] Sections 2.1(a) and 5.18(c) of the Merger Agreement.}

^{[7] For example, if the transaction closes on February 15, 2024, then the total merger consideration will be $33.65; $2.50 of that will be paid out upon shareholder approval, reducing the $33.50 base; $0.10 /month is paid out during the 13 months from January 2023 through January 2024, but only $1.15 of that $1.30 will reduce the $33.50 base, while the $0.15 difference will be used to increase the total consideration to $33.65. If the transaction did not close until July 24, 2023, then, of the $1.80 total Additional Prepayments, only $1.15 will reduce the $33.50 base, while the other $0.65 will be added to the $33.50, resulting in maximum total consideration of $34.15.}

^{[8] Section 7.2(e) of the Merger Agreement.}

^{[9] Section 5.18(f) of the Merger Agreement.}

^{[10] Spirit’s 2021 Form 10-K states that the company has a federal NOL carryover of approximately $1.1 billion (https://www.sec.gov/ix?doc=/Archives/edgar/data/0001498710/000149871022000088/save-20211231.htm).}

^{[11] While E&P is strictly a creation of tax law, we often look to book earnings as a rough indicator of the level of E&P. Spirit’s retained earnings at Dec. 31, 2021 were approximately $1.06 billion. (https://www.sec.gov/ix?doc=/Archives/edgar/data/0001498710/000149871022000088/save-20211231.htm) Through the second quarter, the company reports a loss of approximately $247 million. Certainly from the standpoint of dividend withholding tax, it makes sense to assume there is ample E&P to cover the amount of deemed distribution associated with an IRS recast of the prepayments.}

^{[12] IRC §1(h)(11).}

^{[13] See Rev. Rul. 90-95; Rev. Rul. 67-448.}

^{[14] Slide Presentation, JetBlue, Bringing Low Fares and Great Service to More Customers, slide 6 (http://mediaroom.jetblue.com/~/media/Files/J/Jetblue-IR-V2/reports-and-presentations/jetblue-spirit-presentation-vf.pdf).}

^{[15] See, e.g., Rev. Rul. 2003-7; Rev. Rul. 78-182; Virginia Iron Coal & Coke Co. v. Comm’r, 37 BTA 195 (1938), aff’d, 99 F.2d 919 (4th Cir. 1938), cert. denied, 307 U.S. 630 (1938). That cases provided, among other things, that “‘the question of whether the payment was to be income or not could not be determined until the sale was completed.’”}

^{[16] IRC §1222.}

^{[17] IRC §871(a)(1).}

^{[18] See CCA 202224010, concluding that payment of a reverse breakup fee by a purchaser gave rise to a capital loss under IRC §1234A.}