Rexnord-Regal Beloit Plan to Make RMT Numbers Work with Shareholder Overlap and ‘Skinny-Down’ Dividend

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

Mechanical components and plumbing parts manufacturer Rexnord Corporation (NYSE:  RXN) (Rexnord) announced in February^[1]that it plans to separate its Process & Motion Control segment in a tax-free spin-off to its shareholders and then immediately combine Spinco^[2]with electric motor manufacturer Regal Beloit Corporation (NYSE:  RBC) (Regal Beloit) in a so-called reverse Morris Trust^[3](RMT) transaction expected to close late in the third quarter or early in the fourth quarter of 2021.^[4]

Initially, the newly combined entity (New Regal^[5]) would be expected to be 61.4 percent owned by former Regal Beloit shareholders and 38.6 percent owned by Rexnord shareholders.  But former Regal Beloit shareholders will receive a special dividend (which will correspondingly increase the portion of the combined entity owned by Rexnord shareholders to over 50 percent) of around $300 million in the aggregate “to ensure that RMT ownership requirements are met.”^[6] The transaction is subject approval by shareholders of both Rexnord and Regal Beloit at special meetings scheduled for September 1.

The transactions (the reorganization, spin-off and merger) should qualify as tax-free such that shareholders generally should not recognize any gain or loss for U.S. federal income tax purposes, although the special dividend will give rise to taxable income to former Regal Beloit shareholders (and those who are foreign will generally be subject to 30 percent withholding).  Rexnord investors should be aware that the stock will be trading under New York Stock Exchange’s due-bill procedures, which generally provide that a post-record date purchaser of stock at a market price reflecting the value of an impending distribution (in this case, the Spinco stock) is entitled to receive the distribution from the seller when it is paid by the issuer.^[7]

An RMT, which takes the form of a tax-free spin-off followed by a pre-arranged tax-free merger, is only tax-free at the spin-off stage as long as (in this case) Rexnord shareholders end up retaining more than 50 percent of the post-merger company (in this case, New Regal).^[8] While the initial (before the adjustments) estimated 38.6 percent ownership of New Regal by Rexnord shareholders falls below the greater-than-50-percent ownership threshold^[9]required for an RMT, there are two reasons why such threshold should ultimately be achieved in this case.

First, there is apparently a significant number of shareholders who currently own both Rexnord stock and Regal Beloit stock.  These overlapping shareholders will make it easier to achieve the greater-than-50-percent threshold, because any ownership of New Regal by former Regal Beloit shareholders who also own stock in Rexnord will push the initial estimated 38.6 percent ownership higher.^[10]  A quick review of recently filed quarterly Forms 13F confirms that funds such as Vanguard Group Inc. and BlackRock Inc. hold significant stakes in both entities.^[11]

The parties are seeking a private letter ruling from the Internal Revenue Service (IRS) “on the substantive and procedural criteria that may be used”^[12]to calculate the overlapping shareholders.  The IRS has issued at least one such ruling in the past.  Specifically, LTR 201740015^[13]addressed how to measure shareholder overlap.  Although the identity of the taxpayer was redacted, it is believed that the ruling is addressing the merger and spin-offs planned by DowDuPont Inc. (NYSE:  DWDP), as there were a sizeable number of shareholders that owned both stock in the Dow Chemical Company and E. I. du Pont de Nemours and Company.  For this report, we will refer to LTR 201740015 as the DowDuPont ruling.

According to the definitive proxy, a memorandum was submitted to the IRS on January 22 in advance of a January 29 pre-submission conference call with the IRS “to discuss the contents and potential scope of the parties’ proposed private letter ruling from the IRS.”^[14] The ruling request was then submitted March 17.  A six-month turnaround from ruling submission to receipt in the context of a ruling addressing Internal Revenue Code (IRC) Section 355(e) counting issues seems reasonable to us.  Although receipt of a favorable ruling is not a condition of the deal, without such guidance from the IRS, “Rexnord will not be able to make the assumptions about beneficial ownership needed to treat specified investors as Overlap Shareholders.” Because of this, the parties are also relying on an adjustment mechanism.

The adjustment mechanism is the second approach the parties are taking to make sure they are on the right side of the 50-percent test.  It will take the form of an expected special dividend to Regal Beloit shareholders determined at closing that is designed to “skinny down” the equity of the acquiror, making up for any shortfall after the overlapping shareholders are taken into account.  Based on current information on the amount of shareholder overlap, the parties expect that some amount (likely between about $100 million and $500 million) of a special dividend will be necessary.  However, the dividend could go as high as $1.95 billion if the shareholder overlap disappears before closing “or in the absence of a tax ruling from the IRS” (such a dividend would reduce Regal Beloit shareholders’ ownership from 61.4 percent to 49.9 percent).^[15] For perspective, a $300 million aggregate special dividend to Regal Beloit shareholders works out to about $7.37 per shareholder (or as much as $47.92 per shareholder if the dividend is $1.95 billion).^[16]

Testing for Overlap—How and When?

In general, whether the post-spin merger caused a 50-percent change in the shareholders of either company is determined by looking to the ownership information at the time of closing.  The DowDuPont ruling made clear that if a taxpayer doesn’t have actual knowledge of the overlapping shareholders, it can rely on publicly available information (such as Forms 13F) provided for the most recent filings made prior to the closing date and following the closing date (to determine the percentage change).  It should be noted that there is an important disparity between the information that the Securities and Exchange Commission (SEC) looks for in Form 13F filings and what the IRS needs to see.  A mutual fund manager may make a combined filing for numerous mutual funds it manages, while—for tax purposes—each mutual fund is generally regarded as a separate owner.  Therefore, we expect that this information will have to be distilled by the company to satisfy the IRS about the shareholder overlaps.^[17]

We do not have any reason to think that the parties may not be able to obtain a favorable IRS ruling regarding the method for counting shareholder overlap in time for the expected fourth quarter closing.  However, the merger agreement contemplates the possibility that the IRS may decline to issue the requested ruling or that the ruling request may be withdrawn.  In that case, the deal can proceed with no credit for shareholder overlap and the $1.95 billion dividend.

Tax Treatment of the Dividend

The “skinny-down” distribution is planned to be a pro-rata dividend.  As such, foreign investors in Regal Beloit should expect U.S. withholding tax on the distribution.  As is often the case, the distribution could, instead, be structured in a way as to enable foreign investors to avoid withholding tax by making the distribution a redemption of stock rather than a dividend.  Even as a pro-rata distribution, if it can be arranged for each shareholder’s nominal share holdings to be reduced, then they should be able to test that redemption by reference to the post-merger percentage owned in Regal Beloit, presumably meeting the more-than-20-percent safe harbor under IRC Section 302(b)(2).  This could potentially be incorporated into the terms of the merger.

^{[1] Joint Press Release, Regal and Rexnord, Regal to Combine with Rexnord’s PMC Segment, Creating World-Class Power Transmission Provider (Feb. 16, 2021) (https://s1.q4cdn.com/233624116/files/doc_downloads/2021/Regal-Rexnord-Joint- Release_FINAL_02.15.21.pdf).}

^{[2] Specifically, Phoenix 2021, Inc. (a newly-formed, wholly-owned subsidiary of Regal Beloit also referred to as Merger Sub) will merge with and into Spinco (technically, Land Newco, Inc., which, before it was spun off, was Rexnord’s indirect, wholly-owned subsidiary).  When the dust settles, Land Newco, Inc. (which holds the PMC Business) will be a wholly-owned subsidiary of Regal Beloit.}

^{[3] Commissioner v. Morris Trust, 367 F.2d 794 (4th Cir. 1966).}

^{[4] https://www.sec.gov/Archives/edgar/data/82811/000110465921097608/tm2114810d16_425.htm}

^{[5] Technically, following the combination, Regal Beloit will change its legal name from “Regal Beloit Corporation” to “Regal Rexnord Corporation,” but for this report we will use New Regal to describe the combined entity.}

^{[6] Supra note 1.}

^{[7] In general, the tax consequences of due-bill trading are as follows (although it is somewhat different in the context of a cash distribution).  If Investor A acquired the Rexnord stock from Investor B (the holder of the Rexnord stock on the record date for the spin distribution) under a due‐bill procedure, then while Investor B will nominally receive the Spinco stock and participate in the merger, the Spinco stock will actually be remitted to Investor A (assuming he held it through the ex‐dividend date).  So Investor B will be treated as receiving the stock for tax purposes and effectively selling it to Investor A.}

^{[8] IRS §355(e)(2)(A)(ii).}

^{[9] Per IRC §355(d)(4), 50-percent or greater interest is defined as “stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or at least 50 percent of the total value of shares of all classes of stock.”}

^{[10] According to the definitive proxy statement filed by the parties July 21, 2021, “because the Internal Revenue Code permits parties to a Reverse Morris Trust to count towards the required tax-free status Reverse Morris Trust majority ownership requirement certain shares of the acquiring company in a Reverse Morris Trust that are owned by shareholders that own shares of both the acquiring company and the counterparty to the Reverse Morris Trust, the number of shares of Regal common stock that Regal would be required to issue to satisfy the tax-free Reverse Morris Trust majority ownership requirement could be meaningfully reduced through the application of this principle.” (https://www.sec.gov/Archives/edgar/data/1439288/000110465921094235/tm2115389-13_defm14a.htm)}

^{[11] https://www.sec.gov/Archives/edgar/data/1364742/000108636421000004/xslForm13F_X01/form13fInfoTable.xml and https://www.sec.gov/Archives/edgar/data/102909/000110465921066511/xslForm13F_X01/infotable.xm}

^{[12] Definitive Proxy Statement filed July 21, 2021 (https://www.sec.gov/Archives/edgar/data/1439288/000110465921094235/tm2115389-13_defm14a.htm).}

^{[13] LTR 201740015 is available at https://www.irs.gov/pub/irs-wd/201740015.pdf.}

^{[14] Supra, note 8.}

^{[15] Presentation, Regal Beloit, Merger with Rexnord PMC Business (Feb. 16, 2021) (https://regalbeloit.q4cdn.com/342045820/files/doc_financials/2020/q4/RBC-RXN-Investor-Call_FINAL_02.16.21.pdf).}

^{[16] As of June 30, 2021, Regal Beloit had 40,695,041 shares outstanding; $300 million / 40,695,041 = about $7.37; $1.96 billion / 40,695,041 = about $47.92.  However, the numbers in the definitive proxy are a bit different (assuming a maximum dividend of $1.96 billion or a maximum per-share payout of $48.16).}

^{[17] The IRS has frequently ruled that a taxpayer may rely on information contained in SEC filings to determine the existence of 5-percent shareholders in the context of ownership changes under section 382 (specifically, when an SEC filing reports ownership on behalf of two or more owners of stock but does not affirm the existence of a group, the taxpayer can rely on the absence of the filing of a Schedule 13D or 13G by such owners to determine that such owners are not members of a group that constitutes an entity within the meaning of Section 382 unless the taxpayer has actual knowledge to the contrary).  See PLR 200902007 and PLR 200818020, stating that the investment adviser is not considered the economic owner of stock for purposes of IRC §382.}