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What Happened with the AOL/CompuServe Talks?
by Jim Surowiecki (Surowiecki)

NEW YORK, NY. (Apr. 24, 1997) -- As recently as a week ago, the proposed acquisition of COMPUSERVE (Nasdaq: CSRV) by AMERICA ONLINE (NYSE: AOL) looked to be an almost sure thing. For shareholders of both CompuServe and H&R BLOCK, the rather unlikely parent company which owns 80% of CompuServe, that was very good news. But it now seems almost certain that the deal has hit a permanent snag on some proposed federal legislation to seal up a tax loophole that for three decades has allowed acquisitions to go through on a tax-free basis. This has changed the financial fundamentals of the deal to the point that it no longer makes sense, and both companies appear to be walking away from the table.

For nearly a year now, H&R Block has been trying to divest itself of its entire CompuServe stake. Last year, it had planned to offer the stake in an IPO, but a sharp tumble in CompuServe's share price, coupled with a more general Wall Street malaise about new offerings, put an end to that idea. Investors' flight from CompuServe stock reflected both the flip side of their previous infatuation with anything Internet-related and, more substantively, serious doubts about CompuServe's ability to compete against companies like MICROSOFT (Nasdaq: MSFT) and AOL.

CompuServe's woes have only continued over the last six months. The company announced that it was discontinuing WOW!, the family-friendly version of Internet access that was designed only for Windows 95 users. It suggested that it was re-centering its business around business users, and it brought in new management, although it has not had a CEO for several months now. Although the company has fallen to less than a third of its initial public offering (IPO) price, CompuServe still does have some assets of value. The online subscription part still has more than a two and a half million subscribers in the United States and remains the biggest American player in the European market. The crown jewel of the company remains its network services business.

Compuserve's elaborate infrastructure of modems and high-speed lines would be an important addition to any Internet service. Its network services to business are growing revenues at a 25% annualized rate, despite the well-publicized woes of the rest of the company. At a time when AOL has been struggling to add modems fast enough to meet consumer demand, the technical benefits of an acquisition of CompuServe would not have been negligible. With America Online actively considering a public offering of subsidiary ANS at some point in the future, CompuServe's network services business would not have been without value. In fact, AT&T (NYSE: T) offered to buy CompuServe's modems and lines when it became clear that the company was, so to speak, on the block. But H&R Block held off, in no small part because the very provision that the proposed federal law would repeal made it enormously advantageous to sell the company as a whole, rather than auctioning off its various parts.

What is this tax loophole that makes H&R Block want to sell off all of CompuServe, rather than dice it up piecemeal? The tax loophole that Congress is now attempting to close has to do with so-called "Morris Trust transactions." These transactions involve the restructuring of one company so that it is able to sell part of itself to another firm without paying any taxes on the deal. In this case, it would be H&R Block that would benefit from the Morris Trust provision as it would be selling its majority stake in former subsidiary CompuServe without any tax penalties. Morris Trust transactions are often termed "nonsale sales" because of the lack of tax consequences and are specifically designed to take advantage of a three-decade-old Supreme Court ruling that exempted these deals from taxation.

When two companies merge in a stock-for-stock swap, as U.S. ROBOTICS (Nasdaq: USRX) and 3COM (Nasdaq: COMS) will later this year, the new company generally does not have to pay taxes. When one company acquires a division of another company with cash, though, the transaction is taxable. What the Morris Trust structure does is allow the selling company to spin off the part of the company that isn't being sold. The buyer then acquires the remainder of the company -- which is to say, the division it really wanted in the first place -- by paying in stock and acquiring an agreed-upon level of debt that remains with the "old" company. H&R Block would get rid of CompuServe and some of its debt, AOL would get CompuServe, and neither would pay any taxes.

Although these deals have been legal since the 1960s, it was not until this decade, when restructuring and spinning off became corporate dogma, that Morris Trust transactions took place with regularity. This year alone, RAYTHEON (NYSE: RTN) spent $9.5 billion to acquire Hughes Electronics' defense business; AEGON NV (NYSE: AEG) spent $3.5 billion to buy PROVIDIAN's (NYSE: PVN) insurance business; KNIGHT-RIDDER (NYSE: KRI) bought four newspapers from WALT DISNEY (NYSE:DIS) for $1.65 billion; and, most recently, AIRTOUCH (NYSE: ATI) agreed to buy US WEST's (NYSE: USW) cellular business. Although none of these deals have been completed, both the Senate and House versions of the repeal bill contain a grandfather clause that would allow them to go through unscathed. All Morris Trust transactions announced by April 16 will be permitted to go ahead. That, of course, leaves out any AOL-CompuServe transaction. According to Dow Jones, both AOL and H&R Block are lobbying Congress for an exemption to the law, but the possibility of success is uncertain.

What makes the Morris Trust repeal particularly interesting is that in it one can see the campaign against so-called "corporate welfare" bearing its first fruits. The federal tax code is littered with exceptions and exemptions that allow corporations to get unintended tax breaks, and the recent budget-balancing fervor has led congressmen on both sides of the aisle to look at these provisions more closely. This legislation, in fact, was sponsored in the House by conservative Rep. Bill Archer, head of the Ways and Means Committee, and in the Senate by William Roth of Delaware, the Republican head of the Finance Committee, and by Democrat Daniel Moynihan of New York. As a bipartisan endeavor, it is essentially certain to pass. Roth and Moynihan were clear in their statement on the bill, arguing that Congress had designed the original statute to allow corporations some flexibility in restructuring their businesses internally, and that it had never been meant to "insulate" sales from taxation.

"The recent transactions that raise concerns have very little to do with individual shareholder tax planning," Roth and Moynihan said, implying that these deals were being structured as they were to bypass tax consequences. Archer added, "The misuse of this provision in the tax code to avoid payment of taxes should be terminated." Although Archer has previously expressed some skepticism about the idea that tax loopholes could be considered corporate welfare, he has stated he wants the loophole closed in order to "protect taxpayers." This leaves investment bankers for AOL and H&R Block struggling to find a new way of structuring the deal, with AOL now considering just purchasing parts of CompuServe's business instead of the whole enchilada. CompuServe fell more than ten percent after the Morris Trust news was announced. Perhaps the AT&T offer may start looking a little better.

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