PRIVILEGED AND CONFIDENTIAL — ATTORNEY WORK PRODUCT
CALDERWOOD & HARKNESS LLP
MEMORANDUM
Date: July 18, 2022
To: File — Matter No. HRW-SPIN-001 (Engagement No. 1003-00005)
From: Garrett Simmons and Leila Nazari
Reviewed by: Leonard Cross, Responsible Partner
Re: Analysis of Business Purpose Requirement — Proposed Pro Rata Spin-Off of Meridian Flow Technologies, Inc. from Veldran Industries Holdings, Inc.
Classification: DRAFT — First Draft; Not for Distribution Outside Calderwood & Harkness LLP Without Partner Approval
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I. Executive Summary
This memorandum analyzes whether the proposed spin-off of the Precision Flow Solutions Division from Veldran Industries Holdings, Inc. ("Veldran" or "Distributing") into a newly formed entity, Meridian Flow Technologies, Inc. ("Meridian" or "SpinCo" / "Controlled"), satisfies the business purpose requirement applicable to tax-free distributions under Section 355 of the Internal Revenue Code of 1986, as amended (the "Code" or "IRC"). This analysis is being prepared in connection with Calderwood & Harkness's engagement to deliver a tax opinion regarding the qualification of the proposed transaction under IRC §§ 355(a) and 368(a)(1)(D).
The transaction is structured as a pro rata distribution by Veldran of 100% of the common stock of Meridian to Veldran shareholders at a 1:1 distribution ratio — specifically, one share of Meridian common stock for each of the 74,500,000 outstanding shares of Veldran common stock. The transaction is intended to qualify as a tax-free distribution under IRC § 355(a), in conjunction with a reorganization qualifying under IRC § 368(a)(1)(D). As set forth in greater detail below, the satisfaction of the business purpose requirement is a prerequisite to tax-free treatment, and the analysis of this requirement in the present matter raises significant issues that must be addressed before Calderwood & Harkness can deliver the requested tax opinion.
The client, Harrowgate Private Equity Fund IV, L.P. ("HPE Fund IV"), holds approximately 62.4% of the outstanding Veldran common stock, representing 46,488,000 shares, through its wholly owned subsidiary, Harrowgate Veldran Holdings LLC. Prescott Capital Management LP holds approximately 14.8% of the outstanding Veldran common stock, representing 11,026,000 shares. Management stockholders of Veldran hold approximately 5.3%, or 3,948,500 shares, and the remaining public and institutional float constitutes approximately 17.5% of the outstanding shares, or 13,037,500 shares. HPE Fund IV acquired its controlling stake in Veldran on September 20, 2019 — approximately three years before the anticipated Q4 2022 distribution date — through a negotiated tender offer followed by a merger squeeze-out of the prior controlling shareholder, Greystone Partners Fund III LP. The temporal proximity of this acquisition to the proposed distribution is a significant consideration in the business purpose analysis, as discussed below.
Two preliminary business purposes have been articulated by the client and Veldran management in connection with the proposed spin-off: (i) enabling each business to pursue independent capital-allocation strategies, including separate equity issuances, debt financings, acquisition activity, and dividend policies tailored to the distinct requirements and growth profiles of each business; and (ii) enhancing management focus and operational efficiency by allowing each management team to concentrate on its respective business without the distraction and complexity of operating within a diversified conglomerate structure. Both purposes are analyzed in detail in Section IV of this memorandum.
Key Conclusion: Based on the current factual record, both articulated purposes present meaningful vulnerabilities. The capital-allocation purpose, as currently framed, risks being characterized as primarily serving HPE Fund IV's fund-level monetization and liquidity objectives rather than a genuine corporate-level purpose of Veldran. The factual record does not contain specific, contemporaneous documentation of corporate-level capital-allocation constraints that could not be addressed through means short of a full separation. The management-focus purpose, while more defensible in principle and a purpose that the IRS has accepted in numerous prior contexts, currently lacks sufficient factual support from Veldran management. Neither the CEO of Veldran nor the President of the Precision Flow Solutions Division has provided written statements or detailed factual evidence articulating specific management-attention conflicts or operational inefficiencies attributable to the combined corporate structure.
Accordingly, the business purpose analysis is unresolved and represents a significant impediment to delivering the tax opinion at a "should" level of comfort. We recommend that Veldran management — in particular, Jonathan Caldecott (CEO) and Sandra Waverly (President, Precision Flow Solutions Division) — develop and articulate concrete, company-specific operational justifications that are independent of HPE Fund IV's fund-level strategic objectives. The specific recommendations and next steps are set forth in Section IX below.
II. Background
A. The Proposed Transaction
Veldran Industries Holdings, Inc. is a Delaware corporation (EIN 86-1920347) with its principal office located at 2400 Commerce Park Drive, Suite 500, Charlotte, North Carolina 28217. Veldran currently operates through two principal business segments, each of which constitutes a distinct line of business for purposes of the active trade or business requirement under IRC § 355(b):
Engineered Coatings Division. This division, which would remain with Veldran following the proposed spin-off, manufactures diversified industrial products and engineered materials, including specialty coatings, surface-treatment systems, and related consumable products. The division serves a broad range of industrial end markets, including aerospace, automotive, general manufacturing, and energy. For the fiscal year ended December 31, 2021 ("FY2021"), the Engineered Coatings Division reported revenue of approximately $1.52 billion and EBITDA of approximately $285 million, representing an EBITDA margin of approximately 18.75%. The division is headquartered in Charlotte, North Carolina, and operates fourteen manufacturing facilities across the United States, with additional facilities in Germany, China, and Mexico.
Precision Flow Solutions Division. This division, which would be contributed to Meridian and distributed to Veldran shareholders in the proposed spin-off, designs, manufactures, and sells precision fluid-control systems for industrial, petrochemical, and water-infrastructure end markets. The division's product portfolio includes engineered flow-control valves, metering systems, pump assemblies, and related instrumentation and control technologies. For FY2021, the Precision Flow Solutions Division reported revenue of approximately $820 million and EBITDA of approximately $133 million, representing an EBITDA margin of approximately 16.22%. The division is currently headquartered in Tucker, Georgia, and operates nine manufacturing facilities in the United States and the United Kingdom.
On an aggregate basis, Veldran reported FY2021 revenue of approximately $2.34 billion and aggregate FY2021 EBITDA of approximately $418 million. These figures reflect a combined enterprise encompassing both segments, with certain corporate overhead and shared services allocated across the two divisions.
The proposed transaction consists of two integrated steps:
(a) The Contribution. Veldran would contribute all assets and liabilities of the Precision Flow Solutions Division (including all tangible and intangible property, contracts, permits, employee arrangements, and other rights and obligations associated with the division) to Meridian in exchange for 100% of the common stock of Meridian and Meridian's assumption of certain allocated liabilities, as specified in the Separation Agreement to be entered into between Veldran and Meridian. The Contribution is intended to qualify as a transfer described in IRC § 351 or, in the alternative, as part of a reorganization described in IRC § 368(a)(1)(D).
(b) The Distribution. Promptly following the Contribution, Veldran would distribute 100% of the outstanding Meridian common stock pro rata to its shareholders at a distribution ratio of one share of Meridian common stock for each outstanding share of Veldran common stock (i.e., 74,500,000 shares of Meridian stock would be distributed in the aggregate). The Distribution is intended to qualify as a tax-free distribution under IRC § 355(a).
Meridian Flow Technologies, Inc. is planned to be incorporated as a Delaware corporation with its principal office at 7100 Northlake Parkway, Suite 300, Tucker, Georgia 30084. As of the date of this memorandum, Meridian has not yet been incorporated; its formation and the execution of organizational documents are being coordinated by Whitfield & Gage LLP on behalf of Harrowgate.
Sandra Waverly, who currently serves as President of the Precision Flow Solutions Division, is the planned Chief Executive Officer of Meridian. Derek Okonkwo, who currently serves as Vice President of Finance for the Precision Flow Solutions Division, is the planned Chief Financial Officer of Meridian. Additional members of the planned Meridian senior leadership team and board of directors are expected to be identified as part of the transaction planning process, but have not been finalized as of this date.
Brackenridge & Co. has provided a preliminary valuation analysis of the Precision Flow Solutions Division, received by Calderwood & Harkness on June 10, 2022. Based on that analysis, the estimated fair market value of Meridian (SpinCo) falls within a range of approximately $1.4 billion to $1.7 billion. This range was derived by applying EV/EBITDA multiples of 10.5× to 12.8× to the division's FY2021 EBITDA of $133 million. The Brackenridge analysis remains preliminary and is subject to refinement as part of the ongoing financial advisory engagement. The precise midpoint and final valuation will be relevant to several aspects of the tax analysis, including the quantification of built-in gain for purposes of the § 355(e) analysis.
B. Ownership Structure and HPE Fund IV's Acquisition
Harrowgate Private Equity Fund IV, L.P. ("HPE Fund IV") is a Delaware limited partnership (EIN 84-3291067) with total committed capital of approximately $6.8 billion. HPE Fund IV is a 2018-vintage fund — that is, its final closing occurred in 2018 — managed by Harrowgate Capital Partners IV GP LLC (EIN 84-3291104), which serves as its general partner, and Harrowgate Capital Advisors LLC (EIN 83-2756891), which serves as its investment advisor. The key principals of the Harrowgate organization relevant to this matter are as follows:
• Marcus Adler — Founding Partner and Chairman of Harrowgate Capital Advisors LLC.
• Diana Fenn — Managing Partner and Chief Investment Officer of Harrowgate Capital Advisors LLC; also serves as Chair of the Board of Directors of Veldran Industries Holdings, Inc.
• Tobias Rourke — Partner and Head of Portfolio Operations at Harrowgate Capital Advisors LLC; actively involved in operational strategy for Harrowgate portfolio companies, including Veldran.
• Christine Yeung — General Counsel of Harrowgate Capital Advisors LLC; primary legal contact for the engagement.
HPE Fund IV acquired its 62.4% controlling stake in Veldran on September 20, 2019, through a negotiated tender offer followed by a merger squeeze-out of the prior controlling shareholder, Greystone Partners Fund III LP, a Delaware limited partnership (EIN 81-2683910). The aggregate acquisition price for HPE Fund IV's stake was $1,859,520,000, reflecting a per-share price of $40.00 for 46,488,000 shares. The acquisition was co-funded by HPE Fund IV equity capital of approximately $1.24 billion and a co-investment by Prescott Capital Management LP (a New York limited partnership, EIN 13-4928371; Andrew Kessler, Managing Partner) of $620,000,000 for 15,500,000 shares at the same $40.00 per-share price. Subsequent to the acquisition, Prescott sold 4,474,000 shares in a registered secondary offering, reducing its current stake to 11,026,000 shares, or approximately 14.8% of the outstanding Veldran common stock.
HPE Fund IV holds its Veldran stake through Harrowgate Veldran Holdings LLC, a Delaware limited liability company (EIN 86-1483920) that is wholly owned by HPE Fund IV and serves as the direct stockholder of record.
The temporal proximity of the September 20, 2019 acquisition to the anticipated Q4 2022 distribution — a span of approximately three years — is relevant to the business purpose analysis for several reasons. First, the relatively short interval raises the question of whether the spin-off is primarily motivated by HPE Fund IV's desire to monetize or return capital on its investment, as discussed more fully in Section V. Second, the temporal proximity is relevant to the § 355(e) "plan" analysis, as the spin-off and the change of control in September 2019 may be viewed as parts of a single plan or series of related transactions if the factual record does not adequately establish that the decision to pursue the spin-off post-dated the acquisition and arose from independent corporate-level considerations. Third, the short operating history of the combined entity (Veldran acquired the Precision Flow Solutions business through the Kestrel Precision Controls acquisition in June 2019, only three months before HPE Fund IV acquired control) raises questions about the genuineness of any assertion that the combined structure has created operational inefficiencies warranting separation.
C. Capital Structure Considerations
The existing capital structure of Veldran is relevant to the business purpose analysis, particularly with respect to the capital-allocation purpose discussed in Section IV.A below. As of the date of this memorandum, Veldran's outstanding funded debt consists of the following:
Veldran First Lien Term Loan B. An aggregate principal amount of $1.1 billion, held by a syndicate of institutional lenders and administered by Ashfield National Bank, N.A. as administrative agent. The primary contact at Ashfield National Bank is Margaret Tsao, Managing Director, Leveraged Finance, whose offices are located at 100 Federal Street, Boston, Massachusetts 02110. The First Lien Term Loan B bears interest at a floating rate tied to SOFR (with a credit spread adjustment) and matures in 2026. The term loan is secured by substantially all of the assets of Veldran and its domestic subsidiaries, including the assets of both the Engineered Coatings Division and the Precision Flow Solutions Division. The credit agreement contains financial maintenance covenants, including a maximum first-lien net leverage ratio and a minimum interest coverage ratio.
Veldran 6.250% Senior Unsecured Notes due 2027. An aggregate principal amount of $450 million, issued pursuant to an indenture with Colton Trust Company (10 South LaSalle Street, Chicago, Illinois 60603) as trustee. The Senior Unsecured Notes bear interest at a fixed rate of 6.250% per annum, payable semiannually, and mature on September 15, 2027. The notes are senior unsecured obligations of Veldran and are guaranteed by certain domestic subsidiaries.
The articulation of the capital-allocation business purpose depends in part on how the proposed separation would enable each entity — Veldran (post-spin) and Meridian — to adopt a distinct debt and equity capital structure suited to its business profile, growth trajectory, and cash-flow characteristics. As currently structured, both divisions are subject to a single, consolidated debt structure that was put in place in connection with HPE Fund IV's leveraged acquisition in September 2019. The capital-allocation business purpose, to be persuasive, would need to demonstrate that this consolidated structure imposes specific constraints on one or both divisions that cannot be adequately addressed short of a full separation.
D. Relevant Advisors
The following advisors are engaged in connection with the proposed transaction and are referenced throughout this memorandum:
Whitfield & Gage LLP (51 West 52nd Street, New York, New York 10019) — lead corporate and M&A counsel to Harrowgate Capital Advisors LLC and HPE Fund IV. Priya Chandrasekar (Partner) and Ross Halverson (Counsel) are coordinating the spin-off transaction and drafting the Separation Agreement, Transition Services Agreement, Tax Matters Agreement, and related transaction documents. Whitfield & Gage is also advising on securities law and regulatory matters in connection with the planned registration of the Meridian shares.
Thornapple McCord LLP (227 West Trade Street, Suite 2000, Charlotte, North Carolina 28202) — corporate counsel to Veldran Industries Holdings, Inc. David Ochoa (Partner) is representing Veldran in connection with the spin-off, including advising the Veldran board of directors on its fiduciary duties in the context of the controlled-company dynamic. Given that HPE Fund IV controls Veldran, the engagement of Thornapple McCord as separate counsel to Veldran (as distinct from Whitfield & Gage, which represents Harrowgate) is intended to provide the Veldran board with independent legal advice on the transaction.
Brackenridge & Co. (383 Madison Avenue, New York, New York 10179) — financial advisor to Veldran. Samuel Ng, Managing Director, Industrials Group, is leading the engagement, which includes providing a valuation analysis of the Precision Flow Solutions Division and an expected fairness opinion addressed to the Veldran board. The preliminary valuation analysis was received by Calderwood & Harkness on June 10, 2022, as noted above.
Pemberton Rathbone LLP (One PPG Place, Suite 1600, Pittsburgh, Pennsylvania 15222) — independent auditors and tax-return preparers for Veldran. Lisa Engstrom (Audit & Assurance Partner) is the engagement partner for the annual audit, and Harold Weiss (Tax Partner) is responsible for Veldran's federal and state income tax compliance. Pemberton Rathbone's work papers and tax-return positions regarding the Precision Flow Solutions Division's adjusted tax basis and other tax attributes will be relevant to the quantification of built-in gain and the § 355(e) exposure.
Calderwood & Harkness LLP — engaged by Harrowgate Capital Advisors LLC to provide a tax opinion regarding the qualification of the proposed spin-off under IRC §§ 355(a) and 368(a)(1)(D). Leonard Cross (Partner) is the responsible partner; Garrett Simmons (Senior Associate) and Leila Nazari (Associate) are handling the day-to-day analysis and preparation of opinion work papers.
III. Legal Framework
A. Statutory and Regulatory Requirements — Business Purpose Under § 355
Section 355(a) of the Internal Revenue Code sets forth the conditions under which a distribution of the stock of a controlled corporation by a distributing corporation may be treated as tax-free to the distributing corporation's shareholders. The statute prescribes several explicit requirements, including: (i) the distributing corporation must control the controlled corporation immediately before the distribution within the meaning of IRC § 368(c); (ii) the distribution must not be principally used as a "device" for the distribution of earnings and profits; (iii) both the distributing and controlled corporations must be engaged in the active conduct of a trade or business immediately after the distribution, with each such trade or business having been actively conducted for the five-year period preceding the distribution; and (iv) the distributing corporation must distribute all of the stock and securities of the controlled corporation held by it, or an amount of stock constituting "control" within the meaning of § 368(c).
Notably, IRC § 355(a) does not explicitly contain a "business purpose" requirement in its statutory text. The requirement is not codified in the statute itself but is instead well-established under Treasury Regulations and a long line of judicial authority. The business purpose doctrine, as applied to § 355 distributions, derives from the broader principle — articulated most prominently by the Supreme Court in Gregory v. Helvering, 293 U.S. 465 (1935) — that a transaction lacking economic substance and business purpose may be disregarded for federal income tax purposes, notwithstanding its formal compliance with the literal terms of a statutory provision.
The Treasury Regulations under § 355 codify the business purpose requirement and provide the analytical framework applicable to this memorandum:
Treas. Reg. § 1.355-2(b)(1). This regulation provides that a distribution of stock of a controlled corporation must be motivated, in whole or substantial part, by one or more corporate business purposes. A "corporate business purpose" is defined as a real and substantial non-Federal-tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group (as defined in IRC § 1504(a)) to which the distributing corporation belongs. The purpose must be a purpose of the corporation itself, as distinct from a purpose of a particular shareholder. The regulation further provides that the business purpose requirement is applied based on all the facts and circumstances of a given case, including (but not limited to) the business purpose for the distribution relative to the purpose for any related transaction.
Treas. Reg. § 1.355-2(b)(2). This regulation addresses the distinction between corporate purposes and shareholder purposes. It provides that a shareholder purpose — that is, a purpose that pertains to the interests of a particular shareholder rather than to the business of the distributing or controlled corporation — does not constitute a valid corporate business purpose. The regulation clarifies, however, that a purpose to reduce non-Federal taxes (for example, state or local income taxes, franchise taxes, or foreign taxes) is not treated as a "Federal tax purpose" and may therefore constitute a valid business purpose if the other requirements are met. This distinction between shareholder purposes and corporate purposes is critical to the analysis in this memorandum, as discussed in Section V below.
The distinction between corporate-level and shareholder-level purposes is central to the present analysis. A purpose that benefits the corporation as an entity — such as enhanced operational efficiency, improved access to capital markets, compliance with regulatory requirements, or the resolution of internal conflicts that impede corporate operations — may qualify as a valid corporate business purpose. By contrast, a purpose that primarily benefits a particular shareholder — including, for example, the desire of a private equity fund to return capital to its limited partners, to facilitate the monetization of an investment, or to reduce the shareholder's own tax liability — does not satisfy the regulatory standard. In cases involving controlled companies, where the controlling shareholder exercises significant influence over the corporation's strategic direction, the distinction between shareholder and corporate purposes is often fact-intensive and closely scrutinized.
B. Key Judicial Authorities
The following judicial authorities are central to the business purpose analysis:
*Gregory v. Helvering*, 293 U.S. 465 (1935). This is the foundational authority establishing that a reorganization or distribution that complies with the literal terms of the Code but lacks business purpose may be disregarded for federal income tax purposes. The Supreme Court held that a reorganization must be informed by a business or corporate purpose, and that a transaction carried out solely to obtain a tax benefit — without any genuine non-tax motivation — is not entitled to tax-free treatment. While Gregory addressed a reorganization rather than a § 355 distribution, the principle it announced has been uniformly applied to § 355 transactions and is the conceptual underpinning of the business purpose requirement in Treas. Reg. § 1.355-2(b).
*Commissioner v. Wilson*, 353 F.2d 184 (9th Cir. 1965). The Ninth Circuit held in Wilson that the business purpose must be a purpose of the distributing corporation, not merely a purpose of its shareholders. This case is particularly relevant to the present analysis because it establishes the principle that a spin-off motivated by shareholder-level objectives — even objectives that are closely aligned with the corporation's business strategy — may not satisfy the business purpose requirement if the purpose is properly attributable to the shareholder rather than to the corporation. The court examined whether the evidence showed that the distribution served a purpose germane to the distributing corporation's own business operations, as opposed to the personal objectives of its shareholders.
*Rafferty v. Commissioner*, 452 F.2d 767 (1st Cir. 1971). The First Circuit held that the sufficiency of a business purpose is to be evaluated based on all the facts and circumstances of the case. Rafferty is significant because it confirms that the business purpose inquiry is inherently factual and contextual — there is no bright-line test or checklist that mechanically determines whether a particular purpose is "real and substantial." Rather, the totality of the evidence, including the stated motivations of the parties, the economic substance of the transaction, and the circumstances surrounding the decision to pursue the distribution, must be considered.
*Estate of Parshelsky v. Commissioner*, 303 F.2d 14 (2d Cir. 1962). The Second Circuit addressed the distinction between shareholder-level and corporate-level purposes in the context of a corporate separation. The court's analysis underscored that where the primary impetus for a distribution is to serve the personal or investment objectives of a shareholder, rather than to address a genuine business need of the corporation, the business purpose requirement is not satisfied. The decision is instructive in the PE-sponsor context, where the controlling shareholder's investment objectives and the corporation's business objectives may overlap but are not identical.
These authorities collectively establish the framework within which the present analysis must be conducted. The business purpose must be (i) a real and substantial purpose, not a mere pretext or post-hoc rationalization; (ii) a non-Federal-tax purpose; (iii) germane to the business of the distributing corporation, the controlled corporation, or the affiliated group; and (iv) a purpose of the corporation, not of a shareholder. The adequacy of the business purpose is determined based on all the facts and circumstances, and the burden of establishing a valid business purpose rests with the taxpayer.
C. IRS Guidance and Rulings
In addition to the statutory, regulatory, and judicial framework, the IRS has issued guidance that informs the business purpose analysis:
Rev. Proc. 96-30 (as modified). Prior to the IRS's suspension of private letter rulings on § 355 transactions in certain contexts, Rev. Proc. 96-30 set forth the IRS's ruling guidelines for § 355 distributions, including detailed requirements for business purpose submissions. Taxpayers seeking a private letter ruling were required to provide a comprehensive statement of the business purposes for the distribution, supported by factual evidence and contemporaneous documentation. While no private letter ruling is being sought in connection with the proposed Veldran/Meridian spin-off, the analytical framework articulated in Rev. Proc. 96-30 and the related ruling guidelines remains instructive and reflects the IRS's expectations regarding the quality and specificity of business purpose evidence.
Rev. Rul. 2003-74, Rev. Rul. 2003-75, Rev. Rul. 2004-23. These revenue rulings provide illustrative examples of sufficient and insufficient business purposes in various § 355 contexts. They address, among other things, the treatment of capital-market-related purposes (e.g., enabling separate access to the equity and debt markets), management-focus purposes, and purposes relating to the resolution of operational or strategic conflicts between divisions within a combined corporate structure. The rulings are useful benchmarks for evaluating the types of factual support that the IRS considers adequate to sustain a business purpose finding.
PLR Authorities Addressing PE Sponsor-Driven Spin-Offs. Although private letter rulings may not be cited or used as precedent by taxpayers other than those to whom they are addressed (IRC § 6110(k)(3)), the pattern of private letter rulings in which the IRS has addressed § 355 distributions by companies controlled by financial sponsors is instructive as an indication of the IRS's analytical approach. In a number of such rulings, the IRS has scrutinized distributions that appeared to be motivated primarily by the financial sponsor's exit or monetization objectives, and has required robust evidence that the distribution served a genuine corporate-level purpose independent of the sponsor's fund-level strategy.
D. Interaction with Other § 355 Requirements
The business purpose requirement does not operate in isolation. It interacts with several other § 355 requirements in ways that are relevant to the present analysis.
Interaction with the Device Test. Under IRC § 355(a)(1)(B), a distribution does not qualify for tax-free treatment if it is "used principally as a device for the distribution of the earnings and profits" of the distributing or controlled corporation. The Treasury Regulations under § 355 identify a number of "device" factors and "non-device" factors that are weighed in determining whether a distribution is principally a device. Importantly, under Treas. Reg. § 1.355-2(d)(3)(ii), a strong corporate business purpose is treated as evidence of a non-device — that is, a distribution that is genuinely motivated by a substantial corporate business purpose is less likely to be characterized as a device for the distribution of earnings and profits. Conversely, a weak, pretextual, or shareholder-driven business purpose may diminish the weight of this non-device factor and heighten the risk of a device finding. The interaction between the business purpose analysis and the device test is discussed further in Section VI of this memorandum.
Interaction with § 355(e). Section 355(e) of the Code provides that if a distribution otherwise qualifying under § 355 is part of a "plan (or series of related transactions)" pursuant to which one or more persons acquire, directly or indirectly, a 50-percent-or-greater interest in the distributing or controlled corporation, the distributing corporation must recognize gain on the distribution as if the distributed stock were sold at fair market value. The "plan" inquiry under § 355(e) examines whether the distribution and the acquisition are parts of a single integrated plan. Where the business purpose for the spin-off is closely tied to the acquisition strategy — for example, where the acquiror's original investment thesis contemplated a post-acquisition separation and monetization of a division — the business purpose analysis and the § 355(e) analysis become entangled. The existence of a post-acquisition plan to separate and monetize would support both a weak business purpose finding (the purpose is really the sponsor's exit strategy) and a § 355(e) "plan" finding (the distribution and the acquisition are parts of a single plan). Under Treas. Reg. § 1.355-7, the facts-and-circumstances test applicable to the "plan" determination considers, among other factors, the extent to which the distribution was motivated by a business purpose other than the acquisition. This interplay is discussed further in Section VII.
IV. Analysis of Articulated Business Purposes
As noted in the Executive Summary, two preliminary business purposes have been articulated by the client and Veldran management in connection with the proposed spin-off. This Section analyzes each articulated purpose in turn, evaluating its strengths and vulnerabilities based on the current factual record and the legal framework described in Section III.
A. Business Purpose #1: Independent Capital-Allocation Strategies
1. Description as Currently Articulated
The first articulated business purpose is that separating the Engineered Coatings Division and the Precision Flow Solutions Division into two independently operated, publicly traded entities would enable each entity to pursue independent capital-allocation strategies — including independent equity issuances, debt financings, mergers and acquisitions activity, and dividend and share-repurchase policies — tailored to the specific requirements and growth profiles of each business.
As currently articulated by the client and Veldran management, the argument proceeds as follows:
(a) The Engineered Coatings Division is a mature, cash-generative business with relatively high margins (18.75% EBITDA margin in FY2021) and stable, recurring revenue streams. Post-separation, the Engineered Coatings business (which would remain with Veldran) would pursue a deleveraging strategy, paying down existing acquisition-related indebtedness, and a capital-return strategy, including regular dividends and potential share repurchases, that is appropriate for a mature industrial business with limited near-term organic growth opportunities.
(b) The Precision Flow Solutions Division is a growth-oriented, acquisition-intensive business with a somewhat lower margin profile (16.22% EBITDA margin in FY2021) serving end markets — including petrochemical infrastructure, water and wastewater treatment, and industrial fluid control — that are experiencing secular growth driven by infrastructure investment, environmental regulation, and aging installed base replacement cycles. Post-separation, Meridian (SpinCo) would benefit from a separately leveraged balance sheet, direct access to the public equity markets, and the ability to use its own publicly traded stock as acquisition currency. These capabilities, the argument asserts, would enable Meridian to pursue a more aggressive growth-by-acquisition strategy than is feasible within the current combined corporate structure.
(c) The existing consolidated capital structure of Veldran — consisting of the $1.1 billion First Lien Term Loan B and the $450 million in 6.250% Senior Unsecured Notes due 2027 — was established in connection with HPE Fund IV's leveraged acquisition and does not optimally serve the distinct capital needs of either division. The consolidated debt constrains the Precision Flow Solutions Division's ability to pursue acquisitions (because incremental borrowing capacity under the existing credit facility may be limited and is subject to consolidated leverage tests) and simultaneously limits the Engineered Coatings Division's ability to pursue a de-leveraging and capital-return strategy (because debt reduction at the consolidated level benefits both divisions indiscriminately rather than matching repayment to the cash-flow profile of the specific business generating the repayment capacity).
2. Strengths. The capital-allocation purpose, if adequately supported by the factual record, has a credible basis in the existing body of IRS guidance and rulings. The IRS has recognized "fit" capital-allocation purposes in prior rulings and guidance, particularly where two divisions of a distributing corporation have demonstrably different capital needs, growth profiles, and investor bases such that the combined corporate structure imposes meaningful constraints on the efficient allocation of capital. The following factors support the plausibility of this purpose:
First, there is a plausible factual basis for the assertion that the two divisions operate in different end markets, serve different customers, and exhibit different financial profiles. The Engineered Coatings Division (diversified industrial products and engineered materials) and the Precision Flow Solutions Division (precision fluid-control systems for petrochemical, industrial, and water-infrastructure end markets) have limited operational overlap. Their EBITDA margins differ by approximately 250 basis points, and their respective growth trajectories and capital-intensity profiles differ as described above.
Second, the existing consolidated debt structure — which was established as acquisition financing rather than as a tailored capital structure for either business — arguably constrains each division's ability to pursue its optimal capital-allocation strategy. The First Lien Term Loan B is secured by the assets of both divisions, and the leverage covenants are calculated on a consolidated basis, meaning that the debt capacity and borrowing flexibility of each division is effectively pooled. This pooling may not serve the interests of either division optimally.
Third, the separation would create two distinct publicly traded equity securities, each with its own investor base, trading characteristics, and valuation metrics. To the extent that investors and analysts covering the combined Veldran entity apply a "conglomerate discount" reflecting the complexity and opacity of the combined business, the separation could unlock value by allowing each entity to be valued on the basis of its own financial performance and industry comparables.
3. Vulnerabilities and Concerns
Notwithstanding the plausibility of the capital-allocation purpose in the abstract, the current factual record presents several significant vulnerabilities:
Primary concern: Characterization as a shareholder-level purpose. As currently framed, the capital-allocation purpose is difficult to distinguish from HPE Fund IV's fund-level objective of facilitating monetization of its 62.4% controlling stake in Veldran. HPE Fund IV is a 2018-vintage private equity fund. At the time of the anticipated Q4 2022 distribution, the fund would be approximately four years into its investment horizon (having acquired the Veldran stake in September 2019), which is consistent with typical PE sponsor exit timelines. Fund IV's limited partnership agreement likely contemplates that the fund will begin returning capital to its limited partners within a four-to-six-year period following initial investment, and the fund's investment strategy typically involves operational improvement of portfolio companies followed by a liquidity event — whether through a sale, an IPO, or a spin-off — that enables monetization.
The proposed separation would create a publicly traded Meridian stock that could be more readily sold, or distributed in kind, to HPE Fund IV's limited partners through Harrowgate Veldran Holdings LLC. The "independent capital-allocation" purpose thus has a dual character: while it may serve a corporate-level objective of enabling each business to access capital markets more efficiently, it simultaneously and perhaps primarily serves the sponsor's fund-level objective of creating a liquid security that facilitates monetization and capital return. The IRS would be expected to examine this dual character closely and to assess whether the corporate-level articulation is genuine or whether it is a repackaging of a shareholder-level monetization objective.
Characterization risk under Treas. Reg. § 1.355-2(b)(2). The Treasury Regulations draw a clear distinction between corporate and shareholder purposes. A purpose that is properly characterized as a shareholder purpose — even if it incidentally benefits the corporation — does not satisfy the business purpose requirement. The risk here is that the IRS would characterize the "independent capital allocation" purpose as being, at bottom, about giving HPE Fund IV and its limited partners a liquid, separately tradable security in Meridian that can be monetized independently of the Veldran equity stake — i.e., the purpose is to facilitate the sponsor's exit, not to improve the corporation's capital structure.
Diana Fenn's dual role. Diana Fenn serves simultaneously as Managing Partner and Chief Investment Officer of Harrowgate Capital Advisors LLC and as Chair of the Board of Directors of Veldran. This dual role creates a direct governance linkage between HPE Fund IV's fund-level strategic objectives and the board-level decision-making process at the Distributing corporation. While dual roles of this kind are common in the PE sponsor context, they complicate the business purpose analysis by making it difficult to demonstrate that the Veldran board's decision to pursue the spin-off was motivated by corporate-level considerations independent of Harrowgate's strategic direction. The IRS may point to Ms. Fenn's dual role as evidence that the business purpose articulation reflects Harrowgate's interests rather than an independent corporate-level assessment of the benefits of separation.
Insufficient factual record. The Representation Letter (second draft, July 11, 2022) and the discussions to date between Calderwood & Harkness and the client have not produced detailed, concrete factual evidence that Veldran's board and management — independent of Harrowgate's direction — identified specific capital-allocation constraints under the current combined structure that necessitate a full separation. For example, the current record does not include any of the following:
(a) Evidence of a specific acquisition target that the Precision Flow Solutions Division could pursue only with its own equity currency — i.e., a target that has indicated a willingness to accept Meridian stock as consideration but not Veldran stock, or a target whose acquisition is foreclosed by the consolidated leverage covenants under the existing credit facility.
(b) Evidence of a specific debt refinancing or deleveraging plan for the Engineered Coatings Division that is currently foreclosed by the combined corporate structure — i.e., a plan to repay or refinance a portion of the existing indebtedness that is impracticable as long as both divisions are within the same corporate entity.
(c) Investor or analyst feedback demonstrating that the combined Veldran entity trades at a "conglomerate discount" relative to the sum of the parts — i.e., sell-side research reports, investor call transcripts, or other contemporaneous evidence that investors have identified the combined structure as a source of value destruction.
(d) Internal board presentations or management analyses evaluating the capital-allocation constraints imposed by the combined structure, independent of Harrowgate's strategic direction.
Comparison to alternative structures. Treas. Reg. § 1.355-2(b)(1) requires that the spin-off be motivated by a "real and substantial" business purpose. If the capital-allocation objective could be achieved through less fundamental means — means that do not require a complete separation of the businesses into two public companies — the IRS could argue that the spin-off is not necessary to accomplish the stated purpose and that the choice of a spin-off (rather than an alternative structure) was motivated by other considerations, including the sponsor's exit objectives. Potential alternative structures that should be considered include: (i) a tracking stock arrangement, under which Veldran would issue a class of stock whose economic returns are linked to the performance of the Precision Flow Solutions Division, while retaining both divisions within a single corporate entity; (ii) divisional financing, under which the Precision Flow Solutions Division obtains its own credit facility or issues its own securities within the existing corporate structure; and (iii) a dividend recapitalization or refinancing of the existing consolidated debt, which could tailor the capital structure to the needs of each division without requiring a separation. The current record does not include an analysis of why these alternatives are inadequate.
4. Recommendations. To strengthen the capital-allocation business purpose, the following steps should be taken:
• Veldran management — specifically Jonathan Caldecott (CEO), Rita Subramanian (CFO), and Sandra Waverly (President, Precision Flow Solutions Division) — should be asked to provide specific, documented, corporate-level evidence supporting this purpose. Such evidence should include identified acquisition targets for the Precision Flow Solutions Division, investor or analyst feedback regarding the combined entity's valuation, credit market assessments of the constraints imposed by the consolidated capital structure, and internal board presentations or strategic-planning documents discussing capital-allocation constraints and the benefits of separation.
• The articulation of the purpose should be reframed to emphasize the corporate-level benefit to Veldran as an entity and to Meridian as a stand-alone business — not the benefit to HPE Fund IV as a shareholder — and should specifically address why alternative structures (tracking stock, divisional financing, dividend recapitalization) are inadequate to achieve the stated objective.
• The factual record should demonstrate that the decision to pursue the spin-off for capital-allocation reasons arose from developments that post-date the September 2019 acquisition and that were not part of HPE Fund IV's original acquisition thesis.
B. Business Purpose #2: Management Focus and Operational Efficiency
1. Description as Currently Articulated
The second articulated business purpose is that separating the Engineered Coatings Division and the Precision Flow Solutions Division into two independently operated, publicly traded entities would enhance management focus and operational efficiency by allowing each management team to concentrate on its respective business without the distraction and complexity of operating within a diversified conglomerate structure.
As currently articulated, the argument proceeds as follows:
(a) The Engineered Coatings Division (led by Jonathan Caldecott, CEO of Veldran) and the Precision Flow Solutions Division (led by Sandra Waverly, President) have distinct operational challenges, customer bases, competitive dynamics, and strategic priorities. The Engineered Coatings Division competes in the diversified industrial products and engineered materials space, where the key competitive factors include product performance, cost efficiency, and long-term customer relationships. The Precision Flow Solutions Division competes in the precision fluid-control systems market, where the key competitive factors include engineering innovation, regulatory compliance (particularly in the water-infrastructure and petrochemical sectors), and the ability to provide integrated systems solutions. The operational skill sets, customer engagement models, and strategic imperatives of the two divisions differ materially.
(b) Under the current combined structure, shared corporate overhead functions — including finance, human resources, legal, information technology, and corporate development — must serve the needs of both divisions simultaneously, resulting in sub-optimal resource allocation. Management time and attention are divided between two fundamentally different businesses, and strategic priorities are inevitably compromised as corporate leadership must balance the competing demands of a mature, cash-generative coatings business and a growth-oriented, acquisition-intensive flow-solutions business.
(c) Independent public-company status would create better alignment between management compensation incentives and the performance of the specific business for which each management team is responsible. Under the current structure, equity-based compensation for Veldran executives is tied to the performance of the combined entity, which dilutes the incentive effect for executives responsible for only one of the two divisions. As independent public companies, Veldran (post-spin) and Meridian would each issue equity-based compensation linked to its own stock-price performance, creating a tighter nexus between management effort and compensation outcomes.
2. Strengths. The management-focus purpose is, in principle, among the most widely accepted and recognized business purposes under § 355. The IRS has accepted "management focus" as a valid corporate business purpose in numerous rulings, and courts have likewise recognized that the elimination of management-attention conflicts and the enhancement of operational efficiency can constitute a real and substantial business purpose germane to the business of the distributing or controlled corporation.
First, there is a plausible factual basis for the assertion that the two divisions have distinct operational profiles that would benefit from dedicated management attention. The Engineered Coatings Division and the Precision Flow Solutions Division serve different end markets, face different competitive dynamics, and require different operational skill sets and strategic approaches. The combined entity's management must, by definition, divide its time and attention between two businesses with limited operational overlap.
Second, the IRS has recognized that independent public-company incentive structures — particularly equity-based compensation tied to the stock-price performance of a stand-alone entity rather than a diversified parent — can improve management alignment and operational efficiency. This argument is particularly strong where, as here, the two divisions have different financial profiles and different growth trajectories, such that the performance of the combined entity's stock reflects a blended outcome rather than the specific performance of either division.
Third, the planned leadership structure of Meridian — with Sandra Waverly as CEO and Derek Okonkwo as CFO — suggests that the Precision Flow Solutions Division's management team would be empowered to operate independently and to dedicate 100% of its attention to the flow-solutions business, without the need to coordinate strategic priorities with the Engineered Coatings Division's leadership.
3. Vulnerabilities and Concerns
Notwithstanding the general strength of the management-focus purpose as a category, the current factual record presents several vulnerabilities that must be addressed:
Insufficient specificity. The management-focus purpose is currently stated at a high level of generality that could apply to virtually any diversified company with two or more operating divisions. The IRS scrutinizes vague or boilerplate business purpose assertions, and statements such as "the separation will enhance management focus" or "the combined structure results in sub-optimal resource allocation" are insufficient, standing alone, to establish a real and substantial business purpose. To support a "should" level opinion, we need concrete, specific evidence of identifiable operational inefficiencies or management-attention conflicts that are attributable to the combined structure and that would be remedied by the separation. Such evidence might include, for example, specific instances in which the management teams of the two divisions were unable to pursue strategic opportunities because of competing demands on shared corporate resources; specific resource-allocation disputes between the divisions; or specific customer, supplier, or employee concerns arising from the combined structure.
Veldran's relatively short operating history as a combined entity. Veldran Industries Holdings, Inc. was incorporated on March 14, 2019. The Precision Flow Solutions business was acquired by Veldran through the acquisition of Kestrel Precision Controls, Inc. on June 7, 2019. HPE Fund IV acquired its controlling stake in Veldran on September 20, 2019. As of the anticipated Q4 2022 distribution date, the combined entity would have operated for approximately three years — and for approximately three years under HPE Fund IV's control. This relatively short operating history raises a significant question: if the businesses were combined only three years ago, why is a separation needed so soon? The IRS could infer that the separation was part of the original acquisition plan — i.e., that HPE Fund IV acquired Veldran with the Kestrel Precision Controls business already in the portfolio (or recently added) with the intent to operationally improve the businesses and then separate them to maximize exit value. This inference would support both a weak business purpose finding and an adverse § 355(e) "plan" finding.
Linkage to fund-level objectives. As with the capital-allocation purpose, the management-focus argument is vulnerable to recharacterization as primarily serving HPE Fund IV's portfolio-optimization strategy rather than a genuine corporate-level need. Private equity sponsors routinely pursue operational improvements — including organizational restructurings, management changes, and divisional separations — as part of their value-creation playbooks. The role of Tobias Rourke, Partner and Head of Portfolio Operations at Harrowgate Capital Advisors LLC, in Veldran's operational strategy is particularly relevant. If the evidence shows that Mr. Rourke and the Harrowgate portfolio operations team have been driving the management-focus and operational-improvement agenda at Veldran, the IRS could argue that the management-focus purpose is really a function of the sponsor's value-creation strategy — designed to maximize the exit value of HPE Fund IV's investment — rather than a genuine corporate-level operational need of Veldran.
Lack of Veldran management testimony. To date, neither Jonathan Caldecott (CEO of Veldran) nor Sandra Waverly (planned CEO of Meridian) has provided written statements or detailed factual support articulating specific management-attention conflicts or operational inefficiencies attributable to the combined corporate structure. The absence of such testimony is a significant gap in the factual record. The business purpose must be a purpose of the corporation, and the most persuasive evidence of a corporate business purpose is testimony from the corporation's own management — independent of the controlling shareholder — identifying specific, concrete problems created by the combined structure and explaining how the separation would address those problems.
4. Recommendations. To strengthen the management-focus and operational-efficiency business purpose, the following steps should be taken:
• Obtain detailed written statements from Jonathan Caldecott and Sandra Waverly identifying specific instances in which the combined structure has resulted in management-attention conflicts, resource-allocation disputes, or operational inefficiencies. These statements should be based on the executives' own observations and experience, not on talking points supplied by Harrowgate, and should identify concrete, fact-specific examples rather than general assertions.
• Document internal board discussions (independent of Harrowgate direction) reflecting corporate-level consideration of the separation benefits. Board minutes or resolutions that reflect deliberation by Veldran's directors — including any independent directors — regarding the operational rationale for the spin-off would be valuable evidence of a corporate-level purpose.
• Consider whether the Veldran board (including independent directors, if any) has adopted or should adopt a formal resolution articulating the business purposes for the spin-off from the perspective of Veldran as a standalone entity. Such a resolution, if supported by the evidentiary record and adopted following genuine deliberation, would serve as important evidence of a corporate-level purpose.
• Assess whether additional management-focus evidence can be obtained from lower-level operational personnel within each division — for example, divisional controllers, engineering managers, or sales leaders who can attest to specific ways in which the combined structure has impeded their ability to serve customers, pursue product development, or recruit talent.
V. Shareholder-Level vs. Corporate-Level Purpose: The PE Sponsor Issue
A. The Analytical Framework
As set forth above, Treas. Reg. § 1.355-2(b)(2) draws a critical distinction between a purpose of the distributing corporation and a purpose of a shareholder. Only a corporate business purpose — a purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group — qualifies as a valid business purpose under § 355. A shareholder purpose, by contrast, does not satisfy the requirement, regardless of how closely it may align with the corporation's strategic objectives.
In the context of private equity sponsor-controlled companies, this distinction is particularly fraught. The controlling shareholder — here, HPE Fund IV, acting through Harrowgate Veldran Holdings LLC — exercises significant influence over the board of directors and management of the distributing corporation. The fund's investment thesis, which typically encompasses the identification of value-creation opportunities (including operational improvements, capital structure optimization, and eventual liquidity events), may drive the strategic direction of the portfolio company. In such circumstances, the line between the fund's investment objectives and the corporation's business purposes can become blurred, and it may be difficult to establish — to the satisfaction of the IRS — that the articulated business purposes are genuinely attributable to the corporation rather than to the controlling shareholder.
The IRS has historically scrutinized spin-offs involving financial sponsor-controlled distributing corporations, particularly where one or more of the following circumstances is present: (i) the temporal gap between the sponsor's acquisition of control and the proposed distribution is relatively short, suggesting that the spin-off was part of the original acquisition plan; (ii) the spin-off appears to be a monetization or exit strategy for the sponsor, rather than a response to a genuine corporate-level need; (iii) the sponsor's representatives occupy key governance positions at the distributing corporation, creating a direct conduit between the fund's strategic objectives and the corporation's decision-making; and (iv) the articulated business purposes are stated in general terms that could apply to any diversified company and do not reflect specific, documented, corporate-level considerations.
B. Application to the Proposed Spin-Off
Each of the foregoing circumstances is present, to some degree, in the proposed Veldran/Meridian spin-off:
Governance linkage. HPE Fund IV holds 62.4% of the outstanding Veldran common stock, and Diana Fenn — Managing Partner and Chief Investment Officer of Harrowgate Capital Advisors LLC — serves as Chair of the Veldran Board of Directors. This creates a direct governance linkage between HPE Fund IV's fund-level strategic objectives and the board-level decision-making at the Distributing corporation. While the existence of a dual role is not, by itself, disqualifying, it creates a factual predicate that the IRS could use to argue that the business purpose articulation reflects Harrowgate's interests rather than an independent corporate-level assessment.
Monetization inference. The September 2019 acquisition price for HPE Fund IV's 62.4% stake was $1,859,520,000. The Precision Flow Solutions Division alone — which would become Meridian — is estimated at $1.4 billion to $1.7 billion based on the preliminary Brackenridge & Co. analysis. The creation of a separately traded Meri