PRIVILEGED AND CONFIDENTIAL — ATTORNEY WORK PRODUCT
MEMORANDUM
From: Leila Nazari, Associate, Tax Department, Calderwood & Harkness LLP
Reviewed By: Garrett Simmons, Senior Associate, Tax Department Leonard Cross, Partner, Tax Department
Date: July 25, 2022
Re: Device Test Analysis — Proposed Pro Rata Distribution of Meridian Flow Technologies, Inc. Common Stock by Veldran Industries Holdings, Inc. under IRC § 355(a)(1)(B)
Engagement No.: 1003-00005
Matter Code: HRW-SPIN-001
Client: Harrowgate Private Equity Fund IV, L.P.
This memorandum is an internal working document of Calderwood & Harkness LLP. It is protected by the attorney-client privilege, the work product doctrine, and all other applicable privileges and protections. This memorandum is in draft form and should not be relied upon by any party, including the client, as a final opinion or analysis. Distribution is restricted to persons identified in Section XII hereof. No portion of this memorandum may be disclosed, quoted, or referenced without the prior written approval of Leonard Cross.
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I. Executive Summary
This memorandum analyzes whether the proposed pro rata distribution by Veldran Industries Holdings, Inc. ("Veldran" or "Distributing"), a Delaware corporation (EIN 86-1920347), of 100% of the outstanding common stock of Meridian Flow Technologies, Inc. ("Meridian," "Controlled," or "SpinCo"), a Delaware corporation to be formed, to Veldran's shareholders on a one-for-one basis (one share of Meridian common stock for each of the 74,500,000 shares of Veldran common stock outstanding as of the record date) would be treated as a "device" for the distribution of the earnings and profits of Distributing or Controlled within the meaning of Section 355(a)(1)(B) of the Internal Revenue Code of 1986, as amended (the "Code" or "IRC").
As described more fully below, and based on the facts and circumstances known to us as of the date of this memorandum, it is our preliminary conclusion that the proposed distribution should satisfy the device test — that is, the distribution should not constitute a device for the distribution of the earnings and profits of either Distributing or Controlled — provided that two critical conditions are met. First, robust corporate-level business purposes must be established and articulated that are independent of the fund-level monetization objectives of Harrowgate Private Equity Fund IV, L.P. ("HPE Fund IV"). As discussed extensively in the Business Purpose Memorandum dated July 18, 2022, and as flagged in communications with the engagement team, this issue remains unresolved as of the date hereof and represents the most significant analytical vulnerability in the device test analysis. Second, no agreement, understanding, or arrangement may exist — nor may one come into existence prior to the distribution — regarding a post-spin sale, exchange, merger, or other disposition of either Veldran stock or Meridian stock. The accuracy and completeness of the representations to be provided by Veldran and HPE Fund IV on this point are essential to the analysis.
This memorandum should be read in conjunction with the Comprehensive § 355 Analysis Memorandum dated May 20, 2022 (the "Comprehensive Memo"), which provides the overarching framework for the tax-free qualification of the proposed spin-off, and the Business Purpose Memorandum dated July 18, 2022 (the "Business Purpose Memo"), which addresses the requirements of Treas. Reg. § 1.355-2(b). This memorandum also cross-references the § 355(e) Plan Analysis Memorandum dated June 28, 2022 (the "355(e) Memo") where relevant, as the device analysis and the § 355(e) plan analysis share overlapping factual predicates. This memorandum is in draft form and constitutes an internal working document of Calderwood & Harkness LLP. It should not be relied upon by any party, and it will be updated if and when the matter is reactivated from dormancy or material new facts are brought to our attention.
II. Background and Transaction Summary
A. Parties and Ownership Structure
Veldran Industries Holdings, Inc. Veldran is a Delaware corporation incorporated on March 14, 2019. Its principal office is located at 2400 Commerce Park Drive, Suite 500, Charlotte, North Carolina 28217. Veldran is a diversified industrial products and engineered materials company operating across two principal business segments: the Engineered Coatings Division and the Precision Flow Solutions Division. Veldran's senior management team includes Jonathan Caldecott, Chief Executive Officer; Rita Subramanian, Chief Financial Officer; and Philip Crundell, General Counsel. For the fiscal year ended December 31, 2021 ("FY2021"), Veldran reported consolidated revenue of approximately $2.34 billion and consolidated EBITDA of approximately $418 million. As of the date of this memorandum, Veldran employs approximately 8,200 individuals across its two divisions.
Harrowgate Private Equity Fund IV, L.P. HPE Fund IV is a Delaware limited partnership (EIN 84-3291067) with a total fund size of approximately $6.8 billion (vintage 2018). HPE Fund IV is managed by Harrowgate Capital Advisors LLC (EIN 83-2756891), a Delaware limited liability company. The general partner of HPE Fund IV is Harrowgate Capital Partners IV GP LLC (EIN 84-3291104), a Delaware limited liability company. HPE Fund IV's principal office is located at 600 Lexington Avenue, 38th Floor, New York, New York 10022.
HPE Fund IV holds approximately 62.4% of the outstanding common stock of Veldran, representing 46,488,000 shares. This interest is held through Harrowgate Veldran Holdings LLC ("HVH"), a Delaware limited liability company (EIN 86-1483920) that is wholly owned by HPE Fund IV. 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 Greystone Partners Fund III LP (EIN 81-2683910), the prior controlling shareholder. The aggregate acquisition price was $1,859,520,000, representing $40.00 per share multiplied by 46,488,000 shares.
Diana Fenn, the Managing Partner and Chief Investment Officer of Harrowgate Capital Advisors LLC, serves as Board Chair of Veldran Industries Holdings, Inc. Ms. Fenn's dual role as the senior investment professional of the PE sponsor and the Board Chair of the portfolio company is relevant to the device analysis to the extent it bears on the question of whether the business purposes of the proposed spin-off are genuinely corporate-level purposes or are instead driven by HPE Fund IV's fund-level investment objectives.
B. Other Shareholders
Prescott Capital Management LP. Prescott Capital Management LP ("Prescott") is a New York-based institutional investor (EIN 13-4928371). Its Managing Partner is Andrew Kessler, and its principal office is located at 277 Park Avenue, 42nd Floor, New York, New York 10172. Prescott currently holds approximately 14.8% of Veldran common stock, representing 11,026,000 shares. Prescott originally co-invested alongside HPE Fund IV in September 2019, acquiring 15,500,000 shares at $40.00 per share for an aggregate investment of $620 million. Prescott subsequently sold 4,474,000 shares in a secondary offering, reducing its stake from the original 15,500,000 shares to the current 11,026,000 shares. Prescott is advised by Dunmore Havens & Associates LLC (Irene Salcedo, Principal) on fund-level tax consequences of the proposed spin-off, and we understand that Prescott may seek to obtain its own tax advice regarding the device and other § 355 issues.
Veldran Management Stockholders. Veldran's officers and directors collectively hold approximately 5.3% of Veldran common stock, representing approximately 3,948,500 shares. These shares are held under various equity incentive plans maintained by Veldran. The specific terms of these plans, including vesting schedules, transfer restrictions, and treatment in connection with the proposed spin-off, are being reviewed by Calderwood & Harkness separately in connection with the employee benefits workstream.
Public and Institutional Float. The remaining approximately 17.5% of Veldran common stock, representing approximately 13,037,500 shares, is held by dispersed public and institutional investors. While Veldran is not listed on a national securities exchange and its shares are not publicly traded in the conventional sense, a limited secondary market for its shares exists, and a portion of the float is held by institutional investors who acquired shares through private placements or secondary transactions.
In summary, the ownership structure of Veldran is highly concentrated. HPE Fund IV (62.4%), Prescott (14.8%), and management stockholders (5.3%) collectively hold approximately 82.5% of Veldran common stock, with the remaining 17.5% held by dispersed public and institutional investors. This ownership concentration is directly relevant to several aspects of the device analysis, as discussed in Sections IV and V below.
C. Business Segments and Proposed Spin-Off
Veldran operates through two principal business segments, each of which is engaged in active industrial manufacturing and engineering operations.
Engineered Coatings Division. The Engineered Coatings Division, which will remain with Veldran following the proposed spin-off, develops and manufactures specialty coatings, surface treatments, and protective material solutions for aerospace, defense, and automotive customers. For FY2021, the Engineered Coatings Division reported revenue of approximately $1.52 billion and EBITDA of approximately $285 million, reflecting an EBITDA margin of approximately 18.75%.
Precision Flow Solutions Division. The Precision Flow Solutions Division, which will be contributed to Meridian (SpinCo) in the proposed transaction, designs and manufactures precision fluid-control systems, flow management equipment, and related engineered components for petrochemical, water-infrastructure, and industrial process applications. For FY2021, the Precision Flow Solutions Division reported revenue of approximately $820 million and EBITDA of approximately $133 million, reflecting an EBITDA margin of approximately 16.22%. The Precision Flow Solutions Division is led by Sandra Waverly, who is the planned Chief Executive Officer of Meridian, and Derek Okonkwo, who is the planned Chief Financial Officer of Meridian.
Proposed Spin-Off Transaction. The proposed spin-off transaction (the "Spin-Off") consists of two integrated steps. First, Veldran will contribute all assets and liabilities of the Precision Flow Solutions Division to Meridian Flow Technologies, Inc., a Delaware corporation to be formed as a wholly owned subsidiary of Veldran, in exchange for all outstanding shares of Meridian common stock and the assumption by Meridian of certain liabilities associated with the Precision Flow Solutions Division (the "Contribution"). Immediately following the Contribution, Veldran will distribute all of the outstanding shares of Meridian common stock to the holders of Veldran common stock on a pro rata basis (the "Distribution," and together with the Contribution, the "Spin-Off").
The Distribution will be effected on a one-for-one basis: each holder of Veldran common stock as of the record date established for the Distribution will receive one share of Meridian common stock for each share of Veldran common stock held by such holder on the record date. Because there are 74,500,000 shares of Veldran common stock currently outstanding, Meridian will issue 74,500,000 shares of Meridian common stock in the Distribution. Following the Distribution, each Veldran shareholder will hold both Veldran shares (representing an interest in the Engineered Coatings Division) and Meridian shares (representing an interest in the Precision Flow Solutions Division), in the same proportions as their pre-Distribution holdings of Veldran common stock.
The Spin-Off was originally targeted for completion in the fourth quarter of 2022. The Spin-Off is intended to qualify as a tax-free transaction under IRC §§ 355(a) and 368(a)(1)(D). Veldran has elected not to seek a private letter ruling from the Internal Revenue Service ("IRS") regarding the qualification of the Spin-Off under these provisions. Instead, the Calderwood & Harkness "should" level tax opinion is intended to serve as the sole tax assurance with respect to the qualification of the Spin-Off as a tax-free transaction.
D. Valuation and Earnings Data Relevant to Device Analysis
The following valuation and financial data are relevant to the device analysis conducted in this memorandum.
Meridian Valuation. Based on a preliminary analysis by Brackenridge & Co. ("Brackenridge"), the firm's financial advisor, received by Calderwood & Harkness on June 10, 2022, the estimated aggregate fair market value of Meridian (SpinCo) is in the range of $1.4 billion to $1.7 billion. This range is derived from applying EV/EBITDA multiples of 10.5× to 12.8× to the Precision Flow Solutions Division's FY2021 EBITDA of $133 million, resulting in an implied enterprise value of approximately $1,396.5 million to $1,702.4 million.
Estimated Built-In Gain. Based on the foregoing preliminary valuation range and Veldran's estimated adjusted tax basis of approximately $800 million in the assets of the Precision Flow Solutions Division (as reported by Veldran's internal tax team and subject to further verification), the estimated built-in gain on the Meridian stock held by Veldran (immediately prior to the Distribution) is in the range of approximately $600 million to $900 million. If realized, and taxed at the current corporate rate of 21%, the resulting corporate-level tax would be in the range of approximately $125.3 million to $189.5 million. This built-in gain figure is relevant both to the device analysis (Section VIII below) and to the § 355(e) plan analysis addressed in the 355(e) Memo.
Capital Structure. Veldran's capital structure consists of 100,000,000 authorized shares of common stock, of which 74,500,000 shares are currently outstanding. Veldran's debt consists of a First Lien Term Loan B in an aggregate principal amount of $1.1 billion (Ashfield National Bank, N.A. as administrative agent) and 6.250% Senior Unsecured Notes due 2027 in an aggregate principal amount of $450 million (Colton Trust Company as trustee). The allocation of existing debt between Veldran and Meridian in the Spin-Off is being determined by the finance workstream and is not yet finalized.
Dividend History. Veldran has not paid any regular cash dividends on its common stock. Earnings have been reinvested in operations, used for debt service on the existing credit facilities and notes, or otherwise retained. This dividend history (or, more precisely, the absence thereof) is relevant to the device analysis as discussed in Section V.C below.
III. Applicable Legal Framework
A. Statutory Provision — IRC § 355(a)(1)(B)
Section 355(a) of the Code provides that, under certain circumstances, no gain or loss shall be recognized to a shareholder upon the receipt of stock of a controlled corporation that is distributed by a distributing corporation. To qualify for this tax-free treatment, however, the transaction must satisfy several requirements, including the requirement set forth in Section 355(a)(1)(B). That provision states, in relevant part, that tax-free treatment under Section 355(a) does not apply if "the transaction was used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both."
The device test is a subjective, facts-and-circumstances inquiry. It is not a mechanical test, and no single factor is determinative. The determination of whether a transaction constitutes a "device" requires a balancing of all relevant factors, both those tending to establish the existence of a device and those tending to establish the absence of a device. The legislative history of Section 355 reflects Congress's concern that spin-off transactions could be used as a mechanism to distribute corporate earnings and profits to shareholders at capital gains rates rather than at ordinary income rates — effectively converting what would otherwise be a taxable dividend into a tax-favored stock distribution followed by a sale of the distributed stock.
It is important to distinguish the device test of Section 355(a)(1)(B) from the separate requirement of Section 355(a)(3), which provides that stock of a controlled corporation "shall not be treated as stock or securities of a controlled corporation" if the distribution is part of a plan having as one of its principal purposes the avoidance of federal income tax. While there is conceptual overlap between the two provisions — both are designed to prevent abuse of the § 355 tax-free distribution mechanism — they operate independently, and a distribution may satisfy the device test while failing the principal purpose test, or vice versa. This memorandum addresses only the device test; the § 355(a)(3) principal purpose requirement is addressed in the Comprehensive Memo.
B. Treasury Regulations — Treas. Reg. § 1.355-2(d)
The Treasury Regulations under Section 355, specifically Treas. Reg. § 1.355-2(d), provide the principal administrative guidance for the application of the device test. The regulatory framework establishes three categories of factors relevant to the device determination:
1. Device factors (Treas. Reg. § 1.355-2(d)(2)): factors that tend to establish the existence of a device — i.e., factors that suggest the transaction was used principally as a mechanism for distributing earnings and profits at favorable rates.
2. Non-device factors (Treas. Reg. § 1.355-2(d)(3)): factors that tend to establish the absence of a device — i.e., factors that suggest the transaction was undertaken for legitimate non-tax purposes and was not principally a mechanism for distributing earnings and profits.
3. "Ordinarily not a device" safe harbor (Treas. Reg. § 1.355-2(d)(5)): certain distributions that, by reason of their characteristics, will ordinarily not be considered a device, notwithstanding the presence of device factors.
The regulations make clear that no single factor, whether a device factor or a non-device factor, is determinative. The determination of whether a transaction is a device requires a holistic analysis in which the strength and relevance of each device factor is weighed against the strength and relevance of each non-device factor, in light of all the facts and circumstances. The following subsections describe the specific device factors and non-device factors identified in the regulations.
C. Device Factors (Treas. Reg. § 1.355-2(d)(2))
The regulations identify three principal device factors.
1. Pro Rata Distribution (Treas. Reg. § 1.355-2(d)(2)(ii)). A pro rata (or substantially pro rata) distribution is more likely to be a device than a non-pro rata distribution. The regulation explains that a pro rata distribution "presents the greatest opportunity for the distribution of earnings and profits in the guise of a tax-free reorganization" because all shareholders receive stock of the controlled corporation in the same proportions as their existing holdings of the distributing corporation. This replication of proportionate interests creates an economic result that is analytically similar to a dividend distribution — each shareholder receives additional property (controlled corporation stock) without any change in relative ownership, potentially enabling a shareholder to sell the controlled corporation stock and thereby extract value at capital gains rates.
2. Subsequent Sale or Exchange (Treas. Reg. § 1.355-2(d)(2)(iii)). A sale or exchange of stock of either the distributing corporation or the controlled corporation after the distribution is evidence that the transaction was used as a device. The strength of this evidence depends on several factors, including whether the sale was negotiated or agreed upon before the distribution. The regulations draw a critical distinction between (a) sales that were "negotiated or agreed upon" before the distribution (i.e., prearranged sales), which constitute "substantial evidence" of a device, and (b) sales that were not negotiated or agreed upon before the distribution but that occur after the distribution, which constitute evidence of a device but evidence of relatively less strength. A sale that occurs shortly after the distribution is stronger evidence of a device than a sale that occurs long after the distribution. The absence of any post-distribution sale is a favorable consideration but is not, by itself, determinative.
3. Nature and Use of Assets (Treas. Reg. § 1.355-2(d)(2)(iv)). If either the distributing corporation or the controlled corporation, immediately after the distribution, holds a disproportionate amount of non-operating assets, assets not required in the conduct of an active trade or business, or investment-type assets (such as cash, securities, or real estate held for investment), this factor tends to establish a device. The concern is that the distribution of controlled corporation stock may serve as a mechanism for extracting accumulated earnings that are reflected in such non-business assets, enabling shareholders to realize the value of those earnings at capital gains rates by selling the distributed stock. The regulations further provide, in Treas. Reg. § 1.355-2(d)(4), that the device potential of a distribution is measured in part by comparing the ratio of the earnings and profits of each corporation to the fair market value of its stock.
D. Non-Device Factors (Treas. Reg. § 1.355-2(d)(3))
The regulations identify several non-device factors that tend to establish the absence of a device.
1. Corporate Business Purpose (Treas. Reg. § 1.355-2(d)(3)(ii)). The existence of a corporate business purpose for the distribution is evidence that the transaction is not a device. The regulations specify that the stronger the evidence of a corporate business purpose, the stronger the evidence that the distribution is not a device. The business purpose must be a "real and substantial non Federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group," as set forth in Treas. Reg. § 1.355-2(b)(2). A shareholder-level purpose, as distinguished from a corporate-level purpose, does not qualify. The corporate business purpose is frequently the single most important non-device factor in the analysis, and its absence or weakness can be dispositive.
2. Public Trading (Treas. Reg. § 1.355-2(d)(3)(iii)). The fact that the stock of either the distributing corporation or the controlled corporation is publicly traded, or that either corporation is widely held, is evidence that the distribution is not a device. The rationale is that shareholders of a publicly traded company can sell their stock on the open market and realize capital gains without the need for a spin-off transaction; accordingly, the use of a spin-off as a "device" to extract earnings at capital gains rates is less plausible when shareholders already have access to a liquid market for their stock. This factor applies with respect to both the distributing corporation and the controlled corporation.
3. Absence of Earnings and Profits / Dividend History. While not expressly enumerated as a separate non-device factor in the regulations, the absence of a history of dividend payments by the distributing corporation is a relevant consideration in the overall facts-and-circumstances analysis. Where the distributing corporation has historically retained its earnings rather than distributing them as dividends, the spin-off is less likely to be characterized as a substitute for a dividend distribution.
E. "Ordinarily Not a Device" Safe Harbor (Treas. Reg. § 1.355-2(d)(5))
Treas. Reg. § 1.355-2(d)(5) establishes a safe harbor under which certain distributions are treated as "ordinarily not a device." To qualify for this safe harbor, the distribution must satisfy certain conditions, including that (i) neither the distributing corporation nor the controlled corporation is a "disqualified investment corporation" (i.e., neither corporation holds a substantial amount of non-business assets relative to its total assets), and (ii) the distribution is motivated by a substantial corporate business purpose. The safe harbor provides an additional degree of comfort in cases where the facts clearly indicate that the distribution is not a mechanism for extracting earnings at preferential rates, but it is not an absolute guarantee — the regulations indicate that the safe harbor may not apply in unusual circumstances.
The applicability of the safe harbor to the proposed Spin-Off is discussed in Section VI.B below.
IV. Application of Device Factors to the Proposed Spin-Off
A. Pro Rata Distribution (Device Factor)
The proposed Distribution of Meridian stock to Veldran shareholders is pro rata. Each holder of Veldran common stock will receive one share of Meridian common stock for each share of Veldran common stock held on the record date, resulting in a 1:1 distribution ratio. Following the Distribution, each Veldran shareholder will hold shares of both Veldran and Meridian in identical proportions to their pre-Distribution Veldran holdings. HPE Fund IV (through HVH) will hold 62.4% of both Veldran and Meridian; Prescott will hold 14.8% of both entities; management stockholders will hold 5.3% of both entities; and the remaining public and institutional investors will hold 17.5% of both entities.
Under Treas. Reg. § 1.355-2(d)(2)(ii), a pro rata distribution presents the "greatest opportunity for the distribution of earnings and profits in the guise of a tax-free reorganization" and is therefore more likely to be a device than a non-pro rata distribution. The economic result of the pro rata Distribution is that each shareholder receives Meridian stock — a new asset — without any change in relative ownership, closely mirroring the effect of a dividend distribution. A shareholder who receives Meridian stock could, in theory, sell that stock shortly after the Distribution and realize capital gains on the sale, effectively extracting a portion of the value of the Precision Flow Solutions Division at capital gains rates rather than at ordinary income rates.
Assessment. This factor weighs in favor of a device finding. The degree of concern is moderate. The pro rata nature of the Distribution is an established device factor under the regulations, and there is no basis for distinguishing the proposed Distribution from the type of pro rata distribution contemplated by the regulation. However, it is important to recognize that the pro rata nature of the Distribution, standing alone, is not dispositive of the device inquiry. A very substantial number of spin-off transactions that have been approved by the IRS in private letter rulings and that have been treated as tax-free by taxpayers without rulings have involved pro rata distributions. The critical question is whether the pro rata device factor is outweighed by sufficiently strong non-device factors — a question that turns primarily on the strength of the corporate business purpose.
We note that a non-pro rata distribution was not considered for the proposed Spin-Off because the business rationale for the transaction requires all Veldran shareholders to participate equally in the separation. A non-pro rata distribution (e.g., a split-off or exchange offer) would fundamentally alter the transaction structure and would raise a separate set of transactional, corporate governance, and regulatory considerations that are outside the scope of this memorandum.
B. Subsequent Sale or Exchange (Device Factor)
As of the date of this memorandum, no agreement, understanding, or arrangement regarding a post-spin sale or exchange of either Veldran stock or Meridian stock has been disclosed to Calderwood & Harkness. The draft Representation Letter (Second Draft dated July 11, 2022), which is currently under review by Veldran's management and in-house counsel, includes the following representations that are directly relevant to this device factor:
(i) Neither Veldran nor HPE Fund IV (nor any of their respective affiliates, officers, directors, or representatives) has entered into any agreement, understanding, or arrangement, nor is there any plan or intention, for the sale, exchange, transfer, or redemption of Meridian stock or Veldran stock following the Distribution.
(ii) The Distribution is not being undertaken in connection with, or as a step in, any planned or contemplated acquisition, merger, or other business combination involving Veldran or Meridian.
These representations, if accurate and complete, substantially mitigate the subsequent-sale device factor. In the absence of any prearranged or negotiated sale, the evidentiary weight of this factor is minimal under Treas. Reg. § 1.355-2(d)(2)(iii).
Critical Concern — HPE Fund IV's Controlling Position and PE Fund Dynamic. Notwithstanding the foregoing representations, the engagement team has identified a significant analytical complication arising from HPE Fund IV's 62.4% controlling position in Veldran. HPE Fund IV is, by definition and business mandate, a private equity fund that acquires, improves, and exits portfolio investments. The fund's limited partnership agreement, offering memorandum, and investment thesis all contemplate eventual monetization of portfolio investments for the purpose of generating returns for the fund's limited partners. While HPE Fund IV has not disclosed any specific plan or timeline for the disposition of its Veldran (or post-spin Meridian) stake, the IRS could take the position that the inherent nature of a PE fund's investment strategy creates a reasonable expectation of a future sale or exit transaction, potentially converting what would otherwise be a non-prearranged future disposition into a factor that evidences a device.
This concern requires careful analysis. The regulations governing the subsequent-sale device factor focus on whether a sale was "negotiated or agreed upon" before the distribution, and on the specificity and concreteness of any pre-distribution sale discussions. A PE sponsor's general investment horizon and business model — including the expectation that portfolio investments will eventually be monetized — is not, by itself, a "plan" or "arrangement" for a subsequent sale within the meaning of Treas. Reg. § 1.355-2(d)(2)(iii). The regulations contemplate a degree of specificity and concreteness that goes beyond a general expectation of eventual exit. To constitute a "prearranged" sale, there must be concrete discussions, negotiations, or understandings with identified counterparties regarding specific transaction terms.
However, the engagement team should be acutely aware that if HPE Fund IV were to sell its Meridian stock — or engage in a merger transaction, recapitalization, or other disposition involving Meridian — within a relatively short period following the Distribution, the IRS would very likely scrutinize whether the Spin-Off was used as a device for the distribution of earnings and profits. A post-spin sale occurring within the first twelve to twenty-four months following the Distribution would be particularly problematic, as the temporal proximity would support an inference that the sale was contemplated (if not concretely planned) at the time of the Distribution.
The § 355(e) analysis conducted in the separate § 355(e) Plan Analysis Memorandum dated June 28, 2022 also addresses overlapping concerns regarding the relationship between the September 20, 2019 HPE Fund IV acquisition and the proposed Spin-Off. The § 355(e) "plan" analysis and the device analysis share common factual predicates — most importantly, the presence and nature of any pre-spin exit discussions by HPE Fund IV — and the conclusions of the two analyses should be consistent.
Assessment. This factor is currently neutral to slightly favorable (tending to establish the absence of a device), based on the representations that no post-spin sale or exchange has been agreed upon, negotiated, or planned. However, the PE fund dynamic introduces meaningful uncertainty into this assessment. The strength of this factor is entirely contingent on the accuracy of the no-plan representations in the Representation Letter, and the engagement team should carefully probe the factual basis for these representations before finalizing the opinion.
C. Nature and Use of Assets (Device Factor)
The regulations provide that the holding of significant non-operating, investment-type, or non-business assets by either the distributing corporation or the controlled corporation, immediately after the distribution, is a device factor. The concern is that such assets may represent accumulated earnings and profits that are being distributed to shareholders through the spin-off mechanism at capital gains rates. This section examines the post-spin asset composition of each entity.
Veldran (Distributing) Post-Spin. Following the Contribution and Distribution, Veldran will retain the Engineered Coatings Division, which is an operating business generating approximately $1.52 billion in revenue and approximately $285 million in EBITDA (FY2021). The assets of the Engineered Coatings Division consist principally of manufacturing facilities, equipment, intellectual property (patents, trade secrets, proprietary formulations), customer contracts, and working capital used in the ordinary course of business. Based on the due diligence conducted to date, no material non-operating or investment-type assets have been identified within the Engineered Coatings Division. Veldran's existing indebtedness — the $1.1 billion First Lien Term Loan B and the $450 million Senior Unsecured Notes due 2027 — is attributable to the ongoing operating business and does not indicate the presence of excess cash or investment assets. The allocation of this indebtedness between Veldran and Meridian in the Spin-Off has not been finalized, but regardless of the allocation, the fundamental character of the retained assets as operating assets used in an active trade or business is not affected.
Meridian (Controlled) Post-Spin. Following the Contribution and Distribution, Meridian will hold the assets and liabilities of the Precision Flow Solutions Division, which is an operating business generating approximately $820 million in revenue and approximately $133 million in EBITDA (FY2021). The assets of the Precision Flow Solutions Division consist principally of manufacturing facilities, precision machining equipment, intellectual property (patents, engineering designs, proprietary processes), customer contracts, inventory, and working capital used in the ordinary course of business. The division's assets include those attributable to the Kestrel Precision Controls business, which was acquired on June 7, 2019 from Rennick Industrial Partners Fund II LP for $295 million in a taxable stock acquisition. The Kestrel assets are operating assets used in the manufacture of precision fluid-control systems, and they do not include any material non-operating or investment-type assets.
Based on the information available as of the date of this memorandum, neither Distributing nor Controlled will hold, immediately following the Distribution, any substantial non-business assets, passive investment assets, or assets not required in the conduct of an active trade or business. Both divisions are actively engaged in industrial manufacturing and engineering, and their asset bases consist overwhelmingly of operating assets used in the production of revenue.
Assessment. This factor is neutral to favorable (tending to establish the absence of a device). There is no evidence that either entity holds significant passive investment assets, excess cash, marketable securities, or other non-business assets that would suggest the Spin-Off is being used as a mechanism to extract accumulated earnings at preferential rates. This conclusion is subject to verification through the ongoing due diligence process, and the engagement team should confirm at the time of the opinion that no material non-business assets have been introduced into either entity's balance sheet.
V. Application of Non-Device Factors to the Proposed Spin-Off
A. Corporate Business Purpose (Non-Device Factor)
The corporate business purpose is widely recognized as the single most important non-device factor in the § 355 device analysis. A strong corporate business purpose provides powerful evidence that the distribution is not a device for the distribution of earnings and profits, because it establishes that the transaction is motivated by legitimate operational and strategic considerations unrelated to the extraction of corporate earnings at capital gains rates. Conversely, the absence of a compelling corporate business purpose — or the articulation of purposes that are primarily shareholder-level rather than corporate-level in nature — substantially weakens the non-device case and may be insufficient to offset even moderate device factors.
The Business Purpose Memorandum dated July 18, 2022 identifies two preliminary corporate business purposes for the proposed Spin-Off:
(1) Independent Capital-Allocation Strategies. Enabling each business (Engineered Coatings and Precision Flow Solutions) to pursue independent capital-allocation strategies tailored to their distinct end markets, growth trajectories, and capital needs. The Engineered Coatings business primarily serves the aerospace, defense, and automotive sectors and requires capital for incremental capacity expansion and specialty material development. The Precision Flow Solutions business serves petrochemical, water-infrastructure, and industrial process markets and requires capital for research and development investment and potential bolt-on acquisitions in niche flow-control segments. As a combined enterprise, the two businesses compete for capital allocation within a single corporate structure, and their divergent capital needs may result in sub-optimal investment decisions for one or both divisions.
(2) Enhanced Management Focus and Operational Efficiency. Allowing each entity's management team to concentrate on its specific industry dynamics, customer relationships, and competitive challenges without distraction from the needs and priorities of the other division. The Engineered Coatings business and the Precision Flow Solutions business operate in different end markets, face different competitive pressures, and require different operational capabilities. Separation of the two businesses would allow each management team to focus exclusively on its own division, potentially improving operational performance, strategic decision-making, and accountability.
Significant Concern — Strength of Business Purpose Articulation. Both of the foregoing business purposes, while facially reasonable, are vulnerable to the critique that they are, in substance, reflections of HPE Fund IV's fund-level objectives rather than genuine corporate-level purposes of Veldran. As analyzed in the Business Purpose Memo and as flagged in Leonard Cross's email to Christine Yeung dated July 22, 2022, the current articulation presents several areas of concern.
First, the "independent capital-allocation" purpose could be characterized as serving HPE Fund IV's desire to create two separate "pure-play" investment vehicles that are more attractive to potential acquirers, more easily valued by the market, and more readily monetized than a diversified conglomerate. While independent capital allocation may indeed benefit each business at the corporate level, the risk is that the IRS would view this purpose as primarily motivated by HPE Fund IV's fund-level interest in maximizing exit value and facilitating the return of capital to its limited partners.
Second, the "enhanced management focus" purpose is a frequently cited justification for spin-off transactions, and the IRS has generally accepted it as a valid corporate business purpose when supported by concrete evidence. However, in the context of a PE-controlled portfolio company, the IRS may question whether the management focus rationale is genuinely independent of the PE sponsor's investment strategy or whether it is merely a post-hoc rationalization for a transaction that is primarily driven by the sponsor's exit planning.
Treas. Reg. § 1.355-2(b)(2) provides that a shareholder-level purpose — as opposed to a corporate-level purpose — does not qualify as a valid business purpose for § 355. The purpose must be "a real and substantial non Federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group." The distinction between a corporate-level purpose and a shareholder-level purpose is not always clear-cut, and the line between the two can be particularly difficult to draw in the PE context, where the interests of the controlling shareholder (the PE fund) and the interests of the portfolio company are often closely aligned.
Jonathan Caldecott, Veldran's CEO, has acknowledged (in discussions with the engagement team) difficulty in articulating business purposes that are independent of HPE Fund IV's strategic objectives. This acknowledgment, while commendable in its candor, underscores the analytical vulnerability of the current business purpose articulation. If the business purposes are viewed as weak or primarily shareholder-driven, the non-device weight of this factor is substantially diminished, which significantly increases the overall device risk.
Assessment. The corporate business purpose factor is currently a moderately favorable non-device factor, but it is substantially weakened by the unresolved articulation issues described above. If the business purposes are not strengthened to reflect genuine corporate-level purposes that are independent of — and distinguishable from — HPE Fund IV's fund-level monetization and LP return objectives, this factor may carry insufficient weight to offset the pro rata device factor. The resolution of this issue is, in the judgment of the engagement team, the single most important determinant of the outcome of the device analysis.
B. Public Trading / Widely Held Stock (Non-Device Factor)
Under Treas. Reg. § 1.355-2(d)(3)(iii), the fact that the stock of either the distributing corporation or the controlled corporation is publicly traded or widely held is evidence that the distribution is not a device. The rationale for this non-device factor is straightforward: where shareholders have access to a liquid public market for their stock, they can achieve capital gains treatment by selling their existing shares and do not need the spin-off mechanism to extract value from the corporation. The spin-off is therefore less likely to be a "device" when shareholders already possess a readily available alternative for converting their investment into cash at capital gains rates.
In the case of the proposed Spin-Off, the applicability of this non-device factor is limited by several considerations:
Veldran is not publicly traded. Veldran shares are not listed on a national securities exchange such as the New York Stock Exchange or NASDAQ. While a limited secondary market exists for Veldran shares, and a portion of the outstanding shares are held by institutional investors, Veldran is fundamentally a controlled private company. The lack of public trading significantly limits the weight of this non-device factor, because the rationale underlying the factor — that shareholders can sell their existing shares on the open market — does not apply with equal force to a company whose shares are not publicly traded in a liquid market.
Post-spin, Meridian is expected to be publicly listed. We understand that Brackenridge & Co. is advising Veldran and Meridian on the post-spin capital structure and that a public listing of Meridian shares is contemplated. If Meridian shares are publicly listed following the Spin-Off, this would provide some support for the non-device argument with respect to the controlled corporation. However, the pre-spin status of Veldran as a controlled private company remains the dominant consideration for purposes of this factor.
Concentrated ownership structure. The ownership structure of Veldran is highly concentrated. HPE Fund IV holds 62.4% of the outstanding shares through HVH; Prescott holds 14.8%; and management stockholders hold 5.3%. Only approximately 17.5% of Veldran's outstanding shares are held by dispersed public and institutional investors. This concentration of ownership further reduces the weight of the public trading/widely held stock non-device factor. The largest shareholder is a PE fund that could, by virtue of its controlling position, effect a disposition of Meridian stock without using the Distribution mechanism — a consideration that cuts against the non-device argument. However, the converse argument is also available: HPE Fund IV could sell its Veldran stock directly (e.g., through a secondary sale or a strategic sale of the entire company) and does not need the Spin-Off to achieve capital gains treatment. Both arguments have some force, and neither is dispositive.
Assessment. This factor is a weak to moderate non-device factor given the private-company status of Veldran and the concentrated ownership structure. While the anticipated public listing of Meridian provides some incremental support, the overall weight of this factor in the non-device analysis is limited.
C. Absence of Earnings and Profits / Dividend History (Non-Device Factor)
While not expressly enumerated as a separate non-device factor in Treas. Reg. § 1.355-2(d)(3), the absence of a history of regular dividend payments by the distributing corporation is a relevant consideration in the overall facts-and-circumstances analysis. If the distributing corporation has historically distributed its earnings to shareholders in the form of regular dividends, a spin-off transaction that occurs in the same period may be viewed with greater suspicion as a potential substitute for a dividend. Conversely, if the distributing corporation has historically retained its earnings, the spin-off is less likely to be characterized as a device for distributing those earnings.
Veldran has not paid any regular cash dividends on its common stock since its incorporation in March 2019. Earnings have consistently been reinvested in the business or applied to service the company's outstanding indebtedness. This history of retention, rather than distribution, of earnings is modestly favorable to the non-device case. It suggests that the Distribution of Meridian stock is not a substitute for what would otherwise have been a cash dividend distribution, because Veldran's established practice has been to retain, rather than distribute, its earnings.
However, the weight of this factor should not be overstated. Veldran has substantial accumulated earnings and profits. FY2021 consolidated EBITDA was $418 million. The fact that Veldran has accumulated substantial earnings — even though those earnings have not historically been distributed — means that the potential for a device is real. The device concern arises not from the historical pattern of dividend payments (or lack thereof) but from the potential for the spin-off to serve as a mechanism for extracting those accumulated earnings at capital gains rates in the future.
Assessment. The absence of a dividend history is a modestly favorable non-device factor that provides incremental support for the conclusion that the Spin-Off is not a device. However, it is a relatively weak factor in the overall analysis and does not, by itself, offset the pro rata device factor or substitute for a strong corporate business purpose.
VI. Interaction of Device Factors and Non-Device Factors — Weighing Analysis
A. Balancing Framework
The device test requires a holistic weighing of all relevant device factors against all relevant non-device factors, in light of the totality of the facts and circumstances. The following summary reflects our assessment of the weight of each factor in the context of the proposed Spin-Off.
Summary of Device Factors:
(i) Pro rata distribution: Moderate device factor. The proposed Distribution is pro rata (1:1), which presents the greatest opportunity for the distribution of earnings and profits in the guise of a tax-free reorganization. This factor weighs in favor of a device finding, but is not dispositive.
(ii) Subsequent sale or exchange: Neutral, but with uncertainty introduced by the PE fund dynamic. No prearranged or negotiated post-spin sale has been identified, and the representations in the draft Representation Letter affirmatively deny the existence of any such plan or arrangement. However, the inherent nature of HPE Fund IV's investment strategy creates a reasonable expectation of an eventual exit, which the IRS could characterize as bearing on the subsequent-sale factor. On balance, this factor is neutral to slightly favorable (non-device) as of the date of this memorandum.
(iii) Nature and use of assets: Neutral to favorable (non-device). Both Distributing and Controlled will hold substantially all operating assets used in active trades or businesses; no significant non-business or investment-type assets have been identified. This factor does not support a device finding.
Summary of Non-Device Factors:
(i) Corporate business purpose: Potentially strong, but currently weakened by unresolved articulation concerns. The two preliminary business purposes identified in the Business Purpose Memo — independent capital allocation and enhanced management focus — are facially reasonable but vulnerable to the characterization that they primarily serve HPE Fund IV's fund-level objectives. If the business purposes are strengthened to reflect genuine corporate-level purposes, this factor could carry substantial non-device weight. In its current posture, the factor is only moderately favorable.
(ii) Public trading / widely held stock: Weak to moderate non-device factor. Veldran is a private company with concentrated ownership. The anticipated public listing of Meridian provides some support, but the overall weight of this factor is limited.
(iii) Absence of dividend history: Modestly favorable non-device factor. Veldran has not paid regular dividends, suggesting that the Spin-Off is not a substitute for a dividend distribution. However, this factor is relatively weak in the overall analysis.
Weighing Conclusion. On balance, the non-device factors can outweigh the device factors, and the proposed Spin-Off can satisfy the device test, if and only if the corporate business purpose articulation is strengthened to reflect genuine corporate-level purposes of Veldran and Meridian that are independent of HPE Fund IV's fund-level investment objectives. If the business purposes remain in their current state, the moderate pro rata device factor — combined with the PE fund dynamic and the limited public trading non-device factor — may not be adequately offset, and the device test would present a significant risk to the "should" level opinion.
The non-device case is strongest when the following conditions are satisfied simultaneously: (a) robust, well-documented corporate-level business purposes; (b) no prearranged or negotiated post-spin disposition of Veldran or Meridian stock; (c) operating businesses on both sides of the spin with no significant non-business assets; and (d) post-spin restrictions on stock issuances, mergers, and other transactions that could implicate device or § 355(e) concerns. The engagement team should work to ensure that all four conditions are met before the opinion is issued.
B. "Ordinarily Not a Device" Safe Harbor Analysis
Treas. Reg. § 1.355-2(d)(5) provides that certain distributions will "ordinarily" not be treated as a device. The engagement team has assessed whether this safe harbor is available with respect to the proposed Spin-Off.
Non-Business Assets. The safe harbor requires that neither the distributing corporation nor the controlled corporation, immediately after the distribution, be a "disqualified investment corporation" — i.e., neither corporation may hold a disproportionate amount of non-business or investment-type assets relative to its total assets. As discussed in Section IV.C, both Veldran (post-spin) and Meridian will hold substantially all operating assets used in active trades or businesses, and no significant non-business or investment-type assets have been identified in either entity. This element of the safe harbor appears to be satisfied based on the information available as of the date of this memorandum.
Corporate Business Purpose. The safe harbor generally requires the presence of a substantial corporate business purpose for the distribution. As discussed at length in Section V.A above, the current articulation of the business purposes for the proposed Spin-Off is under-developed and is vulnerable to the critique that the stated purposes are primarily shareholder-level (HPE Fund IV) purposes rather than genuine corporate-level purposes. Until this issue is resolved, we cannot rely on the safe harbor with confidence.
Preliminary View. The "ordinarily not a device" safe harbor may be available if the business purpose concerns are resolved. The non-business asset condition appears to be satisfied, and the remaining conditions of the safe harbor do not present obvious obstacles. However, in its current posture, the safe harbor cannot be relied upon as a basis for the "should" level opinion. The engagement team should revisit this analysis after the business purpose articulation is finalized.
C. The PE Sponsor Dynamic — Special Consideration
The most analytically challenging aspect of the device analysis in this matter is the 62.4% controlling stake held by HPE Fund IV. The PE sponsor dynamic is not a separate device factor or non-device factor expressly identified in the regulations, but it pervades the entire analysis and affects the weight assigned to several factors. This subsection provides an extended discussion of the analytical complications introduced by the PE sponsor's controlling position.
Nature of the PE Fund's Investment. HPE Fund IV is a $6.8 billion private equity fund with a 2018 vintage. Like all PE funds, HPE Fund IV has a limited fund life (typically ten to twelve years, with possible extensions), and its general partner owes fiduciary obligations to the fund's limited partners to generate investment returns through the acquisition, improvement, and monetization of portfolio companies. The fund's limited partnership agreement, offering memorandum, and investment committee materials almost certainly contemplate that each portfolio investment will be exited within the fund's investment horizon — typically five to seven years from the date of initial investment. HPE Fund IV acquired its 62.4% stake in Veldran on September 20, 2019. As of the proposed Distribution date in Q4 2022, HPE Fund IV would be approximately four years into its investment in Veldran, well within the typical PE fund investment horizon but approaching the point at which exit planning is a natural and expected part of the fund lifecycle.
IRS Perspective. The IRS could argue that a spin-off by a PE-controlled company inherently presents a heightened device concern because the PE sponsor's business model contemplates a disposition of the portfolio company investment. Under this view, the spin-off is a preparatory step — creating two separate, potentially more marketable, pure-play companies — that facilitates the PE sponsor's eventual exit. The IRS could further argue that the spin-off enables the PE sponsor to pursue separate exit paths for each company (e.g., a sale of Meridian to a strategic acquirer while retaining Veldran for a future IPO, or vice versa), thereby maximizing the aggregate exit proceeds and the return to the fund's limited partners.
Counterarguments. There are several important counterarguments to the IRS's potential position. First, a PE sponsor's general expectation of an eventual exit is characteristic of all PE investments and does not, by itself, constitute a "plan," "agreement," or "arrangement" for a subsequent sale within the meaning of Treas. Reg. § 1.355-2(d)(2)(iii). The regulations require specificity and concreteness — discussions with identified counterparties, agreed-upon terms, or active negotiations — that go beyond a general investment strategy. Second, the spin-off of a portfolio company division is not inherently a device merely because the PE sponsor controls the company. PE-controlled companies, like all companies, may have legitimate corporate business purposes for separating distinct business lines. Third, HPE Fund IV could monetize its Veldran investment through alternative means — such as a direct sale of its Veldran stock, a sale of the entire company, or an IPO of Veldran itself — without the need for a spin-off. The availability of alternative monetization paths undermines the argument that the spin-off is being used as a "device" to extract earnings at preferential rates.
Analytical Framework. The engagement team should distinguish between (a) a general expectation of eventual exit, which is characteristic of all PE sponsors and does not, by itself, constitute a "plan" or "device," and (b) a concrete plan, agreement, understanding, or active negotiation to sell Meridian stock or engage in a merger or business combination involving Meridian following the Distribution, which would constitute strong (and potentially dispositive) evidence of a device. The representations in the draft Representation Letter (Second Draft, July 11, 2022) are the critical factual predicate for this distinction. Those representations must affirmatively and specifically state that there are no discussions, negotiations, understandings, or arrangements regarding a post-spin sale, merger, or combination involving Meridian, and that HPE Fund IV's investment committee has not approved, discussed, or contemplated such a transaction in connection with the Spin-Off.
Practical Considerations. Given that HPE Fund IV's vintage is 2018 and the proposed Distribution is targeted for Q4 2022, the fund would be approximately four years into its investment at the time of the Distribution. The typical PE fund investment horizon of five to seven years suggests that exit planning may begin to intensify within one to three years following the Distribution. Calderwood & Harkness should recommend that the representations specifically address the timing and status of any exit discussions, including whether HPE Fund IV's investment committee has conducted any preliminary analysis of exit alternatives for either Veldran or Meridian.
Cross-Reference. The § 355(e) Plan Analysis Memorandum dated June 28, 2022 addresses overlapping concerns regarding whether the September 20, 2019 HPE Fund IV acquisition and the proposed Spin-Off are part of a "plan" or "series of related transactions" within the meaning of § 355(e). The § 355(e) analysis and the device analysis share common factual predicates, particularly with respect to pre-spin exit discussions by HPE Fund IV, and the conclusions of the two analyses must be internally consistent.
VII. Impact of the Kestrel Acquisition on Device Analysis
The Precision Flow Solutions Division includes the Kestrel Precision Controls business ("Kestrel"), which was acquired by Veldran on June 7, 2019, from Rennick Industrial Partners Fund II LP for $295 million in a taxable stock acqui