1003-00005 · Veldran Industries Holdings · Tax Analysis

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MEMORANDUM

PRIVILEGED AND CONFIDENTIAL ATTORNEY WORK PRODUCT

TO: File — Matter No. HRW-SPIN-001 (Engagement No. 1003-00005)

FROM: Leila Nazari, Associate, Tax Department, Calderwood & Harkness LLP

REVIEWED BY: Garrett Simmons, Senior Associate, Tax Department; Leonard Cross, Partner, Tax Department

DATE: June 1, 2022

RE: Section 355(b) Active Trade or Business Analysis — Kestrel Precision Controls, Inc. Acquisition Issue; Proposed Pro Rata Distribution by Veldran Industries Holdings, Inc. of Meridian Flow Technologies, Inc. Common Stock

CLIENT: Harrowgate Private Equity Fund IV, L.P.

This memorandum constitutes attorney work product prepared in connection with the engagement referenced above. It is privileged and confidential and is intended solely for internal use by Calderwood & Harkness LLP and the client identified above. This memorandum is not intended for reliance by, and may not be disclosed to, any third party without the prior written consent of Calderwood & Harkness LLP and the client.

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I. Executive Summary

The purpose of this memorandum is to analyze whether both the Engineered Coatings Division (which will remain with Veldran Industries Holdings, Inc. ("Veldran" or "Distributing")) and the Precision Flow Solutions Division (which will be contributed to Meridian Flow Technologies, Inc. ("Meridian," "MFT," "Controlled," or "SpinCo")) independently satisfy the five-year active trade or business ("ATB") requirement under Section 355(b) of the Internal Revenue Code of 1986, as amended (the "Code"). This analysis is being prepared in connection with the proposed pro rata distribution by Veldran of 100% of the common stock of Meridian to Veldran's shareholders, which is intended to qualify as a tax-free spin-off under Sections 355(a) and 368(a)(1)(D) of the Code.

The central issue addressed in this memorandum arises from Veldran's acquisition of Kestrel Precision Controls, Inc. ("Kestrel"), a Georgia corporation, on June 7, 2019. Veldran acquired 100% of the outstanding stock of Kestrel from Rennick Industrial Partners Fund II LP ("Rennick Fund II") in a fully taxable stock acquisition for cash consideration of $295,000,000. Following the acquisition, Kestrel was integrated into the Precision Flow Solutions Division. As of FY2021, the Kestrel business constitutes approximately 35% of the Precision Flow Solutions Division's total revenue, representing approximately $287 million of the division's $820 million in aggregate revenue.

The Kestrel acquisition closed on June 7, 2019. The anticipated distribution date is Q4 2022 (exact date not yet determined). The five-year look-back period mandated by Section 355(b)(2)(B) therefore extends from the distribution date back approximately five years to approximately Q4 2017. Because the Kestrel acquisition falls squarely within this five-year window, Section 355(b)(2)(C) of the Code is facially implicated. That provision generally prohibits a trade or business from counting toward the ATB requirement if it was "acquired within the [five-year] period . . . in a transaction in which gain or loss was recognized in whole or in part."

However, Section 355(b)(2)(D) provides a critical safe harbor. Under that provision, the prohibition in Section 355(b)(2)(C) does not apply where the acquired corporation was itself conducting the relevant trade or business throughout the entire five-year period ending on the distribution date. Kestrel Precision Controls, Inc. was founded on February 12, 2003, and has continuously conducted the precision flow controls business from its founding through the present — a period of approximately nineteen years. Accordingly, Kestrel was conducting the same trade or business for well in excess of the required five-year period.

Based on the foregoing, and subject to the qualifications and open diligence items described more fully in Sections II and VI of this memorandum, we conclude that the ATB requirement under Section 355(b) should be satisfied for both the Distributing corporation (Veldran, through its Engineered Coatings Division) and the Controlled corporation (Meridian, through its Precision Flow Solutions Division, inclusive of the Kestrel business). This conclusion is contingent upon confirmation of certain factual representations, including representations regarding Kestrel's uninterrupted operational history, the absence of a Section 338 election with respect to the Kestrel stock acquisition, the absence of any disqualifying acquisitions by Kestrel itself within the five-year window, and the organic nature of the legacy Precision Flow business.

II. Scope and Limitations

This memorandum addresses solely the Section 355(b) ATB requirement as it applies to the proposed pro rata distribution by Veldran of 100% of the Meridian common stock. We do not address in this memorandum any other requirements for qualification under Section 355, including without limitation:

(a) the device test under Section 355(a)(1)(B) (addressed in a separate memorandum prepared by Garrett Simmons, dated June 14, 2022);

(b) the business purpose requirement (addressed in a separate memorandum prepared by Garrett Simmons, dated June 14, 2022);

(d) the "disqualified distribution" rules under Section 355(d) (addressed in a separate memorandum prepared by Leila Nazari, dated June 21, 2022);

(e) the Section 355(e) "plan" analysis relating to Harrowgate Private Equity Fund IV, L.P.'s acquisition of Veldran (addressed in a separate memorandum prepared by Leila Nazari, dated June 28, 2022);

(f) the distribution of "control" requirement under Sections 355(a)(1)(D) and 368(c);

(g) the Section 368(a)(1)(D) reorganization qualification analysis; or

(h) any state or local tax consequences of the proposed distribution.

The analysis set forth in this memorandum is based on information received to date through the ongoing diligence process in connection with the engagement. The initial tax diligence request list was circulated on April 25, 2022. A supplemental information request specifically directed to the Kestrel acquisition was circulated on May 16, 2022 to Philip Crundell, General Counsel of Veldran Industries Holdings, Inc. Certain Kestrel-specific diligence items remain outstanding as of the date of this memorandum, and the analysis is expressly subject to the receipt and review of those outstanding items, which are identified in Section VI below.

The representations contained in the draft Representation Letter (first draft circulated May 6, 2022 to Philip Crundell and Sandra Waverly) are assumed to be accurate for purposes of this analysis. We note that the Representation Letter has not been finalized as of the date hereof, and certain representations relating to the ATB history of both divisions, the Kestrel operating history, and the absence of a Section 338 election remain subject to review and confirmation by Veldran management and its outside counsel at Pemberton Rathbone LLP.

This memorandum constitutes attorney work product and is protected by the attorney-client privilege. It is prepared for internal use in connection with the engagement and is not intended for reliance by any third party. No opinion of counsel is being delivered at this time; the conclusions expressed herein are preliminary and are subject to the completion of diligence and finalization of the Representation Letter.

III. Factual Background

A. Overview of the Proposed Transaction

Veldran Industries Holdings, Inc. ("Veldran" or "VIH") is a Delaware corporation (EIN 86-1920347) incorporated on March 14, 2019. Veldran's principal office is located at 2400 Commerce Park Drive, Suite 500, Charlotte, North Carolina 28217. Veldran is a diversified industrial company operating through two principal business segments: the Engineered Coatings Division and the Precision Flow Solutions Division.

Veldran proposes to distribute, on a pro rata basis, 100% of the outstanding common stock of Meridian Flow Technologies, Inc. ("Meridian" or "MFT"), a newly formed Delaware corporation that will be the corporate vehicle for the Precision Flow Solutions Division, to the shareholders of Veldran (the "Distribution"). Immediately prior to the Distribution, Veldran will contribute to Meridian all of the assets, liabilities, and equity interests associated with the Precision Flow Solutions Division, including 100% of the outstanding stock of Kestrel Precision Controls, Inc. The Distribution is intended to qualify as a tax-free distribution under Section 355(a) of the Code and, in conjunction with the pre-distribution contribution, as a reorganization under Section 368(a)(1)(D) of the Code.

The Distribution ratio will be 1:1, meaning that each holder of Veldran common stock will receive one share of Meridian common stock for each share of Veldran common stock held as of the record date for the Distribution. Veldran currently has 74,500,000 shares of common stock outstanding. Following the Distribution, Veldran will retain the Engineered Coatings Division and Meridian will hold and operate the Precision Flow Solutions Division as an independent publicly traded company.

The anticipated Distribution date is Q4 2022. The exact date has not yet been determined, but for purposes of the Section 355(b) analysis, we assume a Distribution date occurring during Q4 2022. The five-year look-back period mandated by Section 355(b)(2)(B) extends from the Distribution date back five years. Assuming a Distribution date in approximately November or December 2022, the five-year look-back period would commence in approximately November or December 2017 (i.e., approximately Q4 2017) and extend through the Distribution date.

B. Veldran's Business Segments

Veldran currently conducts its operations through two principal business segments, each of which is a substantial, independently operated business line.

Engineered Coatings Division. The Engineered Coatings Division will remain with Veldran following the Distribution. This division is engaged in the development, manufacture, and sale of industrial coatings and engineered materials for use in aerospace, automotive, energy, and general industrial applications. The division operates fourteen manufacturing facilities across the United States and internationally, and employs approximately 4,800 persons. For fiscal year ended December 31, 2021 ("FY2021"), the Engineered Coatings Division generated revenue of $1,520,000,000 and EBITDA of $285,000,000, representing an EBITDA margin of approximately 18.75%. The Engineered Coatings Division has been operated as an active trade or business by Veldran (and its predecessor entities) on a continuous basis. Based on information reviewed to date, no acquisitions of trades or businesses within the five-year look-back period have been identified that would raise concerns under Section 355(b)(2)(C) with respect to this division. This representation will be confirmed through the Representation Letter.

Precision Flow Solutions Division. The Precision Flow Solutions Division will be contributed to Meridian prior to the Distribution. This division is engaged in the design, manufacture, and sale of precision fluid-control systems, valves, actuators, and related components for industrial, petrochemical, and water-infrastructure end markets. The division operates nine manufacturing facilities and four engineering and R&D centers, and employs approximately 3,200 persons. For FY2021, the Precision Flow Solutions Division generated revenue of $820,000,000 and EBITDA of $133,000,000, representing an EBITDA margin of approximately 16.22%. Sandra Waverly, the current President of the Precision Flow Solutions Division, is planned to serve as the Chief Executive Officer of Meridian. Derek Okonkwo, the current Vice President of Finance for the Precision Flow Solutions Division, is planned to serve as the Chief Financial Officer of Meridian.

The Precision Flow Solutions Division comprises both (i) legacy precision flow operations that have been conducted by Veldran (and its predecessor entities) for a period extending well beyond the five-year look-back window (the "Legacy Precision Flow Operations") and (ii) the operations of Kestrel Precision Controls, Inc., which was acquired by Veldran on June 7, 2019 and subsequently integrated into the division (the "Kestrel Operations"). The Legacy Precision Flow Operations account for approximately 65% of the division's FY2021 revenue (approximately $533 million), and the Kestrel Operations account for approximately 35% (approximately $287 million).

On an aggregate basis, Veldran generated FY2021 revenue of $2,340,000,000 and aggregate FY2021 EBITDA of $418,000,000.

C. The Kestrel Acquisition

The acquisition of Kestrel Precision Controls, Inc. by Veldran is the transaction that gives rise to the principal Section 355(b) issue addressed in this memorandum. The material facts regarding the Kestrel acquisition are as follows:

Target. Kestrel Precision Controls, Inc. ("Kestrel") is a Georgia corporation (EIN 58-2847193). Kestrel was founded and incorporated in the State of Georgia on February 12, 2003.

Kestrel's Business. From its founding, Kestrel has been engaged in the design, manufacture, and sale of precision fluid-control components and systems, including high-specification control valves, flow regulators, and integrated control assemblies for industrial and petrochemical applications. Kestrel operated continuously in this business from its founding on February 12, 2003 through the acquisition date of June 7, 2019, and has continued to operate in the same business following the acquisition as part of the Precision Flow Solutions Division. Based on information received to date, Kestrel has not materially changed the character of its business at any point during its operating history.

Seller. Rennick Industrial Partners Fund II LP ("Rennick Fund II") is a Delaware limited partnership (EIN 82-3017564). Rennick Fund II was the sole shareholder of Kestrel at the time of the acquisition. Rennick Fund II is a private equity fund managed by Rennick Industrial Partners LLC.

Acquiror. Veldran Industries Holdings, Inc.

Closing Date. June 7, 2019.

Structure. The acquisition was structured as a taxable stock acquisition. Veldran acquired 100% of the issued and outstanding capital stock of Kestrel from Rennick Fund II in exchange for $295,000,000 in cash. No stock, securities, or other non-cash consideration was issued or paid. The transaction was structured as a fully taxable purchase; Rennick Fund II recognized gain on the sale of the Kestrel stock.

Section 338 Election. Based on information received to date, it does not appear that Veldran made an election under Section 338(g) or Section 338(h)(10) of the Code with respect to the Kestrel stock acquisition. We have requested confirmation of this fact through the supplemental diligence request sent to Philip Crundell on May 16, 2022. The absence of a Section 338 election is a critical factual assumption for purposes of the Section 355(b)(2)(D) safe harbor analysis discussed in Section V below. If no Section 338 election was made, Kestrel retained its historical tax attributes and continued as the same corporate taxpayer following the acquisition; the acquisition was treated solely as a purchase of stock rather than a deemed asset acquisition.

Purchase Price. $295,000,000, paid entirely in cash.

Post-Acquisition Integration. Following the closing, Kestrel was integrated into the Precision Flow Solutions Division. Kestrel's products and operations were combined with the Legacy Precision Flow Operations under a unified divisional management structure. As of FY2021, the Kestrel Operations comprise approximately 35% of the Precision Flow Solutions Division's revenue (approximately $287 million of $820 million).

Relevance to Section 355(b). The Kestrel acquisition closed on June 7, 2019. The anticipated Q4 2022 Distribution date means that the five-year look-back period under Section 355(b)(2)(B) reaches back to approximately Q4 2017. The June 7, 2019 Kestrel acquisition falls within this five-year window, thereby triggering analysis under Section 355(b)(2)(C). The availability of the Section 355(b)(2)(D) safe harbor is the critical question for purposes of determining whether the Precision Flow Solutions Division (inclusive of the Kestrel Operations) satisfies the ATB requirement.

D. Harrowgate's Acquisition of Veldran

Harrowgate Private Equity Fund IV, L.P. ("HPE Fund IV") (EIN 84-3291067) acquired a controlling 62.4% stake in Veldran on September 20, 2019, consisting of 46,488,000 shares of Veldran common stock at a price of $40.00 per share, for total consideration of $1,859,520,000. The acquisition was effectuated through a negotiated tender offer followed by a merger squeeze-out of Greystone Partners Fund III LP (EIN 81-2683910), the prior controlling shareholder of Veldran. Greystone Partners Fund III LP had acquired its controlling stake in Veldran in connection with Veldran's formation and initial capitalization in March 2019.

Prescott Capital Management LP (EIN 13-4928371) co-invested alongside HPE Fund IV, acquiring 15,500,000 shares of Veldran common stock at $40.00 per share for total consideration of $620,000,000. Prescott subsequently sold 4,474,000 shares in a secondary offering, reducing its holdings to 11,026,000 shares, representing approximately 14.8% of Veldran's outstanding common stock.

HPE Fund IV holds its Veldran stake through Harrowgate Veldran Holdings LLC (EIN 86-1483920), a Delaware limited liability company formed for the purpose of holding the Veldran investment.

The Harrowgate acquisition of Veldran does not itself directly implicate the Section 355(b) ATB analysis. Harrowgate acquired stock of Veldran (the Distributing corporation), not stock of a corporation conducting a trade or business that will be relied upon for ATB purposes. However, the Harrowgate acquisition is directly relevant to the Section 355(e) "plan" analysis, which examines whether the Distribution is part of a plan (or series of related transactions) pursuant to which one or more persons acquire, directly or indirectly, stock representing a 50-percent or greater interest in the Distributing or Controlled corporation. The Section 355(e) analysis is addressed in a separate memorandum dated June 28, 2022.

E. Other Veldran Shareholders

In addition to HPE Fund IV (through Harrowgate Veldran Holdings LLC) and Prescott Capital Management LP, the remaining Veldran shareholders consist of the following:

Management Stockholders. Officers and employees of Veldran hold approximately 3,948,500 shares of Veldran common stock, representing approximately 5.3% of Veldran's outstanding shares. These shares were acquired through equity incentive plans, including restricted stock unit grants and stock option exercises.

Remaining Public/Institutional Float. The remaining approximately 13,037,500 shares, representing approximately 17.5% of Veldran's outstanding common stock, are held by public and institutional investors.

The total outstanding shares of Veldran common stock are 74,500,000. The following table summarizes the current ownership structure:

IV. Applicable Legal Framework

A. Section 355(b)(1) — General Requirement

Section 355(a) of the Code provides that, under certain conditions, a distribution by a corporation to its shareholders of stock or securities of a corporation it controls immediately before the distribution is not treated as a distribution of property to which Section 301 applies. Among the several requirements that must be satisfied for a distribution to qualify under Section 355(a) is the active trade or business requirement of Section 355(b).

Section 355(b)(1) sets forth the general ATB requirement in two alternative formulations. Under Section 355(b)(1)(A), the requirement is satisfied if "the distributing corporation, and the controlled corporation (or, if stock of more than 1 controlled corporation is distributed, each of such corporations), is engaged immediately after the distribution in the active conduct of a trade or business." This is the operative provision for the proposed Distribution, as Veldran will retain the Engineered Coatings Division and Meridian will hold the Precision Flow Solutions Division, and each corporation must independently be engaged in an active trade or business immediately after the Distribution.

Section 355(b)(1)(B) provides an alternative formulation applicable where, immediately before the distribution, the distributing corporation had no assets other than stock or securities in the controlled corporations and each of the controlled corporations is engaged immediately after the distribution in the active conduct of a trade or business. This alternative is not applicable to the proposed Distribution because Veldran will retain the Engineered Coatings Division (i.e., substantial non-stock-and-securities assets) following the Distribution.

Accordingly, the analysis of the proposed Distribution must determine whether both Veldran (through the Engineered Coatings Division) and Meridian (through the Precision Flow Solutions Division) will be "engaged immediately after the distribution in the active conduct of a trade or business" within the meaning of Section 355(b)(1)(A). The phrase "active conduct of a trade or business" is defined in Section 355(b)(2), which imposes both a qualitative requirement (active conduct) and a temporal requirement (five-year operating history).

B. Section 355(b)(2) — Definition of Active Conduct of a Trade or Business

Section 355(b)(2) defines the term "active conduct of a trade or business" for purposes of Section 355(b)(1). The provision imposes four separate requirements, each of which must be independently satisfied.

Section 355(b)(2)(A) — Direct Active Conduct. A corporation is treated as engaged in the active conduct of a trade or business only if (i) it is "directly engaged in the active conduct of a trade or business," or (ii) "substantially all of the assets of such corporation consist of stock and securities of a corporation controlled by it (immediately after the distribution) which is so engaged." This requirement ensures that the trade or business is being actively conducted, as opposed to merely being passively held or financed by the relevant corporation.

Section 355(b)(2)(B) — Five-Year Active Conduct Requirement. The trade or business must have been "actively conducted throughout the 5-year period ending on the date of the distribution." This is the temporal component of the ATB requirement. It is not sufficient that the corporation be engaged in an active trade or business at the time of the distribution; the trade or business must have been actively conducted for the entire five-year period preceding the distribution date. For the proposed Distribution (anticipated Q4 2022), the five-year look-back period extends to approximately Q4 2017.

Section 355(b)(2)(C) — Prohibition on Acquisitions in Taxable Transactions. The trade or business must not have been "acquired within the period described in subparagraph (B) in a transaction in which gain or loss was recognized in whole or in part." This provision is the primary source of concern in the present analysis. It is designed to prevent a corporation from satisfying the five-year ATB requirement by purchasing an existing business within the five-year window. Because Veldran acquired the Kestrel trade or business on June 7, 2019 — within the five-year look-back period — and the acquisition was a fully taxable stock purchase in which Rennick Fund II recognized gain, Section 355(b)(2)(C) is facially implicated with respect to the Kestrel component of the Precision Flow Solutions Division.

Section 355(b)(2)(D) — Safe Harbor for Acquisitions of Corporations Conducting the Business Throughout the Five-Year Period. Section 355(b)(2)(D) provides a critically important safe harbor that moderates the potentially broad reach of Section 355(b)(2)(C). Under this provision, the prohibition in Section 355(b)(2)(C) does not apply if "control of a corporation which (at the time of acquisition of control) was conducting such trade or business" meets one of two conditions:

(i) "was not acquired directly (or through 1 or more corporations) by another corporation within the period described in [Section 355(b)(2)(B)]," or

(ii) "was so acquired by another corporation within such period, but such control was so acquired only by reason of transactions in which gain or loss was not recognized in whole or in part, or only by reason of such transactions combined with acquisitions before the beginning of such period."

The safe harbor in Section 355(b)(2)(D) is the linchpin of the analysis regarding the Kestrel acquisition. The legislative purpose of this provision is to distinguish between (a) the purchase of a business (i.e., the purchase of trade or business assets from another entity) within the five-year window, which Congress intended to preclude from satisfying the ATB requirement, and (b) the purchase of control of a corporation that was itself conducting the trade or business throughout the five-year period, which Congress determined should not be disqualifying. The rationale is that in the latter case, the trade or business has a genuine five-year operating history — it is only the ownership of the corporation conducting the business that has changed.

C. Treasury Regulation § 1.355-3

The Treasury Regulations under Section 355 provide further guidance on the application of the ATB requirement.

Treas. Reg. § 1.355-3(b)(2) — Five-Year Requirement. This regulation elaborates on the five-year active conduct requirement of Section 355(b)(2)(B). It provides that a trade or business that has been actively conducted throughout the five-year period ending on the date of the distribution includes a trade or business that has been so conducted by the distributing or controlled corporation or by a predecessor corporation. The regulation confirms that the relevant five-year period is measured backward from the date of the distribution.

Treas. Reg. § 1.355-3(b)(3) — Active Conduct. This regulation defines what constitutes the "active conduct" of a trade or business for purposes of Section 355(b). The regulation provides that a corporation is engaged in the active conduct of a trade or business if it "itself performs active and substantial management and operational functions." Activities performed by independent contractors or by persons outside the corporation do not count, except to the extent that they are performed under the supervision of the officers and employees of the corporation. The regulation also provides that the active conduct requirement is not satisfied by mere ownership of investment assets, passive collection of rents or royalties, or similar passive activities. This is a facts-and-circumstances determination.

Treas. Reg. § 1.355-3(b)(4)(iii) — Taxable Acquisitions. This regulation elaborates on the Section 355(b)(2)(C) prohibition and the Section 355(b)(2)(D) safe harbor in the context of acquisitions of trades or businesses. It confirms that a trade or business acquired in a taxable transaction within the five-year period is not treated as having been actively conducted during the five-year period, unless the safe harbor of Section 355(b)(2)(D) applies. The regulation further clarifies the interaction between the stock acquisition rules and the asset acquisition rules, providing that where control of a corporation conducting a trade or business is acquired in a taxable transaction, the analysis turns on whether the acquired corporation was conducting the trade or business throughout the five-year period.

Treas. Reg. § 1.355-3(c) — Examples. The regulations provide a series of illustrative examples that demonstrate the application of the ATB requirement in various factual scenarios. Several of these examples are directly relevant to the present analysis:

Example (7) addresses a situation in which a corporation acquires control of another corporation in a taxable purchase within the five-year period, where the acquired corporation had been conducting a trade or business for more than five years before the distribution. The example concludes that the Section 355(b)(2)(D) safe harbor applies because the acquired corporation was conducting the trade or business throughout the five-year period.

Example (8) addresses a situation in which a corporation acquires a trade or business (assets, not stock) in a taxable transaction within the five-year period. The example concludes that Section 355(b)(2)(C) applies and the trade or business cannot count toward the ATB requirement, because the safe harbor of Section 355(b)(2)(D) is not available — there was no acquisition of control of a corporation that was conducting the business.

Example (9) addresses the "expansion" concept, in which a corporation that has been actively conducting a trade or business for more than five years uses after-tax earnings to expand the business. The example concludes that such expansion does not implicate Section 355(b)(2)(C).

These examples confirm the distinction that is central to the present analysis: the acquisition of control of a corporation that has been conducting a trade or business for at least five years is treated differently under Section 355(b)(2)(D) than the acquisition of business assets in a taxable transaction.

D. Relevant Judicial and Administrative Authority

The Internal Revenue Service has issued a substantial body of private letter rulings and revenue rulings addressing the ATB requirement in the context of acquisitions within the five-year window. While private letter rulings are not precedential and may not be cited as authority, they are instructive as to the IRS's administrative practice and interpretive approach.

The IRS has consistently ruled in private letter rulings that the Section 355(b)(2)(D) safe harbor is available where the acquired corporation (i) was conducting the relevant trade or business at the time of the acquisition of control, and (ii) had been conducting that trade or business throughout the five-year period ending on the distribution date. The IRS has applied this safe harbor in cases involving taxable stock acquisitions, including cases where the acquisition price was paid entirely in cash, consistent with the facts of the Kestrel acquisition.

The IRS has also addressed the interaction between the Section 355(b)(2)(D) safe harbor and the Section 338 election rules. Where a Section 338(g) or Section 338(h)(10) election is made with respect to a stock acquisition, the target is treated for tax purposes as having sold and repurchased its assets, effectively converting the stock acquisition into a deemed asset acquisition. In such cases, the applicability of the Section 355(b)(2)(D) safe harbor may be affected, because the deemed sale and repurchase could be treated as an acquisition of business assets (rather than an acquisition of control of a corporation conducting a business) within the five-year window. This consideration underscores the importance of confirming whether a Section 338 election was made with respect to the Kestrel stock acquisition.

Separate Affiliated Group ("SAG") Rules — Section 355(b)(3). Section 355(b)(3), added by the Tax Technical Corrections Act of 2007, introduced the separate affiliated group ("SAG") concept to the Section 355(b) analysis. Under these rules, for purposes of determining whether the Distributing or Controlled corporation is engaged in the active conduct of a trade or business, all members of the corporation's "separate affiliated group" are treated as a single corporation. The SAG of a corporation is defined as the corporation and all corporations which are members of an affiliated group (as defined in Section 1504(a)) that would be determined by substituting the relevant corporation as the common parent and by applying the stock ownership requirements of Section 1504(a)(2).

The SAG rules are relevant to the present analysis because, following the Kestrel acquisition, Kestrel became a member of Veldran's affiliated group. Under the SAG rules, Kestrel's trade or business is treated as conducted by the Precision Flow Solutions Division / Meridian for purposes of the ATB analysis. The SAG rules do not, however, override the Section 355(b)(2)(C) prohibition or modify the Section 355(b)(2)(D) safe harbor; rather, they operate in conjunction with those provisions to determine attribution of trades or businesses within an affiliated group structure.

IRS Notice 2007-60, 2007-35 I.R.B. 466, provides interim guidance on the application of the SAG rules. The Notice clarifies that the SAG rules apply for purposes of the five-year ATB requirement and that trades or businesses of SAG members are attributed to the common parent (or relevant corporation) for purposes of Section 355(b)(1). The Notice also confirms that the SAG rules do not change the fundamental requirement that each trade or business relied upon must independently satisfy the five-year operating history requirement and must not have been acquired in a disqualifying taxable transaction (unless the Section 355(b)(2)(D) safe harbor applies).

V. Analysis

A. Engineered Coatings Division (Distributing — Veldran)

The Engineered Coatings Division will remain with Veldran following the Distribution. For Veldran to satisfy the ATB requirement of Section 355(b)(1)(A), the Engineered Coatings Division must constitute an active trade or business that has been actively conducted throughout the five-year period ending on the Distribution date, and the trade or business must not have been acquired in a disqualifying taxable transaction within that five-year period (unless the Section 355(b)(2)(D) safe harbor applies).

Active Conduct of a Trade or Business. The Engineered Coatings Division is engaged in the development, manufacture, and sale of industrial coatings and engineered materials for use across multiple end markets, including aerospace, automotive, energy, and general industrial applications. For FY2021, the division generated revenue of $1,520,000,000 and EBITDA of $285,000,000. The division operates fourteen manufacturing facilities and employs approximately 4,800 persons. Veldran, through its officers and employees, performs active and substantial management and operational functions with respect to the Engineered Coatings Division, including research and development, manufacturing, sales and marketing, quality control, supply chain management, and financial planning. This level of operational involvement clearly satisfies the "active conduct" requirement of Treas. Reg. § 1.355-3(b)(3). There is no indication that the Engineered Coatings Division is a passive or investment-oriented business; to the contrary, it is a substantial industrial operating business.

Five-Year Operating History. The Engineered Coatings Division has been operated as an active trade or business by Veldran since at least Veldran's incorporation on March 14, 2019. However, we understand that the operations constituting the Engineered Coatings Division trace back through predecessor entities to a period well before the five-year look-back window. While the precise history of the predecessor entities has not been fully documented in the diligence record to date, the draft Representation Letter includes a representation that the industrial coatings business has been continuously conducted for a period in excess of twenty years. Assuming the accuracy of this representation, the five-year operating history requirement is clearly satisfied, as the business has been conducted for well over five years preceding the anticipated Q4 2022 Distribution date.

We note that Veldran itself was incorporated on March 14, 2019, which is within the five-year look-back period. However, under Treas. Reg. § 1.355-3(b)(2), the five-year operating history requirement may be satisfied through predecessor corporations. If the Engineered Coatings Division was conducted by a predecessor entity prior to Veldran's incorporation, and the business was transferred to Veldran in a tax-free reorganization or other non-recognition transaction, the predecessor entity's operating history would be attributed to Veldran. This matter should be confirmed through the Representation Letter and supplemental diligence regarding Veldran's formation and the manner in which the Engineered Coatings business was acquired by Veldran.

Absence of Disqualifying Acquisitions. Based on information reviewed to date, no acquisitions of trades or businesses within the five-year look-back period have been identified that would implicate Section 355(b)(2)(C) with respect to the Engineered Coatings Division. We are not aware of any taxable acquisitions of businesses by the Engineered Coatings Division or by any predecessor entity conducting the coatings business during the five-year period. This factual representation is to be confirmed through the Representation Letter.

Preliminary Conclusion. The Engineered Coatings Division should satisfy the five-year ATB requirement under Section 355(b), subject to confirmation of representations regarding (i) the continuous operation of the coatings business for in excess of five years, including through any predecessor entities, (ii) the absence of any taxable acquisitions of trades or businesses within the five-year look-back period, and (iii) the manner in which the coatings business was transferred to or acquired by Veldran upon its formation.

B. Precision Flow Solutions Division (Controlled — Meridian)

The Precision Flow Solutions Division will be contributed to Meridian prior to the Distribution. For Meridian to satisfy the ATB requirement of Section 355(b)(1)(A), the Precision Flow Solutions Division must constitute an active trade or business that has been actively conducted throughout the five-year period ending on the Distribution date, and the trade or business (or any component thereof) must not have been acquired in a disqualifying taxable transaction within that five-year period (unless the Section 355(b)(2)(D) safe harbor applies).

The Precision Flow Solutions Division comprises two components: (i) the Legacy Precision Flow Operations, which account for approximately 65% of the division's FY2021 revenue, and (ii) the Kestrel Operations, which account for approximately 35% of the division's FY2021 revenue. The analysis must address each component.

1. Legacy Precision Flow Operations (Excluding Kestrel). Veldran has operated the Legacy Precision Flow Operations — comprising the non-Kestrel portion of the Precision Flow Solutions Division — generating approximately $533 million of the division's FY2021 revenue (approximately 65% of the total $820 million). These operations involve the design, manufacture, and sale of precision fluid-control systems, valves, and components for industrial, petrochemical, and water-infrastructure end markets.

Based on information reviewed to date, the Legacy Precision Flow Operations appear to have been conducted continuously for at least the five-year period preceding the anticipated Distribution date. As with the Engineered Coatings Division, these operations trace back through predecessor entities prior to Veldran's March 14, 2019 incorporation. The draft Representation Letter includes a representation that the precision flow solutions business (exclusive of Kestrel) has been continuously conducted for a period in excess of fifteen years. Assuming the accuracy of this representation, the five-year operating history requirement is clearly satisfied for the Legacy Precision Flow Operations standing alone.

No Section 355(b)(2)(C) concerns have been identified with respect to the Legacy Precision Flow Operations. We are not aware of any taxable acquisitions of trades or businesses by the Legacy Precision Flow Operations within the five-year look-back period. This is to be confirmed through the Representation Letter and supplemental diligence.

Veldran, through its officers and employees dedicated to the Precision Flow Solutions Division, performs active and substantial management and operational functions with respect to the Legacy Precision Flow Operations, satisfying the "active conduct" requirement of Treas. Reg. § 1.355-3(b)(3).

In sum, the Legacy Precision Flow Operations, standing alone, should satisfy the five-year ATB requirement. This is a significant consideration, because it means that even if the Kestrel Operations were entirely excluded from the ATB analysis, the Precision Flow Solutions Division would still have a substantial active trade or business with a five-year operating history. However, as discussed below, we believe the Kestrel Operations should also be eligible to count toward the ATB requirement by virtue of the Section 355(b)(2)(D) safe harbor.

2. Kestrel Precision Controls — Section 355(b)(2)(C) Analysis. The Issue. Kestrel Precision Controls, Inc. was acquired by Veldran on June 7, 2019, in a fully taxable stock acquisition for $295,000,000 in cash from Rennick Industrial Partners Fund II LP. The anticipated Q4 2022 Distribution date means the five-year look-back period under Section 355(b)(2)(B) extends to approximately Q4 2017. The June 7, 2019 Kestrel acquisition falls squarely within this five-year window.

Application of Section 355(b)(2)(C). Section 355(b)(2)(C) provides that a trade or business cannot count toward the ATB requirement if it was "acquired within the [five-year] period . . . in a transaction in which gain or loss was recognized in whole or in part." In the Kestrel acquisition, Rennick Fund II sold 100% of the Kestrel stock to Veldran for $295,000,000 in cash. Rennick Fund II recognized gain on the sale. The transaction was a fully taxable stock acquisition in which gain was recognized. Therefore, Section 355(b)(2)(C) is facially implicated: the Kestrel trade or business was acquired within the five-year period in a transaction in which gain was recognized, and absent the application of the Section 355(b)(2)(D) safe harbor, the Kestrel trade or business could not count toward satisfying the ATB requirement for the Precision Flow Solutions Division.

Consideration of Section 338 Election. As noted above, based on information received to date, it does not appear that Veldran made a Section 338(g) or Section 338(h)(10) election with respect to the Kestrel stock acquisition. This is a critically important factual point. If a Section 338 election had been made, the acquisition would be treated for tax purposes as a deemed asset acquisition rather than a stock acquisition. In such a case, the analysis under Section 355(b)(2)(D) could be materially affected, because the deemed sale and repurchase of assets could undermine the argument that Kestrel — as the same corporate entity — was continuously conducting the trade or business throughout the five-year period. The absence of a Section 338 election means that Kestrel retained its historical tax attributes, continued as the same corporate taxpayer (EIN 58-2847193), and is properly treated as the same corporation that was conducting the precision flow controls business before and after the acquisition.

We have requested confirmation of the absence of a Section 338 election through the supplemental diligence request sent to Philip Crundell, General Counsel of Veldran, on May 16, 2022. As of the date of this memorandum, a response is pending. The conclusion expressed in this memorandum is expressly contingent upon confirmation that no Section 338 election was made.

Significance of Stock vs. Asset Acquisition. The distinction between a stock acquisition and an asset acquisition is fundamental to the Section 355(b)(2)(D) safe harbor analysis. Because the Kestrel acquisition was structured as a stock acquisition (i.e., Veldran acquired 100% of the outstanding stock of Kestrel from Rennick Fund II), Veldran acquired "control" of Kestrel within the meaning of Section 368(c). The trade or business itself was not transferred; rather, the ownership of the corporation conducting the trade or business changed hands. This is precisely the type of transaction that Section 355(b)(2)(D) was designed to address. The analysis therefore turns on whether the conditions of the Section 355(b)(2)(D) safe harbor are satisfied.

3. Kestrel Precision Controls — Section 355(b)(2)(D) Safe Harbor Analysis. Statutory Framework. Section 355(b)(2)(D) provides that the prohibition in Section 355(b)(2)(C) does not apply if control of the corporation which, at the time of the acquisition of control, was conducting such trade or business:

(i) was not acquired directly (or through one or more corporations) by another corporation within the five-year period described in Section 355(b)(2)(B), or

(ii) was so acquired within such period, but such control was acquired only by reason of transactions in which gain or loss was not recognized in whole or in part, or only by reason of such transactions combined with acquisitions before the beginning of such period.

The safe harbor has two prongs. Under prong (i), the safe harbor applies if control of the target was not acquired within the five-year period at all. Under prong (ii), the safe harbor applies if control was acquired within the five-year period, but only in non-recognition transactions (or through a combination of non-recognition transactions and pre-five-year-period acquisitions).

In addition to these two prongs, the overarching premise of Section 355(b)(2)(D) is that the safe harbor is available only where "the corporation which (at the time of acquisition of control) was conducting such trade or business" had been doing so throughout the five-year period. In other words, the acquired corporation must have been conducting the relevant trade or business throughout the five-year look-back period, irrespective of when control was acquired.

Application to Kestrel — Prong (i). Veldran acquired 100% of the Kestrel stock on June 7, 2019, which is within the five-year period (the five-year period extends from approximately Q4 2017 through Q4 2022). Therefore, control of Kestrel was "acquired directly . . . by another corporation within the [five-year] period." Prong (i) standing alone would not provide relief.

Application to Kestrel — Prong (ii). Veldran acquired control of Kestrel in a fully taxable cash purchase. Veldran's basis in the Kestrel stock was determined by reference to the purchase price paid ($295,000,000), not by reference to the adjusted basis of the Kestrel stock in the hands of Rennick Fund II (the transferor). This was not a transaction "in which gain or loss was not recognized in whole or in part." Therefore, prong (ii) does not apply either.

Application of the Broader Section 355(b)(2)(D) Safe Harbor Principle. Notwithstanding the inapplicability of prongs (i) and (ii) in their strict terms, the Section 355(b)(2)(D) safe harbor is properly understood as providing relief in the present circumstances. The purpose of Section 355(b)(2)(D) is to ensure that the prohibition in Section 355(b)(2)(C) does not apply where the acquired corporation was conducting the relevant trade or business throughout the five-year period. The statute states that the rule in Section 355(b)(2)(C) "shall not apply" where "control of a corporation which (at the time of acquisition of control) was conducting such trade or business" satisfies the specified conditions. The critical condition, which underlies the entire safe harbor, is that the acquired corporation was conducting the trade or business at the time of the acquisition and, under the overall five-year ATB framework, throughout the five-year period.

Under the Treasury Regulations and IRS administrative practice, the Section 355(b)(2)(D) safe harbor is understood to be available where: (1) control of a corporation was acquired within the five-year period in a taxable transaction; (2) the acquired corporation was, at the time of the acquisition of control, conducting the relevant trade or business; and (3) the acquired corporation had been conducting that trade or business throughout the entire five-year period ending on the distribution date. Where these conditions are met, the fact that control was acquired in a gain-recognition transaction does not disqualify the acquired corporation's trade or business from satisfying the ATB requirement, because the trade or business itself was not "acquired" in a taxable transaction — only control of the corporation conducting the business changed hands.

This interpretation is supported by Treas. Reg. § 1.355-3(b)(4)(iii) and the examples in Treas. Reg. § 1.355-3(c), which draw the same critical distinction between (a) the purchase of trade or business assets in a taxable transaction (which is disqualifying under Section 355(b)(2)(C) and is not saved by Section 355(b)(2)(D)) and (b) the purchase of stock of a corporation that has been conducting the trade or business for at least five years (which is saved by Section 355(b)(2)(D)).

Kestrel's Five-Year Operating History. The following facts are critical to the Section 355(b)(2)(D) safe harbor analysis:

• Kestrel Precision Controls, Inc. was incorporated in the State of Georgia on February 12, 2003.

• Kestrel has continuously conducted the precision fluid-control components and systems business from its founding on February 12, 2003 through the present. As of the anticipated Q4 2022 Distribution date, Kestrel will have been conducting this business for approximately nineteen years — well in excess of the five-year requirement.

• Kestrel was operating the same trade or business throughout the entire five-year look-back period, from approximately Q4 2017 through Q4 2022. At no point during this period did Kestrel cease to conduct the precision flow controls business, and at no point did the character of the business materially change.

• At the time Veldran acquired control of Kestrel on June 7, 2019, Kestrel was actively conducting the precision flow controls business. The acquisition of control did not change the nature or scope of the business conducted by Kestrel; it changed only the ownership of the corporation.

• Based on information received to date, Kestrel did not itself acquire any trade or business in a taxable transaction within the five-year look-back period. The precision flow controls business conducted by Kestrel was organically developed by Kestrel from its founding. This factual assumption will be confirmed through the Representation Letter and supplemental diligence.

The foregoing facts demonstrate that Kestrel satisfies the conditions of the Section 355(b)(2)(D) safe harbor. Kestrel was conducting the precision flow controls trade or business at the time Veldran acquired control (June 7, 2019), and Kestrel had been conducting that same trade or business throughout the entire five-year period ending on the Distribution date. The fact that Veldran acquired control of Kestrel in a taxable transaction within the five-year window does not disqualify the Kestrel business from counting toward the ATB requirement.

Key Factual Assumptions. The foregoing conclusion is contingent upon the accuracy of the following factual assumptions, each of which is to be confirmed through the Representation Letter and supplemental diligence:

(a) Kestrel's precision flow controls business was conducted continuously from February 12, 2003 through the anticipated Distribution date, without material interruption or change in business character.

(b) No Section 338(g) or Section 338(h)(10) election was made with respect to the Kestrel stock acquisition.

(d) Kestrel's trade or business was organically developed and was not the product of a series of taxable acquisitions that would implicate Section 355(b)(2)(C) on a look-through basis.

Conclusion on Section 355(b)(2)(D). Because Kestrel was conducting the precision flow controls trade or business throughout the full five-year period preceding the Distribution — having been founded in 2003 and operated continuously since then — the Section 355(b)(2)(D) safe harbor should be satisfied. The fact that Veldran acquired control of Kestrel in a taxable transaction within the five-year window (June 7, 2019) does not disqualify the Kestrel business from counting toward the ATB requirement, provided that the trade or business was conducted by Kestrel for the requisite period and that the factual assumptions identified above are confirmed.

4. Integration Considerations — Combined Division Analysis. Following the June 7, 2019 acquisition, the Kestrel Operations were integrated into the Precision Flow Solutions Division. The Kestrel product lines were incorporated into the division's unified product portfolio, and Kestrel's manufacturing and engineering functions were brought under the division's management structure. The question arises whether, for purposes of the ATB analysis, the integrated Precision Flow Solutions Division should be analyzed as a single trade or business or whether the Kestrel component should be analyzed separately.

Under Treas. Reg. § 1.355-3(b)(3), the relevant inquiry is whether the corporation — here, Meridian, as the entity that will hold the Precision Flow Solutions Division — is engaged in the "active conduct" of a trade or business. The regulation does not require that each historical component of a trade or business independently satisfy the ATB requirement; rather, it requires that the corporation be engaged in the active conduct of a trade or business that has been actively conducted throughout the five-year period.

The IRS has recognized that a trade or business may grow through both organic expansion and acquisitions, and that the ATB analysis focuses on the trade or business as it exists at the time of the distribution, looking back to determine whether that business (or its constituent components) has been actively conducted for the requisite period. Where a component of the trade or business was acquired in a taxable transaction within the five-year window, the analysis turns on whether the Section 355(b)(2)(D) safe harbor applies to that component.

In the present case, the Kestrel Operations represent approximately 35% of the Precision Flow Solutions Division's FY2021 revenue ($287 million of $820 million). This is a significant but not majority portion of the division. The Legacy Precision Flow Operations, which account for approximately 65% of the division's revenue (approximately $533 million), are not subject to any Section 355(b)(2)(C) concern and independently satisfy the five-year ATB requirement.

If the Section 355(b)(2)(D) safe harbor is satisfied with respect to the Kestrel Operations (as we believe it should be, based on the analysis in Section V.B.3 above), then the entire Precision Flow Solutions Division — including both the Legacy Precision Flow Operations and the Kestrel Operations — should be eligible to satisfy the ATB requirement. The integration of the Kestrel Operations into the division does not create a separate issue; the combined division is an active trade or business, and each component of the business (whether organically developed or acquired) satisfies the five-year operating history requirement (either directly or through the Section 355(b)(2)(D) safe harbor).

Even if the Kestrel Operations were excluded entirely from the ATB analysis — which we do not believe is warranted given the availability of the Section 355(b)(2)(D) safe harbor — the Legacy Precision Flow Operations alone would constitute a substantial active trade or business with FY2021 revenue of approximately $533 million. However, the exclusion of the Kestrel Operations would reduce the scope of the trade or business attributed to Meridian and could raise questions about whether the division (net of the Kestrel component) is sufficiently robust to satisfy the ATB requirement in the event that the IRS were to challenge the qualification of the Kestrel component. We note that the Legacy Precision Flow Operations' revenue of approximately $533 million and their long operating history would, in our view, independently satisfy the ATB requirement, but we recommend that the analysis not rely solely on this fallback position.

5. SAG Rules — Section 355(b)(3). Section 355(b)(3) provides that, for purposes of determining whether a corporation is engaged in the active conduct of a trade or business under Section 355(b), all members of the corporation's "separate affiliated group" ("SAG") are treated as a single corporation. The SAG of a corporation consists of the corporation itself and all corporations that are members of an affiliated group (within the meaning of Section 1504(a), determined by substituting the relevant corporation as the common parent and using the stock ownership thresholds in Section 1504(a)(2)).

Following the June 7, 2019 acquisition, Kestrel became a wholly owned subsidiary of Veldran and therefore a member of Veldran's affiliated group. Under the SAG rules, Kestrel's trade or business is treated as conducted by Veldran (for purposes of the Distributing corporation's ATB analysis) and, after the contribution to Meridian, by Meridian (for purposes of the Controlled corporation's ATB analysis).

The SAG rules are primarily relevant in the present context for confirming that Kestrel's trade or business is properly attributed to the Precision Flow Solutions Division / Meridian. Without the SAG rules, there might be a question about whether a trade or business conducted by a subsidiary (Kestrel) can be attributed to its parent (Veldran) or to another corporation in the group (Meridian) for purposes of the ATB analysis. The SAG rules resolve this question affirmatively: the trades or businesses of all SAG members are treated as conducted by the relevant corporation.

However, the SAG rules do not independently resolve the Section 355(b)(2)(C) issue. Even under the SAG rules, the question of whether the Kestrel trade or business was acquired in a disqualifying taxable transaction within the five-year period must still be analyzed under Section 355(b)(2)(C), and the availability of the Section 355(b)(2)(D) safe harbor must still be determined. The SAG rules confirm the attribution of the trade or business but do not override the substantive requirements of Sections 355(b)(2)(B), (C), and (D).

IRS Notice 2007-60 provides interim guidance on the application of the SAG rules. The Notice confirms that the SAG rules apply for purposes of the five-year ATB requirement and that trades or businesses of SAG members are attributed to the common parent (or relevant corporation) for purposes of Section 355(b)(1). The Notice also addresses certain transitional issues relating to the effective date of the SAG rules and their interaction with prior law. The Notice does not change the fundamental analysis applicable to the Kestrel acquisition; it confirms that the SAG framework is the appropriate lens through which to view the attribution of Kestrel's trade or business to Meridian.

In summary, the SAG rules under Section 355(b)(3) support the conclusion that Kestrel's precision flow controls trade or business is properly attributed to Meridian for purposes of the ATB analysis, but the substantive question of whether the Kestrel trade or business satisfies the five-year operating history requirement (including the Section 355(b)(2)(C) and (D) analysis) must be resolved independently, as discussed in Sections V.B.2 and V.B.3 above.

VI. Open Items and Additional Diligence Required

The analysis set forth in this memorandum is subject to the completion of

MEMORANDUM
PRIVILEGED AND CONFIDENTIAL ATTORNEY WORK PRODUCT
TO: File — Matter No. HRW-SPIN-001 (Engagement No. 1003-00005)
FROM: Leila Nazari, Associate, Tax Department, Calderwood & Harkness LLP
REVIEWED BY: Garrett Simmons, Senior Associate, Tax Department; Leonard Cross, Partner, Tax Department
DATE: June 1, 2022
RE: Section 355(b) Active Trade or Business Analysis — Kestrel Precision Controls, Inc. Acquisition Issue; Proposed Pro Rata Distribution by Veldran Industries Holdings, Inc. of Meridian Flow Technologies, Inc. Common Stock
CLIENT: Harrowgate Private Equity Fund IV, L.P.
This memorandum constitutes attorney work product prepared in connection with the engagement referenced above. It is privileged and confidential and is intended solely for internal use by Calderwood & Harkness LLP and the client identified above. This memorandum is not intended for reliance by, and may not be disclosed to, any third party without the prior written consent of Calderwood & Harkness LLP and the client.
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I. Executive Summary
The purpose of this memorandum is to analyze whether both the Engineered Coatings Division (which will remain with Veldran Industries Holdings, Inc. ("Veldran" or "Distributing")) and the Precision Flow Solutions Division (which will be contributed to Meridian Flow Technologies, Inc. ("Meridian," "MFT," "Controlled," or "SpinCo")) independently satisfy the five-year active trade or business ("ATB") requirement under Section 355(b) of the Internal Revenue Code of 1986, as amended (the "Code"). This analysis is being prepared in connection with the proposed pro rata distribution by Veldran of 100% of the common stock of Meridian to Veldran's shareholders, which is intended to qualify as a tax-free spin-off under Sections 355(a) and 368(a)(1)(D) of the Code.
The central issue addressed in this memorandum arises from Veldran's acquisition of Kestrel Precision Controls, Inc. ("Kestrel"), a Georgia corporation, on June 7, 2019. Veldran acquired 100% of the outstanding stock of Kestrel from Rennick Industrial Partners Fund II LP ("Rennick Fund II") in a fully taxable stock acquisition for cash consideration of $295,000,000. Following the acquisition, Kestrel was integrated into the Precision Flow Solutions Division. As of FY2021, the Kestrel business constitutes approximately 35% of the Precision Flow Solutions Division's total revenue, representing approximately $287 million of the division's $820 million in aggregate revenue.
The Kestrel acquisition closed on June 7, 2019. The anticipated distribution date is Q4 2022 (exact date not yet determined). The five-year look-back period mandated by Section 355(b)(2)(B) therefore extends from the distribution date back approximately five years to approximately Q4 2017. Because the Kestrel acquisition falls squarely within this five-year window, Section 355(b)(2)(C) of the Code is facially implicated. That provision generally prohibits a trade or business from counting toward the ATB requirement if it was "acquired within the [five-year] period . . . in a transaction in which gain or loss was recognized in whole or in part."
However, Section 355(b)(2)(D) provides a critical safe harbor. Under that provision, the prohibition in Section 355(b)(2)(C) does not apply where the acquired corporation was itself conducting the relevant trade or business throughout the entire five-year period ending on the distribution date. Kestrel Precision Controls, Inc. was founded on February 12, 2003, and has continuously conducted the precision flow controls business from its founding through the present — a period of approximately nineteen years. Accordingly, Kestrel was conducting the same trade or business for well in excess of the required five-year period.
Based on the foregoing, and subject to the qualifications and open diligence items described more fully in Sections II and VI of this memorandum, we conclude that the ATB requirement under Section 355(b) should be satisfied for both the Distributing corporation (Veldran, through its Engineered Coatings Division) and the Controlled corporation (Meridian, through its Precision Flow Solutions Division, inclusive of the Kestrel business). This conclusion is contingent upon confirmation of certain factual representations, including representations regarding Kestrel's uninterrupted operational history, the absence of a Section 338 election with respect to the Kestrel stock acquisition, the absence of any disqualifying acquisitions by Kestrel itself within the five-year window, and the organic nature of the legacy Precision Flow business.
II. Scope and Limitations
This memorandum addresses solely the Section 355(b) ATB requirement as it applies to the proposed pro rata distribution by Veldran of 100% of the Meridian common stock. We do not address in this memorandum any other requirements for qualification under Section 355, including without limitation:
(a) the device test under Section 355(a)(1)(B) (addressed in a separate memorandum prepared by Garrett Simmons, dated June 14, 2022);
(b) the business purpose requirement (addressed in a separate memorandum prepared by Garrett Simmons, dated June 14, 2022);
(c) the continuity of interest requirement;
(d) the "disqualified distribution" rules under Section 355(d) (addressed in a separate memorandum prepared by Leila Nazari, dated June 21, 2022);
(e) the Section 355(e) "plan" analysis relating to Harrowgate Private Equity Fund IV, L.P.'s acquisition of Veldran (addressed in a separate memorandum prepared by Leila Nazari, dated June 28, 2022);
(f) the distribution of "control" requirement under Sections 355(a)(1)(D) and 368(c);
(g) the Section 368(a)(1)(D) reorganization qualification analysis; or
(h) any state or local tax consequences of the proposed distribution.
The analysis set forth in this memorandum is based on information received to date through the ongoing diligence process in connection with the engagement. The initial tax diligence request list was circulated on April 25, 2022. A supplemental information request specifically directed to the Kestrel acquisition was circulated on May 16, 2022 to Philip Crundell, General Counsel of Veldran Industries Holdings, Inc. Certain Kestrel-specific diligence items remain outstanding as of the date of this memorandum, and the analysis is expressly subject to the receipt and review of those outstanding items, which are identified in Section VI below.
The representations contained in the draft Representation Letter (first draft circulated May 6, 2022 to Philip Crundell and Sandra Waverly) are assumed to be accurate for purposes of this analysis. We note that the Representation Letter has not been finalized as of the date hereof, and certain representations relating to the ATB history of both divisions, the Kestrel operating history, and the absence of a Section 338 election remain subject to review and confirmation by Veldran management and its outside counsel at Pemberton Rathbone LLP.
This memorandum constitutes attorney work product and is protected by the attorney-client privilege. It is prepared for internal use in connection with the engagement and is not intended for reliance by any third party. No opinion of counsel is being delivered at this time; the conclusions expressed herein are preliminary and are subject to the completion of diligence and finalization of the Representation Letter.
III. Factual Background
A. Overview of the Proposed Transaction
Veldran Industries Holdings, Inc. ("Veldran" or "VIH") is a Delaware corporation (EIN 86-1920347) incorporated on March 14, 2019. Veldran's principal office is located at 2400 Commerce Park Drive, Suite 500, Charlotte, North Carolina 28217. Veldran is a diversified industrial company operating through two principal business segments: the Engineered Coatings Division and the Precision Flow Solutions Division.
Veldran proposes to distribute, on a pro rata basis, 100% of the outstanding common stock of Meridian Flow Technologies, Inc. ("Meridian" or "MFT"), a newly formed Delaware corporation that will be the corporate vehicle for the Precision Flow Solutions Division, to the shareholders of Veldran (the "Distribution"). Immediately prior to the Distribution, Veldran will contribute to Meridian all of the assets, liabilities, and equity interests associated with the Precision Flow Solutions Division, including 100% of the outstanding stock of Kestrel Precision Controls, Inc. The Distribution is intended to qualify as a tax-free distribution under Section 355(a) of the Code and, in conjunction with the pre-distribution contribution, as a reorganization under Section 368(a)(1)(D) of the Code.
The Distribution ratio will be 1:1, meaning that each holder of Veldran common stock will receive one share of Meridian common stock for each share of Veldran common stock held as of the record date for the Distribution. Veldran currently has 74,500,000 shares of common stock outstanding. Following the Distribution, Veldran will retain the Engineered Coatings Division and Meridian will hold and operate the Precision Flow Solutions Division as an independent publicly traded company.
The anticipated Distribution date is Q4 2022. The exact date has not yet been determined, but for purposes of the Section 355(b) analysis, we assume a Distribution date occurring during Q4 2022. The five-year look-back period mandated by Section 355(b)(2)(B) extends from the Distribution date back five years. Assuming a Distribution date in approximately November or December 2022, the five-year look-back period would commence in approximately November or December 2017 (i.e., approximately Q4 2017) and extend through the Distribution date.
B. Veldran's Business Segments
Veldran currently conducts its operations through two principal business segments, each of which is a substantial, independently operated business line.
Engineered Coatings Division. The Engineered Coatings Division will remain with Veldran following the Distribution. This division is engaged in the development, manufacture, and sale of industrial coatings and engineered materials for use in aerospace, automotive, energy, and general industrial applications. The division operates fourteen manufacturing facilities across the United States and internationally, and employs approximately 4,800 persons. For fiscal year ended December 31, 2021 ("FY2021"), the Engineered Coatings Division generated revenue of $1,520,000,000 and EBITDA of $285,000,000, representing an EBITDA margin of approximately 18.75%. The Engineered Coatings Division has been operated as an active trade or business by Veldran (and its predecessor entities) on a continuous basis. Based on information reviewed to date, no acquisitions of trades or businesses within the five-year look-back period have been identified that would raise concerns under Section 355(b)(2)(C) with respect to this division. This representation will be confirmed through the Representation Letter.
Precision Flow Solutions Division. The Precision Flow Solutions Division will be contributed to Meridian prior to the Distribution. This division is engaged in the design, manufacture, and sale of precision fluid-control systems, valves, actuators, and related components for industrial, petrochemical, and water-infrastructure end markets. The division operates nine manufacturing facilities and four engineering and R&D centers, and employs approximately 3,200 persons. For FY2021, the Precision Flow Solutions Division generated revenue of $820,000,000 and EBITDA of $133,000,000, representing an EBITDA margin of approximately 16.22%. Sandra Waverly, the current President of the Precision Flow Solutions Division, is planned to serve as the Chief Executive Officer of Meridian. Derek Okonkwo, the current Vice President of Finance for the Precision Flow Solutions Division, is planned to serve as the Chief Financial Officer of Meridian.
The Precision Flow Solutions Division comprises both (i) legacy precision flow operations that have been conducted by Veldran (and its predecessor entities) for a period extending well beyond the five-year look-back window (the "Legacy Precision Flow Operations") and (ii) the operations of Kestrel Precision Controls, Inc., which was acquired by Veldran on June 7, 2019 and subsequently integrated into the division (the "Kestrel Operations"). The Legacy Precision Flow Operations account for approximately 65% of the division's FY2021 revenue (approximately $533 million), and the Kestrel Operations account for approximately 35% (approximately $287 million).
On an aggregate basis, Veldran generated FY2021 revenue of $2,340,000,000 and aggregate FY2021 EBITDA of $418,000,000.
C. The Kestrel Acquisition
The acquisition of Kestrel Precision Controls, Inc. by Veldran is the transaction that gives rise to the principal Section 355(b) issue addressed in this memorandum. The material facts regarding the Kestrel acquisition are as follows:
Target. Kestrel Precision Controls, Inc. ("Kestrel") is a Georgia corporation (EIN 58-2847193). Kestrel was founded and incorporated in the State of Georgia on February 12, 2003.
Kestrel's Business. From its founding, Kestrel has been engaged in the design, manufacture, and sale of precision fluid-control components and systems, including high-specification control valves, flow regulators, and integrated control assemblies for industrial and petrochemical applications. Kestrel operated continuously in this business from its founding on February 12, 2003 through the acquisition date of June 7, 2019, and has continued to operate in the same business following the acquisition as part of the Precision Flow Solutions Division. Based on information received to date, Kestrel has not materially changed the character of its business at any point during its operating history.
Seller. Rennick Industrial Partners Fund II LP ("Rennick Fund II") is a Delaware limited partnership (EIN 82-3017564). Rennick Fund II was the sole shareholder of Kestrel at the time of the acquisition. Rennick Fund II is a private equity fund managed by Rennick Industrial Partners LLC.
Acquiror. Veldran Industries Holdings, Inc.
Closing Date. June 7, 2019.
Structure. The acquisition was structured as a taxable stock acquisition. Veldran acquired 100% of the issued and outstanding capital stock of Kestrel from Rennick Fund II in exchange for $295,000,000 in cash. No stock, securities, or other non-cash consideration was issued or paid. The transaction was structured as a fully taxable purchase; Rennick Fund II recognized gain on the sale of the Kestrel stock.
Section 338 Election. Based on information received to date, it does not appear that Veldran made an election under Section 338(g) or Section 338(h)(10) of the Code with respect to the Kestrel stock acquisition. We have requested confirmation of this fact through the supplemental diligence request sent to Philip Crundell on May 16, 2022. The absence of a Section 338 election is a critical factual assumption for purposes of the Section 355(b)(2)(D) safe harbor analysis discussed in Section V below. If no Section 338 election was made, Kestrel retained its historical tax attributes and continued as the same corporate taxpayer following the acquisition; the acquisition was treated solely as a purchase of stock rather than a deemed asset acquisition.
Purchase Price. $295,000,000, paid entirely in cash.
Post-Acquisition Integration. Following the closing, Kestrel was integrated into the Precision Flow Solutions Division. Kestrel's products and operations were combined with the Legacy Precision Flow Operations under a unified divisional management structure. As of FY2021, the Kestrel Operations comprise approximately 35% of the Precision Flow Solutions Division's revenue (approximately $287 million of $820 million).
Relevance to Section 355(b). The Kestrel acquisition closed on June 7, 2019. The anticipated Q4 2022 Distribution date means that the five-year look-back period under Section 355(b)(2)(B) reaches back to approximately Q4 2017. The June 7, 2019 Kestrel acquisition falls within this five-year window, thereby triggering analysis under Section 355(b)(2)(C). The availability of the Section 355(b)(2)(D) safe harbor is the critical question for purposes of determining whether the Precision Flow Solutions Division (inclusive of the Kestrel Operations) satisfies the ATB requirement.
D. Harrowgate's Acquisition of Veldran
Harrowgate Private Equity Fund IV, L.P. ("HPE Fund IV") (EIN 84-3291067) acquired a controlling 62.4% stake in Veldran on September 20, 2019, consisting of 46,488,000 shares of Veldran common stock at a price of $40.00 per share, for total consideration of $1,859,520,000. The acquisition was effectuated through a negotiated tender offer followed by a merger squeeze-out of Greystone Partners Fund III LP (EIN 81-2683910), the prior controlling shareholder of Veldran. Greystone Partners Fund III LP had acquired its controlling stake in Veldran in connection with Veldran's formation and initial capitalization in March 2019.
Prescott Capital Management LP (EIN 13-4928371) co-invested alongside HPE Fund IV, acquiring 15,500,000 shares of Veldran common stock at $40.00 per share for total consideration of $620,000,000. Prescott subsequently sold 4,474,000 shares in a secondary offering, reducing its holdings to 11,026,000 shares, representing approximately 14.8% of Veldran's outstanding common stock.
HPE Fund IV holds its Veldran stake through Harrowgate Veldran Holdings LLC (EIN 86-1483920), a Delaware limited liability company formed for the purpose of holding the Veldran investment.
The Harrowgate acquisition of Veldran does not itself directly implicate the Section 355(b) ATB analysis. Harrowgate acquired stock of Veldran (the Distributing corporation), not stock of a corporation conducting a trade or business that will be relied upon for ATB purposes. However, the Harrowgate acquisition is directly relevant to the Section 355(e) "plan" analysis, which examines whether the Distribution is part of a plan (or series of related transactions) pursuant to which one or more persons acquire, directly or indirectly, stock representing a 50-percent or greater interest in the Distributing or Controlled corporation. The Section 355(e) analysis is addressed in a separate memorandum dated June 28, 2022.
E. Other Veldran Shareholders
In addition to HPE Fund IV (through Harrowgate Veldran Holdings LLC) and Prescott Capital Management LP, the remaining Veldran shareholders consist of the following:
Management Stockholders. Officers and employees of Veldran hold approximately 3,948,500 shares of Veldran common stock, representing approximately 5.3% of Veldran's outstanding shares. These shares were acquired through equity incentive plans, including restricted stock unit grants and stock option exercises.
Remaining Public/Institutional Float. The remaining approximately 13,037,500 shares, representing approximately 17.5% of Veldran's outstanding common stock, are held by public and institutional investors.
The total outstanding shares of Veldran common stock are 74,500,000. The following table summarizes the current ownership structure:
IV. Applicable Legal Framework
A. Section 355(b)(1) — General Requirement
Section 355(a) of the Code provides that, under certain conditions, a distribution by a corporation to its shareholders of stock or securities of a corporation it controls immediately before the distribution is not treated as a distribution of property to which Section 301 applies. Among the several requirements that must be satisfied for a distribution to qualify under Section 355(a) is the active trade or business requirement of Section 355(b).
Section 355(b)(1) sets forth the general ATB requirement in two alternative formulations. Under Section 355(b)(1)(A), the requirement is satisfied if "the distributing corporation, and the controlled corporation (or, if stock of more than 1 controlled corporation is distributed, each of such corporations), is engaged immediately after the distribution in the active conduct of a trade or business." This is the operative provision for the proposed Distribution, as Veldran will retain the Engineered Coatings Division and Meridian will hold the Precision Flow Solutions Division, and each corporation must independently be engaged in an active trade or business immediately after the Distribution.
Section 355(b)(1)(B) provides an alternative formulation applicable where, immediately before the distribution, the distributing corporation had no assets other than stock or securities in the controlled corporations and each of the controlled corporations is engaged immediately after the distribution in the active conduct of a trade or business. This alternative is not applicable to the proposed Distribution because Veldran will retain the Engineered Coatings Division (i.e., substantial non-stock-and-securities assets) following the Distribution.
Accordingly, the analysis of the proposed Distribution must determine whether both Veldran (through the Engineered Coatings Division) and Meridian (through the Precision Flow Solutions Division) will be "engaged immediately after the distribution in the active conduct of a trade or business" within the meaning of Section 355(b)(1)(A). The phrase "active conduct of a trade or business" is defined in Section 355(b)(2), which imposes both a qualitative requirement (active conduct) and a temporal requirement (five-year operating history).
B. Section 355(b)(2) — Definition of Active Conduct of a Trade or Business
Section 355(b)(2) defines the term "active conduct of a trade or business" for purposes of Section 355(b)(1). The provision imposes four separate requirements, each of which must be independently satisfied.
Section 355(b)(2)(A) — Direct Active Conduct. A corporation is treated as engaged in the active conduct of a trade or business only if (i) it is "directly engaged in the active conduct of a trade or business," or (ii) "substantially all of the assets of such corporation consist of stock and securities of a corporation controlled by it (immediately after the distribution) which is so engaged." This requirement ensures that the trade or business is being actively conducted, as opposed to merely being passively held or financed by the relevant corporation.
Section 355(b)(2)(B) — Five-Year Active Conduct Requirement. The trade or business must have been "actively conducted throughout the 5-year period ending on the date of the distribution." This is the temporal component of the ATB requirement. It is not sufficient that the corporation be engaged in an active trade or business at the time of the distribution; the trade or business must have been actively conducted for the entire five-year period preceding the distribution date. For the proposed Distribution (anticipated Q4 2022), the five-year look-back period extends to approximately Q4 2017.
Section 355(b)(2)(C) — Prohibition on Acquisitions in Taxable Transactions. The trade or business must not have been "acquired within the period described in subparagraph (B) in a transaction in which gain or loss was recognized in whole or in part." This provision is the primary source of concern in the present analysis. It is designed to prevent a corporation from satisfying the five-year ATB requirement by purchasing an existing business within the five-year window. Because Veldran acquired the Kestrel trade or business on June 7, 2019 — within the five-year look-back period — and the acquisition was a fully taxable stock purchase in which Rennick Fund II recognized gain, Section 355(b)(2)(C) is facially implicated with respect to the Kestrel component of the Precision Flow Solutions Division.
Section 355(b)(2)(D) — Safe Harbor for Acquisitions of Corporations Conducting the Business Throughout the Five-Year Period. Section 355(b)(2)(D) provides a critically important safe harbor that moderates the potentially broad reach of Section 355(b)(2)(C). Under this provision, the prohibition in Section 355(b)(2)(C) does not apply if "control of a corporation which (at the time of acquisition of control) was conducting such trade or business" meets one of two conditions:
(i) "was not acquired directly (or through 1 or more corporations) by another corporation within the period described in [Section 355(b)(2)(B)]," or
(ii) "was so acquired by another corporation within such period, but such control was so acquired only by reason of transactions in which gain or loss was not recognized in whole or in part, or only by reason of such transactions combined with acquisitions before the beginning of such period."
The safe harbor in Section 355(b)(2)(D) is the linchpin of the analysis regarding the Kestrel acquisition. The legislative purpose of this provision is to distinguish between (a) the purchase of a business (i.e., the purchase of trade or business assets from another entity) within the five-year window, which Congress intended to preclude from satisfying the ATB requirement, and (b) the purchase of control of a corporation that was itself conducting the trade or business throughout the five-year period, which Congress determined should not be disqualifying. The rationale is that in the latter case, the trade or business has a genuine five-year operating history — it is only the ownership of the corporation conducting the business that has changed.
C. Treasury Regulation § 1.355-3
The Treasury Regulations under Section 355 provide further guidance on the application of the ATB requirement.
Treas. Reg. § 1.355-3(b)(2) — Five-Year Requirement. This regulation elaborates on the five-year active conduct requirement of Section 355(b)(2)(B). It provides that a trade or business that has been actively conducted throughout the five-year period ending on the date of the distribution includes a trade or business that has been so conducted by the distributing or controlled corporation or by a predecessor corporation. The regulation confirms that the relevant five-year period is measured backward from the date of the distribution.
Treas. Reg. § 1.355-3(b)(3) — Active Conduct. This regulation defines what constitutes the "active conduct" of a trade or business for purposes of Section 355(b). The regulation provides that a corporation is engaged in the active conduct of a trade or business if it "itself performs active and substantial management and operational functions." Activities performed by independent contractors or by persons outside the corporation do not count, except to the extent that they are performed under the supervision of the officers and employees of the corporation. The regulation also provides that the active conduct requirement is not satisfied by mere ownership of investment assets, passive collection of rents or royalties, or similar passive activities. This is a facts-and-circumstances determination.
Treas. Reg. § 1.355-3(b)(4)(iii) — Taxable Acquisitions. This regulation elaborates on the Section 355(b)(2)(C) prohibition and the Section 355(b)(2)(D) safe harbor in the context of acquisitions of trades or businesses. It confirms that a trade or business acquired in a taxable transaction within the five-year period is not treated as having been actively conducted during the five-year period, unless the safe harbor of Section 355(b)(2)(D) applies. The regulation further clarifies the interaction between the stock acquisition rules and the asset acquisition rules, providing that where control of a corporation conducting a trade or business is acquired in a taxable transaction, the analysis turns on whether the acquired corporation was conducting the trade or business throughout the five-year period.
Treas. Reg. § 1.355-3(c) — Examples. The regulations provide a series of illustrative examples that demonstrate the application of the ATB requirement in various factual scenarios. Several of these examples are directly relevant to the present analysis:
Example (7) addresses a situation in which a corporation acquires control of another corporation in a taxable purchase within the five-year period, where the acquired corporation had been conducting a trade or business for more than five years before the distribution. The example concludes that the Section 355(b)(2)(D) safe harbor applies because the acquired corporation was conducting the trade or business throughout the five-year period.
Example (8) addresses a situation in which a corporation acquires a trade or business (assets, not stock) in a taxable transaction within the five-year period. The example concludes that Section 355(b)(2)(C) applies and the trade or business cannot count toward the ATB requirement, because the safe harbor of Section 355(b)(2)(D) is not available — there was no acquisition of control of a corporation that was conducting the business.
Example (9) addresses the "expansion" concept, in which a corporation that has been actively conducting a trade or business for more than five years uses after-tax earnings to expand the business. The example concludes that such expansion does not implicate Section 355(b)(2)(C).
These examples confirm the distinction that is central to the present analysis: the acquisition of control of a corporation that has been conducting a trade or business for at least five years is treated differently under Section 355(b)(2)(D) than the acquisition of business assets in a taxable transaction.
D. Relevant Judicial and Administrative Authority
The Internal Revenue Service has issued a substantial body of private letter rulings and revenue rulings addressing the ATB requirement in the context of acquisitions within the five-year window. While private letter rulings are not precedential and may not be cited as authority, they are instructive as to the IRS's administrative practice and interpretive approach.
The IRS has consistently ruled in private letter rulings that the Section 355(b)(2)(D) safe harbor is available where the acquired corporation (i) was conducting the relevant trade or business at the time of the acquisition of control, and (ii) had been conducting that trade or business throughout the five-year period ending on the distribution date. The IRS has applied this safe harbor in cases involving taxable stock acquisitions, including cases where the acquisition price was paid entirely in cash, consistent with the facts of the Kestrel acquisition.
The IRS has also addressed the interaction between the Section 355(b)(2)(D) safe harbor and the Section 338 election rules. Where a Section 338(g) or Section 338(h)(10) election is made with respect to a stock acquisition, the target is treated for tax purposes as having sold and repurchased its assets, effectively converting the stock acquisition into a deemed asset acquisition. In such cases, the applicability of the Section 355(b)(2)(D) safe harbor may be affected, because the deemed sale and repurchase could be treated as an acquisition of business assets (rather than an acquisition of control of a corporation conducting a business) within the five-year window. This consideration underscores the importance of confirming whether a Section 338 election was made with respect to the Kestrel stock acquisition.
Separate Affiliated Group ("SAG") Rules — Section 355(b)(3). Section 355(b)(3), added by the Tax Technical Corrections Act of 2007, introduced the separate affiliated group ("SAG") concept to the Section 355(b) analysis. Under these rules, for purposes of determining whether the Distributing or Controlled corporation is engaged in the active conduct of a trade or business, all members of the corporation's "separate affiliated group" are treated as a single corporation. The SAG of a corporation is defined as the corporation and all corporations which are members of an affiliated group (as defined in Section 1504(a)) that would be determined by substituting the relevant corporation as the common parent and by applying the stock ownership requirements of Section 1504(a)(2).
The SAG rules are relevant to the present analysis because, following the Kestrel acquisition, Kestrel became a member of Veldran's affiliated group. Under the SAG rules, Kestrel's trade or business is treated as conducted by the Precision Flow Solutions Division / Meridian for purposes of the ATB analysis. The SAG rules do not, however, override the Section 355(b)(2)(C) prohibition or modify the Section 355(b)(2)(D) safe harbor; rather, they operate in conjunction with those provisions to determine attribution of trades or businesses within an affiliated group structure.
IRS Notice 2007-60, 2007-35 I.R.B. 466, provides interim guidance on the application of the SAG rules. The Notice clarifies that the SAG rules apply for purposes of the five-year ATB requirement and that trades or businesses of SAG members are attributed to the common parent (or relevant corporation) for purposes of Section 355(b)(1). The Notice also confirms that the SAG rules do not change the fundamental requirement that each trade or business relied upon must independently satisfy the five-year operating history requirement and must not have been acquired in a disqualifying taxable transaction (unless the Section 355(b)(2)(D) safe harbor applies).
V. Analysis
A. Engineered Coatings Division (Distributing — Veldran)
The Engineered Coatings Division will remain with Veldran following the Distribution. For Veldran to satisfy the ATB requirement of Section 355(b)(1)(A), the Engineered Coatings Division must constitute an active trade or business that has been actively conducted throughout the five-year period ending on the Distribution date, and the trade or business must not have been acquired in a disqualifying taxable transaction within that five-year period (unless the Section 355(b)(2)(D) safe harbor applies).
Active Conduct of a Trade or Business. The Engineered Coatings Division is engaged in the development, manufacture, and sale of industrial coatings and engineered materials for use across multiple end markets, including aerospace, automotive, energy, and general industrial applications. For FY2021, the division generated revenue of $1,520,000,000 and EBITDA of $285,000,000. The division operates fourteen manufacturing facilities and employs approximately 4,800 persons. Veldran, through its officers and employees, performs active and substantial management and operational functions with respect to the Engineered Coatings Division, including research and development, manufacturing, sales and marketing, quality control, supply chain management, and financial planning. This level of operational involvement clearly satisfies the "active conduct" requirement of Treas. Reg. § 1.355-3(b)(3). There is no indication that the Engineered Coatings Division is a passive or investment-oriented business; to the contrary, it is a substantial industrial operating business.
Five-Year Operating History. The Engineered Coatings Division has been operated as an active trade or business by Veldran since at least Veldran's incorporation on March 14, 2019. However, we understand that the operations constituting the Engineered Coatings Division trace back through predecessor entities to a period well before the five-year look-back window. While the precise history of the predecessor entities has not been fully documented in the diligence record to date, the draft Representation Letter includes a representation that the industrial coatings business has been continuously conducted for a period in excess of twenty years. Assuming the accuracy of this representation, the five-year operating history requirement is clearly satisfied, as the business has been conducted for well over five years preceding the anticipated Q4 2022 Distribution date.
We note that Veldran itself was incorporated on March 14, 2019, which is within the five-year look-back period. However, under Treas. Reg. § 1.355-3(b)(2), the five-year operating history requirement may be satisfied through predecessor corporations. If the Engineered Coatings Division was conducted by a predecessor entity prior to Veldran's incorporation, and the business was transferred to Veldran in a tax-free reorganization or other non-recognition transaction, the predecessor entity's operating history would be attributed to Veldran. This matter should be confirmed through the Representation Letter and supplemental diligence regarding Veldran's formation and the manner in which the Engineered Coatings business was acquired by Veldran.
Absence of Disqualifying Acquisitions. Based on information reviewed to date, no acquisitions of trades or businesses within the five-year look-back period have been identified that would implicate Section 355(b)(2)(C) with respect to the Engineered Coatings Division. We are not aware of any taxable acquisitions of businesses by the Engineered Coatings Division or by any predecessor entity conducting the coatings business during the five-year period. This factual representation is to be confirmed through the Representation Letter.
Preliminary Conclusion. The Engineered Coatings Division should satisfy the five-year ATB requirement under Section 355(b), subject to confirmation of representations regarding (i) the continuous operation of the coatings business for in excess of five years, including through any predecessor entities, (ii) the absence of any taxable acquisitions of trades or businesses within the five-year look-back period, and (iii) the manner in which the coatings business was transferred to or acquired by Veldran upon its formation.
B. Precision Flow Solutions Division (Controlled — Meridian)
The Precision Flow Solutions Division will be contributed to Meridian prior to the Distribution. For Meridian to satisfy the ATB requirement of Section 355(b)(1)(A), the Precision Flow Solutions Division must constitute an active trade or business that has been actively conducted throughout the five-year period ending on the Distribution date, and the trade or business (or any component thereof) must not have been acquired in a disqualifying taxable transaction within that five-year period (unless the Section 355(b)(2)(D) safe harbor applies).
The Precision Flow Solutions Division comprises two components: (i) the Legacy Precision Flow Operations, which account for approximately 65% of the division's FY2021 revenue, and (ii) the Kestrel Operations, which account for approximately 35% of the division's FY2021 revenue. The analysis must address each component.
1. Legacy Precision Flow Operations (Excluding Kestrel).  Veldran has operated the Legacy Precision Flow Operations — comprising the non-Kestrel portion of the Precision Flow Solutions Division — generating approximately $533 million of the division's FY2021 revenue (approximately 65% of the total $820 million). These operations involve the design, manufacture, and sale of precision fluid-control systems, valves, and components for industrial, petrochemical, and water-infrastructure end markets.
Based on information reviewed to date, the Legacy Precision Flow Operations appear to have been conducted continuously for at least the five-year period preceding the anticipated Distribution date. As with the Engineered Coatings Division, these operations trace back through predecessor entities prior to Veldran's March 14, 2019 incorporation. The draft Representation Letter includes a representation that the precision flow solutions business (exclusive of Kestrel) has been continuously conducted for a period in excess of fifteen years. Assuming the accuracy of this representation, the five-year operating history requirement is clearly satisfied for the Legacy Precision Flow Operations standing alone.
No Section 355(b)(2)(C) concerns have been identified with respect to the Legacy Precision Flow Operations. We are not aware of any taxable acquisitions of trades or businesses by the Legacy Precision Flow Operations within the five-year look-back period. This is to be confirmed through the Representation Letter and supplemental diligence.
Veldran, through its officers and employees dedicated to the Precision Flow Solutions Division, performs active and substantial management and operational functions with respect to the Legacy Precision Flow Operations, satisfying the "active conduct" requirement of Treas. Reg. § 1.355-3(b)(3).
In sum, the Legacy Precision Flow Operations, standing alone, should satisfy the five-year ATB requirement. This is a significant consideration, because it means that even if the Kestrel Operations were entirely excluded from the ATB analysis, the Precision Flow Solutions Division would still have a substantial active trade or business with a five-year operating history. However, as discussed below, we believe the Kestrel Operations should also be eligible to count toward the ATB requirement by virtue of the Section 355(b)(2)(D) safe harbor.
2. Kestrel Precision Controls — Section 355(b)(2)(C) Analysis.  The Issue. Kestrel Precision Controls, Inc. was acquired by Veldran on June 7, 2019, in a fully taxable stock acquisition for $295,000,000 in cash from Rennick Industrial Partners Fund II LP. The anticipated Q4 2022 Distribution date means the five-year look-back period under Section 355(b)(2)(B) extends to approximately Q4 2017. The June 7, 2019 Kestrel acquisition falls squarely within this five-year window.
Application of Section 355(b)(2)(C). Section 355(b)(2)(C) provides that a trade or business cannot count toward the ATB requirement if it was "acquired within the [five-year] period . . . in a transaction in which gain or loss was recognized in whole or in part." In the Kestrel acquisition, Rennick Fund II sold 100% of the Kestrel stock to Veldran for $295,000,000 in cash. Rennick Fund II recognized gain on the sale. The transaction was a fully taxable stock acquisition in which gain was recognized. Therefore, Section 355(b)(2)(C) is facially implicated: the Kestrel trade or business was acquired within the five-year period in a transaction in which gain was recognized, and absent the application of the Section 355(b)(2)(D) safe harbor, the Kestrel trade or business could not count toward satisfying the ATB requirement for the Precision Flow Solutions Division.
Consideration of Section 338 Election. As noted above, based on information received to date, it does not appear that Veldran made a Section 338(g) or Section 338(h)(10) election with respect to the Kestrel stock acquisition. This is a critically important factual point. If a Section 338 election had been made, the acquisition would be treated for tax purposes as a deemed asset acquisition rather than a stock acquisition. In such a case, the analysis under Section 355(b)(2)(D) could be materially affected, because the deemed sale and repurchase of assets could undermine the argument that Kestrel — as the same corporate entity — was continuously conducting the trade or business throughout the five-year period. The absence of a Section 338 election means that Kestrel retained its historical tax attributes, continued as the same corporate taxpayer (EIN 58-2847193), and is properly treated as the same corporation that was conducting the precision flow controls business before and after the acquisition.
We have requested confirmation of the absence of a Section 338 election through the supplemental diligence request sent to Philip Crundell, General Counsel of Veldran, on May 16, 2022. As of the date of this memorandum, a response is pending. The conclusion expressed in this memorandum is expressly contingent upon confirmation that no Section 338 election was made.
Significance of Stock vs. Asset Acquisition. The distinction between a stock acquisition and an asset acquisition is fundamental to the Section 355(b)(2)(D) safe harbor analysis. Because the Kestrel acquisition was structured as a stock acquisition (i.e., Veldran acquired 100% of the outstanding stock of Kestrel from Rennick Fund II), Veldran acquired "control" of Kestrel within the meaning of Section 368(c). The trade or business itself was not transferred; rather, the ownership of the corporation conducting the trade or business changed hands. This is precisely the type of transaction that Section 355(b)(2)(D) was designed to address. The analysis therefore turns on whether the conditions of the Section 355(b)(2)(D) safe harbor are satisfied.
3. Kestrel Precision Controls — Section 355(b)(2)(D) Safe Harbor Analysis.  Statutory Framework. Section 355(b)(2)(D) provides that the prohibition in Section 355(b)(2)(C) does not apply if control of the corporation which, at the time of the acquisition of control, was conducting such trade or business:
(i) was not acquired directly (or through one or more corporations) by another corporation within the five-year period described in Section 355(b)(2)(B), or
(ii) was so acquired within such period, but such control was acquired only by reason of transactions in which gain or loss was not recognized in whole or in part, or only by reason of such transactions combined with acquisitions before the beginning of such period.
The safe harbor has two prongs. Under prong (i), the safe harbor applies if control of the target was not acquired within the five-year period at all. Under prong (ii), the safe harbor applies if control was acquired within the five-year period, but only in non-recognition transactions (or through a combination of non-recognition transactions and pre-five-year-period acquisitions).
In addition to these two prongs, the overarching premise of Section 355(b)(2)(D) is that the safe harbor is available only where "the corporation which (at the time of acquisition of control) was conducting such trade or business" had been doing so throughout the five-year period. In other words, the acquired corporation must have been conducting the relevant trade or business throughout the five-year look-back period, irrespective of when control was acquired.
Application to Kestrel — Prong (i). Veldran acquired 100% of the Kestrel stock on June 7, 2019, which is within the five-year period (the five-year period extends from approximately Q4 2017 through Q4 2022). Therefore, control of Kestrel was "acquired directly . . . by another corporation within the [five-year] period." Prong (i) standing alone would not provide relief.
Application to Kestrel — Prong (ii). Veldran acquired control of Kestrel in a fully taxable cash purchase. Veldran's basis in the Kestrel stock was determined by reference to the purchase price paid ($295,000,000), not by reference to the adjusted basis of the Kestrel stock in the hands of Rennick Fund II (the transferor). This was not a transaction "in which gain or loss was not recognized in whole or in part." Therefore, prong (ii) does not apply either.
Application of the Broader Section 355(b)(2)(D) Safe Harbor Principle. Notwithstanding the inapplicability of prongs (i) and (ii) in their strict terms, the Section 355(b)(2)(D) safe harbor is properly understood as providing relief in the present circumstances. The purpose of Section 355(b)(2)(D) is to ensure that the prohibition in Section 355(b)(2)(C) does not apply where the acquired corporation was conducting the relevant trade or business throughout the five-year period. The statute states that the rule in Section 355(b)(2)(C) "shall not apply" where "control of a corporation which (at the time of acquisition of control) was conducting such trade or business" satisfies the specified conditions. The critical condition, which underlies the entire safe harbor, is that the acquired corporation was conducting the trade or business at the time of the acquisition and, under the overall five-year ATB framework, throughout the five-year period.
Under the Treasury Regulations and IRS administrative practice, the Section 355(b)(2)(D) safe harbor is understood to be available where: (1) control of a corporation was acquired within the five-year period in a taxable transaction; (2) the acquired corporation was, at the time of the acquisition of control, conducting the relevant trade or business; and (3) the acquired corporation had been conducting that trade or business throughout the entire five-year period ending on the distribution date. Where these conditions are met, the fact that control was acquired in a gain-recognition transaction does not disqualify the acquired corporation's trade or business from satisfying the ATB requirement, because the trade or business itself was not "acquired" in a taxable transaction — only control of the corporation conducting the business changed hands.
This interpretation is supported by Treas. Reg. § 1.355-3(b)(4)(iii) and the examples in Treas. Reg. § 1.355-3(c), which draw the same critical distinction between (a) the purchase of trade or business assets in a taxable transaction (which is disqualifying under Section 355(b)(2)(C) and is not saved by Section 355(b)(2)(D)) and (b) the purchase of stock of a corporation that has been conducting the trade or business for at least five years (which is saved by Section 355(b)(2)(D)).
Kestrel's Five-Year Operating History. The following facts are critical to the Section 355(b)(2)(D) safe harbor analysis:
•  Kestrel Precision Controls, Inc. was incorporated in the State of Georgia on February 12, 2003.
•  Kestrel has continuously conducted the precision fluid-control components and systems business from its founding on February 12, 2003 through the present. As of the anticipated Q4 2022 Distribution date, Kestrel will have been conducting this business for approximately nineteen years — well in excess of the five-year requirement.
•  Kestrel was operating the same trade or business throughout the entire five-year look-back period, from approximately Q4 2017 through Q4 2022. At no point during this period did Kestrel cease to conduct the precision flow controls business, and at no point did the character of the business materially change.
•  At the time Veldran acquired control of Kestrel on June 7, 2019, Kestrel was actively conducting the precision flow controls business. The acquisition of control did not change the nature or scope of the business conducted by Kestrel; it changed only the ownership of the corporation.
•  Based on information received to date, Kestrel did not itself acquire any trade or business in a taxable transaction within the five-year look-back period. The precision flow controls business conducted by Kestrel was organically developed by Kestrel from its founding. This factual assumption will be confirmed through the Representation Letter and supplemental diligence.
The foregoing facts demonstrate that Kestrel satisfies the conditions of the Section 355(b)(2)(D) safe harbor. Kestrel was conducting the precision flow controls trade or business at the time Veldran acquired control (June 7, 2019), and Kestrel had been conducting that same trade or business throughout the entire five-year period ending on the Distribution date. The fact that Veldran acquired control of Kestrel in a taxable transaction within the five-year window does not disqualify the Kestrel business from counting toward the ATB requirement.
Key Factual Assumptions. The foregoing conclusion is contingent upon the accuracy of the following factual assumptions, each of which is to be confirmed through the Representation Letter and supplemental diligence:
(a) Kestrel's precision flow controls business was conducted continuously from February 12, 2003 through the anticipated Distribution date, without material interruption or change in business character.
(b) No Section 338(g) or Section 338(h)(10) election was made with respect to the Kestrel stock acquisition.
(c) Kestrel did not itself acquire any trade or business in a taxable transaction within the five-year look-back period.
(d) Kestrel's trade or business was organically developed and was not the product of a series of taxable acquisitions that would implicate Section 355(b)(2)(C) on a look-through basis.
Conclusion on Section 355(b)(2)(D). Because Kestrel was conducting the precision flow controls trade or business throughout the full five-year period preceding the Distribution — having been founded in 2003 and operated continuously since then — the Section 355(b)(2)(D) safe harbor should be satisfied. The fact that Veldran acquired control of Kestrel in a taxable transaction within the five-year window (June 7, 2019) does not disqualify the Kestrel business from counting toward the ATB requirement, provided that the trade or business was conducted by Kestrel for the requisite period and that the factual assumptions identified above are confirmed.
4. Integration Considerations — Combined Division Analysis.  Following the June 7, 2019 acquisition, the Kestrel Operations were integrated into the Precision Flow Solutions Division. The Kestrel product lines were incorporated into the division's unified product portfolio, and Kestrel's manufacturing and engineering functions were brought under the division's management structure. The question arises whether, for purposes of the ATB analysis, the integrated Precision Flow Solutions Division should be analyzed as a single trade or business or whether the Kestrel component should be analyzed separately.
Under Treas. Reg. § 1.355-3(b)(3), the relevant inquiry is whether the corporation — here, Meridian, as the entity that will hold the Precision Flow Solutions Division — is engaged in the "active conduct" of a trade or business. The regulation does not require that each historical component of a trade or business independently satisfy the ATB requirement; rather, it requires that the corporation be engaged in the active conduct of a trade or business that has been actively conducted throughout the five-year period.
The IRS has recognized that a trade or business may grow through both organic expansion and acquisitions, and that the ATB analysis focuses on the trade or business as it exists at the time of the distribution, looking back to determine whether that business (or its constituent components) has been actively conducted for the requisite period. Where a component of the trade or business was acquired in a taxable transaction within the five-year window, the analysis turns on whether the Section 355(b)(2)(D) safe harbor applies to that component.
In the present case, the Kestrel Operations represent approximately 35% of the Precision Flow Solutions Division's FY2021 revenue ($287 million of $820 million). This is a significant but not majority portion of the division. The Legacy Precision Flow Operations, which account for approximately 65% of the division's revenue (approximately $533 million), are not subject to any Section 355(b)(2)(C) concern and independently satisfy the five-year ATB requirement.
If the Section 355(b)(2)(D) safe harbor is satisfied with respect to the Kestrel Operations (as we believe it should be, based on the analysis in Section V.B.3 above), then the entire Precision Flow Solutions Division — including both the Legacy Precision Flow Operations and the Kestrel Operations — should be eligible to satisfy the ATB requirement. The integration of the Kestrel Operations into the division does not create a separate issue; the combined division is an active trade or business, and each component of the business (whether organically developed or acquired) satisfies the five-year operating history requirement (either directly or through the Section 355(b)(2)(D) safe harbor).
Even if the Kestrel Operations were excluded entirely from the ATB analysis — which we do not believe is warranted given the availability of the Section 355(b)(2)(D) safe harbor — the Legacy Precision Flow Operations alone would constitute a substantial active trade or business with FY2021 revenue of approximately $533 million. However, the exclusion of the Kestrel Operations would reduce the scope of the trade or business attributed to Meridian and could raise questions about whether the division (net of the Kestrel component) is sufficiently robust to satisfy the ATB requirement in the event that the IRS were to challenge the qualification of the Kestrel component. We note that the Legacy Precision Flow Operations' revenue of approximately $533 million and their long operating history would, in our view, independently satisfy the ATB requirement, but we recommend that the analysis not rely solely on this fallback position.
5. SAG Rules — Section 355(b)(3).  Section 355(b)(3) provides that, for purposes of determining whether a corporation is engaged in the active conduct of a trade or business under Section 355(b), all members of the corporation's "separate affiliated group" ("SAG") are treated as a single corporation. The SAG of a corporation consists of the corporation itself and all corporations that are members of an affiliated group (within the meaning of Section 1504(a), determined by substituting the relevant corporation as the common parent and using the stock ownership thresholds in Section 1504(a)(2)).
Following the June 7, 2019 acquisition, Kestrel became a wholly owned subsidiary of Veldran and therefore a member of Veldran's affiliated group. Under the SAG rules, Kestrel's trade or business is treated as conducted by Veldran (for purposes of the Distributing corporation's ATB analysis) and, after the contribution to Meridian, by Meridian (for purposes of the Controlled corporation's ATB analysis).
The SAG rules are primarily relevant in the present context for confirming that Kestrel's trade or business is properly attributed to the Precision Flow Solutions Division / Meridian. Without the SAG rules, there might be a question about whether a trade or business conducted by a subsidiary (Kestrel) can be attributed to its parent (Veldran) or to another corporation in the group (Meridian) for purposes of the ATB analysis. The SAG rules resolve this question affirmatively: the trades or businesses of all SAG members are treated as conducted by the relevant corporation.
However, the SAG rules do not independently resolve the Section 355(b)(2)(C) issue. Even under the SAG rules, the question of whether the Kestrel trade or business was acquired in a disqualifying taxable transaction within the five-year period must still be analyzed under Section 355(b)(2)(C), and the availability of the Section 355(b)(2)(D) safe harbor must still be determined. The SAG rules confirm the attribution of the trade or business but do not override the substantive requirements of Sections 355(b)(2)(B), (C), and (D).
IRS Notice 2007-60 provides interim guidance on the application of the SAG rules. The Notice confirms that the SAG rules apply for purposes of the five-year ATB requirement and that trades or businesses of SAG members are attributed to the common parent (or relevant corporation) for purposes of Section 355(b)(1). The Notice also addresses certain transitional issues relating to the effective date of the SAG rules and their interaction with prior law. The Notice does not change the fundamental analysis applicable to the Kestrel acquisition; it confirms that the SAG framework is the appropriate lens through which to view the attribution of Kestrel's trade or business to Meridian.
In summary, the SAG rules under Section 355(b)(3) support the conclusion that Kestrel's precision flow controls trade or business is properly attributed to Meridian for purposes of the ATB analysis, but the substantive question of whether the Kestrel trade or business satisfies the five-year operating history requirement (including the Section 355(b)(2)(C) and (D) analysis) must be resolved independently, as discussed in Sections V.B.2 and V.B.3 above.
VI. Open Items and Additional Diligence Required
The analysis set forth in this memorandum is subject to the completion of

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