<PAGE> 1
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON FEBRUARY 9, 2000
REGISTRATION NO. 333-89179
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------
POST-EFFECTIVE AMENDMENT NO. 1
TO
FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
---------------------
KNOLOGY, INC.
(Exact name of registrant as specified in its charter)
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<S> <C> <C>
DELAWARE 4812 58-2424258
(State or of Incorporation) (Primary Standard Industrial (I.R.S. Employer
Identification No.) Classification Code Number)
</TABLE>
1241 O.G. SKINNER DRIVE
WEST POINT, GEORGIA 31833
(706) 645-8553
(Address, including zip code, and telephone number, including
area code, of registrant's principal executive offices)
CHAD S. WACHTER
VICE PRESIDENT, GENERAL COUNSEL AND SECRETARY
KNOLOGY, INC.
1241 O.G. SKINNER DRIVE
WEST POINT, GEORGIA 31833
(706) 645-8553
(Name, address, including zip code, and telephone number,
including area code, of registrant's agent for service)
---------------------
Copies to:
STEVEN M. KAUFMAN, ESQ.
HOGAN & HARTSON L.L.P.
555 THIRTEENTH STREET, N.W.
WASHINGTON, D.C. 20004
(202) 637-5600
APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as
practicable after this Registration Statement becomes effective.
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act,
check the following box. [X]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, check the following box and
list the Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant Rule 462(c) under
the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [X] 333-89179
If delivery of the prospectus is expected to be made pursuant to Rule 434,
check the following box. [ ]
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CALCULATION OF REGISTRATION FEE
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PROPOSED
MAXIMUM
TITLE OF EACH CLASS OF AGGREGATE AMOUNT OF
SECURITIES OFFERING PRICE REGISTRATION
TO BE REGISTERED (1) FEE
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Common Stock $.01 par value (3) Series A Preferred Stock,
$.01 par value Options to Purchase Series A Preferred
Stock..................................................... $234,980,443 $65,324.56(2)
</TABLE>
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(1) Estimated solely for purposes of calculating the registration fee pursuant
to Rule 457(o) under the Securities Act of 1933.
(2) A fee of $66,334.58 was paid previously.
(3) Includes an indeterminate number of shares of common stock issuable upon
conversion of the Series A preferred stock. Pursuant to Rule 457(i), no
separate registration fee is payable with respect to these shares of common
stock. Pursuant to Rule 416, this Registration Statement also covers such
shares of common stock as may be issuable pursuant to the anti-dilution
provisions of the Series A preferred stock.
---------------------
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF
THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(a),
MAY DETERMINE.
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<PAGE> 2
EXPLANATORY NOTE
This Post-Effective Amendment No. 1 to the KNOLOGY Inc. Registration
Statement on Form S-1 has been filed solely for the purpose of filing exhibits
to the Registration Statement pursuant to Rule 462(d) under the Securities Act.
<PAGE> 3
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT DESCRIPTION
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<C> <C> <S>
2.1(1) -- Agreement and Plan of Merger, dated December 5, 1997, by and
among KNOLOGY Holdings, Inc., KNOLOGY of Panama City, Inc.,
Beach Cable, Inc. and L. Charles Hilton
2.2(2) -- Purchase Agreement between Cable Alabama Corporation and
KNOLOGY of Huntsville, Inc., dated as of October 19, 1998.
3.1(6) -- Certificate of Incorporation of KNOLOGY, Inc.
3.2(6) -- Bylaws of KNOLOGY, Inc.
4.1(6) -- Specimen Certificate for Shares of Common Stock, par value
$0.01, of KNOLOGY, Inc.
4.2(6) -- Specimen Certificate for Shares of Series A Preferred Stock,
par value $0.01, of KNOLOGY, Inc.
4.4(1) -- Indenture dated as of October 22, 1997 between KNOLOGY
Holdings, Inc. and United States Trust Company of New York,
as Trustee, relating to the 11 7/8% Senior Discount Notes
Due 2007 of KNOLOGY Holdings, Inc.
4.5(1) -- Registration Rights Agreement, dated October 22, 1997,
between KNOLOGY Holdings, Inc., the Placement Agents and
SCANA Communications, Inc.
4.6 -- Form of Senior Discount Note (contained in Indenture filed
as Exhibit 4.5)
4.7 -- Form of Exchange Note (contained in Indenture filed as
Exhibit 4.5)
5.1(6) -- Opinion of Hogan & Hartson, L.L.P.
8.1(5) -- Opinion of Arthur Andersen LLP regarding certain tax
matters.
10.1(1) -- Unit Purchase Agreement, dated as of October 16, 1997
between KNOLOGY Holdings, Inc. and SCANA Communications,
Inc.
10.4(1) -- Lease Agreement dated April 15, 1996 by and between D.L.
Jordan and American Cable Company, Inc.
10.5(1) -- Pole Attachment Agreement dated January 1, 1998 by and
between Gulf Power Company and Beach Cable, Inc.
10.6(1) -- Telecommunications Facility Lease and Capacity Agreement,
dated September 10, 1996, by and between Troup EMC
Communications, Inc. and Cybernet Holding, Inc.
</TABLE>
II-1
<PAGE> 4
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT DESCRIPTION
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<C> <C> <S>
10.7(1) -- Master Pole Attachment Agreement dated January 12, 1998 by
and between South Carolina Electric and Gas and KNOLOGY
Holdings, Inc. d/b/a/ KNOLOGY of Charleston.
10.8(1)*) -- License Agreement dated September 29, 1995 by and between
Montgomery Cablevision and Entertainment, Inc. and American
Communications Services of Montgomery, Inc.
10.9(1)*) -- License Agreement dated January 17, 1996 by and between
American Cable, Inc. and American Communication Services of
Columbus, Inc.
10.10(1)*) -- Addendum to License Agreement dated April 21, 1997 by and
between American Cable, Inc. and American Communication
Services of Columbus, Inc.
10.11(1) -- Lease Agreement, dated December 5, 1997 by and between The
Hilton Company and KNOLOGY of Panama City, Inc.
10.13(1) -- Certificate of Membership with National Cable Television
Cooperative, dated January 29, 1996, of Cybernet Holding,
Inc.
10.18(2) -- Ordinance No. 99-16 effective March 16, 1999 between
Columbus consolidated Government and KNOLOGY of Columbus,
Inc.
10.19(1) -- Ordinance No. 16-90 (Montgomery, Alabama) dated March 6,
1990.
10.20(1) -- Ordinance No. 50-76 (Montgomery, Alabama)
10.21(1) -- Ordinance No. 9-90 (Montgomery, Alabama) dated January 16,
1990.
10.22(1) -- Resolution No. 58-95 (Montgomery, Alabama) dated April 6,
1995.
10.23(1) -- Resolution No. 92-7 (Panama City Beach, Florida) dated July
23, 1992.
10.24(1) -- License (Bay County, Florida) dated January 5, 1993.
10.25(1) -- Resolution No. 97-22 (Panama City Beach, Florida) dated
December 3, 1997.
10.26(1) -- Resolution No. 2075 (Bay County, Florida) dated November 18,
1997.
10.27(3) -- Ordinance No. 5999 (Augusta, Georgia) dated January 20,
1998.
10.28(3) -- Ordinance No. 1723 (Panama City, Florida) dated March 10,
1998.
10.30(2) -- Ordinance No. 98054 (Mount Pleasant, South Carolina) dated
March 9, 1999.
10.31(2) -- Franchise Agreement (Charleston County, South Carolina)
dated December 15, 1998.
10.32(2) -- Ordinance No. 1998-47 (North Charleston, South Carolina)
dated May 28, 1998.
10.33(2) -- Ordinance No. 1998-77 (Charleston, South Carolina) dated
April 28, 1998.
10.34(2) -- Ordinance No. 98-5 (Columbia County, Georgia) dated August
18, 1998.
</TABLE>
II-2
<PAGE> 5
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT DESCRIPTION
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<C> <C> <S>
10.36(2) -- Network Access Agreement dated July 1, 1998 between SCANA
Communications, Inc., f/k/a MPX Systems, Inc. and KNOLOGY
Holdings, Inc.
10.37(2) -- Internet Access Contract dated September 1, 1998 between
ITC* DeltaCom, Inc. and KNOLOGY Holdings, Inc.
10.38(2) -- Collocation Agreement for Multiple Sites dated on or about
June 1998 between Interstate FiberNet, Inc. and KNOLOGY
Holdings, Inc.
10.39(2)*) -- Lease Agreement dated October 12, 1998 between Southern
Company Services, Inc. and KNOLOGY Holdings, Inc.
10.40(2) -- Facilities Transfer Agreement dated February 11, 1998
between South Carolina Electric and Gas Company and KNOLOGY
Holdings, Inc., d/b/a KNOLOGY of Charleston.
10.41(2) -- License Agreement dated March 3, 1998 between BellSouth
Telecommunications, Inc. and KNOLOGY Holdings, Inc.
10.44(2) -- Pole Attachment Agreement dated February 18, 1998 between
KNOLOGY Holdings, Inc. and Georgia Power Company
10.46(2) -- Assignment Agreement dated March 4, 1998 between Gulf Power
Company and KNOLOGY of Panama City, Inc.
10.47(2) -- Adoption Agreements dated March 1, 1999 between KNOLOGY
Holdings, Inc. and BellSouth Telecommunications, Inc.
10.48(2)*) -- Lease Switching Agreement between South Carolina Net for TTE
Inc. and KNOLOGY Holdings, Inc.
10.50(2)*) -- Carrier Services Agreement dated September 30, 1998 between
Business Telecom, Inc. and KNOLOGY Holdings, Inc.
10.51(2)*) -- Reseller Services Agreement dated September 9, 1998 between
Business Telecom, Inc. and KNOLOGY Holdings, Inc.
10.52(2)*) -- Private Line Services Agreement dated September 10, 1998
between BTI Communications Corporation and KNOLOGY Holdings,
Inc.
10.53(2) -- Credit Facility Agreement between First Union National Bank,
First Union Capital Markets Corp. and KNOLOGY Holdings, Inc.
dated December 22, 1998.
10.54(2) -- Ordinance No. 284 (Cedar Grove, Florida) dated June 9, 1998.
10.55(2) -- License Agreement dated January 5, 1993 between County
Commissioners of Bay County Florida and Beach Cable, Inc.
10.56(2) -- Ordinance No. 647 (Lynn Haven, Florida) dated May 12, 1998
between KNOLOGY of Panama City, Inc. and the City of Lynn
Haven.
10.57(2) -- Ordinance No. 1723 (Panama City, Florida) dated March 10,
1998 between KNOLOGY of Panama City, Inc. and the City of
Panama City.
</TABLE>
II-3
<PAGE> 6
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT DESCRIPTION
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<C> <C> <S>
10.58(2) -- Resolution No. 97-22 (Panama City Beach, Florida) dated
December 3, 1997 between Panama City Beach, Florida and
KNOLOGY Holdings, Inc.
10.59(6) -- Form of Tax Separation Agreement between ITC Holding and
KNOLOGY, Inc.
10.60(6) -- Right of First Refusal and Option Agreement, dated November
19, 1999 by and between KNOLOGY of Columbus, Inc. and ITC
Service Company, Inc.
10.61(6) -- Services Agreement dated November 2, 1999 between KNOLOGY,
Inc. and ITC Service Company, Inc.
10.62(6) -- Support Agreement, dated November 2, 1999 between Interstate
Telephone Company, Inc. and ITC Service Company, Inc.
10.63(6) -- 1995 KNOLOGY Holdings, Inc. Stock Option Plan, assumed by
KNOLOGY, Inc. as of November 23, 1999.
10.64(6) -- KNOLOGY, Inc. Long Term Incentive Plan.
10.65(6) -- Warrant Agreement, dated as of December 3, 1999, between
KNOLOGY, Inc. and United States Trust Company of New York
(including form of Warrant Certificate).
10.66(6) -- Warrant Registration Rights Agreement, dated as of December
3, 1999, between KNOLOGY, Inc. and United States Trust
Company of New York.
10.67(6) -- Section 351 Agreement by and among KNOLOGY, Inc., InterCall,
Inc., Valley Telephone Company and Globe Telecommunications,
Inc., dated November 1, 1999.
10.68(6) -- Amendment to Section 351 Agreement by and among KNOLOGY,
Inc., InterCall, Inc., Valley Telephone Company and Globe
Telecommunications, Inc., dated November 22, 1999.
10.69(6) -- Form of Stockholder Letter of Transmittal relating to the
exchange of KNOLOGY, Inc. capital stock for KNOLOGY
Holdings, Inc. capital stock.
10.70(6) -- Form of Warrant Holder Letter of Transmittal relating to the
exchange of KNOLOGY, Inc. warrants for KNOLOGY Holdings,
Inc. warrants.
10.71(6) -- KNOLOGY, Inc. Spin-Off Plan.
10.72(6) -- Loan Agreement between InterCall, Inc. and KNOLOGY, Inc.
dated December 22, 1999
10.73(6) -- Line of Credit Note from KNOLOGY, Inc. to InterCall, Inc.
dated December 22, 1999
10.74(6) -- Form of Residual Note from KNOLOGY, Inc. to ITC Holding
Company, Inc.
12.1(6) -- Statement regarding Computation of Ratio of Earnings to
Fixed Charges.
</TABLE>
II-4
<PAGE> 7
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT DESCRIPTION
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<C> <C> <S>
21.1(6) -- Subsidiaries of KNOLOGY, Inc.
23.1(6) -- Consent of Arthur Andersen LLP.
23.2(6) -- Consent of Deloitte & Touche LLP.
23.3(6) -- Consent of Morgan Stanley & Co. Incorporated.
23.4(6) -- Consent of Hogan & Hartson L.L.P. (included in its opinion
filed as Exhibit 5.1 hereto).
23.5(5) -- Consent of Arthur Andersen LLP relating to Exhibit 8.1.
24.1(6) -- Power of Attorney.
27.1(6) -- Financial Data Schedule for year ended 1997 (for SEC use
only).
27.2(6) -- Financial Data Schedule for year ended 1998 (for SEC use
only).
99.1(6) -- IRS Private Letter Ruling, dated April 1, 1999.
99.2(6) -- IRS Private Letter Ruling, dated December 22, 1999.
99.3(6) -- Letter to ITC Holding Company, Inc. from Morgan Stanley &
Co. Incorporated, dated August 22, 1999.
</TABLE>
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(1) Filed previously in connection with KNOLOGY Holdings, Inc.'s Registration
Statement on Form S-4, (File No. 333-43339) and incorporated herein by
reference.
(2) Filed previously in connection with KNOLOGY Holdings, Inc.'s Annual Report
on Form 10-K in the year ended December 31, 1998 and incorporated herein by
reference.
(3) Filed previously in connection with KNOLOGY Holdings, Inc.'s Annual Report
on Form 10-K in the year ended December 31, 1997 and incorporated herein by
reference.
(4) To be filed by amendment.
(5) Filed herewith.
(6) Previously filed.
* Certain confidential portions of this Exhibit were omitted by means of
redacting a portion of the text. This Exhibit was filed separately with the
Secretary of the Commission without such text pursuant to the approval of
our Application Requesting Confidential Treatment under Rule 406 of the
Securities Act.
(b) Financial Statement Schedules
Schedules have been omitted because the information required to be set
forth therein is not applicable or is included elsewhere in the Financial
Statements or the notes thereto.
II-5
<PAGE> 8
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Company has
reasonable grounds to believe that it meets all of the requirements for filing
on Form S-1 and has duly caused this Amended Registration Statement to be signed
on its behalf by the undersigned, thereunto duly authorized, in the city of
Washington, DC on this 9th day of February, 2000.
KNOLOGY, INC.
By: *
------------------------------------
Rodger L. Johnson
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Act of 1933, this Amended
Registration Statement has been signed as of February 9, 2000 by the following
persons in the capacities indicated.
<TABLE>
<CAPTION>
SIGNATURES TITLE
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<C> <S>
* President, Chief Executive Officer
- ------------------------------------- and Director
Rodger L. Johnson
* Chief Financial Officer (Principal
- ------------------------------------- Financial and Accounting Officer)
Robert K. Mills
* Chairman of the Board of Directors
- -------------------------------------
Campbell B. Lanier, III
* Director
- -------------------------------------
William H. Scott
* Director
- -------------------------------------
Richard Bodman
* Director
- -------------------------------------
Alan A. Burgess
* Director
- -------------------------------------
Donald W. Burton
* Director
- -------------------------------------
L. Charles Hilton, Jr.
* Director
- -------------------------------------
Donald W. Weber
*By: /s/ CHAD WACHTER
- -------------------------------------
Chad Wachter
Attorney-in-Fact
</TABLE>
II-6
<PAGE> 1
EXHIBIT 8.1
[ARTHUR ANDERSEN LLP LETTERHEAD]
February 8, 2000
STRICTLY CONFIDENTIAL
Mr. Chad Wachter
Vice President, General Counsel and Secretary
KNOLOGY, Inc.
1241 O.G. Skinner Drive
West Point, GA 31833
Dear Chad:
As requested, this letter sets forth our opinion regarding the federal income
tax treatment of the adjustment of ITC Holding Company, Inc. ("ITC Holding")
options and distribution of KNOLOGY, Inc. ("KNOLOGY") options in connection with
the creation and distribution of KNOLOGY stock. The following paragraphs discuss
the background, issues, our conclusions, the analysis of the applicable tax law,
risks and the scope of our opinion.
BACKGROUND
ITC Holding Company, Inc. and subsidiaries ("ITC Holding") are engaged in a
corporate reorganization ("reorganization") in which KNOLOGY, Inc. and
subsidiaries ("KNOLOGY") will be structurally separated from ITC Holding. The
reorganization will take the form of a "spinoff" whereby the shares of KNOLOGY
owned by ITC Holding will be distributed to ITC Holding shareholders. KNOLOGY,
Inc. is a newly formed subsidiary that owns 100% of KNOLOGY Holdings Inc.,
Interstate Telephone Company, Valley Telephone Company, Globe
Telecommunications, Inc., and ITC Globe, Inc. In connection with the
reorganization, each currently outstanding but unexercised stock option under
the ITC Holding Company, Inc. Amended and Restated Stock Option Plan and the ITC
Holding Company, Inc. Nonemployee Director Stock Option Plan (the "ITC Holding
Options") will effectively split into separately exercisable options to acquire
shares of stock of each of ITC Holding and of KNOLOGY.
Each ITC Holding option holder will receive new options to acquire shares of
KNOLOGY Series A preferred stock. The new options will be substituted for a
proportionate value of the ITC Holding options. Additionally, the exercise price
of the remaining ITC Holding options will be reduced in an amount equal to the
aggregate exercise price of the distributed KNOLOGY options. The "spread" (i.e.,
the difference between the exercise price of the option and the fair market
value of the underlying stock) in the new KNOLOGY options and the
<PAGE> 2
Mr. Chad Wachter
Page 2
February 8, 2000
adjusted ITC Holding options will equal the value of the spread that each option
holder would have realized had he or she exercised ITC Holding options
immediately prior to the issuance of the KNOLOGY options and the adjustment of
the ITC Holding options. For each unexercised ITC Holding option, the option
holder will receive approximately 1.09153 KNOLOGY options and continue to hold
one ITC Holding option at the reduced exercise price. The replacement ratios of
1.09153-to-one and one-to-one are a result of the number of shares and stock
options of ITC Holding outstanding compared to the number of shares and stock
options of KNOLOGY owned by ITC Holding. Cash payment will be made to each
holder in lieu of issuing options for fractional shares of KNOLOGY. The
aggregate option price payable with respect to the unexercised ITC Holding
options will be allocated between the new options based on the relative fair
market values of ITC Holding and KNOLOGY as of the day before the effective date
of the Reorganization. The original grant date, vesting schedule, and term of
the options will remain the same. The receipt of the KNOLOGY options and the
adjustment of the ITC Holding options will occur after the formation of the
KNOLOGY holding company and at least one day prior to the distribution of
KNOLOGY stock.
Prior to the formation of KNOLOGY, all employees were employees of the ITC
Holding consolidated group. After the distribution of KNOLOGY stock, some
employees within the current consolidated group will remain ITC Holding
employees and the rest will become employees of KNOLOGY. Therefore, employees of
ITC Holding will hold options to purchase stock of both ITC Holding and KNOLOGY
and employees of KNOLOGY will hold options to purchase stock of both ITC Holding
and KNOLOGY.
The ITC Holding stock options and the options to purchase the KNOLOGY Series A
preferred stock to be distributed by ITC Holding consist of two types of stock
options - stock options intended to qualify under Section 422 of the Code as
"incentive stock options" and stock options not intended to qualify under
Section 422 of the Code, i.e. nonqualified stock options ("NSOs").
ISSUES
1. What is the federal tax effect of the distribution of KNOLOGY stock options
to ITC Holding employees who hold ITC Holding incentive stock options?
2. What is the federal tax effect of the distribution of KNOLOGY stock options
to KNOLOGY employees who hold ITC Holding incentive stock options?
3. What is the federal tax effect of the distribution of the KNOLOGY stock
options to nonemployees and employees of ITC Holding and KNOLOGY holding NSOs in
ITC Holding?
4. What is the federal tax effect of the adjustment in exercise price of ITC
Holding incentive stock options for ITC Holding employees?
<PAGE> 3
Mr. Chad Wachter
Page 3
January 28, 2000
5. What is the federal tax effect of the adjustment in exercise price of ITC
Holding incentive stock options for KNOLOGY employees?
6. What is the federal tax effect of the adjustment in exercise price of ITC
Holding NSOs for nonemployees and employees of ITC Holding and KNOLOGY holding
NSOs in ITC Holding?
CONCLUSIONS
1. The KNOLOGY options distributed to ITC holding employees holding ITC Holding
ISOs are more likely than not ISOs. The issuance of KNOLOGY options to ITC
Holding employees is more likely than not treated as a nontaxable substitution
of KNOLOGY options for ITC Holding ISOs and not treated as a taxable
modification. In the case of ISOs that do not subsequently become nonqualified,
there will be a taxable event at the time the stock underlying the options is
sold based upon the difference between the fair market value of the stock at the
date of sale and the exercise price. Alternative minimum tax may also apply when
ISOs are exercised.
Even if the KNOLOGY stock options distributed are ISOs, they will become NSOs
three months after the distribution. The conversion to a NSO will not be a
taxable event. With a NSO, the holder will have taxable income at the date of
exercise for the difference between the fair market value of the stock at the
date of exercise and the exercise price.
If the IRS were to recharacterize the KNOLOGY stock options as NSOs, the
distribution will not be a taxable event for the employees receiving such grant.
With an NSO, the holder will have taxable income at the date of exercise for the
difference between the fair market value of the stock at the date of exercise
and the exercise price.
2. The KNOLOGY options distributed to KNOLOGY employees holding ITC Holding
ISOs should be ISOs after the distribution of KNOLOGY. The issuance of KNOLOGY
options to KNOLOGY employees should be treated as a nontaxable substitution of
KNOLOGY options for ITC Holding ISOs and not treated as a taxable modification.
In the case of ISOs that do not subsequently become nonqualified, there will be
a taxable event at the time the stock underlying the options is sold based upon
the difference between the fair market value of the stock at the date of sale
and the exercise price. Alternative minimum tax may also apply when incentive
stock options are exercised.
If the IRS were to recharacterize the KNOLOGY stock options as NSOs, the
distribution will not be a taxable event for the employees receiving such grant.
With an NSO, the holder will have taxable income at the date of exercise for the
difference between the fair market value of the stock at the date of exercise
and the exercise price.
3. The KNOLOGY stock options distributed to nonemployees and employees holding
NSOs of ITC Holding should be treated as NSOs. With a NSO, the holder will have
taxable income at the date of exercise for the difference between the fair
market value of the stock at the date of exercise and the exercise price.
If the IRS were to recharacterize the distribution of KNOLOGY NSOs as a grant of
discounted options, the distribution will not be a taxable event for the
employees and nonemployees receiving such a grant. With an NSO, the holder would
be subject to tax at the time of exercise.
4. ITC Holding ISOs with the adjusted exercise prices that are held by ITC
Holding employees should remain ISOs after the distribution of KNOLOGY. The
adjustment of the exercise price of ITC Holding ISOs currently held by ITC
Holding employees should not be treated as a modification for the employees of
ITC Holding. In the case of ISOs that do not subsequently become nonqualified,
there will be a taxable event at the time the stock underlying the options is
sold based upon the difference between the fair market value of the stock at the
date of sale and the exercise price. Alternative minimum tax may also apply when
incentive stock options are exercised.
If the IRS were to recharacterize the ITC Holding stock options as NSOs, the
adjustment will not be a taxable event for the employees receiving such
adjustment. With an NSO, the holder will have taxable income at the date of
exercise for the difference between the fair market value of the stock at the
date of exercise and the exercise price.
5. ITC Holding ISOs with the adjusted exercise prices that are held by KNOLOGY
employees should be ISOs. The adjustment of the exercise price of ITC Holding
ISOs held by KNOLOGY employees should not be treated as a modification for the
employees of KNOLOGY. In the case of ISOs that do not subsequently become
nonqualified, there will be a taxable event at the time the stock underlying
the options is sold based upon the difference between the fair market value of
the stock at the date of sale and the exercise price. Alternative minimum tax
may also apply when incentive stock options are exercised.
The ITC Holding ISOs with the adjusted exercise prices that are held by KNOLOGY
employees after the distribution will become NSOs three months after the
distribution. The conversion to a NSO will not be a taxable event. With a NSO,
the holder will have taxable income at the date of exercise for the difference
between the fair market value of the stock at the date of exercise and the
exercise price.
If the IRS were to recharacterize the ITC Holding stock options as NSOs, the
adjustment will not be a taxable event for the employees receiving such
adjustment. With an NSO, the holder will have taxable income at the date of
exercise for the difference between the fair market value of the stock at the
date of exercise and the exercise price.
6. ITC Holding NSOs with the adjusted exercise prices that are held by
nonemployees and employees of ITC Holding and KNOLOGY should continue to be
treated as NSOs. With a NSO, the holder will have taxable income at the date of
exercise for the difference between the fair market value of the stock at the
date of exercise and the exercise price.
If the IRS were to recharacterize the adjustment in exercise price of ITC
Holding NSOs as a grant of discounted options, the adjustment will not be a
taxable event for the employees and nonemployees receiving such adjustment. With
an NSO, the holder would be subject to tax at the time of exercise.
DISCUSSION
SECTION I- DESCRIPTION OF KEY TERMS
<PAGE> 4
Mr. Chad Wachter
Page 4
February 8, 2000
For purposes of our analysis we have explained significant terms based on
descriptions provided in the Code and Treasury Regulations below:
Incentive Stock Options (ISOs)
Incentive Stock Options provide special tax treatment to an employee. An ISO has
no federal income tax consequences upon grant to either the employer or
employee. Additionally, an ISO has no federal tax consequences upon exercise to
either the employer or employee. Upon the ultimate sale of the related stock,
the employee has capital gain or loss equal to the difference between the sale
price and the exercise price (assuming the requisite holding periods have been
met). However, in order to qualify as an ISO, the option must meet the following
statutory requirements under Code Section 422(b):
1) The option plan must specify the aggregate number of shares that may be
issued, identify the employees or class of employees eligible and be
approved by stockholders within 12 months before or after the plan is
adopted.
2) The option must be granted within 10 years of the earlier of either the
adoption of the plan or the date of its approval by the shareholders.
3) The term of the option may not exceed 10 years.
4) The option price must not be less than the fair market value of the stock at
the date of grant.
5) The option by its terms must be nontransferable other than at death and must
be exercisable during the executive's lifetime only by the employee.
6) If the employee owns, immediately before the option is granted, more than 10
percent of the combined voting power of the employer, or its parent or
subsidiary, the option price must be at least 110 percent of the stock's
fair market value at the date of grant and the option must not be
exercisable for more than five years after grant.
If all of the above requirements are met, the holder may generally exercise the
options free of federal income taxes, postponing the taxable event until the
stock received as a result of the exercise is sold. As long as the shares
acquired through an ISO are held for at least one year following exercise and
are not disposed of until at least two years after the option is granted, the
difference between the option price and the sale price is taxed as a long-term
capital gain. If the requisite holding periods for an ISO are not satisfied, the
employee recognizes taxable ordinary income to the extent that the value of the
stock at the date of exercise exceeds the exercise price. Note, however, that in
the case where ISO treatment is attained, the bargain element of the option,
i.e., the "spread" - is treated as a preference item that increases taxable
income for alternative minimum tax ("AMT") purposes. The tax basis of stock
exercised through an ISO for AMT is equal to the FMV of the stock at exercise.
This higher basis will result in AMT lower than regular tax when the stock is
sold.
Additionally, Code Section 422(a) provides that the holder of the ISO must be an
employee of the corporation (or a parent or subsidiary corporation) issuing or
assuming a stock option to which Code Section 424 (a) applies at all times
during the period beginning on the date the
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option is granted and ending on the day 3 months before the date of such
exercise. If the option holder does not meet the employment requirement, then
the ISO becomes a nonqualified option.
A Modification versus Assumption or Substitution
If the terms of any stock option are modified, such modification shall be
considered as the granting of a new option. A modification is defined as a
"change in the terms of the option which gives the employee additional benefits
under the option, but such term shall not include a change in the terms of the
option attributable to the issuance or assumption of an option under Section
424(a)."(1) Incentive stock options must satisfy four requirements to be
considered a substitution of existing options, rather then the modification of
existing options.
1) The first requirement is that the substitution of an ISO must be made by
either an employer corporation or a parent or subsidiary of such
corporation.(2)
2) The second requirement is that the substitution of an ISO must be pursuant
to a corporate merger, consolidation, acquisition of property or stock,
separation, reorganization, or liquidation.(3)
3) The third requirement is the excess of the aggregate fair market value of
the shares subject to the option immediately after the substitution or
assumption over the aggregate option price of such shares is not more than
the excess of the aggregate fair market value of all shares subject to the
option immediately before such substitution or assumption over the aggregate
option price of such shares
4) The fourth requirement states that the new option or the assumption of the
old option does not give the employee additional benefits which he did not
have under the old option.
If the distribution of KNOLOGY stock options or the adjustment of the exercise
price of ITC Holding ISOs were characterized as a modification, i.e., a new
grant, the options would no longer meet the requirements of an ISO. An ISO must
be granted at the current fair market value of the underlying stock. The fair
market value of the stock of ITC Holding is expected to be higher on the day it
is substituted and adjusted than the exercise price/fair market value on the day
the options were originally granted. If the substitution or adjustment, based on
the current value of the options, were recharacterized as a new grant, the
substituted or adjusted options would be considered to have been granted at a
discount and would, therefore, not meet the requirements of an ISO.
Definitions of Parent Corporation and Subsidiary
Code Section 422(a)(2) refers to the parent-subsidiary relationship, which is
critical to the analysis regarding the substitution and adjustment of the
incentive stock options in this transaction. Code Sections 424(e), 424(f) and
424(g) define these relationships.
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(1) IRC Section 424(h)(1) and Section 424(h)(3)
(2) IRC Section 424(a) and Treasury Regulation Section 1.425-1(a)
(3) IRC Section 424(a) and Treasury Regulation Section 1.425-1(a)
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1) Parent Corporation. Under 424(e) a parent corporation is any corporation
(other than the employer corporation) in an unbroken chain of corporations
ending with the employer corporation if, at the time of the granting of
the option, each of the corporations other than the employer corporation
owns stock possessing 50 percent or more of the total combined voting
power of all classes of stock in one of the other corporations in such
chain.
2) Subsidiary Corporation. Under 424(f), a subsidiary corporation is any
corporation (other than the employer corporation) in an unbroken chain of
corporations beginning with the employer corporation if, at the time of
the granting of the option, each of the corporations other than the last
corporation in the unbroken chain owns stock possessing 50 percent or more
of the total combined voting power of all classes of stock in one of the
other corporations in such chain.
3) Code Section 424(g) identifies special rules for applying Code Sections
424(e) and 424(f). This section provides that for purposes of applying
subsections (e) and (f) to 424(a)(2), the term "corporation issuing or
assuming a stock option in a transaction to which section 424(a) applies"
is substituted for "employer corporation."
Definition of a Section 424(a) Transaction
Code Section 424(a) and Treas. Reg. Section 1.425-1(a) describe special rules
applicable to statutory options, i.e., ISOs, with respect to corporate
reorganizations. Under Treas. Reg. Section 1.425-1(a), "... a transaction to
which 424(a) applies means a substitution of a new option for the old option or
an assumption of a new option for the old option, by an employer corporation, or
a parent of subsidiary of such corporation, by reason of a corporate merger,
consolidation, acquisition of property or stock, separation, reorganization, or
liquidation." The formation and distribution of KNOLOGY from ITC Holding is a
transaction as defined above, and therefore treatment of ISOs would fall under
the above sections.
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SECTION II - ISSUES 1 AND 2
Issue 1. What is the federal tax effect of the distribution of KNOLOGY stock
options to ITC Holding employees who hold ITC Holding incentive stock options?
Issue 2. What is the federal tax effect of the distribution of KNOLOGY stock
options to KNOLOGY employees who hold ITC Holding incentive stock options?
Substitution of an Existing Option
KNOLOGY is a recently formed subsidiary of ITC Holding. The formation of KNOLOGY
and the subsequent distribution of this subsidiary are two separate
transactions. The substitution of the percentage value of ITC Holding incentive
stock options for incentive stock options in KNOLOGY will occur at least one day
prior to the anticipated distribution of KNOLOGY, while incentive stock holders
are still employees of ITC Holding or its subsidiary, KNOLOGY. As a result of
the reorganization, employees who hold incentive stock options in ITC Holding
will hold incentive stock options in ITC Holding, as well as KNOLOGY, Inc. The
issuance of KNOLOGY ISOs for ITC Holding ISOs must meet the four requirements
above to be considered a substitution of existing options, otherwise a
modification will occur. These requirements are tested below.
Requirement #1. The first requirement is that the substitution of an ISO must be
made by either an employer corporation or a parent or subsidiary of such
corporation. In this case, the substitution of KNOLOGY ISOs, held by KNOLOGY
employees, for ITC Holding ISOs is a substitution by the employer. The
substitution of KNOLOGY ISOs, held by ITC Holding employees, for ITC Holding
ISOs is a substitution by a subsidiary of the parent.
Under Code Section 424(a), "the parent-subsidiary relationship shall be
determined at the time of any such transaction under this subsection."
Furthermore, under Treas. Reg. Section 1.425-1(a)(5), an assumption or
substitution, which occurs by reason of a corporate transaction, may occur
before or after the corporate transaction. Under Treas. Reg. Section
1.425-1(a)(8), the determination of whether the parent-subsidiary relationship
exists is based on circumstances existing immediately after the corporate
transaction. This section, 1.425-1(a)(8), appears to conflict with
1.425-1(a)(5). We interpret 1.425(a)(8) to apply to situations that are not
relevant to the reorganization, i.e., a distribution situation, in which it is
impossible to have a parent-subsidiary relationship after the transaction.
Treas. Reg. Section 1.425-1(a)(8) is relevant for a purchase or acquisition
transaction in which the company wants to determine the opportunity to grant
ISOs to employees of a company going forward. For example, if Acquirer Co. (A)
purchases Target Co. (T), (A) could not issue ISOs to employees of (T) until
after the transaction has occurred and there is a parent-subsidiary
relationship. Therefore, for purposes or our analysis, we refer back to Code
Section 424(a) and Treas. Reg. 1.425(a)(5) to determine whether it is possible
to substitute ISOs in KNOLOGY for ISOs of ITC Holding.
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To apply 1.425-1(a)(8) to transactions such as a distribution in connection with
a corporate separation appears to be inconsistent with Code section 424(a) and
would be an unreasonable restriction on the statutory language. Even if we
interpret 1.425-1(a)(8) to mean the status of the employee after the
reorganization, i.e., the creation of KNOLOGY, there is still a
parent-subsidiary relationship for the period between the creation of KNOLOGY
and the distribution.
Furthermore, if the KNOLOGY ISOs had been granted two months ago, not in
connection with a distribution, a substitution of ISOs would not be a
modification. Under Code Section 424(a), where there is a parent-subsidiary
relationship, it is permissible for employees to hold ISOs in both the parent
and subsidiary, effectively giving employees equal economic opportunity
regardless of reporting relationship within the parent-subsidiary organization.
Requirement #2. The second requirement is that the substitution of an ISO must
be pursuant to a corporate merger, consolidation, acquisition of property or
stock, separation, reorganization, or liquidation.(4) The substitution of the
ITC Holding ISOs is pursuant to a reorganization.(5) Based on the definition of
reorganization in Code Section 424 and our understanding of the formation of the
ITC Holding subsidiary, KNOLOGY, Inc., and the distribution of its stock, any
corresponding substitution of incentive stock options would meet the
requirements of occurring under a transaction described in Code Section 424(a).
Requirement #3. The third requirement is that the excess of the aggregate fair
market value of the shares subject to the option immediately after the
substitution over the aggregate option price of such shares is not more than the
excess of the aggregate fair market value of all shares subject to the option
immediately before the substitution over the aggregate option price of such
shares. Treas. Reg. Section 1.425-1(a)(6) provides that a substitution of an
option may include some but not all of the incentive stock options. The language
of Treas. Reg. Section 1.425-1(a)(6) states that "It is not necessary, however,
to have a complete substitution of a new option for the old option." Since the
"spread" (i.e., the difference between the exercise price of the option and the
fair market value of the underlying stock) in the new KNOLOGY options and the
adjusted ITC Holding options will equal the value of the spread that each option
holder would have realized had he or she exercised ITC Holding options
immediately prior to the issuance of the KNOLOGY options and the adjustment of
the ITC Holding options, the substitution follows the requirements for an
assumption or substitution of statutory options, per 1.425-1(a)(6). Therefore,
the partial substitution should not be considered a modification of an incentive
stock option.
Requirement #4. The fourth requirement states that the new option or the
assumption of the old option does not give the employee additional benefits
which he did not have under the old option. Since the terms of the options,
e.g., vesting schedule, period to exercise (term), will
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(3) IRC Section 424(a) and Treasury Regulation Section 1.425-1(a)
(5) IRC Section 424(a) and Treasury Regulation Section 1.425-1(a)
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remain the same, the employee will receive no additional benefits that he or she
did not have under the old option and, therefore, the substitution satisfies
this requirement.
Requirements for an ISO
As discussed in Section 1, in order to qualify as an ISO, the option must meet
the statutory requirements under Code Section 422(b). We have determined that a
parent-subsidiary employment relation exists when the ISOs are substituted.
Additionally, since none of the other terms of the option have changed, the ISOs
still meet the remaining requirements.
The employment relationships of incentive stock option holders will change at
the time of the distribution of KNOLOGY from ITC Holding. KNOLOGY employees will
no longer have a parent-subsidiary relationship ITC Holding and vice versa. As a
result, under Section 422(a) incentive stock options of ITC Holding for KNOLOGY
employees will convert to nonqualified options three months after the
distribution of KNOLOGY. Additionally, incentive stock options of KNOLOGY held
by ITC Holding employees will also convert to nonqualified stock options three
months after the distribution of KNOLOGY.
Summary
It is more likely than not that the distribution of KNOLOGY incentive stock
options to ITC Holding option holders, who are employees of ITC Holding, will
not be treated as a modification and thus will continue to qualify as incentive
stock options. There is some risk, however, that since the issuance of the
KNOLOGY ISOs was in connection with a corporate distribution, the Service may
interpret 1.425-1(a)(8) to mean that a modification did occur because there was
no parent subsidiary-relationship at the time of the substitution.
With respect to ITC Holding incentive stock option holders who are employees of
KNOLOGY there should be no modification upon the distribution of KNOLOGY ISOs
and such ISOs should continue to continue to qualify as ISOs.
SECTION III - ISSUES 4 AND 5
Issue 4. What is the federal tax effect of the adjustment in exercise price of
ITC Holding incentive stock options for ITC Holding employees?
Issue 5. What is the federal tax effect of the adjustment in exercise price of
ITC Holding incentive stock options for KNOLOGY employees?
Adjustment of ITC Holding Incentive Stock Options
The exercise price of the balance of the ITC Holding options will be adjusted to
reflect the new value of ITC Holding shares at the distribution of KNOLOGY.
Under Treas. Reg. Section
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February 8, 2000
1.425-1(e)(5)(ii)(b), a change in the number or price of options to reflect a
corporate transaction is not a modification of the option provided that the
excess of the aggregate fair market value (determined immediately after such
corporate transaction) of the shares subject to the option immediately after
such change over the aggregate new option price of such shares is not more than
the excess of the aggregate fair market value of the shares subject to the
option immediately before the transaction over the aggregate former option price
of such shares, and provided that the option after such change does not give the
employee additional benefits which he did not have before such change. The ratio
of the option price immediately after the change to the fair market value of the
stock subject to the option immediately after the corporate transaction must not
be more favorable to the optionee on a share by share comparison than the ratio
of the old option price to the fair market value of the stock subject to the
option immediately before such transaction. A reduction in the option price of
an option, other than as specifically provided for in this section, is a
modification of such option.
Additionally, under Rev. Rul. 71-385, 1971-2 CB 215, a change in the price of
outstanding stock options to reflect a decline in the value of the corporation's
stock resulting from a distribution reflects a corporate transaction as defined
in section 425(c) of the Code and is not a modification.
Requirements for an ISO
After the adjustment in the exercise price, the ITC Holding ISOs continue to
meet the statutory requirements under Code Section 422(b). The adjusted option
price still reflects the value of the option based on the fair market value of
the stock at the date of grant. In Section 2, we determined that a
parent-subsidiary employment relation exists when the ISOs are substituted and
adjusted. Additionally, since none of the other terms of the option have
changed, the ISOs still meet the remaining requirements.
As previously discussed, after the distribution of KNOLOGY, the employment
relationships of incentive stock option holders will change. As a result, under
Section 422(a) the adjusted ITC Holding ISOs held by KNOLOGY employees will
convert to nonqualified options three months after the distribution. ITC Holding
ISOs held by ITC Holding will continue to retain their ISO status since holders
are still employees of ITC Holding.
Summary
The adjustment of the aggregate exercise prices of the ITC Holding options in
connection with the distribution of the options to purchase KNOLOGY stock will
be made in proportion to the relative fair market values of ITC Holding and
KNOLOGY stock and satisfies criteria of the above requirements of Treas. Reg.
Section 1.425.
Therefore, the change in the exercise price of an ITC Holding incentive stock
option that reflects the decreased value of a share of ITC Holding stock and
excludes the value of KNOLOGY should not disqualify an incentive stock option.
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January 28, 2000
The adjustment of ITC Holding ISOs held by KNOLOGY employees should not result
in a taxable event for holders and should retain their ISO status until 3 months
after the distribution. The adjustment of ITC Holding ISOs held by ITC Holding
employees also should not result in a taxable event and should continue to
retain their ISO status post-distribution since holders are still employees of
ITC Holding.
SECTION IV - ISSUES 3 AND 6
Issue 3. What is the federal tax effect of the distribution of the KNOLOGY stock
options for nonemployees and employees of ITC Holding and KNOLOGY holding NSOs
in ITC Holding?
Issue 6. What is the federal tax effect of the adjustment in exercise price of
ITC Holding NSOs for nonemployees and employees of ITC Holding and KNOLOGY?
Analysis
The nonqualified stock options of ITC Holding will be adjusted to reflect the
reduction in value that was caused by the substitution of KNOLOGY options for
ITC Holding options. In general, the adjustment of a nonqualified option is not
taxable because the existing option, which is not currently taxable, has been
replaced by another such option, which is also not currently taxable. Also, if
there were no adjustment, but instead the transaction was the grant of
discounted options, the result would not be different, as the grant of
discounted stock options generally does not result in taxable income to the
optionee. Furthermore, no financial consideration is being given to ITC Holding
option holders for the adjustment of their options. The paragraphs that follow
discuss the basis for the tax treatment of each such options, as well as rulings
covering the exchange of one nontaxable option for another.
Taxability of Discounted Stock Options
In general, the taxation of stock options other than incentive stock options is
governed by IRC Section 83. Options are not taxed upon grant under Section 83
unless they have a readily ascertainable fair market value. IRC Section 83(c).
For such value to exist the options must be traded on an established market or
meet several conditions. Regulation Section 1.83-7(b). Such conditions include
(i) the option is transferable by the optionee, (ii) the option is vested, (iii)
the option (or stock underlying the option) is not subject to any condition
affecting the value of the option, and (iv) the value of the option is readily
ascertainable under Regulation 1.83-7(b)(3). The ITC Holding options are neither
traded on an established market nor meet the conditions of the regulation. The
taxable event therefore occurs at the time the options are exercised and
property (i.e., the stock) is delivered to the employee. Regulation Section
1.83-7(a).
The ITC Holding options that are being adjusted are considered discounted or "in
the money" options. Discounted options are subject to the same rules under IRC
Section 83. Absent a readily ascertainable fair market value, the option is not
taxed even though it is "in the money"
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when granted. Indeed, the regulations even acknowledge that discounted options
do not have a readily ascertainable fair market value equal to the "in the
money" amount or "profit." Regulation 1.83-7(b)(3) provides:
"For example, if at some time during the exercise period of an option to buy,
the fair market value of the property subject to the option is greater than the
option's exercise price, a profit may be realized by exercising the option and
immediately selling the property so acquired for its higher fair market value.
Irrespective of whether any such gain may be realized immediately at the time an
option is granted, the fair market value of an option to buy includes the value
of the right to benefit from any future increase in the value of the property
subject to the option (relative to the option exercise price), without risking
any capital. Therefore, the fair market value of an option is not merely the
difference that may exist at a particular time between the option's exercise
price and the value of the property subject to the option, but also includes the
value of the option privilege for the remainder of the exercise period."
(Emphasis added)
In effect, discounted stock options are treated the same as "in the money"
options. In both cases, the value over the remainder of the exercise period
cannot be ascertained and this precludes taxation of the unexercised option or
right.
Applicable case law is consistent with the regulations. In LoBue, 351 U.S. 243,
(1956), the Supreme Court held that options with approximately a 75% discount in
the option price should be taxed upon exercise and not grant. There the taxpayer
was granted options to purchase 340 shares of employer stock. The Court
determined that the options were compensatory in nature and rejected the
argument that tax should be imposed on the date of grant. The Court acknowledged
that it is possible for an optionee to realize an immediate taxable gain but
only where the options have a readily ascertainable fair market value and are
transferable upon grant. It concluded that LoBue was not such a case, despite
the fact that the option price for LoBue's options was discounted approximately
75% from the value of the shares on the date of grant. Thus, the Supreme Court
in LoBue did not endorse the principle that discounted options are to be taxed
differently from nondiscounted options.
Two other cases have held that the right to buy stock at a discount of 99
percent was not taxable in the year granted. Rather, taxation was postponed
until the right was exercised and the property transferred. Victorson, 326 F.2d
264, (2nd Cir., 1964), aff'g TCM 1962-231 and Simmons, TCM 1964-237. Neither of
these cases involved executive stock options but both cases held that there was
no income on grant if the option has no readily ascertainable fair market value
and is nontransferable.
Despite such authority, the Internal Revenue Service has a formal no-rule policy
on discounted stock options. Rev. Proc. 94-3, 1994-1 CB 447, Section 5.04. The
IRS view apparently is that if it is substantially certain that a taxpayer will
exercise an option, the form of the option should be disregarded and the
arrangement should be treated, in substance, as the direct purchase (or award)
of the stock. It is not clear what the basis for this position is, given the
case law.
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Taxability of exchanging one nontaxable option for another
IRC Section 424 provides a means for a substitution of a new option for an old
option in certain circumstances pertaining to "qualified options", i.e., options
governed by IRC Sections 422 and 423. Such a substitution is the exchange of one
nontaxable option for another. Under Example (2) of Regulation Section 1.425 -
1(a)(4)(ii) (IRC Section 424 was formerly IRC Section 425), 60 qualified stock
options with an exercise price of $12 per share in the Target corporation are
exchanged for 80 qualified stock options with an exercise price of $9 per share
in the Acquiring corporation without triggering taxation to the optionee. At the
time of exchange, the fair market value of the Target and Acquirers stock was
$32 and $24 per share, respectively.
Consistent with IRC Section 424, but applicable to nonqualified stock options,
is LTR 8928051 (April 18, 1989). In LTR 8928051, Target merged into a subsidiary
of Parent. At the time of the merger and pursuant to the merger agreement, all
outstanding nonqualified options to buy Target stock were converted to options
to buy Parent stock. The IRS determined that since neither the Target options
nor the Parent options had a readily ascertainable fair market value within the
meaning of IRC Section 83, the substitution of the Parent nonqualified options
for Target options did not result in the recognition of income to the Target
option holders.
Summary
The case law provides quite clearly that discounted stock options, so long as
they have no ascertainable fair market value and are nontransferable, are not
taxable until exercised. Thus, if there were no exchange but instead a grant of
discounted options (i.e., the same result as the exchange), the cases (and
regulations) are clear that the employees receiving such a grant would not be
subject to tax at the time of the grant.
Accordingly, based on the authorities cited above, as well as the general tax
principles applicable to stock options, we conclude that ITC Holding option
holders, who are employees of ITC Holding, that receive the adjusted
nonqualified stock options should not be subject to federal income tax at the
time of the adjustment. Additionally, we conclude that ITC Holding option
holders, who are non employees of ITC Holding, that receive the adjusted
nonqualified stock options should also not be subject to federal income tax at
the time of the adjustment.
RISKS
1) Issue 1. What is the federal tax effect of the distribution of KNOLOGY stock
options to ITC Holding employees who hold ITC Holding incentive stock
options?
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January 28, 2000
Issue 2. What is the federal tax effect of the distribution of KNOLOGY stock
options to KNOLOGY employees who hold ITC Holding incentive stock options?
If the IRS were to successfully challenge the treatment of the distribution
and assert it was a modification, the option, which would otherwise be
treated as an ISO for 90 days, would be recharacterized as a nonqualified
option. With a nonqualified option, the holder will have taxable income at
the date of exercise for the difference between the fair market value of the
stock at the date of exercise and the exercise price. In general, the
classification of the KNOLOGY stock option as an ISO will not result in
taxable income to the option holder until the stock underlying the stock
option is sold. The taxable income will be equal to the excess of the sales
price less the exercise price. The spread, however, will be a "tax
preference" item for alternative minimum tax ("AMT") purposes. AMT is a
separate system of taxation, which requires a taxpayer to pay a minimum tax
based upon the taxpayer's taxable income base adjusted for AMT preference
and adjustment items. If a taxpayer becomes subject to AMT in a year during
which ISO's are exercised, a portion of the benefit associated with the
ISO's may be lost.
We believe it is appropriate to observe that the IRS is unlikely to
challenge the treatment of an option as an ISO because of the negative
effect on the public fisc. There is no corporate tax deduction in connection
with the exercise of an ISO or sale of ISO stock. Thus, tax revenues are
generated through the capital gain taxes paid by the employee, without any
offset for a corresponding deduction. Nonqualified options, however, when
exercised trigger ordinary income to the employee and a corresponding
deduction for the employer.
2) Issue 4. What is the federal tax effect of the adjustment in exercise
price of ITC Holding incentive stock options for ITC Holding employees?
Issue 5. What is the federal tax effect of the adjustment in exercise price
of ITC Holding incentive stock options for KNOLOGY employees?
If the IRS were to successfully challenge the treatment of the adjustment
and assert it was a modification, the option would be recharacterized as a
nonqualified option. With a nonqualified option, the holder will have
taxable income at the date of exercise for the difference between the fair
market value of the stock at the date of exercise and the exercise price. In
general, the classification of the ITC Holding stock option as an ISO will
not result in taxable income to the option holder until the stock underlying
the stock option is sold. The taxable income will be equal to the excess of
the sales price less the exercise price. The spread, however, will be a "tax
preference" item for alternative minimum tax ("AMT") purposes. AMT is a
separate system of taxation, which requires a taxpayer to pay a minimum tax
based upon the taxpayer's taxable income base adjusted for AMT preference
and adjustment items. If a taxpayer becomes subject to AMT in a year during
which ISO's are exercised, a portion of the benefit associated with the
ISO's may be lost.
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January 28, 2000
3) Issue 3. What is the federal tax effect of the distribution of the
KNOLOGY stock options for nonemployees and employees of ITC Holding and
KNOLOGY holding NSOs in ITC Holding?
Issue 6. What is the federal tax effect of the adjustment in exercise price
of ITC Holding NSOs for nonemployees and employees of ITC Holding and
KNOLOGY?
If the IRS were to recharacterize the adjustment in exercise price or the
distribution of KNOLOGY options as a grant of a discounted option, the
employees receiving such a grant would be subject to tax at the time of
exercise.
4) Level of Opinion: Issue 1. The Code, regulations, and guidance issued by
the Service, including revenue rulings and revenue procedures, do not
specify whether or not 1.425-1(a)(8) applies to the specifics of this
transaction. Since the distribution of the ISOs occurred in connection with
a corporate separation, the Service may interpret 1.425-1(a)(8) to mean that
there was no parent-subsidiary relationship at the time of the distribution.
Therefore, Arthur Andersen is not able to provide a "should" opinion on this
Issue.
5) Level of Opinion: Issues 2, 3, 4, 5 and 6. We are not able to issue a
"will" opinion since the Code, regulations, and guidance issued by the
Service including revenue rulings and revenue procedures are not identical
to facts and circumstances pertaining to the transactions of ITC Holding and
KNOLOGY. However, we are unaware of the IRS making an argument that is
inconsistent with our opinion.
SCOPE OF OPINION
The opinion expressed herein is based on the factual assumptions that you have
provided to us and other factual assumptions discussed herein. Any misstatement
or omission of any fact, or any amendment or change in any of the facts, may
require a modification of all or part of this opinion. We have no responsibility
to update this opinion for events, transactions, or circumstances occurring
after the opinion's date of issuance.
The opinion expressed herein is based upon our interpretation of the Internal
Revenue Code and income tax regulations, as interpreted by court decisions, and
by rulings and procedures issued by the IRS as of the date of this letter. The
opinion expressed herein is not binding on the IRS, and there can be no
assurance that the IRS will not take a position contrary to any opinions
expressed herein.
We have not considered any state or local income tax consequences and,
therefore, do not express any opinion regarding the treatment that would be
given the transactions by the applicable authorities on any nontax or any state
or local tax issues. Similarly, we have not
<PAGE> 16
Mr. Chad Wachter
Page 16
January 28, 2000
considered the financial statement effects of this conversion, and thus do not
express any opinion thereon.
If there should be any change in the Internal Revenue Code, the regulations
issued thereunder, the current administrative rulings, published cases, or in
previous judicial interpretations, the opinions expressed herein would
necessarily have to be reevaluated in light of any such changes.
We are issuing this opinion to KNOLOGY, Inc. and the participants in the stock
option adjustment and issuance discussed herein, based solely upon the factual
representations and assumptions discussed herein, and our opinion is limited
solely to the issue of the application of the federal income taxation to those
issues listed herein. Without Arthur Andersen's prior written consent, this
letter may not be quoted in whole or in part or otherwise referred to in any
documents or delivered to any other person or entity other than as expressly
permitted hereby.
Very truly yours,
/s/ ARTHUR ANDERSEN LLP
<PAGE> 1
EXHIBIT 23.5
[ARTHUR ANDERSEN LLP LETTERHEAD]
February 9, 2000
We hereby consent to the use of our opinion letter as an exhibit to the
registration statement on Form S-1 of KNOLOGY, Inc., filed with the Securities
and Exchange Commission (the "Registration Statement") and to the use of our
name in the Registration Statement. In giving the consent, we do not thereby
admit that we are an "expert" within the meaning of the Securities Act of 1933,
as amended.
Very truly yours,
/s/ ARTHUR ANDERSEN LLP
ARTHUR ANDERSEN LLP
