Vol. 1 No. 18
Goodwin, Procter & Hoar LLP, a firm of over 350 lawyers, has one of the largest financial services practices in the United States. We have created the Financial Services Alert as a service to alert our clients and other financial institutions to news of importance to the industry in a timely manner. Some issues of the Alert will principally summarize significant recent developments in financial services law and regulation. Other issues, such as this one, will provide more in-depth analysis about specific areas of financial services law. We hope that you will find the Financial Services Alert to be helpful. We welcome your suggestions for future topics of interest.
General Considerations in Bank Mergers and Acquisitions: Part I - Tax Issues
Since the enactment of federal interstate banking legislation in 1994, bank mergers and acquisitions have occurred at a record pace. Moreover, as described in previous issues of the Financial Services Alert, regulatory initiatives have encouraged significant holding company acquisitions of nonbank entities, including large investment banking firms. While economies of scale and other synergies are often of varying importance in structuring and pricing these transactions, two issues are highly relevant in any merger or acquisition: (1) the competitive effect (e.g., will any divestitures be required); and (2) the tax effect. The competitive issues will be the subject of a future issue of the Financial Services Alert.
As to the tax effects, an early analysis will allow an acquiror to effectively evaluate the economics of a proposed transaction and consider alternative structures that may produce significant tax savings. To aid in this inquiry, this article highlights the principal federal tax and related considerations that generally are encountered in these transactions. First, the article summarizes shareholder and corporate federal taxes to be considered (in any bank or nonbank acquisition), then describes approaches to avoid or minimize that taxation, and finally describes 1996 federal law changes which have reduced the costs historically imposed when making acquisitions, particularly of thrifts.
I. Shareholder and Corporate Level Federal Taxation in Mergers and Acquisitions
Shareholder Level Taxation. Generally, a shareholder is subject to taxation on the appreciation of stock upon its disposition. In the context of mergers and acquisitions, this taxation may result from the transfer of stock or its conversion into another asset. Thus, to the extent that an acquiror is able to utilize an approach that will avoid or limit shareholder taxation, the proposal may be perceived by the target company to provide significantly more value to the shareholders than another proposal which provides similar total consideration but results in taxation of share appreciation.
Corporate Level Taxation. At the corporate level, a merger or acquisition may be tax free or may be deemed to be a taxable sale of assets subjecting the target corporation to taxation. Depending on the structure of the transaction, any corporate level taxation could have a direct, negative impact on either the acquiror or the shareholders of the target. Specifically, if the transaction is structured as a merger, the surviving entity will be responsible for payment of the target's corporate level taxation. Conversely, if the transaction is structured as an asset purchase, the corporate level taxation of the target ultimately will reduce the amount of proceeds to the target's shareholders.
II. Approaches to Avoiding or Minimizing Federal Taxation
Tax Free Reorganizations. The three principal types of tax free reorganizations under the Internal Revenue Code are Type A, B and C Reorganizations, which cover the three methods of acquisition, namely: statutory mergers, stock purchases (e.g., tender offers), and asset purchases, respectively. If properly structured, tax free reorganizations avoid recognition of both corporate level taxation and taxation to the target company shareholders (to the extent that the shareholder receives stock of the acquiring corporation or its parent). The common thread among the three principal types of tax free reorganizations is that the owners of the target retain a continuing interest in the reorganized corporation (the so-called "continuity-of-interest doctrine"). This means that stock of the acquiror, or its parent (in the case of subsidiary mergers, described below), must be the principal consideration. The amount of stock necessary varies from 100% for Type B Reorganizations (stock purchases) to at least 40% for Type A Reorganizations (statutory mergers).
Important variations of the Type A Reorganization are the forward subsidiary merger and the reverse subsidiary merger. In a forward subsidiary merger, the acquiror creates a subsidiary and then merges the target into it. In a reverse subsidiary merger, the acquiror creates a subsidiary and then merges it into the target. These variations allow a company to structure a transaction as a tax free reorganization while taking into account non-tax considerations. For example, because state corporate law generally only requires the approval of the shareholders of the two entities that actually merge, use of a subsidiary to engage in the merger may allow the parent acquiror to complete an acquisition without the expense and administrative burden of obtaining its shareholders' approval (although stock exchange rules nonetheless may require approval of parent acquiror's shareholders if a significant percentage of the acquiror's stock is issued). In addition, a reverse subsidiary merger permits an acquiror to maintain the separate corporate existence of the target, avoid transfer of title problems and preserve current contracts of target. A forward subsidiary merger, on the other hand, allows the acquiror to complete a transaction with less of its own stock. In this regard, in order for these variations to qualify as tax free reorganizations, stock of the parent acquiror must account for at least 80% of the consideration in the case of a reverse subsidiary merger, but only 40% of the consideration in the case of a forward subsidiary merger.
In addition to the tax benefits of a tax free reorganization, a potential additional benefit is that a tax free reorganization may also be treated as a "pooling" transaction for accounting purposes and thereby reduce the ongoing charge to earnings (to amortize goodwill) that would be incurred if the transaction were accounted for as a "purchase." On the negative side, the acquiror will not be able to adjust the basis of the acquired assets to fair market value for tax purposes.
Hybrid Transactions/Non-qualifying Reorganizations. Even if it is not possible to structure a particular transaction as a tax free reorganization at both the shareholder and corporate levels, generally due to the inability or undesirability of using a sufficient amount of acquiror's stock, it is still possible to improve the tax result if the transaction is correctly structured. Specifically, although taxation at the target company shareholder level cannot be avoided if acquiror stock is not principally used, it is possible to avoid target company corporate level taxation by using either a reverse subsidiary merger or a direct stock purchase. A reverse subsidiary merger, like a direct stock purchase, will result in the transaction being deemed a sale of the target company shareholders' stock (which is only taxable to the target company's shareholders) rather than a taxable sale of the assets of the target company (which would be taxable to the company and then to its shareholders if the proceeds are distributed to the shareholders). In a transaction not qualifying as an A, B, or C Reorganization, such as an "all-cash" deal, these may be important methods of minimizing taxation.
III. Other Bank Acquisition Issues and the Effect of 1996 Events
Bad Debt Reserve Recapture. Prior to 1987, both commercial banks and thrifts generally accounted for loan loss reserves utilizing the "reserve method," which allowed them to allocate funds to a loan loss reserve and use the allocation as a tax deduction in the year allocated. As a result of the Tax Reform Act of 1986, however, most commercial banks with assets in excess of $500 million (taking into account assets of other members of the group) were required to switch to the "specific charge-off method," which allows tax deductions only in the year in which the debt becomes worthless in whole or in part. Commercial banks required to switch also were required to recapture existing reserves over a period of time, which in most cases resulted in the recognition of taxable income. In order to facilitate the then anticipated legislative merger of the bank and thrift charters, thrifts became subject to similar rules after the Small Business Job Protection Act of 1996. Unlike banks, however, thrifts required to switch methods are only required to recapture their post-1987 additions to their bad debt reserve. A merger or acquisition transaction can trigger a recapture of an institution's bad debt reserve with potentially significant adverse tax consequences. As a result, in pricing an acquisition it is important to ascertain whether either the acquiror or the target is currently using the reserve method and whether either still maintains a bad debt reserve account that may be subject to recapture upon the consummation of the transaction.
BIF/SAIF Hurdles Lowered. Prior to the Savings Association Insurance Fund ("SAIF") recapitalization at the end of 1996, and the resulting equalization in insurance premiums between Bank Insurance Fund ("BIF") members and SAIF members, there were considerable uncertainties surrounding the costs to be born by thrifts (and thus their acquirors) in connection with the savings and loan crisis of the late 1980s. As a result of the alleviation of these uncertainties at the end of 1996 (which included assessments to both BIF and SAIF members to recapitalize SAIF), hurdles to transactions between BIF and SAIF insured institutions have been lessened. Transactions between BIF and SAIF members (other than the acquisition of a thrift by a holding company) must still be treated as so-called "Oakar transactions" (i.e., result in payment of proportionate assessments to BIF and SAIF) in order to avoid the imposition of insurance fund entrance and exit fees.
Conclusion. As this article demonstrates, significant federal tax savings can be achieved with appropriate structuring of bank mergers and acquisitions. Of course, state tax issues, along with non-tax considerations, also must be considered.
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The contents of this publication are intended for informational purposes only and should not be construed as legal advice or legal opinion, which can be rendered properly only when related to specific facts. This document may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts. (c)GPH LLP 1997
