June 12, 2018

How Tax Laws Can Impact Merger Activity

Here’s the intro from this blog:

One of the measures taken by federal authorities to manage the financial crisis in the fall of 2008 was a remarkable piece of administrative guidance from the IRS. Issued on September 30th of that year and less than a page long, IRS Notice 2008-83, which was styled as an interpretation of existing law, had a dramatic positive effect on the value of banks’ tax assets. The Notice effectively turned off with respect to banks an aspect of Internal Revenue Code Section 382 that generally restricts the ability of a corporation to use unrecognized tax losses from underperforming loans to offset taxable income from other sources if that corporation undergoes a significant change in equity ownership, including an acquisition.

The direct result of the guidance was that tax assets of a target bank that otherwise would have been impaired following an acquisition could be fully utilized by an acquirer, with the further implication that targets with such tax assets became more attractive to profitable acquirers who could more rapidly deduct those losses than acquirers with less taxable income to offset. This implication played out only a few days after the Notice was issued, when Wells Fargo re-entered negotiations for the acquisition of Wachovia and outbid Citibank after determining that its ability to utilize Wachovia’s tax assets would allow it to acquire Wachovia without FDIC assistance. One estimate placed the value of the Notice in respect of Wachovia’s tax assets to Wells Fargo at roughly $20 billion. Controversy over the Notice, including whether it was a proper exercise of the Treasury Department’s authority and whether it was issued specifically to favor Wells Fargo, followed quickly and the Notice was overruled when the American Recovery and Reinvestment Act was signed into law in early 2009. Thus, there was a small window of roughly 3½ months in which the Notice was in effect and part of Section 382 was disabled with respect to banks.

In a recent paper, “Taxes and Mergers: Evidence from Banks during the Financial Crisis,” we examine the impact of IRS Notice 2008-83 and, by implication, the effects of Section 382, a controversial tax rule designed to discourage tax-motivated acquisitions. The adoption and subsequent repeal of the Notice presents a unique opportunity to explore the significance of taxes in the merger decision with a natural experiment and contribute to a literature with mixed results on the importance of taxes in that context. In general, the evidence suggests the effects of taxes on the frequency of acquisitions are modest but the effects on the price and structure of corporate acquisitions are more robust. Understanding these effects is important, not least because various tax rules, including Section 382, that target tax-motivated acquisitions also impose compliance and monitoring costs as well as create other distortions in merger decisions. If taxes have little effect on merger activity then a reconsideration of these rules may be in order.

Broc Romanek