Taxes and Mergers: Evidence from Banks During the Financial Crisis

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.

After presenting a model of the effect of the Notice on bank mergers, we use Call Report data and merger data from the Federal Reserve to measure changes in bank mergers around the time of the Notice. We compare mergers during the Notice window to pre-Notice mergers and examine whether the determinants of mergers differed before and during the Notice window. We also present data on the post-merger performance of Notice and pre-Notice mergers, and present evidence about strategic decisions made by banks around the timing of recognizing built-in tax losses on their loan portfolios.

Drawing conclusions about the effect the Notice is complicated to a substantial degree by the unusual (to say the least) period during which it was in effect. The 2008-09 financial crisis put enormous stress on banks, and there is not a control group of firms subject to these same stresses, but not subject to the Notice, against which to measure the Notice effect. Nevertheless, in light of the importance and controversy around Section 382 and the absence of empirical evidence on the efficacy of such anti-avoidance tax rules, documenting what happened when Section 382 was partially disabled, even during a period of market turmoil, provides valuable information.

We find only modest evidence that lifting the Notice had an effect on merger activity. While there is a visible increase in mergers during the Notice period, this period corresponds to the peak of the financial crisis and the increase is only barely statistically significant when we control for other determinants of merger activity, such as the TED spread. We find no important differences in the determinants of mergers during the Notice period, relative to the pre-notice period, such as we would expect if the suspension of 382 drove a wave of tax-motivated acquisitions. All of this is broadly consistent with the modest findings in the literature on the effects of taxes on merger frequency. We do, however, find that banks that engage in Notice-window acquisitions show lower income growth in the two years after the Notice, consistent with the possibility that tax-motivated mergers led to lower operational synergies and the higher acquisition premiums created by tax assets documented in the literature. We also find suggestive evidence that banks that merged during the Notice window deferred recognition of the losses on their loan portfolios to exploit the benefits of the Notice.

While we resist drawing strong conclusions given the limitations of our setting, the empirical evidence casts doubt on the view that Section 382 is an important constraint on tax-motivated mergers. Given that Section 382 is a costly and controversial tool for policing tax-motivated activity, and our model shows its welfare consequences are ambiguous, our results provide some support for those who question Section 382’s value. Moreover, our results provide additional evidence that taxes tend to affect merger matching and pricing, but not frequency.

The complete paper is available here.