BOA Could Find Merrill Deal Taxing

A timing issue related to one of the Treasury Department's rescue proposals means Bank of America might lose its tax-free status for the Merrill Ly...
Marie LeoneNovember 3, 2008

Taking a handout from the federal government’s rescue plan could turn the tax-free merger between Bank of America and Merrill Lynch into a taxable event. At least that’s the conclusion of a new client advisory put out by Robert Willens LLC.

Willens, a corporate tax and accounting expert, told CFO.com that the tax-free status of the Bank of America/Merrill deal is “now imperiled,” because of the possibility that Merrill may sell stock to the Treasury Department through its Capital Purchase Program before the acquisition is complete.

If that happens, the Treasury Department will likely be left holding non-voting shares of Merrill, which in turn would sink the so-called “control for voting stock” requirement that allows the transaction to remain tax free under current Internal Revenue Service rules.

As a result, before Bank of America and Merrill agree to take part in the government’s largesse program, they may want to consider the timing of accepting the rescue funds and wait until after the merger is complete. Here’s why timing matters in this case.

The Robert Willens report contends that Bank of America and Merrill went to “some lengths to insure” that their merger would be treated as a tax-free reorganization under the tax code. As a result, the deal is being structured as a reverse triangular merger, which at its conclusion would produce a stock-for-stock exchange that is tax free.

In short, Bank of America will form a new corporation which will be capitalized with its own stock. The new corporation merges with and into Merrill, and the stock of the new corporation is converted into Merrill stock, with the new corporation dissolving and a new Merrill surviving. In the end, the old Merrill stock would be converted into the Bank of America stock the new corporation delivered at the beginning of the deal.

To qualify for tax-free treatment under Section 368 of the tax code, a few key criteria must be met as the banks run through the reverse triangular merger. For instance, shareholders of the surviving corporation, which in this case is Merrill, must surrender stock in exchange for voting stock of the controlling corporation, which is Bank of America. More importantly, the surrendered stock must represent a controlling interest of the surviving corporation.

So to maintain tax-free status, shareholders of Merrill must exchange at least 80 percent (a controlling interest) of Merrill’s voting stock as well as 80 percent of Merrill’s non-voting stock for Bank of America shares.

“When the dust settles,” writes Willens, Bank of America will have acquired all of Merrill’s voting common stock and all of its preferred stock in exchange for Bank of America voting stock. Only Merrill’s convertible stock will be left, but the “control for voting stock” requirement will have been met. In the end, there will be no classes of non-voting stock outstanding at the time that Bank of America acquires Merrill.

But that’s not the case if the Treasury Department steps in ande buys Merrill stock before the Bank of America merger. The unintended consequence of the government purchasing non-voting Merrill stock is that the Merrill stock held by the Treasury will remain outstanding because Treasury will not exchange its shares for Bank of America shares. As a result, the control requirement will not be met, and the transaction will fail the tax-free status test.

One way around failing the tax-free test, says Willens, is to take the Treasury bailout funds after the merger is complete. In that way, Bank of America is the recipient of the capital injection, and its non-voting preferred stock is issued to the Treasury, which is of no consequence in the context of the prior merger’s tax-free treatment.