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INSIGHT: Schwab/TD Merger Not Assured of Reorganization Status

Dec. 6, 2019, 2:00 PM

The Charles Schwab Corp. acquisition of TD Ameritrade Holding Corp. may not achieve the desired tax-free status, because Schwab will have to issue non-voting stock to TD Bank, TD Ameritrade’s largest shareholder.

Schwab and TD Ameritrade recently announced that they had entered into a definitive agreement for Schwab to acquire TD Ameritrade in an all-stock transaction valued at $26 billion. The transaction will be structured as a so-called “reverse triangular merger.” Thus, Schwab will create a new subsidiary that will be merged with and into TD Ameritrade with the TD Ameritrade surviving as a wholly owned subsidiary of Schwab.

At the effective time of the merger, each share of TD Ameritrade common stock outstanding immediately prior to the effective time will be converted into the right to receive 1.0837 (exchange ratio) shares of Schwab voting common stock (merger consideration).

However, if the merger consideration issuable in respect of shares of TD Ameritrade common stock that are owned by TD Bank as of immediately prior to the effective time, together with any other shares of Schwab common stock then owned by TD Bank, would equal a number of shares of Schwab common stock exceeding the “maximum percentage” (i.e., 9.9%), the merger consideration issuable to TD Bank will be (i) a number of shares of Schwab common stock equal to the maximum percentage, less the amount of any other shares of Schwab common stock then owned by TD Bank, and (ii) the remainder of the merger consideration will be shares of non-voting common stock. Thus, depending on the extent of TD Bank’s ownership of Schwab’s voting common stock immediately prior to the effective time, a portion of the consideration issued to TD Bank will be comprised of Schwab’s non-voting common stock.

Control For Voting Stock Requirement

The merger agreement expressly provides that “the parties intend that the Merger will qualify as a reorganization within the meaning” of tax code Section 368(a). While it is likely that the merger will so qualify, such treatment, thanks to the possibility of non-voting common stock being used, in part, as merger consideration, means that such qualification is by no means assured.

A reverse triangular merger will qualify as a reorganization under Section 368(a)(1)(A) (by reason of Section 368(a)(2)(E)) if, and only if, (i) after the transaction, the corporation surviving the merger (TD Ameritrade) “holds” substantially all of its properties and of the properties of the merged corporation (Schwab’s new subsidiary) (other than stock of the controlling corporation distributed in the transaction); and (ii) In the transaction, former shareholders of the surviving corporation exchanged, for voting stock of the controlling corporation (Schwab) an amount of stock in the surviving corporation which constitutes control of such corporation.

This requirement is known as the “control for voting stock” requirement. The regulations clarify the parameters of this requirement. They provide that “in the transaction, shareholders of the surviving corporation must surrender stock in exchange for voting stock of the controlling corporation. The stock so surrendered (in exchange for voting stock of the controlling corporation) must constitute control of the surviving corporation.” Control is defined in Section 368(c). The amount of stock constituting control is measured immediately before the transaction. Section 368(c) defines control as the “ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote; and at least 80% of the total number of shares of all other classes of stock.”

Also excluded from the “substantially all” determination will be any cash contributed by the controlling corporation to the merging corporation and used by such merging corporation to pay dissenting shareholders, to pay cash in lieu of issuing fractional shares, and/or to pay expenses of the merging corporation attributed solely to the merger. See Revenue Ruling 77-307.

The instant transaction cannot qualify as a ’B’ reorganization. In order to qualify as a reorganization under Section 368(a)(1)(B), the acquisition by the acquiring corporation of stock of another corporation must be in exchange solely for voting stock of the acquiring corporation. If, for example, X, in one transaction, exchanges non-voting stock in addition to voting stock in the acquisition of Y, the transaction is not a reorganization under Section 368(a)(1)(B).

Thus, the instant transaction, if it is to qualify as a reorganization, must attain ’A’ reorganization status by reason of Section 368(a)(2)(E). For that to occur, however, the control for voting stock requirement must be met; and for the control for voting stock to be met, at least 80% of the merger consideration must consist of voting stock of Schwab. Thus, this transaction will fail to qualify as an ’A’ reorganization (by reason of Section 368(a)(2)(E)) if more than 20% of such merger consideration consists of Schwab’s non-voting common stock.

Qualification of the merger as a reorganization is not a condition of the deal, suggesting that the parties recognize that the potential for “excessive” non-voting common stock issuance might remove the transaction from reorganization status. Presumably, the amount of non-voting common stock to be issued to TD Bank in the transaction will not breach the 20% ceiling, but that is by no means assured since the amount of non-voting common stock to be so issued is dependent on the extent of TD Bank’s ownership of Schwab’s voting common stock at the effective time.

If the merger fails to qualify as a reorganization, there will be no untoward corporate level tax consequences, since no assets will be leaving TD Ameritrade’s corporate solution, but the shareholders of TD Ameritrade will not be governed by the nonrecognition rules contained in Section 354(a) and, instead, will be governed by Section 1001, necessitating their recognition of the gain (or loss) each might realize on the exchange of their TD Ameritrade stock for the merger consideration.

A reverse triangular merger is “tested” as a ’B’ reorganization where the merging corporation is newly created and, hence, its “transitory existence” can be disregarded. In such a case, the transaction is analyzed as a direct acquisition by the controlling corporation of the stock of surviving corporation from the shareholders thereof. See Rev. Rul. 74-564. Here, however, ’B’ reorganization treatment of the transaction will be denied if as little as one share of non-voting common stock is issued to TD Bank in connection with the merger. The words, “solely for voting stock,” contained in Section 368(a)(1)(B) leave no leeway for other forms of consideration to be issued to the shareholders of the acquired corporation.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.

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