Tax Notice Drives Wachovia Takeover Turmoil

On September 29, in a deal orchestrated by federal regulators, Citigroup Inc. ("Citigroup") agreed to purchase ailing Wachovia for approximately 2 billion dollars. On October 3, Wells Fargo & Co. ("Wells Fargo") announced an agreement to acquire Wachovia for approximately 15 billion dollars. The substitution of Wells Fargo for Citibank after the original deal was announced, combined with the dramatic increase in acquisition price, stunned observers and has Citigroup scrambling to block the new agreement.

Wells Fargo's late, increased offer for Wachovia appears to lack consistency with their prior stance in takeover negotiations, however, Wells Fargo's offer was most likely adjusted to reflect a recent change in the tax law. On September 30, one day after the original agreement with Citibank was announced, the Treasury Department released IRS Notice 2008-83.

In general, the tax law limits the amount of losses an acquiring company may use, which are attributable to an acquired company, to offset its own profits. Notice 2008-83 states that with respect to banks, f or purposes of section 382(h), any deduction properly allowed after an ownership change (as defined in section 382(g)) to a bank with respect to losses on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts) shall not be treated as a built-in loss or a deduction that is attributable to periods before the change date.

This tax law change has the effect of easing restrictions on losses that can be written off after a bank's change in management. As a result, Wells Fargo may be able to use the losses from loans and other bad debts that they acquire to offset their current and future taxable income. The amount of future income and losses on the instruments to be acquired by Wells Fargo are currently undetermined, however, some estimates indicate that Wells Fargo may ultimately offset approximately $74 billion in income as a result of its Wachovia acquisition.

Whether this enormous tax benefit will be realized remains to be seen. A temporary restraining order blocking the Wells Fargo acquisition was requested and granted to Citigroup on Saturday night October 4 through a New York state court order, and promptly overturned Sunday evening October 5, in part because the decision was not made in New York, but rather in Connecticut. On October 7, a federal judge is expected to preside over a hearing to determine the validity of Citigroup's claim regarding their exclusivity agreement with Wachovia. As of this writing, officials from the Federal Reserve are actively involved in facilitating a compromise agreement between Citigroup and Wells Fargo. While the outcome of these negotiations is uncertain, it is evident that tax considerations are the driving force behind this controversy.