Some tactics of community banks that offer protection from unwanted suitors may carry related tax costs or have uncertain tax treatment.
Take, for instance, stock repurchases.
For a variety of reasons, many institutions are starting to repurchase stock on the open market. This may have the effect not only of improving financial return ratios through the use of excess capital but also of consolidating power among insiders.
However, the tax deduction for most expenses associated with repurchasing stock (such as legal, accounting, and brokerage fees) was eliminated in the 1980s by Congress in response to the large payments made to buy out hostile stockholders (often referred to as "greenmail") or at least stop their advances through so-called "standstill" agreements.
Unfortunately, the tax law was so broadly written that it covers any stock repurchase, even if no greenmail or standstill agreement is involved. As a result, expenses associated with a repurchase of stock are not deductible (except for a certain amount of interest on debt, otherwise deductible dividends, and expenses incurred by mutual funds).
This absence of deductibility can be significant where a dissident stockholder is bought out after the company incurs significant legal and investment banker expenses. In addition, if the company borrows to finance the buyback, interest expenses above a certain level are not deductible.
Further, stockholders should also be careful that their sale of stock to the company is not treated as a taxable dividend. A stockholder would be taxed on the entire amount of cash received from a company, not just net proceeds, if dividend treatment were required. This could occur if a stockholder sells too small a portion of his or her stock to the company or if the stockholder sells all of his or her stock but is still treated, solely for tax purposes, as owning stock held by a relative such as spouse or child.
Some other tactics that could have unanticipated tax consequences:
Rights offerings. Companies seeking to raise capital may be inclined to do so by first selling shares to existing stockholders. In addition to tapping investors who already know the company, a rights offering may help to shore up a friendly stockholder base.
This additional stock can be common, or it can be preferred stock if the company wants to be able to force stockholders to sell the shares back to the company after a certain number of years. Generally, rights distributed to stockholders in a rights offering are tax-free if nontransferable.
If preferred stock is sold in the rights offering and is redeemable at a premium by the company, the stock could carry with it an implicit interest expense that would require the holders to recognize taxable income just for holding the stock. However, this can be avoided if properly structured.
Further, issuing preferred stock rather than common stock could also help a company raise capital without losing the ability to deduct its tax net operating losses or potential losses (so-called "built-in losses"), such as from an underwater portfolio.
Poison pills. In addition, companies are adopting shareholder rights plans, also known as poison pills. These plans usually provide for distribution of significant amounts of preferred stock or common stock, or both, to existing stockholders if an unwanted suitor acquires more than, say, 15% or 20% of the outstanding shares.
While effective when properly used, poison pills have also been subject to attack as an improper means of entrenching management. The Internal Revenue Service has ruled that the mere adoption of a poison pill will be a "nonevent" for tax purposes.
What remains unclear, however, is the effect on a company's tax net operating losses once the rights are distributed. It is also unclear whether stockholders must recognize taxable income when those rights are later redeemed by either the company or the acquirer in a successful merger.
Golden parachutes. Companies may enter into employment or severance agreements with key employees to offer some assurance of either future employment or a specific severance payment in the event the employee is terminated for other than reasonable cause.
These agreements may also contain a "golden parachute" provision, under which the employee is guaranteed a significant severance payment if the company is acquired and the employee is either terminated or reassigned to a less desirable post. This is intended both to compensate the employee and to increase the cost of a takeover, thereby deterring all but the most serious of suitors.
However, employees should not be lulled into thinking that payment of a golden parachute is automatic. To avoid tax penalties, a golden parachute must be less than three times the employee's average annual taxable income over the preceding five years. This is why many golden parachutes provide for a payment equal to 2.99, rather than three, times the employee's average income.
If a larger golden parachute payment is made, then the employee must pay a 20% excise tax, and the company is denied a deduction on most of the payment.
Because the tax penalty for these larger golden parachutes is so stiff, some agreements provide that the severance payment will be automatically reduced by any other payment that is treated as part of a golden parachute. These other payments can take such unforeseen forms as the value of accelerated vesting of options or restricted stock awards. In some cases, this "cutback" can completely eliminate any severance payment.
In any case, a golden parachute may have only a limited antitakeover effect. Even where there is no automatic cutback, managers of potential target companies may find themselves in the uncomfortable position of being asked to forgo any payment under the contract in order to make the acquisition work.
Additionally, a sophisticated acquirer will have either reviewed the employment agreements or studied their terms in public filings such as proxy statements and adjusted the acquisition price downward to reflect this cost.
Spinoff of assets or subsidiary. Although not commonly viewed as an antitakeover tactic, spinning off a particularly profitable subsidiary (such as a mortgage banking or credit card unit) to stockholders could cause potential acquirers to hesitate. Where no subsidiary exists, a profitable operation could be transferred to a such a unit, then spun off.
For tax purposes, any spinoff must satisfy a battery of strict conditions so that stockholders get shares of the subsidiary tax-free. A spinoff also represents a fundamental change in a company's structure and therefore should not be approached lightly.
Finally, companies should be aware that the deductibility of costs incurred in defending against a takeover remains uncertain.
While such costs are generally not deductible if they produce a long- term benefit, such as an eventual merger, they may be deductible if incurred solely to repel hostile suitors. This tax rule should be kept in mind when adopting antitakeover strategies.
Mr. Borja is a tax and securities law attorney at Housley Goldberg Kantarian & Bronstein in Washington, D.C.