Choice Hotels’ Cash-and-Stock Offer for Wyndham May or May Not Qualify as a Tax-Free Reorganization

By Stuart E. Leblang, Michael J. Kliegman and Amy S. Elliott

On December 12, Choice Hotels International, Inc. (NYSE:  CHH) (Choice) announced it was launching an exchange offer to acquire Wyndham Hotels & Resorts, Inc. (NYSE:  WH) (Wyndham) for cash and stock consideration, to be followed by a series of squeeze-out mergers (the Second-Step Mergers) to acquire all untendered shares.^[1]This comes after four previous, failed attempts by Choice to enter into a negotiated transaction with Wyndham’s management.^[2]Payment under the exchange offer is conditioned on Choice obtaining, through a combination of Wyndham shares it already owns and those tendered, at least a majority of the outstanding Wyndham common stock.  Thereafter, the Second-Step Mergers will occur as discussed below.  Choice disclosed that it currently owns some 1.5 million shares of Wyndham stock, approximately 1.8 percent of the approximately 83 million shares outstanding.^[3]

As detailed in the offer, the base consideration for a share of Wyndham stock would consist of $49.50 in cash and 0.324 share of Choice common stock (the Standard Election Consideration), the stock portion valued at $40.50 based on Choice’s trading price as of October 16 (the day before Choice’s initial offer), and $36.87 based on the December 11 closing price of $113.81, for total consideration of $86.37 (which represents a nearly 9 percent premium to $79.56, the December 11 closing price of Wyndham common stock).

Each tendering Wyndham shareholder may elect to receive (subject to proration) either:

• The Standard Election Consideration (a mix of cash and stock); or
• An amount in cash equal to the equivalent market value of the Standard Election Consideration^[4](the Cash Election Consideration); or
• A number of shares of Choice common stock having a value equal to the equivalent market value of the Standard Election Consideration (the Stock Election Consideration).

For purposes of determining the amount of cash in the Cash Election Consideration or the amount of stock in the Stock Election Consideration, the equivalent market value of the Standard Election Consideration is determined by valuing the Choice stock at the volume-weighted average price as reported by Bloomberg, L.P. (VWAP) as quoted on the New York Stock Exchange over the five trading days ending on the tenth business day preceding the date of expiration of the tender offer.  As set forth in the registration statement,^[5]since Choice intends to pay an aggregate amount of approximately $4.2 billion in cash (Total Cash Payable), it will make adjustments for an oversubscription of the Cash Election Consideration or the Stock Election Consideration as necessary to arrive at the Total Cash Payable (the proration mechanism).  Also, Choice will apportion the Total Cash Payable between the amount paid to tendering shareholders and the amount to be paid in the Second-Step Mergers based on the relative number of Wyndham shares being acquired pursuant to the exchange offer and the Second-Step Mergers.

Promptly following successful consummation of the exchange offer (which expires on March 8, unless extended), Choice (as the now-majority shareholder of Wyndham) will bring about a series of two mergers for the purpose of acquiring all remaining outstanding shares of Wyndham.  The first merger will be a merger of Choice’s wholly owned subsidiary WH Acquisition Corporation (Purchaser) with and into Wyndham, with Wyndham as the surviving corporation (First Merger).  This will be immediately followed by a merger of Wyndham with and into a second wholly owned subsidiary of Choice (NewCo), with NewCo as the surviving corporation (Second Merger).  The two mergers are collectively referred to as the Second-Step Mergers.  In the First Merger, Wyndham shareholders will be offered the same three consideration elections as in the exchange offer.

The parties expect that the waiting period to obtain antitrust approvals for the transaction may be lengthy.  If, one year after Wyndham has received the requisite amount of stock tendered to be able to proceed with the Second-Step Mergers, such antitrust approvals have not yet been obtained (or the time for objecting has not yet elapsed) (the Ticking Fee Commencement Date), a ticking fee (Additional Consideration) will be added to the consideration payable for shares tendered and paid in the Second-Step Mergers.  The Additional Consideration is generally equal to $0.45 per Wyndham share for each month between the Ticking Fee Commencement Date and when the combination is permitted to proceed.  The Additional Consideration may be paid in cash or in Choice stock, at Choice’s option.

Tax Treatment of the Exchange Offer and Merger

As the Choice tax disclosure states, there is an overriding open factual question as to how much of the total consideration to the Wyndham shareholders will be Choice stock relative to the amount of cash.  As discussed in more detail below, the steps will be viewed one way if there is sufficient stock consideration to satisfy the continuity of interest requirement under the reorganization rules and will be viewed differently if there is not.  Generally, except for certain types of reorganizations, an acquisitive transaction meeting the statutory requirements can only qualify as a reorganization if it satisfies the continuity of interest test.  Though judicial authority is a bit more lenient,^[6]the accepted continuity of interest standard based on current regulations is that at least 40 percent of the total consideration value must be stock, allowing cash and any other nonqualifying consideration (boot) of up to 60 percent.^[7]

Based on the December 11 value of Choice stock referred to above, the value of stock consideration looks to be approximately 42.7 percent of the total.^[8]  Although the value of the Choice stock as of the time that the transaction closes many months from now could be significantly less (or more), the tax regulations contain rules to provide certainty where there is a mix of stock and taxable consideration.  Where the amounts of stock and cash are fixed, the value of the stock on the day before a binding agreement is reached can be relied on for purposes of testing continuity of interest.  In the case of a tender offer, the offer is generally treated as such a binding agreement.^[9] Further, under IRS guidance, using an average VWAP over a period of days preceding the relevant date (e.g., the date of a binding merger agreement or the date a tender offer is made public) is permissible.^[10]

Assuming the continuity of interest requirement is satisfied, there is clear authority for treating a tender offer and subsequent merger as a single, integrated reorganization where, as here, the announced tender offer explicitly anticipates the subsequent merger after achieving the requisite amount of stock acquired in the tender.^[11] A transaction standing alone whereby Choice acquires 51 percent of the Wyndham stock for a combination of stock and cash, or even solely stock, would not fit within any of the tax-free reorganization provisions.  But if the exchanges pursuant to the tender offer are swept into the culminating merger transaction, then, provided the merger itself meets the statutory definition, both the tender offer exchanges and the merger consideration can be treated as occurring pursuant to a tax-free reorganization.

The Second-Step Mergers consist of two mergers, one following immediately after the other.  In the First Merger, Purchaser will merge into Wyndham, with Wyndham as the surviving corporation.  The merger consideration will be issued to Wyndham shareholders in the First Merger.  In the Second Merger, Wyndham will merge into NewCo, with NewCo as the survivor.  The First Merger (a reverse subsidiary merger) would not meet the statutory requirements for a reorganization,^[12] but the Second Merger (a forward subsidiary merger) will.^[13] Where we have back-to-back mergers such as these, authority is clear that it will be the latter that will determine which of the statutory reorganization provisions will govern.^[14]

There is an important tax advantage to having the Second-Step Mergers consist first of a reverse subsidiary merger and then a forward subsidiary merger.  Although the reorganization rules require that all integrated steps—the tender offer and both of the Second-Step Mergers—be viewed together under the step-transaction doctrine, if we step out of the reorganization realm into the domain of taxable transactions, the Second Merger is viewed as a transaction separate from the tender offer and First Merger.  If the Second Merger were stepped together with the prior steps and there were insufficient stock consideration to satisfy continuity of interest, the transactions would be taxable not only to the Wyndham shareholders but also at the corporate level.^[15]  However, under well-established authority, if there is insufficient stock to qualify under the reorganization rules, then the tender offer and the First Merger will be treated as a taxable purchase by Choice of the Wyndham stock, taxable only to the Wyndham shareholders, followed by a tax-free internal merger of Wyndham into NewCo.^[16]

Drilling Down on Continuity of Interest

We find the tax disclosure in the Form S-4 filed by Choice to be unusual in the way it refers to uncertainty about reorganization status.  After indicating that the transaction may qualify as a reorganization, it states:  “However, if Choice elects to pay the Additional Consideration in cash in an amount sufficient to cause the stock component of the Offer Consideration to constitute less than 40% of the aggregate fair market value of the Offer Consideration, if the Offer and the Second-Step Mergers are not treated as component parts of an integrated transaction for U.S. federal income tax purposes, if the Second-Step Mergers are not completed or if the transaction otherwise fails to qualify as a ‘reorganization’ . . . ,” the transaction will be taxable.

Of the four listed contingencies that could prevent the transaction from qualifying as a reorganization, two of them—payment of the Additional Consideration in cash and failure to complete the Second-Step Mergers—seem to be within the power of Choice.  The third, regarding the Offer and the Second-Step Mergers not being part of an integrated transaction, involves a possible failure in the tax analysis that we regard as very unlikely.  And the final one, that the transaction “otherwise” fails to qualify as a reorganization, is even less instructive.  It would certainly be helpful if Choice would explain what could influence its decision to pay the Additional Consideration in cash or stock, and certainly to explain how it might possibly not end up consummating the Second-Step Mergers after obtaining the requisite amount of Wyndham stock in the exchange offer.

Although not discussed in the tax disclosure, even if there is no Additional Consideration,^[17]we see some uncertainty in the way the deal consideration is structured as to whether there will be sufficient stock consideration to satisfy the continuity of interest test.  Our concern arises from the fact that the amount of total consideration value will be based on the value of Choice common stock not at the time of the tender offer but nearer to the time it expires, and while the total consideration value may be diminished by a reduction in the trading price of the Choice stock, the amount of aggregate cash in the transaction—$4.2 billion—is fixed.  Based on the December 11 Choice share price of $113.81, per share consideration being $86.37, and with approximately 81.5 million shares being acquired, the total consideration paid for all outstanding stock not held by Choice would be approximately $7 billion, of which approximately 40 percent ($3 billion) would be in stock and 60 percent ($4 billion) in cash.  However, if, for example, the VWAP of Choice stock during the days prior to expiration of the tender offer were $110, then the Standard Election Consideration for a Wyndham share would be $85.14 (($110 x 0.324) + $49.50).  The tender offer indicates that the aggregate consideration paid for all shares will be adjusted so that $4.2 billion remains in the mix.  As a result, in the example, total consideration paid for 81.5 million shares would be $6.9 billion, of which $4.2 billion cash would be approximately 60.5 percent, and the stock portion would be only 39.5 percent, not meeting the 40 percent continuity requirement.

There is further doubt about whether the transaction will qualify as a reorganization under the continuity of interest test.  There is an issue as to how to treat the $1.5 million Wyndham shares held by Choice.  The regulations, building on prior law, provide that stock in the target corporation owned by the acquiring corporation is generally treated favorably under the continuity of interest test, provided that stock was not acquired in connection with the acquisition plan.^[18]  But insofar as Wyndham stock was purchased by Choice as part of its attempt to acquire the company, it is very possible that the denominator of the continuity of interest fraction would include those shares (the full 83 million rather than only the 81.5 million in the hands of the public) and that the 1.5 million shares held by Choice would be treated as having been acquired solely for cash.^[19]

If the transaction fails to qualify as a reorganization, Wyndham shareholders will generally recognize capital gain or loss and foreign investors should generally not be exposed to U.S. withholding tax.  If the reorganization rules apply, and with the likelihood that Wyndham shareholders will end up receiving at least some stock, they will recognize gain, but not loss, on the exchange, with the gain limited to the amount of cash.  There will be some risk of dividend withholding tax to foreign investors.^[20]

^{[1] Press Release, Choice, Choice Hotels Launches Exchange Offer to Acquire All Outstanding Shares of Wyndham Hotels & Resorts (Dec. 12, 2023) (https://www.sec.gov/Archives/edgar/data/1046311/000119312523293430/d659293dex992.htm); the offer is technically being made by a wholly owned subsidiary of Choice, WH Acquisition Corporation, referred to in the documents as Purchaser (https://www.sec.gov/Archives/edgar/data/1046311/000119312523293048/d615790ds4.htm); https://www.sec.gov/ix?doc=/Archives/edgar/data/1722684/000172268423000025/wh-20230930.htm.}

^{[2] Priyamvada C, Wyndham rejects Choice Hotels’ $7.8 billion takeover bid, Reuters, Oct. 17, 2023 (https://www.reuters.com/markets/deals/choice-hotels-offers-buy-wyndham-78-billion-2023-10-17/).}

^{[3] This is “essentially the maximum allowable amount” Choice could acquire “without obtaining prior regulatory approval,” according to Choice’s Investor Presentation, dated Dec. 12, 2023 (https://www.sec.gov/Archives/edgar/data/1046311/000119312523293430/d659293dex991.htm).}

^{[4] Based on the volume-weighted average price (VWAP) of the Choice common stock over the five trading days ending on the tenth business day preceding the date of expiration of the exchange offer.}

^{[5] Choice, Form S-4 Registration Statement filed Dec. 12, 2023 (https://www.sec.gov/Archives/edgar/data/1046311/000119312523293048/d615790ds4.htm).}

^{[6] See John A. Nelson Co. v. Helvering, 296 US 374 (1935), finding continuity of interest satisfied with 38% stock consideration.}

^{[7] Treas. Reg. §1.368-1(e)(2)(v), Example 9.}

^{[8] On a per-share basis, this is based on total consideration value of $86.37 as of the date before the exchange offer, consisting of $36.87 in stock and $49.50 in cash.}

^{[9] Treas. Reg. §1.368-1(e)(2)(ii).}

^{[10] Rev. Proc. 2018-12.}

^{[11] See Rev. Rul. 2001-26.}

^{[12] IRC §368(a)(2)(E) limits non-stock consideration to 20%.}

^{[13] IRC §368(a)(2)(D) has no limitation on the amount of nonstock consideration, so the only limitation is under the continuity of interest rule.}

^{[14] See Rev. Rul. 2001-46.}

^{[15] See Rev. Rul. 69-6.}

^{[16] See Rev. Rul. 90-95.}

^{[17] Note that if any Additional Consideration—the ticking fee of $0.45 per Wyndham share paid either in cash or in Choice stock, at Choice’s option—is paid out, the registration statement indicates it would factor into the continuity analysis.  But as such contingent consideration would only potentially be paid starting 12 months from when the requisite amount of stock is tendered, we have not taken its potential impact into account in this report.}

^{[18] Treas. Reg. §1.368-1(e)(8), Example 7.}

^{[19] See Chapman v. Comm’r, 618 F.2d 856 (1st Cir. 1980).}

[20] See IRC §356(a).