On September 30, the IRS issued a notice that creates a major tax incentive for buying or making major investments in banks. Losses and deductions attributable to a target bank's troubled portfolio can now be used to shelter the buyer's operating income without limitation after a merger. This action greatly increases the investment and merger opportunities for banks and bank holding companies.
- If a loss corporation undergoes an ownership change (i.e., a more than 50 percent change in stock ownership over a three-year period), the loss corporation's net operating losses ("NOLs") will be subject to an annual limitation equal to the annual long-term tax-exempt bond rate (approximately 4.6 percent) times the value of the loss corporation's equity immediately before the change of ownership.
- If a loss corporation has a net unrealized built-in loss (a "NUBIL") in its assets on the effective date of the change of control, then deductions attributable to that NUBIL will in most cases be subject to a similar limitation for the next five years.
- Many distressed banks are likely to be in a NUBIL position, because the writedowns that they have taken to date for book purposes (which are generally mirrored by tax deductions reflected in their additions to bad debt reserves) have been insufficient to reflect the lower true value of their assets in today's distressed markets. Therefore, under the law as it stood prior to the issuance of Notice 2008-83 on September 30, 2008 (the "Notice"), a bank in a NUBIL position that underwent a change of ownership (either at the bank level or at the holding company level) would be subject to an annual limitation on its use of future tax deductions attributable to its built-in losses in its loan and debt portfolio.
- Notice 2008-83 changed that result by announcing that "any deduction properly allowed after an ownership change . . . 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." See FAQ #4 below for a discussion of the items that are treated as "bad debts."
- FASB Statement No. 141R requires mark-to-market on all assets and liabilities in a merger. With most asset prices currently depressed, this accounting treatment has discouraged mergers in the banking industry. Notice 2008-83 offers tax benefits that may offset some of the economic effects of FASB 141R and facilitate consolidation in the industry.
The Notice creates a major tax incentive for buying or making major investments in banks. Losses and deductions attributable to the target bank's troubled portfolio could be used to shelter the buyer's operating income without limitation after a merger or to substantially improve after-tax returns to investors in a bank that has undergone a change in control for tax purposes. Combined with the Federal Reserve's September 22 Policy Statement on Equity Investments in Banks and Bank Holding Companies, the Notice greatly increases the investment and merger opportunities for banks and bank holding companies.
Question #1: How big an effect will the Notice have?
Answer: Big. If it is true that there are $1 trillion in housing-related losses in the U.S. banking system, and if only $585 billion of them have been taken into account to date, that suggests there may be as much as $400 billion in built-in losses still in the system. At a corporate statutory rate of 35 percent, that suggests a net nominal tax savings potential of something like $140 billion. Within the first two days after the Notice was published, a major bank acquisition was announced as a superior bid to an agreement reached by the target banking organization with another bank holding company on the day before the Notice. The new buyer of the major banking operation publicly estimated that it would write off $74 billion in losses on the target bank's loan portfolios. This suggests a nominal tax savings of more than $25 billion. Many banks may be worth more to an acquiror or to new investors than they are currently worth to their existing shareholders, providing a strong incentive to consolidation and capital raising in the industry.
Question #2: What types of entities are covered by the Notice?
Answer: The Notice applies only to "banks" as defined in IRC Section 581. Section 581 defines "bank" as "a bank or trust company incorporated and doing business under the laws of the United States (including laws relating to the District of Columbia) or any State, a substantial part of the business of which consists of receiving deposits and making loans and discounts, or of exercising fiduciary powers similar to those permitted to national banks under authority of the Comptroller of the Currency, and which is subject by law to supervision and examination by State, or Federal authority having supervision over banking institutions." Such term also means a "domestic building and loan association," such as S&Ls that meet the "qualified thrift lender" or "QTL" test. In the discussion that follows, "bank" includes all these eligible entities.
Question #3: Does the acquired bank have to be a "real" bank (one that takes deposits from and offers loans to the public)?
Answer: No. All banks, including credit card banks, industrial loan companies, trust companies (depository and nondepository), and thrifts are covered.
Question #4: Does the Notice apply only to losses on mortgages?
Answer: No. The Notice applies to all losses on loans and bad debts. For tax purposes, most of the riskiest securities held by banks—mortgage-backed securities, CDOs, CDO Squareds, etc.—qualify as debts and are presumably covered by the Notice. (Credit default swaps and other hedge-type positions may not be covered.)
Question #5: What time periods are covered by the notice?
Answer: Unclear. The Notice has no stated effective date, but instead sets forth the Service's position in general. The Notice does indicate that it can be relied upon "unless and until there is additional guidance," suggesting that the Service feels free to modify or even reverse its position at some time in the future, although presumably on a prospective basis only. Given the three to six months it normally takes for a bank acquisition to complete the regulatory process, persons desiring to take advantage of this rule may want to accelerate their plans.
Question #6: Does the Notice apply to transactions that have already taken place?
Answer: Apparently yes. It is therefore conceivable that taxpayers which engaged in covered transactions in prior open years (at least the three preceding taxable years, and more if the statute of limitations has been extended) will be able to amend their returns to take advantage of the Notice's more favorable treatment of built-in bank losses, which would presumably produce immediate tax refunds.
Question #7: Does the Notice apply to asset purchases?
Answer: No. The purchase of assets and liabilities from the FDIC as receiver or as part of a loan portfolio or branch sale would not be covered. Ordinarily, where assets being acquired have built-in losses, those losses would be triggered at the time of the asset purchase and would remain with the seller. These losses would presumably be useless to the seller, unless the sale was accompanied by a plan involving a change in control of the seller, such as a substantial sale of stock. If the transaction took the form of an acquisition of the bank by another (profitable) bank, the acquiror could use the losses. If the bank or bank holding company sold stock to new investors that resulted in a change of control for tax purposes, then the bank would be able to use its losses to shield its future income from tax and boost its returns to its shareholders.
Question #8: How will the Notice affect private equity and other investors in banks?
Answer: In addition to promoting investments in banks that seek to grow by acquisition, the Notice should encourage bank investments large enough to result in a change in control for tax purposes. A change in control occurs if more than 50 percent, by value, of the bank's (or its parent's) stock is acquired within a three-year period by one or more 5 percent stockholders. All stock counts for this purpose except for "plain vanilla preferred"—nonvoting, nonparticipating, nonconvertible, nonredeemable preferred. Convertible preferred stock is counted in determining whether a change in control has occurred for tax purposes. A change in control can occur for tax purposes even where the transactions do not involve a change in control for bank regulatory purposes, thereby facilitating capital investments in banks. Question #9: How does the Notice help a buyer of a bank?
Answer: First, a profitable buyer of a whole bank through a merger or similar acquisition of 100 percent of the bank or its bank holding company's stock will be able to offset its own operating income with the deductions attributable to the target bank's built-in losses, which will result in lower tax obligations in the future. Second, it may be possible to engage in transactions involving the built-in loss assets that result in a large one-time net operating loss that can be carried back to prior years to recover a refund. Where a bank or bank holding company has sold stock to investors sufficient to have a change in control for tax purposes, all bank shareholders will benefit from greater after-tax returns when the bank becomes profitable.
Question #10: How soon could a tax refund be obtained?
Answer: Once the fiscal year of a buyer of a bank or of a bank that has had a change in control and a loss for tax purposes has ended and its return for the year has been prepared, a quickie refund request can be filed with IRS, indicating the amount of the refund that is owed. Under IRS procedures, such a refund request is not subject to substantive review and is generally paid within 30 to 45 days. That would mean the refund might be available as early as the end of the first quarter in the year following the acquisition.
Question #11: To which returns would the operating loss be carried back and carried forward?
Answer: This depends on how the acquisition is structured. There are two basic choices in a whole bank deal: (i) a transaction (such as a reverse triangular merger, stock swap, or straight stock purchase, either as a taxable or a nontaxable deal) in which the bank survives as an entity; and (ii) a nontaxable transaction (such as a forward merger for buyer stock) in which the bank goes out of existence and conveys its assets to a member of the buying group.
In the first type of transaction, the portion of the buying group's consolidated net operating loss ("CNOL") for the year that is allocable to the target bank may be carried back to the target bank group's last two taxable years for a refund (generally payable to the old target group's parent), or it may be carried forward to offset future buying group income. In the second type of transaction, the buying group's CNOL for the year that is allocable to the bank entity into which the target bank merged may be carried back to the buying group's last two taxable years for a refund (payable to the buying group's parent), or carried forward. Operational issues and the realization of merger cost savings and synergies would make the second approach generally more attractive as well.
Where a change in control has occurred through a new investment instead of acquisition by another banking entity, any tax loss carryback would be to the bank's prior two taxable years if it had profits in either of those years and elects to carry back, and otherwise the losses would be carried forward to future profitable, years.
Question #12: What sorts of considerations will this raise for the buyer's advisors?
Answer: Since the form of merger transaction will dictate the years to which the bank's post-acquisition losses can be carried, the buyer's advisors will need to model the present value benefit achieved under the various scenarios. In many cases, the preference may be for the forward merger scenario, because the buyer may have larger carryback potential than the acquired distressed banks. Similar modeling will have to be conducted for investors in other change in control transactions.
Question #13: Are there any limits on the identity of the buyer of a bank in a merger?
Answer: The principal economic requirement is that the buyer (i) is currently generating taxable income, (ii) expects to be generating taxable income at some point over the next 20 years, and/or (iii) has had taxable income within the last two years, so that the shelter produced by the bank's built-in loss deductions can be used. The buyer must also be a bank or an entity that can be a bank holding company or a savings and loan holding company. Others that invest in a bank sufficient for there to be a change in control for tax purposes will benefit indirectly from increased after-tax returns, if the target bank has been profitable in the past two years or becomes profitable after the transaction.
Question #14: What are the effects of the Notice on a bank's capital for regulatory purposes?
Answer: Sales of distressed or risky assets, or sales of concentrations of assets, should reduce regulatory requests for higher than normal capital. Any tax refunds should boost capital directly for regulatory purposes. Any tax refunds should be reported to the bank's regulators where the regulators have been seeking additional capital to avoid enforcement actions or noncompliance with an existing enforcement action. If a tax loss carryforward arises because there were insufficient taxes paid in the prior two taxable years to cover the tax losses permitted under the Notice, then a tax loss carryforward would be created, which would in turn result in a deferred tax asset for the bank. Under the Federal Reserve's bank holding company capital guidelines, deferred tax assets can be counted as capital for regulatory purposes up to the lesser of the amount expected to be realized in one year or 10 percent of Tier 1 capital. The balance of the deferred tax assets are deducted from capital and assets in calculating regulatory capital. On September 30, 2008, the Federal banking regulators issued a proposed rule that also should be considered. This proposal would reduce the amount of goodwill that must be deducted from Tier 1 capital by the amount of any deferred tax liability associated with that goodwill that arises in a taxable acquisition of another bank. No offset of such deferred tax liabilities against deferred tax assets would be permitted for regulatory capital purposes.
Question #15: Is there any interplay between the Notice and the Paulson Plan legislation?
Answer: Potentially, a great deal. The Paulson Plan was enacted and signed into law on October 3 as the "Emergency Economic Stabilization Act of 2008" or "EESA." We would expect that buyers may want to consider using the target bank's built-in loss by selling distressed mortgage-related securities to Treasury pursuant to Treasury's Troubled Asset Relief Program ("TARP") after a change in control of the target bank has occurred for tax purposes. That could establish several sources of funds for the target bank or its acquiror and investors. First, the target bank (or its successor) would receive cash from Treasury for its distressed assets and would be less risky as a result. Second, the sale would likely generate tax losses, and those losses could be carried back to prior years to obtain a refund and/or carried forward to enhance future cash flows. In either case, the bank may be more attractive to new investors or merger partners. The Notice effectively generates additional cash benefits for the banking system over and above the Paulson Plan and TARP without the need for Congressional appropriation or review. It may also allow Treasury to bid for distressed assets at a somewhat lower price level than it would otherwise need to do and still clear the market, since many sellers will know that they are going to get what amounts to a second payment for those assets once their losses have been taken. Banks and bank investors should look carefully at participation in TARP, because the EESA mandates that participating banks issue warrants, preferred stock, or debt to the Treasury in connection with any sale of troubled assets. These instruments could be economically unattractive to existing and future investors and merger partners, and their terms must be weighed against the above benefits, including the tax benefits under the Notice.
Section 301 of the EESA provides relief independent of the Notice for losses on sale or exchanges of Fannie Mae and Freddie Mac preferred stock by treating those losses as ordinary in character and thereby capable of offsetting ordinary operating income.