The Internal Revenue Service issued two notices this week addressing the tax treatment of certain aspects of the Troubled Asset Relief Program (“TARP”) of the Emergency Economic Stabilization Act of 2008, Div. A of Pub. Law No. 110-343 (“EESA”). IRS Notice 2008-100 provides relief from the impact of the Internal Revenue Code (the “Code”) section 382 net operating loss limitation rules on financial institutions that sell preferred stock and warrants to the Treasury Department under its Capital Purchase Program (CPP) announced earlier this week as part of TARP. IRS Notice 2008- 101 clarifies the treatment under section 597 of the Code of amounts furnished to a financial institution pursuant to TARP.
Treasury Capital Purchase Program Will Not Trigger Loss Deduction Limitations - As a general matter, section 382 of the Code limits a corporation’s ability to deduct losses incurred before an “ownership change” against post-change corporate income. For purposes of this provision, an “ownership change” is deemed to occur if there has been an increase of more than 50 percentage points in the amount of “stock” held by shareholders holding at least 5 percent of the corporation stock (determined by comparing such shareholders’ ownership percentage at the time of the change with the lowest percentage of stock owned at any time during the applicable testing period).
The “stock” that is considered for purposes of section 382 includes all stock other than so-called “pure preferred stock” under section 1504(a)(4) of the Code (stock that is non-voting, limited and preferred as to dividends, limited as to redemption and liquidation rights and nonconvertible). Such “pure preferred stock” is ignored for purposes of determining changes in ownership by its holders and is not counted as outstanding in measuring the ownership changes of others (however, such stock is counted for purposes of determining the value of the loss corporation). Options are generally deemed to be exercised and thus considered to be “stock” owned by the holder if that ownership would trigger (or contribute to triggering) an ownership change.
If a loss corporation has experienced an ownership change, the limitation on the corporation’s utilization of its losses is determined by multiplying the long-term tax-exempt rate applicable at the change date by the equity value of the corporation immediately before the ownership change. For purposes of calculating the loss corporation’s equity value, certain capital contributions made as part of a plan to avoid or increase the section 382 limitation are disregarded.
Prior to this week, it has been unclear how the provisions in the CPP authorizing the Treasury to acquire preferred stock and warrants from qualifying financial institutions would impact those institutions’ utilization of losses under the rules described above. Notice 2008-100 addresses a number of these questions by largely excluding such purchases from the calculations made under section 382.
More specifically, the Notice disregards any shares of stock purchased by Treasury pursuant to the CPP (whether directly or upon the exercise of an option) for purposes of determining the change in Treasury’s ownership but generally counts those shares as outstanding for purposes of determining changes in the ownership percentage of other 5-percent shareholders. One exception to this is that shares acquired and held by Treasury under the CPP and then later redeemed will be treated as if they were never outstanding for purposes of determining ownership changes on the date of the redemption or any subsequent testing date. This will prevent the redemption of Treasury’s shares from increasing the ownership percentage of other 5-percent shareholders. Another exception provided in the Notice is that any preferred stock purchased by Treasury pursuant to the CPP (whether owned by Treasury or another person) will be treated as “pure-preferred stock” under section 1504(a)(4) of the Code. Thus, although the value of the preferred stock will be included for purposes of determining the loss corporation’s value, it will be disregarded for purposes of calculating Treasury’s ownership and in determining a loss corporation’s total outstanding shares.
Any warrants purchased by Treasury pursuant to the CPP will be treated as options rather than as stock, and, unlike options held by others, will not be deemed to be exercised under the normal option rule described above. Thus, such warrants (and any other options held by Treasury pursuant to the CPP) will be ignored for purposes of section 382 until exercised for stock.
Finally, Notice 2008-100 provides that capital contributions made by Treasury pursuant to the CPP will not be considered to have been made as part of a plan to avoid or increase the section 382 limitation. Thus, the value of the corporation will reflect such contributions for purposes of determining the corporation’s value and the amount of its section 382 limitation.
The IRS and Treasury intend to issue regulations that set forth the rules described in the Notice, but taxpayers may rely on the Notice unless and until there is additional guidance.
Treasury Financing Provided Under Troubled Asset Relief Program Will Not Result in Taxable Income Under Section 597 - Section 597(a) of the Code states that the federal income tax treatment of any “transaction in which Federal financial assistance is provided with respect to a bank or domestic building and loan association shall be determined under regulations” prescribed by the Secretary of the Treasury. The regulations under section 597 provide that, with certain exceptions, such Federal financial assistance is includible as ordinary income to the recipient for Federal income tax purposes at the time the assistance is received or accrued in accordance with the recipient’s method of accounting. Treas. Reg. §1.597-2(a)(1).
The regulations define “Federal financial assistance” to mean any money or other property provided by the Resolution Trust Corporation, the Federal Deposit Insurance Corporation, any similar instrumentality of the United States government, or any predecessor or successor of the foregoing, to a bank or building and loan association, or to certain direct or indirect stockholders of such financial institution, regardless of whether any note, obligation, stock, warrant, or other right to acquire stock is issued in exchange therefor. Treas. Reg. §1.597-1(b).
Pursuant to Notice 2008-101, until the Department of Treasury and the IRS issue guidance to the contrary, no amount furnished by the Department of the Treasury to a financial institution pursuant to the TARP established by the Secretary under EESA will be treated as the provision of Federal financial assistance within the meaning of section 597 of the Code and the regulations thereunder. Any future contrary guidance will not apply to transactions with the Department of the Treasury, or to securities issued by financial institutions to the Department of the Treasury, prior to the publication of that guidance, or pursuant to written binding contracts entered into prior to that date.
The IRS cautioned that no inference may be drawn from this Notice regarding the treatment under section 597 of the Code or the regulations thereunder of any other program or payments not described in the Notice