- Financial Rescue Plan Includes Significant Tax Relief Measure for Financial Firms
- October 25, 2008 | Author: N. Pendleton Rogers
- Law Firms: LeClairRyan - Washington Office ; LeClairRyan - Richmond Office ; LeClairRyan - Virginia Beach Office
On October 3, 2008, the President signed into law the financial system rescue bill, hopefully titled the “Emergency Economic Stabilization Act of 2008,” P.L. 100-343 (the “Act”). Among a variety of financial rescue-related provisions and other “wooden arrows,” the Act provides potentially significant federal tax relief to institutions affected by the current global financial and credit crisis. In addition, the Internal Revenue Service (“IRS”) has also recently issued several pronouncements aimed at providing further tax relief.
Well publicized tax provisions of the Act impose a number of burdens on participants in the U.S. Treasury’s “Troubled Asset Relief Program” or “TARP,” among other financial market participants. These include limitations on the deductibility of executive compensation and amendments to the “golden parachute” provisions of the Internal Revenue Code (“IRC”). These and other revenue raisers, including broker reporting of tax cost basis for securities transactions, will be analyzed in a separate Client Alert.
Tax Relief for Community Banks
Hundreds of community banks hold preferred stock issued by the Federal National Mortgage Corporation (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). When Fannie and Freddie were bailed out by the federal government, this preferred stock became worthless. Under § 582(c) of the IRC, the Fannie Mae or Freddie Mac preferred stock held by a financial institution described in § 582(c) is a capital asset for tax purposes. Thus, any loss on the disposition of this preferred stock would be a capital loss under IRC § 1221, eligible to offset only capital gains. Unfortunately, because of certain regulatory limits, community banks do not as a general rule generate capital gains, and capital losses are not deductible against ordinary income. As a result, the worthless Fannie Mae and Freddie Mac preferred stock held by community banks effectively would not give rise to deductible capital losses.
Under the Act, for sales and exchanges of Fannie Mae or Freddie Mac preferred stock that occur after December 31, 2007, an eligible community bank may treat the loss as an ordinary loss. A bank can use the loss to offset its ordinary banking income, as long as it was an “applicable financial institution” or “AFI” as described in IRC § 582(c)(2) at the time of the sale or exchange of stock and the sale occurs on or after January 1, 2008, and before September 7, 2008. In addition, the ordinary loss rule applies to preferred stock held by an AFI on September 6, 2008, as long as the bank remains an AFI for all dates from September 6, 2008, and ending on the date the preferred stock is sold.
The Act also gives the IRS authority to issue guidance extending the ordinary loss provision to other sales or exchanges of Fannie Mae or Freddie Mac preferred stock in two other situations. If, after September 6, 2008, an AFI acquires such preferred stock in a merger or acquisition with another bank, that is also an AFI, the Committee Report intends that a sale or exchange of that preferred stock post merger or acquisition will qualify for ordinary loss treatment. Further, if an AFI was a partner in a partnership that held Fannie Mae or Freddie Mac preferred stock on September 6, 2008, and later sold that stock, the Committee Report intends for the IRS to issue guidance extending ordinary loss treatment to that transaction.
Before and after the enactment of the Act, the IRS has issued several notices and revenue procedures aimed at providing other tax relief to entities affected by the current crisis.
Purchase of Replacement Securities Upon Default of Securities Lending Agreement
Financial institutions, hedge funds, and mutual funds routinely lend securities to broker-dealers. The lender holds collateral from the borrower equal to the value of the securities lent. If the borrower defaults, the lender has the right under the lending agreement to use the collateral it holds to buy replacement securities for the securities that it lent. Under IRC § 1058, as long as the requirements of section 1058(b) are satisfied, no gain or loss is recognized on the exchange of such securities. However, the bankruptcy of Lehman Brothers raised concerns that a default under a securities lending arrangement would not be covered by IRC § 1058. This in turn made owners of securities reluctant to enter into securities lending arrangements.
In Rev. Proc. 2008-63 (Sept. 26, 2008), the IRS minimized those concerns by clarifying that, as long as the requirements set forth in the revenue procedure are satisfied, the purchase of replacement securities will be treated as an exchange of rights under a securities lending agreement for identical securities to which IRC § 1058(a) applies (i.e., a nonrecognition event).
Repatriating Earnings from Controlled Foreign Corporations (“CFCs”) to Ease Liquidity Crunch
A United States shareholder of a CFC is taxed under the “Subpart F ” rules of the IRC on, among other things, the shareholder’s pro rata share of the average amount of U.S. property held by the CFC. Under IRC § 956(c), “U.S. property” of a CFC includes an “obligation” of a U.S. person (e.g., a debt instrument of a U.S. person issued to a CFC).
Because the ongoing financial and credit crisis is affecting liquidity and making it difficult for some U.S. taxpayers to fund their operations, the IRS issued Notice 2008-91 (Oct. 6, 2008) to facilitate short-term liquidity. In the Notice, the IRS indicated that it will issue regulations that exclude from the definition of the term “obligation” an obligation held by a CFC that is collected within 60 days from the time it is incurred. This is intended to facilitate the issuance of short-term commercial paper by U.S. borrowers. Until the regulations are issued, U.S. taxpayers may rely on Notice 2008-91 for the first two tax years of the CFC ending after October 3, 2008. Thus, if a CFC’s tax year is a calendar year, the Notice applies for the CFC’s tax years ending December 31, 2008, and December 31, 2009.
Making Loss Banks More Attractive Acquisition Targets
When a loss corporation is acquired, the “loss limitation” rules of IRC § 382 apply to limit the extent to which net operating losses, built-in losses, and capital losses of the acquired corporation can be deducted after the acquisition. Any capital contribution received by the loss corporation that is considered part of a plan a principal purpose of which is to avoid or increase the section 382 loss limitation is not taken into account. That is, the capital contribution is disregarded and does not increase the section 382 loss limitation. Under IRC § 382(l)(1)(B), any capital contribution received by a loss corporation during a two-year period ending on the date of acquisition is treated as part of such a plan.
In Notice 2008-78 (Sept. 27, 2008), the IRS indicated that it will issue regulations relaxing the two-year rule, but taxpayers may rely on the Notice prior to issuance of the regulations, as long as the safe harbors set forth in the Notice are satisfied. Taxpayers may rely on the Notice for purposes of determining whether a capital contribution is part of a plan in connection with ownership changes occurring on or after September 26, 2008.
Further, in Notice 2008-83 (Sept. 30, 2008), the IRS announced that acquirors of financial institutions will be allowed to deduct built-in losses and bad debts of an acquired bank (as defined in IRC § 581) regardless of whether IRC § 382(h) would otherwise limit or prevent such deductions. Unfortunately, the preferential suspension of IRC § 382(h) does not apply to financial institutions that are not banks defined in IRC § 581.