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Firm Urges Treasury to Issue Guidance to Facilitate Bank Rescues

NOV. 14, 2008

Firm Urges Treasury to Issue Guidance to Facilitate Bank Rescues

DATED NOV. 14, 2008
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November 14, 2008

 

 

The Honorable Eric Solomon

 

Assistant Secretary for Tax Policy

 

Department of the Treasury, Room 3120

 

1500 Pennsylvania Avenue, NW

 

Washington, DC 20220

 

 

The Honorable Karen Gilbreath Sowell

 

Deputy Assistant Secretary for Tax Policy

 

Department of the Treasury, Room 3112

 

1500 Pennsylvania Avenue, NW

 

Washington. DC 20220

 

 

Re: Facilitating Bank Rescues through Clarification of Section 597

Dear Eric and Karen:

We are writing to request that the Treasury Department issue guidance clarifying or providing that Internal Revenue Code section 597 will be applied in a manner that will encourage financial institutions to acquire distressed banks when the Federal Deposit Insurance Corporation ("FDIC") provides assistance. We appreciate your consideration of our request. This letter explains (1) our specific request for relief; (2) why relief is appropriate; and (3) the authority of the Treasury Department to provide the requested guidance.

Our Specific Request

We respectfully request that the Treasury Department issue guidance applying section 597 in a manner that will not create a disincentive for solvent financial institutions to acquire distressed banks in transactions in which the FDIC provides a loss guarantee. As discussed below and illustrated in the sample notices contained in an appendix to this letter, such guidance could be issued in a form that constitutes merely a clarification of the current regulations. Alternatively, it could be issued in broader form as a modification to the current regulations. Even such broader guidance would, however, be more consistent with the legislative intent of section 597 than the current regulations.

First, a Notice could be issued stating that (1) the FDIC's mere provision of a loss guarantee, in contrast to an actual payment from the FDIC under a loss guarantee, does not constitute "federal financial assistance" under section 597,1 and (2) a loss guarantee payment made other than at the time of the stock acquisition, although includible in the amount realized on the sale of an asset covered by such guarantee, does not trigger the deemed asset sale rules of Treas. Reg. § 1.597-5.2 We believe this would be merely a clarification and not a change of the current rules.

Second, the Treasury Department could issue guidance clarifying that the deemed asset sale rules in Treas. Reg. § 1.597-5(b) do not apply to a taxable stock purchase. Although this broader guidance would constitute a change to the current regulations, it would be more consistent with the legislative intent behind section 597 than the current regulations. In fact, this is the approach the IRS and Treasury Department itself took in Notice 89-102, which governed before the current final regulations were promulgated.

The Treasury Department could rely on both the legislative history of section 597 and the Emergency Economic Stabilization Act of 2008, P.L. 101-343, ("EESA") for authority to issue such guidance.

Why This Relief is Appropriate

Failure to provide guidance on the application of section 597 will frustrate the purposes of EESA and recent Treasury efforts to encourage the acquisition of distressed banks. The Treasury Department should provide parity for all acquirers of distressed banks. If the provision of an FDIC loss guarantee in connection with a taxable stock sale triggers the deemed asset sale provisions of section 597, a financial institution receiving an FDIC loss guarantee would be treated worse than a financial institution receiving a guarantee, capital infusion, or other assistance from the Treasury Department under EESA.3

Furthermore, financial institutions acquiring distressed banks with FDIC assistance are treated worse than similar institutions acquiring distressed banks with built-in losses that would normally be limited under section 382. Notice 2008-83 suspended the section 382 limitations on the use of built-in losses after an ownership change of a bank. Because the section 597 regulations provide that the acquisition of a distressed bank in which federal financial assistance is provided is treated as an asset purchase, such an acquisition will generally result in a limit or the elimination of the target bank's built-in losses. As such, the tax treatment conferred by Notice 2008-83 is apparently available only to financial institutions acquiring distressed banks without financial assistance.

There is no legal or policy reason for this inequitable treatment, which creates a disincentive for financial institutions to join forces with the federal government to acquire deeply distressed banks. Such private sector assistance may be not only desirable but necessary. Deeply distressed banks may be unable to survive with federal assistance alone but may be unattractive acquisition candidates without federal assistance. As such, treating FDIC assistance the same as TARP assistance can be critical to resolving our current financial crisis. Financial institutions partnering with the FDIC should receive equal treatment to those partnering with the Treasury Department because they play an equally important role in preserving the nation's financial system.

The Treasury Department Has the Authority to Provide Guidance on this Issue and Effectuate Congressional Intent

Section 597 was enacted in its current form in the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, P.L. 101-73 ("FIRREA"). Before current section 597, a bank receiving financial assistance from the federal government was not required to include such assistance in income or make a downward basis adjustment to its assets. As such, a taxpayer might receive duplicative tax benefits due to the provision of tax-free financial assistance with no limitation on the deductibility of losses. Section 597 provided the Treasury Department with authority to promulgate regulations on the tax treatment of federal financial assistance as long as the regulations did not allow the utilization of "any deduction (or other tax benefit) which is, in effect, reimbursed by Federal financial assistance that is not includible in income."4

 

The Regulations Are Overbroad and Create a Double Detriment Rather than Merely Preventing a Double Benefit

 

Congress provided the Treasury Department with specific authority to promulgate regulations providing for the treatment of a transaction in which "federal financial assistance" is provided. Section 597(a) provides that "[t]he treatment for purposes of this chapter 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."

Rather than write specific rules governing the treatment of federal financial assistance in bank acquisitions, Congress instead provided, in section 597(b) and the Ways and Means Committee report, general principles to be followed by the Treasury Department in promulgating regulations. In "any acquisition of assets to which section 381(a) does not apply," e.g., any acquisition of assets that did not qualify as a tax-free reorganization. Congress instructed the Treasury Department to prescribe regulations providing that federal financial assistance shall be properly taken into account by the institution from which the assets were acquired and provide the proper method of allocating basis among the assets so acquired.5 In the case of "other transactions," the Treasury Department was also instructed to provide for the proper treatment of federal financial assistance and appropriate adjustments to basis or other tax attributes.6 In either taxable asset acquisitions or other transactions, the Treasury Department was instructed that "no regulations prescribed under this section shall permit the utilization of any deduction (or other lax benefit) if such amount was in effect reimbursed by nontaxable Federal financial assistance."7

The current regulations under section 597, however, not only prohibit utilization of deductions for amounts reimbursed by nontaxable federal financial assistance -- they may prohibit utilization of deductions for amounts reimbursed by taxable federal financial assistance. In fact, they go so far as to prohibit utilization of deductions for amounts that are not reimbursed at all. As such, the regulations are overbroad. If the mere provision of an FDiC loss guarantee triggers a deemed asset sale, the regulations eliminate all built-in losses in the acquired institution's assets. At the same time, they require a financial institution to include the guarantee payment in the amount realized on the disposition of a guaranteed asset,8 not only precluding the double benefit of a loss deduction and an exclusion of federal assistance from gross income but going so far as to create a double detriment.9

Congress did not provide specific rules in section 597, and in the absence of a specific rule, it is hard to see how Congressional intent to deny a double benefit can be stretched to deny both the loss and the exclusion of financial assistance. As such, it is clear that section 597 itself provides the Treasury Department with authority to promulgate the requested relief. Because the requested guidance is consistent with the principles provided by Congress, the Treasury Department would be acting within Congress's grant of regulatory authority.

 

The Treasury Department Has Promulgated Guidance Not Requiring Deemed Asset Sale Treatment

 

Before issuing the current regulations, the Treasury Department and IRS provided preliminary guidance on section 597 in Notice 89-102. That Notice did not require deemed asset sale treatment in taxable stock purchases.10 Notice 89-102 provides, "[i]n the case of carryover basis and stock purchase acquisitions (unless the purchaser elects to treat the transaction as a Taxable Asset Acquisition), the following rules apply. . . . assets covered by a Loss Guarantee will be treated as having a fair market value at least equal to the amount of the Loss Guarantee, but the basis of such assets will not be affected by the existence of the Loss Guarantee. . . . Any Federal financial assistance received pursuant to a Loss Guarantee will be treated as an amount realized from the sale or exchange of assets covered by such Loss Guarantee, provided the recipient is considered to be the owner of such assets.'" The very fact that the Treasury Department and IRS issued Notice 89-102 is strong evidence that our approach is fully consistent with Congressional intern.11 Revival of the rule in Notice 89-102 would address the situation in a manner fully consistent with Congressional intent.

 

A Loss Guarantee is Not "Federal Financial Assistance" and Treasury Guidance Constitutes Merely a Clarification of Section 597

 

The Treasury Department could provide the relief requested in this letter by promulgating guidance that an FDIC loss guarantee is not federal financial assistance for purposes of triggering the deemed asset sale rules.12 "Federal financial assistance" is defined in Treas. Reg. § 1.597-1(b) as any "money or property" provided by a federal agency, including the FDIC.13 The regulation provides that "loss guarantee payments" (emphasis added) are federal financial assistance, but the regulation does not state that the provision of a loss guarantee itself (as opposed to payments on the guarantee) is ''money or property" constituting federal financial assistance.

Other language in the regulations supports this view. For example, Treas. Reg. § 1.597-2(d)(2)(i) provides a rule for the treatment of "FFA provided pursuant to a Loss Guarantee. . . ." Similarly. Treas. Reg. § 1.597-2(a)(2) offers a cross reference to "additional rules regarding the treatment of FFA . . . paid pursuant to a Loss Guarantee." If federal financial assistance is paid or provided pursuant to a loss guarantee, the loss guarantee itself is not federal financial assistance.

Furthermore, the only logical reading of the regulations is that federal financial assistance must be provided at the time of the transaction to be considered to be provided "in connection" therewith. Under Treas. Reg. § 1.597-5(b)(1), an event listed in Treas. Reg. § 1.597-5(b)(2) will result in a deemed asset sale only if such event occurs "in connection with a transaction in which FFA is provided."

Although a loss guarantee payment, as opposed to the guarantee itself, is federal financial assistance under Treas. Reg. § 1.597-(b), a loss guarantee payment should only be considered to be made "in connection" with an event listed in Treas. Reg. § 1.597-5(b)(2) if such guarantee payment is provided at the time of the transaction. It would be illogical for a loss guarantee payment, which might be made years after an acquisition, to be deemed to cause a stock sale that may have occurred years earlier to be treated retroactively as an asset sale. It is doubtful that the Treasury intended such a result.

The Emergency Economic Stabilization Act Provides the Treasury Department with Additional Authority to Provide the Requested Guidance

EESA provides the Secretary of the Treasury with additional authority to "take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation . . . issuing such regulations and other guidance as may be necessary or appropriate to define terms or carry out the authorities or purposes of this act."14 Although this authorization is made in the context of establishing the Troubled Asset Relief Program ("TARP"). Treasury guidance under section 597 will help carry out the purposes of the EESA, one of which is "to immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States."15 Financial institutions that join forces with the federal government play an important role in protecting the nation's financial system and ensuring confidence in our banks. By providing certainty on the treatment of taxable stock safes in which the FDIC provides a loss guarantee, the Treasury may encourage solvent financial institutions to acquire troubled banks in partnership with the FDIC.

EESA itself contains a guarantee provision.16 EESA instructs the Treasury Department to "establish a program to guarantee troubled assets" and "develop guarantees of troubled assets and the associated premiums for such guarantees." As such, Congress' instruction to the Treasury to create a guarantee program creates an inference that Congress did not want to create a tax disincentive to using such guarantees in the current economic environment. Rather, Congress recognized that that loss guarantees are helpful in "restor[ing] liquidity and stability to the financial institution."

Guarantees provided under EESA may not trigger section 597 due to Notice 2008-101, which provides that amounts furnished by the Treasury Department to a bank under the Troubled Asset Relief Program in the Emergency Economic Stabilization Act of 2008 are excluded from the scope of section 597. There is no apparent reason why EESA guarantees should be treated more favorably than FDIC guarantees. Failure to provide parity may unnecessarily subject taxpayers receiving FDIC guarantees to the double detriment discussed above while taxpayers receiving EESA guarantees are treated much more favorably.

Conclusion

For the foregoing reasons, we respectfully request that the Treasury Department issue guidance stating that the provision of an FDIC loss guarantee in connection with a taxable stock sale does not trigger the deemed asset sale rules of Treas. Reg. § 1.597-5(b). A taxable stock sale need not be treated as a deemed asset sale to carry out the purposes of section 597. Rather, such treatment may create a double detriment.

The requested guidance is consistent with the principles set forth by Congress in section 597 and it may constitute merely a clarification of the current section 597 regulations. Alternatively, the requested guidance may be issued as a modification of the current regulations pursuant to the Treasury Department's authority under section 597 as well as its authority under EESA.

We appreciate your consideration of this issue.

Very truly yours,

 

 

Philip R. West

 

Steptoe & Johnson LLP

 

Washington, DC

 

 

Amanda Pedvin Varrna

 

Steptoe & Johnson LLP

 

Washington, DC

 

* * * * *

 

 

Appendix 1

 

 

Sample Notice 1

The purpose of this Notice is to provide guidance on the application of section 597 of the Internal Revenue Code. Section 597(a) grants the Secretary of the Treasury authority to prescribe regulations on the treatment of any transaction in which Federal financial assistance is provided with respect to a bank or domestic building and loan association.

Unless and until guidance is issued by the Department of the Treasury and the Internal Revenue Service to the contrary, a "Loss Guarantee," as defined in Treas. Reg. § 1.597-1(b), provided by the Federal Deposit Insurance Corporation ("FDIC") does not constitute "Federal financial assistance" under section 597 and does not trigger the deemed asset sale rules of Treas. Reg. § 1.597-5(b). Any loss guarantee payment that is not made at the time of a stock acquisition also does not trigger the deemed asset sale rules of Treas. Reg. § 1.597-5(b). As provided in Treas. Reg. § 1.597-2(d)(3), any loss guarantee payment received with respect to the disposition of property will be included in the amount realized for such property. Any future contrary guidance will not apply to transactions prior to the publication of that guidance, or pursuant to written binding contracts entered into prior to that date.

This Notice does not address the application of any Code provision other than section 597. Except with respect to the treatment of a Loss Guarantee provided by the FDIC, no inference should be drawn from this Notice regarding the treatment under section 597 of the Code or the regulations thereunder of any other program or payments.

Sample Notice 2

The purpose of this Notice is to provide guidance on the application of section 597 of the Internal Revenue Code. Section 597(a) grants the Secretary of the Treasury authority to prescribe regulations on the treatment of any transaction in which Federal financial assistance is provided with respect to a bank or domestic building and loan association.

Unless and until guidance is issued by the Department of the Treasury and the Internal Revenue Service to the contrary, a taxable stock purchase will not be treated as a deemed asset sale under Treas. Reg. § 1.597-5(b). Any future contrary guidance will not apply to transactions prior to the publication of that guidance, or pursuant to written binding contracts entered into prior to that date.

This Notice does not address the application of any Code provision other than section 597.

 

Appendix 2

 

 

Under Treas. Reg. § 1.597-2(d)(3), a guarantee payment must be included in the amount realized when a guaranteed asset is sold or otherwise charged off.17 As such, an acquiring financial institution will not receive a loss deduction that has been reimbursed by federal assistance, as illustrated in the examples below. In addition, if a taxable stock sale is treated as a deemed asset sale, the acquiring financial institution will be denied built-in losses even to the extent they are not reimbursed by federal financial assistance and even if the acquiring institution receives no guarantee payment. The deemed asset sale eliminates the built-in loss simply because the FDIC provides a guarantee, whether or not the FDIC reimburses the taxpayer for such built-in loss.

As an example, assume that a financial institution ("Bank X") acquires the stock of a distressed bank ("Bank Y") in a taxable purchase. Bank Y has a single asset with a basis of $ 100. At the time of the stock purchase, the fair market value of the asset has declined to $60. The following three scenarios illustrate the inequitable result created by the deemed asset sale:

 

Situation 1: Bank X did not receive an FDIC loss guarantee. Because the transaction is treated as a stock sale and not a deemed asset sale, Bank X succeeds to Bank Y's adjusted basis in the asset, which is $100. Bank X later sells the single asset to a third party for $60. Bank X has a $40 loss on the sale.

Situation 2: The FDIC provides a loss guarantee to Bank X in connection with the stock sale, guaranteeing the value of the asset at $60. In exchange for this guarantee, Bank X pays the FDIC $3. Bank X later sells the asset to a third party for $50, the asset's fair market value at that time. The FDIC pays Bank X $10 pursuant to the loss guarantee. Under Treas. Reg. § 1.597-2(d)(3), the $10 guarantee payment is included in Bank X's amount realized so that Bank X's total amount realized is $60. Because Bank X received a cost basis in the asset as a result of the deemed asset sale, Bank X's basis in the asset was $60. Bank X has no gain or loss on the sale. Although the asset declined in value $10 since being acquired by Bank X, Bank X may not lake that loss because it was reimbursed by the FDIC guarantee payment.

Situation 3: The FDIC provides a loss guarantee to Bank X, as in Situation 2. Bank X later sells the asset to a third party for $60. The FDIC provides no guarantee payment because Bank X is able to sell the asset for its guaranteed value. Because Bank X received a cost basis in the asset as a result of the deemed asset sale, Bank X's basis in the asset was $60. Therefore, X has no gain or loss on the sale.

 

As these examples illustrate, requiring the guarantee payment to be included in the amount realized on the disposition of a guaranteed asset appropriately denies an acquiring bank a loss to the extent it is reimbursed. However, when a financial institution receives a guarantee from the FDIC, it is denied the built-in loss, even though such amount is not reimbursed and the FDIC may never actually make a guarantee payment. We believe that the following result is more appropriate:

 

Situation 4: Bank X receives an FDIC guarantee of $60 in connection with its stock purchase and retains Bank Y's $100 basis in the asset. Bank X later sells the asset to a third party for $50, the asset's fair market value at that time. The FDIC pays Bank X $10 pursuant to the loss guarantee. Under Treas. Reg. § 1.597-2(d)(3), the $10 guarantee payment is included in Bank X's amount realized so that Bank X"s total amount realized is $60. Bank X has a $40 loss on the sale. Although the asset had depreciated a total of $50, Bank X may not deduct the portion of the loss attributable to the FDIC payment ($10).

 

By allowing a taxable stock sale to be treated as such and not recharacterizing it as a deemed asset sale, any built-in loss in the acquired assets is preserved. As such, the acquiring financial institution may be able to deduct all or part of such loss when the asset is sold, but only to the extent the loss is not reimbursed by a loss guarantee payment. Thus, the acquiring financial institution will not receive the double benefit of tax-free assistance that does not reduce the amount of any loss.

 

FOOTNOTES

 

 

1 This conclusion would appear to flow directly from the language of the current regulations. "The term Federal Financial Assistance (FFA), as defined by section 597(c), means any money or properly provided by Agency to an Institution or to a direct or indirect owner of stock in an Institution under section 406(1) of the National Housing Act (12 U.S.C. 1729(1)), section 21 A(b)(4) of the Federal Home Loan Bank Act (12 U.S.C. 1441a(b)(4)). section 11(f) or 13(c) of the Federal Deposit Insurance Act (12 U.S.C. 1821 (i), 1823(c)), or under any similar provision of law. Any such money or property is FFA, regardless of whether the institution or any of its affiliates issues Agency a note or other obligation, stock, warrants, or other rights to acquire stock in connection with Agency's provision of the money or property. FFA includes Net Worth Assistance, Loss Guarantee payments, yield maintenance payments, cost to carry or cost of funds reimbursement payments, expense reimbursement or indemnity payments, and interest (including original issue discount) on an Agency Obligation." Treas. Reg. § 1.597-1 (b) (emphasis added).

2 Under Treas. Reg. § 1.597-5(b)(1), an event listed in Treas. Reg. § 1.597-5(b)(2) will result in a deemed asset sale only if it occurs "in connection with a transaction in which FFA is provided." The better reading of the regulations is thai federal financial assistance must be provided at the time of the transaction to be considered "in connection" therewith.

3 The Treasury Department's recently issued Notice 2008-101 provides that "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.'"

4 Section 597(b)(3).

5 Section 597(b)(1); H.R. Rep. No. 101-54. Pt. 2, at 26 (1989).

6 Section 597(b)(2); H.R. Rep. No. 101-54, Ft 2, at 26. The types of transactions constituting "other transactions" are not specified, but the juxtaposition of "taxable asset acquisitions" and "other transactions" suggests that "other transactions" refers to, inter alia, taxable stock transfers.

7 Section 597(b)(3); H.R. Rep. No. 101-54, Pt. 2, at 26.

8 Treas. Reg. § 1.597-2(a) requires thai all "federal financial assistance" is includible as ordinary income to the recipient. Treas. Reg. § 1.597-2(c) limits the amount of federal financial assistance that a financial institution must include in income, but such limitations do not apply to a financial institution that has acquired a distressed bank.

9See Appendix 2 for examples illustrating the double detriment.

10 Notice 89-102, 1989-2 C.B. 436.

11 The Treasury and IRS issued proposed regulations on section 597 in 1992 creating the deemed asset sale treatment of the current regulations, but neither the summary nor the preamble of the proposed regulations discuss why the rules on carryover basis transactions and stock purchases were eliminated. FI-46-89 (Apr. 22, 1992). The 1995 final regulations also provided for the deemed asset sale but also did not discuss why the rules on carryover basis transactions and stock purchases were eliminated. T.D. 8641 (Dec. 20. 1995).

12 Treas. Reg. § 1.597-5(b)(2) lists three events, the occurrence of which will cause a transaction to be treated as a deemed transfer of assets: (1) the acquired bank becomes a non-member of its consolidated group; (2) the acquired bank becomes a member of a new affiliated group; or (3) the acquired bank issues stock such that the stock outstanding before the transaction represents 50 percent or less of the vote or value of its outstanding stock. Even if one of these events has occurred, however, Treas. Reg. § 1.597-5(b)(l) provides that such an event results in a deemed asset transfer only if it occurs (1) in connection with a transaction in which federal financial assistance is provided: (2) while the acquired bank is a bridge bank, (3) while the old entity has a positive balance in a deferred federal financial assistance account; or (4) with respect to a consolidated subsidiary while the subsidiary's parent is under the control of a federal agency.

13See supra note 1.

14 § 101(c), Emergency Economic Stabilization Act of 2008, P.E. 110-343.

15Id § 2.

16 This guarantee program has not been implemented as of the date of this letter, but the Treasury Department has requested public input on "an insurance program for troubled assets which is required by the Emergency Economic Stabilization Act of 2008 (EESA), The purpose of this program is to restore liquidity and stability to the financial system, while minimizing any potential long term negative impact on taxpayers." Federal Register Notice, Department of Treasury (October 10, 2008).

17 The Committee on Ways and Means report on FIRREA describes "capital loss guarantees" as "amounts that the insurer proposes to pay to the acquiring institution to guarantee that the acquiring institution will receive a designated amount from a specified asset for (pool of assets)." H.R. 101-54, Pt. 2, at 28. As currently reflected in Treas. Reg. § 1.597-2(d)(3), the committee "intend[ed] that amounts received under the capital loss guarantee will be treated as amounts received from the disposition of the guaranteed asset. Thus, the committee expects that, in most cases, there will be no taxable income from the receipt of a payment pursuant to a capital loss guarantee and the disposition of the specified asset because the sum of the amount received from the disposition of the asset and the guarantee will not exceed the amount of basis allocated to those assets." Id.

 

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