Firm Asks Treasury for Guidance to Facilitate Bank Rescues

Dear Eric:

On behalf of TD Bank Financial Group ("TD Bank"), we are writing to request that the Treasury Department provide additional 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. As you know, the Treasury Department and the Internal Revenue Service ("IRS") have recently provided guidance relaxing certain other provisions of the Internal Revenue Code to encourage the acquisition of troubled financial institutions in the current economic crisis.¹ We believe guidance regarding the application of section 597 is warranted for the same, or even more compelling, reasons.

Current Rules Provide a Disincentive for Potential Rescuers of Troubled Banks

The current regulations under section 597 address the tax consequences of the federal government's provision of financial assistance to distressed banks.² For instance, the regulations provide that the acquisition of 50% or more of the stock of a troubled financial institution that has received federal financial assistance or has been under the control of certain government agencies, including the FDIC, will be treated as a deemed asset sale.³

The effect of the deemed asset sale generally is to require the acquirer to take a cost basis in the acquired assets, eliminating losses inherent in those assets.⁴ For example, assume that a financial institution acquires a distressed bank owning assets with a total fair market value of $10 billion and a total adjusted basis of $15 billion. If the FDIC provides even $1 of assistance, section 597 will apply and the acquiring financial institution will take a cost basis of $10 billion. The $5 billion built-in loss will be eliminated, even to the extent that such loss is not reimbursed by federal assistance. If no FDIC assistance is provided, the acquiring financial institution will succeed to the $15 billion inside basis and all $5 billion of loss will be preserved.

The elimination of the losses inherent in the acquired assets may discourage solvent financial institutions from acquiring distressed banks, a result that could deepen the current financial crisis. A solvent financial institution is likely to pay more for a distressed bank if it can utilize the distressed bank's losses, thereby increasing the amount paid to shareholders of the distressed bank and decreasing the amount of direct government assistance needed.

In fact, the elimination of losses when the federal government provides assistance arguably creates a disincentive for financial institutions to acquire more deeply distressed financial institutions, which are more likely to have been placed under government control or to receive financial assistance. The government should provide an incentive, not a disincentive, for financial institutions to acquire such deeply distressed banks. Without a clarification or modification, the current rules under section 597 make acquisitions of the most deeply distressed banks less likely and are arguably inconsistent with the Treasury Department's recent notices, which recognize the acquisition incentive created by allowing solvent financial institutions to succeed to the losses of acquired banks.⁵

Recent Guidance May Supply a Precedent and May Make the Requested Guidance Merely Clarification

The Treasury Department has addressed the application of the loss limitation rules of section 382 in its recent guidance.⁶ Significantly, in Notice 2008-83, the IRS indicated that it would suspend the section 382 limitations on the use of built-in losses after an ownership change of a bank. Notice 2008-83 recognizes that allowing a solvent financial institution to succeed to and utilize the losses inherent in a distressed bank provides an incentive for solvent financial institutions to acquire distressed banks.⁷ The IRS has also released Notice 2008-101, under which 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. It is possible that Notice 2008-101, especially when considered in conjunction with Notice 2008-83's relaxation of the loss limitation rules of section 382, provides authority for the position that the application of section 597 is limited in other situations in which the federal government provides relief to distressed financial institutions. As such, any Treasury Department guidance along the lines we are requesting may constitute merely a clarification rather than an extension of the recently issued guidance.

The Treasury Department's effort, implicit in Notice 2008-83, to encourage the private sector to acquire distressed banks without federal assistance allows the federal government to provide assistance elsewhere, if needed. 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. Currently, unless Notice 2008-101 is clarified or extended, taxpayers acquiring banks with financial assistance are treated less favorably than other banks, creating a disincentive for financial institutions to acquire deeply distressed banks that receive government assistance. The Treasury Department should provide equal incentives for all taxpayers to rescue distressed banks.

Conclusion

For these reasons, we respectfully request that the Treasury Department provide additional guidance, whether deemed a clarification or extension of Notice 2008-101, stating that section 597 will not be applied to situations in which the FDIC, or other federal entities, operating either with or separately from the Treasury Department, provides assistance to troubled financial institutions. We respectfully request that the Treasury Department specifically clarify that financial institutions may succeed to a distressed bank's losses to the extent that such losses are not reimbursed by federal assistance. This guidance would continue the Treasury Department's recent policy of relaxing certain loss limitation rules to facilitate acquisitions of troubled financial institutions or loss assets and would allow financial institutions, such as TD Bank, to provide more effective private sector support to the Treasury's effort to ensure the integrity of the nation's financial system and protect the nation's bank depositors.

We thank you for your consideration of this issue at this very busy time. We will call you to follow up on this letter.

² 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 FIRREA, a taxpayer receiving certain government assistance when acquiring assets from a distressed financial institution was not required to include such assistance as taxable income or to make a downward basis adjustment to the assets acquired from the distressed financial institution. FIRREA required federal assistance to be included in the gross income of the distressed financial institution, eliminated special rules under section 382 applying to net operating losses and built-in losses, and gave the Treasury Department authority to promulgate regulations on these matters.

³ Treas. Reg. § 1.597-5(a)(1), (b)(2). The regulations provide specific rules for the tax consequences resulting from such deemed asset transfers. Id. § 1.597-5. In general, the purchase price for assets deemed acquired is the sum of the grossed-up basis of the stock acquired plus the liabilities assumed. Id. § 1.597-5(d)(1). Federal financial assistance provided is treated as being received by the troubled financial institution immediately before the transfer and may be treated as an asset of the transferor troubled financial institution that is sold to the acquiring financial institution. Id. § 1.597-5(c)(1). The amount realized by the transferor is the sum of the grossed-up basis of the stock acquired plus the liabilities assumed. Id. § 1.597-5(c)(2). The acquiring financial institution will determine its basis in the transferred assets by allocating the purchase price under rules provided in the section 338 regulations. Id. § 1.597-5(d)(2). If all of the stock of the troubled financial institution is not acquired, the regulations provide the IRS Commissioner with discretion to make appropriate adjustments to the extent using a grossed-up basis of the stock of a corporation results in an aggregate amount realized for, or basis in, the assets other than the aggregate fair market value of the assets. Id. § 1.597-5(d)(5).

⁴ Gains in the assets would similarly be eliminated to the extent there were any such gains.

⁵ This request is potentially made more urgent by the October 14, 2008 effective date of the FDIC's Temporary Liquidity Guarantee Program, which could subject nearly all U.S. banks to section 597. Under the FDIC's Temporary Liquidity Guarantee Program, effective October 14, 2008, and established pursuant to section 13(c)(4)(G) of the Federal Deposit Insurance Act, the FDIC will guarantee the payment of certain newly-issued senior unsecured debt and certain noninterest-bearing transaction accounts. All eligible entities are covered for the first thirty days of the program at no cost. Entities may opt-out of the program, but an eligible entity that does not opt out will be deemed to participate in the program.

It is arguable that the Temporary Liquidity Guarantee Program constitutes "federal financial assistance" under section 597, which is defined in the regulations as including "any money or property provided . . . under . . . section 11(f) or 13(c) of the Federal Deposit Insurance Act, or under any similar provision of law." Treas. Reg. § 1.597-1(b). The program arguably could also constitute a "loss guarantee." Id. If the program constitutes either "federal financial assistance" or a "loss guarantee," section 597 could be triggered, resulting in a deemed asset sale and loss disallowance in a future acquisition.

⁶ In Notice 2008-76, the IRS indicated that it will issue regulations to modify the phrase "testing date" in section 382 to exclude dates on which the United States acquires stock or options in Fannie Mae or Freddie Mae. In Notice 2008-84, the IRS similarly indicated that it would issue regulations modifying the phrase "testing date" to exclude a date on which the United States government owns more than 50 percent of a loss corporation.

⁷ It has been reported that Notice 2008-83 played an important role in persuading Wells Fargo to pursue a $15 billion acquisition of the troubled Wachovia. Wells Fargo has said that it will absorb approximately $74 billion in losses. In contrast, Wachovia's earlier agreement was subject to a loss sharing agreement with the FDIC under which Citigroup would have absorbed up to $42 billion of losses on a $312 billion pool of loans, with the FDIC absorbing any further losses. Thus, the more flexible interpretation of section 382 in Notice 2008-93 allowed the FDIC to shoulder fewer losses. It is also possible that, because of FDIC assistance in the form of a loss guarantee in the potential Citigroup-Wachovia transaction, Citigroup may have been forced into a lower bid because it may have been subject to the loss limitations in section 597. As such, Citigroup would not have been able to receive the tax benefits created by Notice 2008-83 because the losses inherent in the assets would have been eliminated by the deemed asset sale.