By: Roger S. Wise
Notice 2008-83, quietly issued by the Internal Revenue Service (“IRS”) on September 30, 2008, removes significant limitations that would otherwise apply to a category of tax losses upon a change of control involving a bank. The notice’s brevity – its operative section contains a single sentence – should not obscure the profound impact that it may have on merger and acquisition activity involving banks.
Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), was originally enacted to prevent “trafficking” in loss corporations. Congress was concerned about transactions where one corporation would acquire a target corporation – perhaps even one that had disposed of its historic business – solely to utilize the target’s loss carryforwards. Under current law, when a corporation undergoes an “ownership change,” Section 382 limits the amount of income that may be offset with historic losses. This limit is generally equal to the value of the loss corporation at the time of the ownership change multiplied by the long-term tax-exempt rate, a rate which is published monthly by the IRS. In essence, this limitation gives the acquiring corporation the benefit of the target’s losses only to the extent of the benefit it would have received if it had instead made an investment in tax-exempt bonds.
An ownership change generally occurs when there is a more than 50 percentage point change in the ownership of the loss corporation by 5 percent shareholders during the three-year period ending on the testing date. An ownership change can arise if shares of a target corporation are acquired from existing shareholders, or if a new equity investment is made in the target.
The rules described above deal with losses that have already been recognized. Section 382(h) of the Code extends these limitations to certain built-in losses – i.e., losses existing at the time of an ownership change that are not recognized until later. If a corporation has a net unrealized built-in loss (“NUBIL”) at the time of an ownership change and meets certain other conditions, any deductions relating to the recognition of those NUBILs during the following 5 years will be subject to the limitations described above. Certain deductions during the 5-year period that are attributable to periods before the ownership change may also be treated similarly.
Under the new IRS notice, the rules on NUBILs do not apply “to 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).” This simple statement appears designed to encourage mergers with, and investments in, troubled banks, by permitted loss deductions arising from bad debts held by the banks. By removing a significant limitation that would otherwise apply to these losses, the notice in effect creates a tax asset that would otherwise not be available.
A bank is defined in Section 581 of the Code 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 of any state, which among other things is subject by law to supervision and examination by State, Territorial, or Federal authority having supervision over banking institutions, and also includes a domestic building and loan association.
The long-term impact of the notice is difficult to predict, but it had an almost immediate impact on the takeover of Wachovia, in that the bid by Wells Fargo – which came shortly after the release of the notice, when an offer by Citibank was nearly finalized – appears to have been encouraged by the change in tax law.
The notice was effective upon issuance and may be relied upon unless and until additional guidance is issued.
