Revenue Code Section 382: in the face of a financial crisis

I gave a presentation in my tax policy seminar today, scratchy throat and all, based on the topic of a paper I am writing for the class. The U.S. Treasury Department intrigued and scared me with some of the moves it made in September and October so I ended up writing my paper on the actions it is taking. In particular, I focus on one notice of guidance issued by the I.R.S. that essentially waives application of a section of the code – 26 U.S.C. 382(h) – for banks only. This waiver is credited with Wells Fargo snatching up Wachovia, which had already agreed to a sale to Citibank. The drama of it all. I estimate Wells Fargo will save about $26 billion in taxes and enlarge itself to boot.

The slides below are followed by my notes, including for the missing slide. Keep in mind that this presentation greatly simplifies one of the most complex sections of the code. Comments are welcome. Enjoy!

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  • I am interested in how the tax code is being used to help combat the current financial crises.
  • one place Treasury started was 382, which limits the use of losses and gains by a new loss corporation

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We will quickly cover …

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The treasury department has been active in identifying trouble spots and issing guidance to corporations to help deflect some of the market turmoil.

  • it started with the rescue of Fannie Mae and Freddi Mac, which remain publicly traded corporations
  • then it was confronted with AIG
  • then it decided to help recapitalize corporations so it gave a safe harbor from the law
  • The last one is the topic of my paper
    • treasury excuses banks from 382(h) which restricts trafficking in built-in losses
    • we’ll come back to this, but first …382

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NOL:

  • Occurs when tax-deductible expenses exceed taxable revenues
  • carry back: to offset income during the previous two tax years;
    • OR
  • carry over for a 20 years before they expire.
  • considered a tax asset under GAAP accounting standard and shows as an asset on balance sheets
    • Good example: GM took a $39 billion write-down in September 2007 to realize losses on tax assets that were expiring or it did not expect to redeem.  GM lists â??Other current assets and deferred income taxesâ? in its 10Q. In the August 2008 10Q, it is  $3.58 Billion.Key terminology:

Loss Corporation is entitled to use the loss

  • Old loss corporation is the one that generated the loss before the change date
  • New loss corporation is the one that can use the NOL after the change date

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382(b) â?? places annual limits on NOLs after ownership change

Change in ownership is complex

  • Just know it can be triggered by a number of things:
  • sale of the corporation, reorganizations, recapitalization, capital injection, stock transfer, IPO.The old and new loss corp can be the same
  • Assumption here: corporation acquired all at once

Annual limit

  • equal to, or less than, the value of the old loss corporation times the long-term federal tax-exempt bond rate – set by the IRS monthly 4.65%
  • Carryforward allowed, carry back prohibited.
  • Wachovia example: 24.5 Billion * 4.65% = 1.14 Bill.
  • GM example: 3.64 Billion * 4.65% = 169 million

NOLs expire after 20 years.

  • If the annual limit is $5 million dollars due to 382, the maximum deductible amount is $100 million dollars.
  • Wachovia ex: 1.14 Billion * 20 years = $22.79 Bill.
  • GM example: 169 million * 20 years = $3.4 billion – based on market cap on Y! Finance
  • These are the  NOLs that can be utilized by the new loss corporation over the 20 year carry forward term.

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  • 382(h): Limits new loss corporations from using net unrealized built-in gains or losse (I’ll cover losses only)
  • Without 382(h), a loss corporation could speed up or slow down recognition of gains or losses.

NUBIL: net unrealized built-in losses

  • includes depreciation, amortization, and depletion.
  • When built-in loss is recognized, that loss is then added to the pre-change NOL carryovers and limited as such.
  • limits are only placed on losses recognized during the five years after the change date.
  • Elements
    • must be accrued at the time of the ownership changes
    • the amount must be substantial (>=15% fmv of the assets or $10mill) â?? de minimis rule
    • recognized within a limited period (five years).
    • After year 5, the built-in losses are carried over without limitation.

Burden on the new loss corp. to establish that a loss recognized during the recognition period is not a RBIL.

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IRS Notice 2008-83

  • Waives application 382(h) for banks
  • Applies only to banks
  • Has no termination date

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Immediately after the merger is complete

  • Wells can recognize NUBILs it owns through its acquisition of Wachovia
  • apply those losses through carry back mechanism to offset income during the past two tax years.
  • gets a refund check from the I.R.S.

Wells expects to eventually write down $74 Billion in value from Wachovia’s loan portfolio – NUBIL.

  • once recognized, those $74 billion in losses would be attributed to Wells Fargo, rather than Wachovia.
  • immediately be used to offset income
  • Any remaining amount can then be carried over as NOL to subsequent tax years, to offset future gains, either as NOLs that are carried forward or that offset income during a given tax year.

Possible scenario for carryback:

  • Taxable income â?? 2007: $11.6 Billion
    • annual report: 3.57Bill. tax paid / 30.7% effective tax rate
  • Taxable income â?? 2006: $12.7 Billion
    • annual report: $4.23 Billion tax paid / 33.4% effective tax rate

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  • Unequal treatment creates macroeconomic distortions.
  • Generally, similarly situated taxpayers should be treated similarly.
  • Others w/ large NUBIL: insurance companies, investment banks, manufacutures, real estate developers or holding companies, and

Similarly situated taxpayers can include both small and large corporations and span across different industries because the corporations follow the same tax laws and regulations. It can also be used more narrowly to only apply to companies large or small or only companies within a particular industry. I think it should apply broadly and inclusively.

argument for providing the banks (under 581) a bypass around 382(h).

  • perhaps saving the financial system could trump economic efficiency arguments.
  • Counter: Citibank bid for Wachovia without this provision.
    • Citi had the gov’t assume certain risks. Here Wells assumed the risk and paid a premium for Wachovia, versus Citi.
  • Counter what about all the other companies part of the finanical system not covered? And other important industries?

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distortions are pushing non-bank financial servicers to become banks or bank holding companies

  • take advantage of tax breaks and other government assistance that is being provided to banks.
  • take advantage of 2008-83.
  • GMAC announced on Nov. 5
  • Amex on Monday
  • Investment banks Goldman Sachs and Morgan Stanley have already received permission to become bank holding companies.
  • Will insurance companies be next?

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Moral Hazard â?? taxpayer behavior distorted by removing some risk of failure

Missing slide:

Start by asking what is this regulation intended to correct? Does it actually accomplish that goal or are there other intended or unintended consequences

  • Seems this guidance is intended to help recapitalize banks.
  • If so, compare to other methods to recapitalize banks. Are there better ways? Direct capitalization? Bankruptcy?

Direct capitalization

  • Wells: $74 billion write off – Assume 35% tax rate â?? expect $25.9 billion in taxes lost
  • Is $25.9 billion in lost tax revenue better used recapitalizing Wachovia?

Bankruptcy or receivership?

  • 382 includes a bankruptcy exception that provides what amounts to a waiver of 382.

Creates super bank

  • Is Wells taking risks it would not otherwise take (moral hazard)?
  • What if Wells Fargo is mistaken about the risks inherent in the bank it acquires or their own portfolios?
  • Is it worth the risks to have two banks fail rather than one if there are bigger losses than anticipated in the new loss corporation as a result of the acquisition?

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[no notes]

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  • Notice 2008-83 has received public attention of Senators from both parties
    Charles Schumer (democrat)
    Charles Grassley (republican)
    Both are upset because Congress was not consulted, yet this will cost hundreds of billions of dollars.

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Poor tax policy to give only one industry a waiver to 382(h) requirements.

Better choice?

  • Apply waiver temporarily to all corps that can show the purpose was not to traffic in NOLs
    • require sale of an operating business & business continuity
  • Limits macroeconomic distortions by encouraging investment and recapitalization of all business types
  • Ensures the original intent of Congress, to prevent or limit trafficking in NOLs
  • More administrable than ad hoc regulation directed to correct market failures in one industry or group of corporations
  • Might not be politically acceptable because it will limit Federal revenues and it will

I think it would have also been better for Treasury to insert this into the discussions of the big bailout package since Notice 2008-83 came out while Congress was debating the bailout.

… now for me to finish writing the paper.

Update (12/18/08): I finished the paper. Sources for the information given above is identified in the paper. 🙂

4 thoughts on “Revenue Code Section 382: in the face of a financial crisis

  1. ricky

    Dear Danny,

    This is an excellent summary and analysis of section 382, which has been described by experts as one of the most difficult sections of the code to understand which is hard to believe as there is so much competition. The banks are receiving a wonderful tax break why the auto companies are still begging for scraps. Why don’t they extend the loss carry backwards to five or ten years which would assist the autos and any corporation that would like to take advantage of losses. It is not a bailout and it would even the playing field. Thanks for a great explanstion of a complex issue. RNF JD.

    1. danny Post author

      Thanks Ricky. Yes, it is a difficult section to understand. I’m certain I’ve barely scratched the surface of the rules. In fact, I think the change in ownership portion of Section 382(h) invites several scholarly papers. I did not touch change in ownership in my presentation or paper. I found the following in my notes yesterday as I quickly finished up to make my deadline. “382(h) is bang your head into a wall complex, guaranteeing tax lawyers and accountants jobs for years to come.” 😀

      A loss carry back extension is unlikely to help the automakers. I do not know their exact situation but that’s what it seems. Sadly, this is a hole the automakers have been digging for 30 years. GM reported a $39 Billion loss last year, mostly due to its needing to write down NOLs it had been carrying over. Some expired and others it did not ever expect to use. Also, expect to see even the Japanese automakers take it on the chin in this global economic slowdown. They just aren’t showing the strains as quickly as the Detroit 3. What the Detroit 3 need to do is make cars that people want to buy. That sadly is their problem. A lot of people I know gave up on them because of quality issues (think Pinto or Vega or Grenada). Sure, that is the past but when you spend a large chunk of your savings, and then some, on a piece of equipment …

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