One of the consequences of the TARP Capital program is that some banks will use some of the capital infusion to acquire other banks. We believe that the “winners” in the TARP race will also attract additional private capital as investors decide who the long-term survivors are. The Internal Revenue Service recently released two notices intended to provide relief to banks and other financial institutions that are looking to raise capital from the tax rules limiting the use of losses after there has been an ownership change in the stock of a corporation. We believe that once it is widely understood by banks it will add momentum to the merger activity.
Generally, a corporation that has a taxable loss (i.e., tax deductions in excess of taxable income and gains) for federal income tax purposes during a taxable year generally may carry that loss back to each of the two (2) preceding years (to recoup federal income taxes paid in those years) and then forward to each of the following twenty (20) taxable years. There are special rules, however, that limit the use of a tax loss (commonly referred to as a net operating loss or “NOL”) carryforward that arose prior to the time when the corporation underwent an ownership change with respect to its stock.
If an ownership change has occurred, generally the annual amount of taxable income that can be “sheltered” (i.e., the amount of NOL deduction that can be claimed with respect to) by an NOL that arose prior to the ownership change (the “annual NOL limitation”) is limited to the fair market value of the corporation’s stock (determined immediately before the ownership change) times the federal long-term tax-exempt rate (which, for the month of October 2008, was 4.65%).
Calculation of Fair Market Value in Connection with an Ownership Change
The rules for computing the annual NOL limitation provide that any capital contribution received by a corporation experiencing an ownership change that is part of a plan that will, as a principal purpose, avoid or increase the limitation is not taken into account in computing the fair market value of the corporation’s stock. Further, the rules state that any capital contribution made during the two-year period ending on the ownership change date is presumed to be part of the plan unless excepted by regulations issued by the Treasury. Thus, this rule requires that the fair market value of a corporation for purposes of computing the annual NOL limitation after an ownership change has occurred must be reduced by any amount paid to the corporation in connection with any issuance of its stock in the two-year period leading up to the ownership change, unless an exception in the Treasury Regulations is met.
IRS Notice 2008-78 provides several changes in the rules and safe harbors for determining when fair market value must be reduced by amounts paid for stock issuances occurring within two years of an ownership change. First, the Notice states that the presumption that a stock issuance within two years of an ownership change is part of a plan to increase the value of the corporation’s stock no longer applies. Second, the Notice provides that the fair market value of a corporation experiencing an ownership change is not reduced by the amount paid for stock issued within the two-year period prior to the ownership change unless the stock was issued as part of a plan that will, as a principal purpose, increase the annual NOL limitation. Further, whether a stock issuance is part of such a plan is based on all the facts and circumstances. In addition, if a stock issuance meets a published safe harbor, the amount paid for the stock will not reduce the fair market value of the corporation’s stock for purposes of computing the annual NOL limitation even if it might otherwise appear to be part of a plan to increase the limitation. Finally, the fact that a stock issuance does not meet a safe harbor does not constitute evidence that it was part of a plan to increase the annual NOL limitation.
Treatment of Built-in Losses
The rules limiting the use of an NOL carryforward after an ownership change has occurred in some instances also can apply to limit unrealized losses that have economically accrued before the ownership change occurs, but which losses are not reported for tax purposes until after the stock ownership change. These losses, which are referred to as “built-in losses,” treat the losses as additional NOL carryforward subject to the annual NOL limitation.
If a loss is a built-in loss, the built-in loss is, in affect, added to (stacked on top of) the NOL carryforward and the amount of deduction that may be claimed for the total of both the NOL carryforward and the built-in loss cannot exceed the corporation’s annual NOL limitation. For example, if a corporation that has experienced a stock ownership change, for which the annual NOL limitation equals $500,000, and has $10,000,000 of pre-change NOL carryforward and has recognized $2,000,000 of built-in loss in a prior taxable year (but in a year after the ownership change has occurred), in any subsequent taxable year in which the corporation has taxable income, the combined amount of NOL carryforward and built-in loss that may be used to shelter taxable income in that year cannot exceed $500,000. It should be noted that if the annual NOL limitation is not fully utilized during a taxable year after an ownership change has occurred, the unused limitation increases the next year’s annual NOL limitation.
Notice 2008-83 states that the IRS and Treasury are studying the proper treatment of certain items (namely, bad debt deductions and losses on loans) that could give rise to a built-in loss. The Notice provides that any deduction allowed to a bank after it has experienced an ownership change with respect to its stock, which is with respect to a loss on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts), shall not be treated as a built-in loss or a deduction that is attributable or treated as if it was incurred prior to such ownership change. Banks (as that term is defined in Section 581 of the Internal Revenue Code) may rely on the principles set forth in the Notice until additional guidance is issued by the IRS. (Note: On November 18, 2008, the Treasury announced that its Inspector General is reviewing the Treasury’s authority to issue Notice 2008-83.)
The net result of these changes is that some acquisition transactions will practically pay for themselves due to the tax advantages obtained under the revised regulations. It certainly changes the economics of some of the already announced deals such as Wells Fargo and Wachovia. Instead of amortizing the tax losses over 25 years at $1 billion per year, Wells will get the benefit of $25 billion of Wachovia’s losses in the first year.