Notice 2008-83: The Ripples Keep Spreading
Few Treasury announcements have drawn as much attention as the September release of Notice 2008-83 (“Wells Fargo Ruling”). Here’s why.
February 2, 2009
Briefly stated, Notice 2008-83 calls off the § 382 limitations on built-in losses (BILs) for domestic banks, i.e., those covered by § 581. In general, § 382 limits the amount of BILs (and NOLs) that can be deducted following a change in ownership in the loss corporation. The purpose of § 382, when enacted in 1986, was to deter “trafficking” in loss corporations, i.e., new owners were to be denied access to losses generated by others.
A noble objective but times change. What happens when it becomes imperative to encourage the acquisition of a big bank on the verge of collapse? That certainly describes the condition of Wachovia Corp. in late September. Wachovia was sitting on a vault-full of bad paper — by some estimates, as much as $74 billion — as a result of its investment in the sub-prime mortgage market.
Sec. 382 would ordinarily prevent a new owner from obtaining full access to these losses. Instead, deductions for these losses would be dribbled out each year following the change in ownership. The annual amount allowable is the product of 1) the value of the loss company’s stock multiplied by two) an interest rate. By late September, the value of Wachovia stock had fallen to $2 billion (the amount bid by Citigroup). Assuming an interest rate of 4.65 percent for ownership changes during September (Rev. Rul. 2008-46), the allowable deduction each year might be as low as $93 million. At that rate, it would take almost 800 years to absorb Wachovia’s BILs, or slightly longer than the allowable 20-year carryforward period. Or put differently, less than $2 billion of the BILs could be deducted during the 20-year carryforward period. Wachovia was the poster child for BILs.
The immediate impact of Treasury’s action in freeing up Wachovia’s BILs was to “facilitate” its acquisition by Wells Fargo & Co. (Some have called it a shot-gun marriage with Treasury wielding the weapon.) Overnight, the value of Wachovia stock took off. Wells Fargo quickly swamped Citigroup’s bid with a bid of $15 billion. Wachovia’s $74 billion portfolio of bad loans can now be used by Wells, to yield a tax benefit of perhaps as much as $25 billion.
It did not take long for criticism of Treasury’s action to develop. Not many tax professionals were willing to comment, perhaps out of an appreciation of the client-friendly nature of the Notice, but the few who did were nearly unanimous that Treasury exceeded its authority. Sec. 382(m) grants Treasury the authority the authority to “to prescribe regulations ... to carry out the purposes of this section ...”
A December letter to Sen. Charles Schumer (D-NY) from Treasury Assistant Secretary Eric Solomon explains Treasury’s rationale for the Notice. (2008 TNT 248-16.) The letter refers to the current instability of the sub-prime mortgage market, which makes it difficult to determine when the loss in value of a bank’s portfolio occurred. If the decline occurred before the change in ownership, the losses would be BILs. If the decline occurred afterwards, the losses would not be § 382-limited. The resulting uncertainty made it difficult to value a troubled bank, thus inhibiting imperative acquisitions.
Comment: This explanation should probably be taken with a grain of salt. The alleged difficulty in determining when the loss in value of a bank’s portfolio has occurred did not seem to present much of a challenge to Citigroup whose rock-bottom bid of $2 billion for Wachovia clearly reflected its conclusion that by late September Wachovia’s portfolio had gone south.
Far more robust was the chorus of criticism from Congress. Sen. Charles Grassley (R-Iowa), the ranking member on the Finance Committee, seemed particularly offended, perhaps because, in an unprecedented breach of protocol, Treasury had not given the Finance Committee a “heads-up” on the Notice. (Sen. Grassley complained that he did not know about the Notice until he read the newspaper.) In the weeks following release of the Notice, several bills (S. 3692 and H.R. 7300) were introduced, calling for its reversal. S. 3692 would make the reversal retroactive which would turn Wells Fargo $15 billion purchase into a disaster; H.R. 7300’s reversal would be prospective, leaving prior acquisitions unaffected.
Initial impressions of the Notice were that its benefits would be obtainable only on current and future tax returns. But subsequent developments have emerged indicating its ripple effects extend backwards in time.
First, any losses freed up by the Notice can be carried back, as well as forward. Once the BIL taint is removed, § 382(h)(4), which mandates a carryforward only for BILs, is inoperative.
Second, in mid-December, senior IRS officials confirmed that the provisions of the Notice are open-ended, both forward and backwards, i.e., retroactively. (DTR, December 2008.) That means that the provisions of the Notice can be applied to any open year, e.g., even on an amended return.
Finally, it appears that provisions of the Notice might extend backwards beyond open years. Robert Willens’ (author and former Managing Director in the Equity Research department at Lehman Brothers) excellent analysis (2008 TNT 237-32) states that Wachovia will merge into Wells Fargo, i.e., Wells Fargo will be the “acquiring corporation” in a transaction described in § 381(a)(2). Thus, if Wells Fargo has a NOL in the current year, it cannot be carried back to any prior year of Wachovia (§ 381(b)(3)). Instead, it must be carried back to prior years of Wells Fargo.
It’s conceivable that, in the context of bank acquisitions (other than Wells Fargo/Wachovia) that have taken place in prior years, the provisions of the Notice might have an impact on a closed year of the acquiring corporation, if an amended return showed a NOL that carried back to such years.
Practice point: For practitioners with bank clients involved in acquisitions, a review of prior years’ returns might turn up interesting refund possibilities.
The effects are not limited to Wells Fargo. Many states piggy-back their corporate income tax on the Internal Revenue Code. The state of California, where Wells Fargo is headquartered, has indicated that it will lose almost $2 billion in tax revenues on account of the Notice.
Less obvious is the Notice’s effect on two seemingly unrelated Code provisions: the low-income housing credit (§ 42) and the renewable energy credit (§ 45). A senior Ways & Means Committee staffer has noted that, in the past, Wells Fargo has been a major investor in these tax-favored programs. These programs are expected to suffer in the future, as Wells Fargo obtains the far greater returns offered by the Notice. Evidence of the shrinking investment market for these programs is an end-of-the year proposal from Rep. Barney Frank (D-MA), Chair of the House Financial Services Committee, to allow Treasury to invest $5 billion in the low-income housing program. (2009 TNT 1-2.)
Also, it appears that congressional hostility to the Notice is based more upon its procedural irregularities, rather than on its substantive provisions. For instance, the automakers’ bail-out bill (H.R. 7321) that passed the House in mid-December contained a provision that would have called off all of § 382, BILs and NOLs, for the big-three automakers. H.R. 7321 failed to pass the Senate.
Sen. Grassley has called attention to a nontechnical aspect of the Notice. He has sent a letter to the Inspector General of the Treasury Department, requesting an investigation of the role played by Robert Steel, CEO of Wachovia, in the issuance of the Notice. (2008 TNT 222-73.) Until this past summer, he was a senior Treasury official (Undersecretary for Domestic Finance), a position for which he was recruited from Goldman Sachs by Secretary Paulson, his former Goldman colleague. Sen. Grassley’s letter states that he is concerned about the “independence of the decision-makers.”
Despite the controversy surrounding the Notice, a note of caution is appropriate. The circumstances surrounding the Notice must not be forgotten. The dire condition of Wachovia in late September necessitated quick action. An FDIC (Federal Deposit Insurance Corporation) official has recently disclosed that the agency shut down Wachovia overnight while the Wells Fargo acquisition was being finalized. At the time, Wachovia was reportedly holding billions in customers’ payroll reserves. The possibility that thousands of workers might not get paid, if Wachovia collapsed, was not something the Federal government was prepared to allow to happen.
Having said that, what seems to have gone unnoticed (or unremarked) is Treasury’s clear conflict of interest. On the one hand, Treasury has its traditional role under the Constitution to administer the tax law, primarily through regulatory guidance. On the other hand, Treasury has a new and totally unprecedented role as the lead agency in the Executive branch’s effort to stabilize the nation’s economy, in particular, the banking industry. Given the imperatives of the financial crisis, it’s conceivable that Treasury’s judgments on regulatory guidance have been unduly influenced by its role as savior of the banking industry.
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George White a CPA and attorney, is with the AICPA Tax Division, Washington, D.C. office. His duties include acting as liaison to the Tax Accounting Technical Resource Panel and Corporations and Shareholders Technical Resource Panel. He is a retired tax partner from Ernst & Young, and a prolific author and editor. He holds a B.A. from Holy Cross College, an M.B.A. from the University of Pennsylvania and an LL.B. from Harvard University.