Federal Assisted Acquisitions

Transcription

1 Federal Assisted Acquisitions

2 Background Current Rules - Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ( FIRREA ) Prior to FIRREA, federal financial assistance ( FFA ) was excluded from gross income, and 50% of excluded FFA reduced tax attributes. FIRREA was enacted in the wake of the S&L crisis and amended section 597 to give Treasury broad regulatory authority. The purpose of the current regulations is to tax the institution receiving FFA and to provide rules for determining the bases of any assets acquired from the troubled institution. Treasury issued proposed regulations that were finalized in 1995, and therefore have not been applicable until the recent financial crisis. Almost no authority or commentary addresses the regulations Active /22/2011

3 Typical Transactions Whole Bank Acquisition A troubled financial institution ( Institution ) in FDIC receivership sells its loan portfolio (and other assets, including stock of subsidiaries) to Acquiring which assumes Institution s deposit liabilities and possibly other liabilities as well. FDIC may also provide Acquiring with cash in exchange for its assumption of the deposit liabilities. Typically, in connection with the purchase, the FDIC and Acquiring enter into a loss sharing agreement under which the FDIC guarantees a portion of the loan portfolio. Unique Process Non negotiable structure/documents. Binding bids with immediate closing. Limited diligence Active /22/2011

4 Typical Transactions Pooled Asset Sale Where FDIC Retains Equity Interest FDIC, as receiver for Institution, transfers a pool of the bank s assets (such as real estate mortgages) to an LLC. In connection with the transfer, the LLC issues both equity and debt instruments to the FDIC. FDIC sells 40% of the LLC interests to a successful bidder (often a partnership owned by a consortium of private equity funds), with the FDIC retaining a portion of the LLC interests. FDIC may intend to sell the debt instruments issued by the LLC to third party investors Active /22/2011

5 Summary of Important Terms FFA : Any money or property provided by Agency (FDIC or similar) to an Institution pursuant to statute. Applies regardless of whether the Institution issues Agency a note, stock, warrants or other rights to acquire stock in connection with Agency s provision of the money or property. Includes Net Worth Assistance, loss guarantee payments and a broad range of other payments. Open question: Does mere provision of Loss Guarantee constitute FFA? Institution : An entity that is, or immediately before being placed under Agency control was, a bank or domestic building and loan association. Acquiring : A corporation that is a transferee in a Taxable Transfer (described later). Net Worth Assistance : Money or property that Agency provides as an integral part of a Taxable Transfer, other than FFA that accrues after the date of the Taxable Transfer Active /22/2011

6 Taxable Transfers Any transaction in which an entity transfers: Any deposit liability (whether or not the Institution also transfers assets), if FFA is provided in connection with the transaction; or Any asset for which Agency has any financial obligation (e.g., pursuant to a loss guarantee or agency obligation). Also includes deemed asset transfers (including acquisitions of consolidated subsidiaries). Effectively creates a forced section 338 election (i.e., a deemed asset transfer) upon a stock purchase if FFA is provided in connection with a specified stock purchase event (or certain other requirements are satisfied) The Institution or consolidated subsidiary that is purchased ( Old Entity ) is treated as selling all of its assets to a new corporation ( New Entity ) Active /22/2011

7 Taxable Transfers Noteworthy Issues NOLs not available post acquisition (parent or sub). Historic Tax Liability Unlike 338 transactions, the New Entity in deemed Taxable Transfers (and Acquiring in actual transfers) do not inherit any tax liability of the Institution in FDIC receivership (including liability under Reg. Sec ) unless there is continuing equity. State, local and foreign tax liability may still attach to New Entity in a deemed Taxable Transfer. FDIC, however, has been willing to give indemnity with respect to pre-change tax liability Active /22/2011

8 Typical Whole Bank Acquisition Facts A troubled financial institution ( Old Entity ) in FDIC receivership sells its loan portfolio (and other assets, including equity interests in subsidiaries such as REO subsidiaries) to another financial institution ( Acquiring ). Acquiring assumes Old Entity s deposit liabilities (and possibly other liabilities). FDIC may also provide Acquiring with cash (treated as Net Worth Assistance). In connection with the purchase, FDIC and Acquiring enter into a loss sharing agreement ( Loss Guarantee ) under which FDIC guarantees a portion of the loan portfolio. Typically FDIC is responsible for 80% of losses up to Threshold Amount and 95% of losses thereafter. Losses are calculated off of Book Value NOT fair market value. More recently the FDIC has cut back on assistance and announced a single-tier reduced loss sharing program Active /22/2011

9 Typical Whole Bank Acquisition Treatment Taxable Transfer, since FFA has been provided in connection with the transaction. Acquiring s purchase of the consolidated subsidiaries is a deemed Taxable Transfer. Non-consolidated subsidiaries (such as captive REITs formed for state tax savings purposes) do not seem to be subject to these rules. Old Entity is treated as having directly received immediately before a Taxable Transfer any Net Worth Assistance ( NWA ) that FDIC provides to New Entity or Acquiring. NWA is treated as an asset of Old Entity (cash provided by FDIC). Payments received by Acquiring under the loss sharing agreement are not NWA Active /22/2011

10 Special Loss Sharing Basis Rules and Income Inclusion Assets covered by Loss Guarantee are treated as Class II assets (including real estate and mortgages). If fair market value of Class I and Class II assets is greater than purchase price, basis of those assets equals their fair market value, and the excess is included in income ratably as ordinary income over 6 years (subject to acceleration if a Section 481 event (such as a contribution of the portfolio to a partnership) occurs). Fair market value of an asset covered by a Loss Guarantee is deemed to be not less than the greater of (1) the asset s highest guaranteed value or (2) the highest price at which the asset can be put. FDIC guarantees are not asset-by-asset, so unclear how rules should apply (in the case of two-tiered arrangements). Reasonable approach seems to be weighted average of the two-tier guarantee (90%). Example: $12 billion subject to Loss Guarantee of 80% above $8 billion and 95% thereafter. If assets go to zero, Acquiring is entitled to $10.8. If purchase price (assumption of liabilities less NWA) is $8 billion, the excess of $2.8 billion is included ratably over 6 years as ordinary income Active /22/2011

11 Special Loss Sharing Basis Rules and Income Inclusion For banks focus is typically timing rather than character. Section 582(c) generally gives banks ordinary treatment on loans. Note that section 582(c) rules don t apply to assets held by disregarded entities. After Acquired Assets Rule - if New Entity or Acquiring has the right to designate specific assets covered to be by a Loss Guarantee (not covered at the time of the Taxable Transfer), then basis adjustments must be made to treat the asset as having been acquired at the time of the Taxable Transfer. Perhaps, this is the proper treatment of a REIT subsidiary which is later liquidated Active /22/2011

12 Special Loss Sharing Basis Rules and Income Inclusion Potential Mismatches: 6 year timing rule is arbitrary and creates a timing windfall to either the government or the taxpayer depending upon actual realization of portfolio. If non-covered assets are purchased (i.e., real estate assets, securities portfolios) those are not Class II assets and NO purchase price will be remaining to allocate to such assets Active /22/2011

13 Loss Guarantee Payments Inclusion in Amounts Realized FFA provided pursuant to a Loss Guarantee is included in the amount realized from property s sale to the extent the total amount realized from the sale does not exceed the greater of The property s fair market value, or The guaranteed value or price at which the property can be put at the time of transfer (which can be less than what the put price is). Here there seems to be an asset-by-asset approach. How should a two-tier Loss Guarantee be handled? Determine put rights at time of transaction? Excess is FFA. Note: under typical Loss Guarantee, Acquiring cannot seek IRS guidance without FDIC approval Active /22/2011

14 Loss Guarantee Payments Example Book Value = 10; Guaranteed Value = 8; Sell for FMV =9; Loss is 1 for Loss Guarantee Purposes; Loss Guarantee Payment =.8. Amount Realized = FMV of 9. Loss Guarantee payment of.8 is FFA. Same facts but instead sell for 7. Loss for Loss Guarantee purposes is 3 and Loss Guarantee payment is 2.4. Total received is 9.4. Amount Realized = Guaranteed Value of of Loss Guarantee payment is FFA. Same but asset worthless. Amount Realized = full 8 Loss Guarantee payment. No FFA Active /22/2011

15 Losses and Deductions Relating to Covered Assets General Rule Prior to a disposition, asset covered by a Loss Guarantee cannot be charged off, marked to market, depreciated, amortized or otherwise treated in a manner that supposes an actual or possible diminution of value below the guaranteed value. Interaction with Debt Modification Regulations Rule does not mesh with the debt modification regulations, which were promulgated after the section 597 regulations Active /22/2011

16 REIT Subsidiaries REIT Subsidiaries Old Entity might sell a captive REIT, which is not a consolidated subsidiary for purposes of the section 597 regulations, to Acquiring. Possible strategy is to purposely fail the REIT test (for example, through a redemption of preferred shareholders). The goal is cause the captive REIT to be a member of Old Entity s consolidated group. Unclear how Loss Guarantee payments should be treated when Acquiring receives payment. Possible application of the After Acquired Assets Rule. Unfavorable result would be that Loss Guarantee payments give rise to ordinary income to Acquiring, while REIT has capital loss from the nonpayment of its assets Active /22/2011

17 Instruments Issued to Agency Equity and Debt Interests Held by Agency Debt instruments, stock, warrants, or other rights to acquire stock of an Institution (or its affiliates) that Agency receives in connection with a transaction in which FFA is provided are not treated as debt, stock or other equity interests for any tax purpose while held by Agency. Effect on Basis The purchase price of assets will not include equity and debt interests received by Agency. Interest and Principal Payments on Debt Instruments If an Institution makes payments on of interest and principal, those payments will: First, reduce the amount of FFA includible in income and the Deferred FFA account to zero (unlikely to apply in acquisition). Next, increase purchase price (and basis). Both interest and principal payments are effectively capitalized while Agency holds an Institution s debt instruments. However, the purchase price would be allocated amongst remaining portfolio Active /22/2011

18 Instruments Issued to Agency Potential Mismatches Interest received on portfolio are includible in income and interest payments are capitalized. Sale proceeds allocated pro-rata to increase basis in remaining portfolio creating mismatch. Excess of basis over FMV of assets essentially becomes amortized goodwill. If dividend payments are made, such amounts create basis (and therefore are amortizable). Distortions compounded where Loss Guarantee is also in place (because taxpayer is not given basis credit for FDIC instrument and must include in income difference over LG amount). If equity in a partnership is issued, and Section 597 applies, 100% of income will be allocated to the taxpayer Active /22/2011

19 Instruments Issued to Agency Third Party Acquisition If Agency sells the Institution debt instruments to third party investors, the amount Agency receives in exchange for the debt instruments will be treated as their issue price. AHYDO generally inapplicable: Debt instruments are often zero-coupon, but are also often FDIC-guaranteed so the yield to maturity likely will not equal the AFR plus 5%. On the date of any transfer of the disregarded debt or equity instruments to third parties, the Institution is treated as having transferred to Agency an amount of money equal to that paid by the third party investors. Accordingly, the Institution will be entitled to an increase in purchase price (and basis) for such amount Active /22/2011

20 Joint Venture with FDIC Transaction Structure Pooled Asset Sale Where FDIC Retains Equity Interest FDIC, as receiver for a failed Institution, transfers a pool of the Institution s assets (such as real estate mortgages and stock in REO subsidiaries) to an LLC. In connection with the transfer, the LLC issues both equity and debt instruments to the FDIC. The debt issued to LLC takes the form of fixed maturity notes (the Notes ) and a revolving facility (the Revolver ). FDIC sells 40% of the LLC interests to a successful bidder (the Managing Member ), with the FDIC retaining a portion of the LLC interests. FDIC intends to sells the Notes issued by the LLC to third party investors and retain the Revolver, but may also retain the Notes Active /22/2011

21 Joint Venture with FDIC Issues Presented Taxable Mortgage Pool Status of JV Market Discount Application of Section 597 Use of a REIT? ECI/UBTI Portfolio Interest Rule Tax Distributions Active /22/2011

22 Taxable Mortgage Pool Consequences Treated as a corporation for all tax purposes. Cannot be part of a consolidated group. Requirements Substantially all at least 80% of the entity s assets are debt obligations; More than 50% of those obligations are real estate mortgages; The entity is the obligor on debt obligations with two or more maturities; and Payments on the debt obligations on which the entity is obligor bear a relationship to payments on the debt obligations that the entity holds as assets. Possible Out A safe harbor treats seriously impaired real estate mortgages (payments more than 59 days delinquent with no expectation of payment) as assets other than debt obligations. Stock in REO subsidiaries is also an asset other than a debt obligation. Public-Private Investment Program Exclusion: Rev. Proc excludes Public-Private Investment Funds through which Treasury co-invests in mortgage backed securities from TMP status. Exclusion only applies to funds that participate in the Public-Private Investment Program (and does not apply to an FDIC-assisted acquisition). FDIC Documentation FDIC documentation for LLC will characterize LLC as a partnership for tax purposes Active /22/2011

23 Market Discount Character Mismatch Mortgages will likely have market discount because of their distressed nature, which leads to character mismatch. Any gain will be ordinary income to the extent of accrued market discount. Any loss will generally be capital loss. Note: Character mismatch is not a problem in the whole bank acquisition (discussed above), because section 582(c) treats gains or losses on debt instruments as ordinary income to a bank. Distressed Debt Exception? Distressed nature of the mortgages could arguably make the market discount rules inapplicable Active /22/2011

24 Application of Section 597 Applicability of Section 597 Is Unclear Is LLC Treated as Acquiring? Regulations provide that Acquiring means a corporation that is a transferee in an actual Taxable Transfer. LLC is intended to be a partnership for tax purposes, so application of the section 597 regulations seems unclear. Institution receiving FFA? Regulations specify that an Institution must be either a bank or a domestic building and loan association. However, former institution is deemed to receive FFA in taxable acquisition Active /22/2011

25 Special Issues Difficult to Structure LLC as a REIT For purposes of 75% gross income test, interest from a mortgage covering both real and personal property must be apportioned based on the fair market value of the real property and the amount of the loan. Reg. Sec (c). Interest apportioned to the real property equals the fair market value of the real property over the amount of the loan. Testing date is the date at which the commitment to purchase the mortgage becomes binding. This rule results in an unfavorable apportionment when the value of the real property is depressed. 100% tax of dealer profits of a REIT will also be problematic. ECI/UBTI Issues LLC will be a flow-through entity and private equity funds must structure their investment to avoid ECI and UBTI. Portfolio Interest Rule Mortgages will likely be in unregistered form and so will not be eligible for the portfolio interest exception. Placing mortgages into a trust that issues registered certificates to LLC may be a possible solution. FDIC may not be comfortable with the trust arrangement. Tax Distributions LLC agreement offered by FDIC will likely not contemplate tax distributions to the Managing Member, and the FDIC is not flexible with respect to the documentation Active /22/2011