RE: Proposed Regulations under Internal Revenue Code Section 265(b)

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1 1120 Connecticut Avenue, NW Washington, DC BANKERS World-Class Solutions, Leadership & Advocacy Since 1875 Francisca Mordi Tax Counsel Director for ABA Center for Community Bank Tax Phone: Fax: The Honorable Eric Solomon Assistant Secretary, Tax Policy Department of the Treasury 1500 Pennsylvania Avenue Washington, D.C RE: Proposed Regulations under Internal Revenue Code Section 265(b) Dear Assistant Secretary Solomon: It has come to our attention that the Treasury Department is considering issuing proposed regulations 1 that would overturn the recent Tax Court decision in PSB Holdings, Inc. v. Commissioner. 2 The Court in PSB Holdings held that, in calculating the interest expense disallowance of a bank under Section 265(b), the (IRS) could not include the investments of a non-bank subsidiary. The American Bankers Association decided to write this letter prior to the issuance of any proposed regulations in order to make the Treasury aware of the banking industry s concerns, with the hope that the Treasury would be able to take these concerns appropriately into account as it worked on such proposed regulations. The American Bankers Association brings together banks of all sizes and charters into one association. ABA works to enhance the competitiveness of the nation s banking industry and strengthen America s economy and communities. Its members the majority of which are banks with less than $125 million in assets represent over 95 percent of the industry s $13.3 trillion in assets and employ more than two million men and women. We understand that the IRS believes regulations are needed to reverse PSB Holdings because, under the holding of the court in the case, a bank 3 is able to reduce its interest expense disallowance under Section 265(b) by moving tax-exempt 1 This was indicated by the addition of [g]uidance under sections 265 and 291 involving the treatment of bank and investment subsidiaries in the Department of the Treasury s First Periodic Update of the Priority Guidance Plan released on or about April 22, T.C. 15 (2007). 3 Section 265(b) applies to financial institutions, i.e., entities that accept deposits from the public. In this letter when we refer to financial institutions we intend that to include what is defined in the statute as banks.

2 investments (tax-exempts) to the bank s non-bank subsidiary. 4 This might be accomplished by either (i) making a capital contribution of the tax-exempts directly to the subsidiary, or (ii) making a capital contribution of cash to the subsidiary which would, in turn, purchase the tax-exempts. We understand that the IRS intends to provide a rule consolidating a bank and its non-bank subsidiaries for purposes of calculating the Section 265(b) formula. According to the IRS, the objective in drafting such a rule is to ensure that the policy behind Section 265(b) is complied with by taxpayers. The threshold questions of whether a consolidation rule is needed to address this issue and whether such a regulation would be valid without Congressional action is not the subject of this letter. Rather, we want to ensure that in crafting new rules to address the facts and holding in PSB Holdings, the IRS understands the scope of the problem and the intent of Congress in enacting Section 265(b). Purpose of Section 265(b) When reading the legislative history under Section 265(b), there is no doubt that Congress did not intend the provision to be a new special tax on banks, but intended to impose a more effective mechanism for calculating a bank s interest expense disallowance. This was achieved by supplementing the sufficient connection approach developed under Section 265(a)(2) with the allocation methodology provided for in Section 265(b). There is no question that, when Section 265(a)(2) was enacted, the IRS administered its provisions in a way that virtually exempted banks from its application ( i.e., banks were able to escape the interest disallowance rules of that section, unlike other types of businesses). The unequal treatment of banks compared to other taxpayers resulted in the enactment of Section 265(b), which was expressly intended to equalize the tax treatment of banks and non-banks. The Committee Report under Section 265 provides in relevant part as follows: The committee believes that the present law treatment of financial institutions for purposes of the interest disallowance rule should be changed for two reasons. First, the present law rules, by allowing financial institutions to deduct interest payments regardless of tax-exempt holdings, discriminate at the expense of other taxpayers. Second, the committee was concerned that financial institutions may drastically reduce their tax liability as a result of the present law rules. For example, under present conditions, a bank may totally eliminate its tax liabilities by investing one-third or less of its assets in tax-exempt obligations. To correct these problems, the committee bill denies financial institutions an interest deduction in direct proportion to their tax-exempt holdings. The 4 The non-bank subsidiary is not a financial institution e.g., it does not accept deposits from the public. 2

3 committee believes that this proportional disallowance rule is appropriate because of the difficulty of tracing funds within a financial institution and the near impossibility of assessing a financial institution s purpose in accepting particular deposits. The committee believes that the proportional disallowance rule will place financial institutions on approximately an equal footing with other taxpayers. 5 (Emphasis added.) Under current law, a non-bank is able to invest its earnings and profits and equity capital (i.e., non-borrowed funds) in tax-exempts and not be subject to an interest expense disallowance. This is the case as long as the funds used to purchase or carry the tax-exempt assets are not sufficiently connected to borrowed money. Proposed regulations issued under Section 265(a)(2) on May 7, 2004, re-emphasize that being able to trace funds from a borrowing to a purchase of tax-exempts is the dominant test for sufficient connection. The tracing rule governs whether the borrowing and purchase of tax-exempts take place within one entity or take place in different affiliated entities. In other words, a non-bank is able to invest in taxexempts without being subject to an interest expense disallowance as long as the funds used to make the investment are not traceable to, or otherwise sufficiently connected with, money that the company (or an affiliate) has borrowed. In contrast, when a bank invests in tax-exempts, because of the allocation methodology of Section 265(b), the bank is subject to an interest expense disallowance, even if it uses only non-borrowed funds to make the investments. This is because the allocation formula takes into account the bank s customer deposits and other borrowings even if these are not traceable to, or otherwise sufficiently connected with, the purchase or carry of tax-exempts. Therefore, the only way for a bank to invest in tax-exempts without suffering an interest expense disallowance is to earn the tax-exempt income in a subsidiary that is not subject to Section 265(b). If the non-bank subsidiary of a bank uses only its earnings and profits or capital to purchase or carry tax-exempts, then those tax-exempts will be neither sufficiently connected nor allocable to its own or an affiliated entity s debt. The practice of a non-bank subsidiary of a bank investing in tax-exempts does not run afoul of Section 265(a)(2) or (b), because if the non-bank subsidiary has no debt, it will not be claiming an interest expense deduction for money borrowed to purchase or carry tax-exempts. In fact, this non-consolidated application of Section 265(b) effectively puts a banking group on equal footing with non-banking groups. It should also be noted that since the earnings of the bank itself are still taxable, concerns regarding the elimination of the bank s tax liability as a result of investing in tax-exempt assets can never be realized. Any proposed regulations issued under Section 265(b) that consolidate a bank with its non-bank subsidiaries would mean that even a non-bank subsidiary that has independently earned income and has no debt would be unable to purchase or carry tax-exempt assets without causing its parent bank to suffer an interest expense 5 H.R. Rep. No. 426, 99 th Cong., 1 st Sess (1985). 3

4 disallowance. Such a rule would mean banks would no longer be on equal footing with other taxpayers as intended by Congress. In fact, new regulations requiring consolidation under Section 265(b) would put banks at a distinct disadvantage compared to non-banks. This is because an affiliated group that includes a bank would always have an interest expense disallowance under Section 265(b) resulting from the bank s business of taking deposits. In contrast, affiliated groups that do not include a bank could avoid an interest expense disallowance by ensuring that there is not the requisite connection between borrowings and the purchase or carry of tax-exempts that is required by Section 265(a)(2). The irony of issuing regulations requiring consolidation for banking groups is that such a rule would create the reverse problem Congress intended to correct in enacting Section 265(b). Before Section 265(b) was enacted, Congress viewed nonbanking groups to be disadvantaged compared to banks, and Section 265(b) was passed to level the playing field. New consolidating regulations would turn this situation on its head by continuing to benefit non-banks while unfairly placing banks in a disadvantageous position. In drafting regulations under Section 265(b), Treasury should consider Congress desire to maintain equality between banks and non-banks in the application of the interest expense disallowance rules relating to tax-exempts. This could be achieved by including an exception in any consolidation rule under Section 265(b) that would permit a banking group to purchase or carry tax-exempts if it does not use borrowed funds to do so. For example, tax-exempts held in a non-bank subsidiary could be excluded from consolidation with its bank parent, to the extent the tax-exempts do not exceed the non-bank subsidiary s retained earnings. This could be drafted in the form of a safe harbor. The effect of such a rule would be that the funds used to purchase the tax-exempts would not be connected to the bank s deposits or other borrowings; rather, they would be connected to the non-bank subsidiary s cumulative after tax income. It would also satisfy Congress intent to maintain equality between banking and non-banking groups, by allowing banks to purchase or carry tax-exempt assets with non borrowed funds (i.e., the non-bank subsidiary earnings) without suffering an interest expense disallowance in the same way that non-banking groups can. We would welcome the opportunity to discuss this with you further. Please feel free to contact me at or fmordi@aba.com. Sincerely, Francisca N. Mordi 4

5 cc: Stephen R. Larson Associate Chief Counsel Financial Institutions & Products 1111 Constitution Ave., NW Washington, DC Michael Novey Associate Tax Legislative Counsel Office of Tax Policy U.S. Treasury Department 1500 Pennsylvania Avenue, NW Washington, D.C Vincent J. Guiliano Senior Counsel Commercial & Foreign Banking Industry Counsel 33 Maiden Lane 12 th Floor New York, NY Sharon Galm Senior Technical Reviewer Financial Institutions & Products - Branch Constitution Ave., NW Washington, DC Jeffrey Kammerman Technical Advisor - Commercial Banking 110 West 44th Street - 6th Floor New York, NY