U.S. forfeiting billions in future taxes to let Citi repay TARP

The Washington Post is reporting that the federal government has quietly decided to exempt Citigroup from a large future tax bill in allowing it to exit the TARP program.  This is a backdoor bailout worth billions and is an outrage that demonstrates the lengths to which government will go to gift these organizations taxpayer money.

At issue is accounting for loss carry-forwards. Basically, it works like this: if a company loses money in one year, the company can then offset its profit during a fixed number of subsequent years with that prior loss to reduce its tax bill. For instance, if Megacorp loses $100 million in year 0, but makes $200 million in Year 1, it can pay Year 1 taxes as if it had only made $100 million.  This tax treatment is designed to level the playing field for cyclical companies that operate at a loss for part of the business cycle.

The problem, however, is that this can be used by predators in mergers. The predator company can swoop in and buy a company in a deal that makes no sense except to gain a tax benefit from the huge net operating losses (NOLs) it inherits from its prey.  In order to prevent tax-motivated acquisitions of loss-making companies, the IRS limits how much of the NOLs a company can use post-merger. In Canada, unclaimed NOLs expire immediately when change of control occurs.

During the credit crisis, the Bush Administration relaxed these rules. Initially Treasury Secretary Hank Paulson benefitted Fannie Mae and Freddie Mac under IRS Issue Notice 2008-76 (link below) when they were taken into conservatorship. (See Yves Smith’s post here.) Treasury then rewrote tax law to include banks under IRS Issue Notice 2008-83 (link below). For example, Wells Fargo was exempted from a change of control NOL loss when it acquired Wachovia. I assume the same was true in all the bank mergers after Lehman failed. The rationale for the exemption was that tax law needed to make accommodation as it was only designed to prevent the kind of predatory acquisition I mentioned earlier. 

But the law is the law and it applies to everyone.  Exemptions under this law are a huge hidden freebie. In November of last year the Washington Post quoted the number $140 billion as the windfall for banks.

The financial world was fixated on Capitol Hill as Congress battled over the Bush administration’s request for a $700 billion bailout of the banking industry. In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention.

But corporate tax lawyers quickly realized the enormous implications of the document: Administration officials had just given American banks a windfall of as much as $140 billion.

The sweeping change to two decades of tax policy escaped the notice of lawmakers for several days, as they remained consumed with the controversial bailout bill. When they found out, some legislators were furious. Some congressional staff members have privately concluded that the notice was illegal. But they have worried that saying so publicly could unravel several recent bank mergers made possible by the change and send the economy into an even deeper tailspin.

"Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no," said George K. Yin, the former chief of staff of the Joint Committee on Taxation, the nonpartisan congressional authority on taxes. "They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks."

The story of the obscure provision underscores what critics in Congress, academia and the legal profession warn are the dangers of the broad authority being exercised by Treasury Secretary Henry M. Paulson Jr. in addressing the financial crisis. Lawmakers are now looking at whether the new notice was introduced to benefit specific banks, as well as whether it inappropriately accelerated bank takeovers.

Senator Chuck Grassley questioned whether Wells Fargo and Wachovia had received “preferential treatment” because Wachovia CEO Robert Steel was a former Undersecretary for Domestic Finance in the Bush Administration and a vice chairman at Goldman Sachs (see press release below). In fact, as Paulson consulted no one on the tax-writing committees before promulgating these edicts, Congress inserted language into the Stimulus Bill earlier this year in order to shut down the executive branch’s ability to create these exemptions, specifically repealing IRS Notice 2008-83. I should re-iterate that the provision repealing Notice 2008-83 was added specifically to prevent the executive branch from acting outside of its authority in interpreting tax law.

The House draft version says:

SEC. 1431. CLARIFICATION OF REGULATIONS RELATED TO LIMITATIONS ON CERTAIN BUILT-IN LOSSES FOLLOWING AN OWNERSHIP CHANGE.

(a) FINDINGS.—Congress finds as follows:

• (1) The delegation of authority to the Secretary of the Treasury under section 382(m) of the Internal Revenue Code of 1986 does not authorize the Secretary to provide exemptions or special rules that are restricted to particular industries or classes of taxpayers.
• (2) Internal Revenue Service Notice 2008–83 is inconsistent with the congressional intent in enacting such section 382(m).
• (3) The legal authority to prescribe Internal Revenue Service Notice 2008–83 is doubtful.
• (4) However, as taxpayers should generally be able to rely on guidance issued by the Secretary of the Treasury legislation is necessary to clarify the force and effect of Internal Revenue Service Notice 2008–83 and restore the proper application under the Internal Revenue Code of 1986 of the limitation on built-in losses following an ownership change of a bank.

Yet here we are again with Citigroup receiving an exemption. I broached about Citi last month when I asked How is Citi going to deal with $38 billion in deferred tax assets?  My question at the time was whether Citigroup when make enough money to use these loss carry-forwards. If not, they would need to take a writedown. 

However, the issue with the government concerns accounting for change of control in a merger. The government’s 34 percent stake in Citi is enough to count as a change of control under tax law in the event of sale.  A sale of that stake by the government should reduce the $38 billion in deferred tax assets that Citigroup has on its balance sheet, meaning they should have to write this down immediately. But, apparently they are being gifted taxpayer money as Secretary Geithner and the IRS have exempted Citi. Now in all fairness, the concept that Citi should pay more taxes to the government as a result of that very government selling a controlling interest is a bit twisted.

Nevertheless, Robert Willens, my tax professor from my business school days, is apoplectic. The Post quotes him saying:

The government is consciously forfeiting future tax revenues. It’s another form of assistance, maybe not as obvious as direct assistance but certainly another form… I’ve been doing taxes for almost 40 years, and I’ve never seen anything like this, where the IRS and Treasury acted unilaterally on so many fronts.

As you would expect, this revelation has turned partisan. The Post says:

A Democratic aide to the Senate Finance Committee, which oversees federal tax policy, said the Obama administration had the legal authority to issue the new exception, but Republican aides to the committee said they were reviewing the issue.

A senior Republican staffer also questioned the government’s rationale. "You’re manipulating tax rules so that the market value of the stock is higher than it would be under current law," said the aide, speaking on the condition of anonymity. "It inflates the returns that they’re showing from TARP and that looks good for them."

Treasury is defending this decision by saying this is not a ‘new’ exemption, but one that applies to the aid guidelines that financial institutions received when TARP was first formulated.  I thought those provisions were repealed in the stimulus bill.

Experts calculate this decision will cost the treasury several billion dollars. Personally, I am astounded that the handouts keep coming.

Sources

• U.S. gave up billions in tax money in deal for Citigroup’s bailout repayment – Washington Post
• Application of Section 382 in the Case of Certain Acquisitions Made Pursuant to the Housing and Economic Recovery Act of 2008 – IRS (pdf)
• Notice 2008-83: Application of Section 382(h) to Banks – IRS (pdf)
• Grassley Seeks Inspector General Review of Treasury Bank Merger Move – Senate Press Release, 14 Nov 2008 (pdf)
• H.R.1: 111th Congress, 1st session – U.S. House of Representatives (pdf)