7th Circuit Reverses Tax Court in Vainisi –
Subchapter S and Q Sub Banks Following Notice 97-5 with Respect to Expenses Relating to Tax Exempt Income
Should Consider Filing Refund Claims
On March 17, 2010, the U.S. Court of Appeals, Seventh Circuit, reversed the U.S. Tax Court’s decision in Vainisi v. Commissioner, 132 T.C. No. 1 (2009), which held that a sub-S corporation that is a bank (or in this case a bank holding company that owned a bank that had made a qualified S subsidiary or “Q-sub” election) is required, under the provisions of Section 291 of the Internal Revenue Code of 1986, as amended, (the “Code”), to increase the amount of its taxable income by 20-percent of the amount of the bank’s interest expense that is considered attributable to certain qualified tax exempt-obligations that are owned by the sub-S bank, despite the plain language of Code Section 1363(b)(4), which provides that “section 291 shall apply if the S corporation (or any predecessor) was a C corporation for any of the 3 immediately preceding taxable years.” The bank in the Vainisi case had been a Q-sub for longer than 3 years.
On April 13, 2009, the Treasury Department published the standard agreements for Subchapter S institutions to participate in the TARP Capital Purchase Program. As previously discussed, the TARP Capital Purchase Program for Sub S institutions consists of a subordinated debt instrument paying interest at a rate of 7.7% per annum until the fifth anniversary, and then at 13.8% per annum, plus an immediately exercised warrant for additional subordinated debt equal to 5% of the investment, paying interest at a rate of 13.8% per annum. The investment has a 30 year term, and, like trust preferred securities, interest can be deferred for up to 20 consecutive quarterly periods.
Like the documents for public and private participants, the standard documents consist primarily of a letter agreement that incorporates the standard terms contained in a securities purchase agreement, as well as documents defining the investment instruments.
- Form of Letter Agreement
- Securities Purchase Agreement
- Form of Senior Subordinated Securities
- Form of Warrant Senior Subordinated Securities
- Form of Warrant
For some reason, the Securities Purchase Agreement defines the subordinated debt instrument to be the “Senior Notes,” presumably to be comparable to the “Senior Preferred” issued under the TARP Capital Purchase Program for public and private institutions. However, these “Senior Notes” are subordinated to virtually all other indebtedness, whether outstanding at the time of the investment or subsequently incurred. The TARP subordinated debt instruments are senior to any subordinated debt issued in connection with trust preferred securities.
The American Recovery and Reinvestment Act of 2009 (the “Act”) contained a number of tax provisions that are likely to be of particular interest to and will directly impact most, if not all, of our bank and other financial institution clients. One of the tax provisions, the provision increasing the period that a net operating loss (“NOL”) can be carried back from two (2) to up to five (5) years, saw the addition of a provision that will substantially limit the number of taxpayers eligible to take advantage of the expanded carryback period. The new limitation makes it likely that only smaller financial institutions will be able to take advantage of the expanded carryback period allowed by the Act. The Act also repealed (with limited transitional protection) the relief provided in Notice 2008-83 issued by the Internal Revenue Service (“IRS”) in the fall of 2008 that exempted certain losses on loans and foreclosure property incurred by banks from the NOL limitation rules applicable to built-in losses.
Increase in the Net Operating Loss Carryback Period
Original provisions coming out of the tax writing committees of the House and Senate included a provision extending the period in which 2008 and 2009 NOLs could be carried back from two (2) to up to five (5) years. The provision also eliminated the 90% limitation on the use of AMT NOLs that were carried back from 2008 or 2009. The limitations in the original provisions were that the expanded carryback period did not apply (i) if the bank or other financial institution received any money under the Troubled Assets Relief Program (TARP) (ii) to Fannie Mae, Freddie Mac, or (iii) any corporation that is a member of the same affiliated group for income tax purposes as a bank or other financial institution that received TARP funds.
The Act retains the expanded carryback period for NOLs, but only for those generated in 2008 (or, at the election of the taxpayer, taxable years beginning in 2008). Further, only taxapayers that are “eligible small businesses” may take advantage of the expanded carryback period. An “eligible small business” that elects may carryback a 2008 NOL for up to five (5) years. An eligible small business is a taxpayer having less than $15,000,000 in average annual gross receipts for the three (3) years prior to the year in which the NOL occurs. Thus, the usefulness to most financial institutions of the expanded NOL carryback provisions appears to have been severely limited by the change in eligibility requirements.
Repeal of IRS Notice 2008-83
The Act retains the provisions repealing IRS Notice 2008-83 originally included in the House bill and subsequently added to the Senate bill. An explanation of these provisions is set forth below.
As a reminder, the deadline for Subchapter S institutions to apply for the TARP Capital Purchase Program is Friday, February 13, 2009. (Review the terms for Subchapter S institutions.)
The application form is unchanged from the initial application, and is available from the Treasury or as a Word document. The Treasury has also confirmed that Subchapter S institutions that applied prior to the announcement of the terms for Subchapter S institutions do not need to re-apply.
While there is significant uncertainty over the application of TARP 2.0 rules to the TARP Capital Purchase program, with over 2,000 applications in the hands of the banking regulators, there is likely to be significantly more clarity to the program before an institution has to make a final decision on whether to accept TARP Capital. Filing an application by the deadline preserves the institution’s flexibility to make a final decision, while declining to make an application effectively constitutes an irrevocable decision not to participate. (See our big picture thoughts on whether to apply for TARP Capital.)
On January 14, 2009, the Treasury published a Term Sheet for S Corporations and a Frequently Asked Questions for S Corporations. In order to comply with the limitations on stock ownership for entities that elected to be taxed as S Corporations, the Treasury is planning to use subordinated debt as the investment vehicle.
The subordinated debt will pay interest at a rate of 7.7% per annum until the fifth anniversary, and then pay at a rate of 13.8% per annum. This equates to after-tax effective rates of 5% and 9%, the same rates applied to public and private C corporations under the TARP Capital program. Bank holding companies can defer interest for up to 20 quarters.
Like it did for private and public companies, the Treasury plans for the Federal Reserve to issue a special rule to permit the vehicle be treated as Tier 1 Capital for bank holding companies. Stand-alone banks will only be able to treat the subordinated debt as Tier 2 capital (and only to the extent that all subordinated debt does not exceed 50% of Tier 1).
The subordinated debt will have a maturity of 30 years, and cannot be redeemed within the first three years unless a “Qualified Securities Offering” raises at least 25% of the amount of the investment. All redemptions are subject to regulatory approval, and are at 100% of the issue price (plus any accrued and unpaid interest).
On January 13, 2009, Treasury Assistant Secretary Kashkari announced that the Treasury has completed a term sheet for Subchapter S corporations to participate in the TARP Capital Purchase Program. He stated that the term sheet for Subchapter S corporations will be posted on the Treasury website on Wednesday, January 14, 2009. The application period is expected to open at that time and remain open for 30 days.
Informed sources tell us that Treasury officials met with the federal banking agencies on January 5, 2009 and re-confirmed that:
- there are sufficient TARP Capital funds available to fulfill the needs of all eligible public, private and Subchapter S institutions; and
- Treasury is fully committed to completing the TARP Capital program for all eligible public, private, and Subchapter S institutions.
While no term sheet has been released for Subchapter S institutions, we continue to receive assurances that S Corp TARP Capital funding is on the way.
We spoke with an official with the Federal Reserve Bank of Atlanta official yesterday who informed us that:
- Non-exchange-listed public companies are being considered “private companies” or as “not publicly traded” by the Treasury Department; and
- While the federal banking regulators will continue to review applications by private companies at this time, they have been instructed not to forward such applications to the Treasury Department until further guidance is published by the Treasury Department.