The Mother of All Tax Breaks
by Charles Lemos, Tue Dec 15, 2009 at 11:35:49 PM EST
The Washington Post is reporting that the Internal Revenue Service granted an exemption late last week allowing Citigroup, the nation's third largest bank, to preserve a $38 billion tax benefit that Citibank would have forfeited if it repaid the money it had borrowed via the Troubled Asset Relief Program (TARP) back to the US Treasury. The decision essentially waives a longstanding rule that disqualified certain tax breaks if a significant ownership stake changed hands in an effort to discourage outside investors from buying tax benefits.
The Internal Revenue Service on Friday issued an exception to long-standing tax rules for the benefit of Citigroup and a few other companies partially owned by the government. As a result, Citigroup will be allowed to retain billions of dollars worth of tax breaks that otherwise would decline in value when the government sells its stake to private investors.
While the Obama administration has said taxpayers are likely to profit from the sale of the Citigroup shares, accounting experts said the lost tax revenue could easily outstrip those profits.
The IRS, an arm of the Treasury Department, has changed a number of rules during the financial crisis to reduce the tax burden on financial firms. The rule changed Friday also was altered last fall by the Bush administration to encourage mergers, letting Wells Fargo cut billions of dollars from its tax bill by buying the ailing Wachovia.
"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," said Robert Willens, an expert on tax accounting who runs a firm of the same name. "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."
It's effectively a subsidy though perhaps unavoidable in order to unwind the Treasury Department's one-third ownership of Citigroup. The US Treasury Department plans to begin selling its shares that it received as part of the TARP loan along with the Citibank's planned $17 billion follow-on stock offering. Such an ownership change would have required a forfeiture of these tax breaks. While the value of US Treasury held shares are likely to appreciate, only 34 percent of that benefit accrues to the government. The rest will benefit Citibank shareholders. Still no matter which way you slice it, it is a $38 billion dollar hit to the Treasury Department.
Edward Harrison of Credit Writedowns defines the issue:
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 (pdf.) 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 (pdf.). 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.
Furthermore as the New York Times notes the "ruling raises questions about whether federal officials moved too quickly to allow Citigroup to begin untangling itself from the government, given its fragile health. " Additionally given the political climate, the deal is likely to draw sharp criticism even as if the sweeping changes to two decades of tax policy were initially and quietly effected under Hank Paulson and the Bush Treasury Department. The decision will provide ammunition to those who argue that Obama is just like Bush.