A recent decision by the United States Tax Court gives rise to a favorable planning opportunity for financial institutions and their affiliates that own tax-exempt bonds. The decision in PSB Holdings, Inc. v. Commissioner limits Section 265(b) of the Internal Revenue Code, under which financial institutions are penalized for owning tax-exempt bonds. For bonds other than "bank qualified" bonds, the penalty arises from the operation of Section 265(b), which does not permit a financial institution to deduct any portion of the financial institution's interest expense attributable to ownership of non-bank qualified tax-exempt debt. The portion disallowed is the portion of interest the financial institution pays on its indebtedness, based on the ratio of the financial institution's tax basis for its tax-exempt bonds to its total tax basis for all of its assets. This means that the more non-bank qualified bonds held by a financial institution, the greater the penalty.
"Bank qualified" bonds do not get counted in the calculation under Section 265(b). These are governmental bonds or 501(c)(3) bonds issued by an entity that issues less than $10 million of such bonds in any calendar year. The penalty for owning "bank qualified" bonds is reduced to only a 20 percent disallowance of the deduction for interest on the debt attributable to owning such bonds. Because the designation for "bank qualified" bonds is very narrow, most bonds do not fit within the definition. The result has been that historically Section 265(b) has acted as a significant barrier to financial institutions owning tax-exempt bonds.
In PSB Holdings, Inc. v. Commissioner, Peoples State Bank was successful in convincing the U.S. Tax Court that Section 265(b) does not require tax-exempt bonds held by affiliates of the financial institution to be aggregated with the tax-exempt bonds held by the financial institution itself for the purpose of calculating the Section 265(b) interest expense disallowance. Peoples State Bank successfully argued that even though the bank's parent filed a consolidated return for the parent's wholly owned bank subsidiary and the parent's wholly owned investment company subsidiary, the investment company's tax-exempt bond holdings were not relevant for purposes of calculating the Section 265(b) interest expense disallowance at least where the investment company's tax-exempt holdings were purchased directly from the governmental issuer and were not transferred to the investment company by the affiliated bank. Because the bank and the investment company were two separate and distinct corporations and the language of Section 265(b) of the Code does not explicitly state that a financial institution must aggregate all tax-exempt bonds held by it with its affiliated entities, the Tax Court ruled that the financial institution in question was permitted to look only to its own holdings of tax-exempt bonds. It did not have to aggregate those holdings with the tax-exempt holdings of its affiliates for the purpose of making the Section 265(b) calculation where those holdings were directly obtained from the governmental issuers and were not transferred from the bank.
Obviously, this is a favorable decision for financial institutions. The effect of the decision is to permit an affiliated investment company to acquire tax-exempt obligations directly from the issuer without subjecting a related financial institution itself to Section 265(b) penalties. The case does not decide whether tax-exempt obligations can be transferred to an affiliated investment company from a related bank and be accorded similar treatment. In fact, the Court expressly declined the opportunity to rule that any tax-exempt obligation owned by the investment subsidiary could be excluded from the calculation. The case suggests that the tax-exempt holdings of an investment company may need to be aggregated with those of its affiliated bank where the investment company acquired the tax-exempt obligations from its affiliate bank unless the bank can demonstrate that the transfer took place for reasons other than tax avoidance. From a planning perspective, it makes sense to plan for an investment subsidiary to purchase tax-exempt obligations directly from the governmental entity to avoid the Section 265(b) penalty that might otherwise be imposed on a related bank. As a consequence of the decision, there is likely to be an increase in the appetite of investment companies affiliated with financial institutions in owning tax-exempt debt since the penalty of Section 265(b) can be easily avoided with a little pre-planning.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.