The CU Tax EXEMPTION examined

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Few financial issues raise the emotional thermostat as high as credit union taxation.

For many credit unionists the federal tax exemption on income is clear-cut-if lost, credit unions face a dark future and will cease to exist in their current state. For bankers and others in the for-profit financial services industry, the tax exemption is an unfair advantage for a competitor that is using it to expand and is evolving into a powerhouse. For Congress and the White House, which mostly support the exemption, it is an issue that they wish would simply go away; there is no political capital to be accrued by joining the battle.

While the credit union story of the early 20th century is well-known to readers and need not be repeated in its entirety, a brief visit provides a backdrop to the taxation journey. Savings and loan associations, credit unions and mutual banks were formed during that era to provide working and trades people access to savings and credit services. Each of the three types of organizations viewed their mission differently. Savings and loan associations focused on mortgages; mutual banks centered on savings, and credit unions offered loans as an alternative to moneylenders.

Myths & The Moneylender

The image of the moneylender-with equal doses of myth and reality-has been used to justify the tax exemption for credit unions. It is true that usurious rates of interest have burdened, even financially ruined, citizens since the founding of the republic. Indeed, Europeans fled debtors' prisons to make a new start in America.

What is also true is that the various mutations of money lenders-loan sharks, pawn shops and today's payday lender-all serve a purpose. That purpose, of course, is quick and convenient cash when needed. If other forms of credit are unavailable to fund your sick child's care, for instance, a moneylender can be a godsend. The reality is that when traditional sources of credit-including banks and credits unions-are closed to a consumer faced with an emergency, the moneylender serves a purpose.

Let's jump ahead 100 years, but only for a moment. The need for quick and convenient credit in an emergency or other urgent need is still evident today. Some credit unions are finally getting the message that a payday lending alternative is a good business model when offered with fair rates and safeguards to protect members. And the existence of credit unions in a community serves to reform financial markets by driving down loan rates by other financial institutions.

Credit unions interviewed for a December 2005 white paper by the National Association of Community Credit Unions, "Credit Union Payday Loan Alternatives," reported that when credit unions offered a payday loan alternative, the payday loan shops in the community lowered their rates. Offering payday loan alternatives is being used to justify the tax exemption.

"The combination of sharing risk and seeking education for frequent users of payday loans may help our credit unions become a powerful force for helping people avoid high- cost lenders," said Doug Fecher, CEO of the $1.1-billion Wright-Patt Credit Union in Dayton, Ohio. "We're not trying to make money, necessarily, because we see this as a responsibility in exchange for our tax exemption."

But, let's return to the early 1900s. While moneylenders offered usurious rates during that time, commercial banks served high-income people and were unwilling to offer financial services to working people. Banks and other traditional financial institutions simply viewed working people and others of modest means as unprofitable.

Credit unions and other mutual associations-which are cooperatives owned by members-were not charities and for the most part didn't serve the poor. This is true today; there are credit unions that do an able job of serving low-income members, but for the most part credit unions don't serve people at poverty levels; the majority of members tend to be low- and middle-income.

Early Justification

When St. Mary's Bank was chartered in 1909, there were no tax laws for credit unions on the books. The ratification of the 16th Amendment to the Constitution in 1913 established the foundation for the income tax. The Revenue Acts of 1913 and 1916 exempted savings and loans, cooperative banks and mutual banks. The justification for the tax exemption was the structure of a mutual financial institution; they were not-for-profit, advocated self-help for members and attempted to fill a need in the financial market unmet by existing financial institutions, according to Taxation of Credit Unions, by Albert Burger and Gregory Lypny, published by Filene Research Institute in 1991.

Even though credit unions had a similar mission as the other mutual financial institutions, they didn't receive a tax exemption until a few years later. At that time, a 1916 statute provided federal tax exemption for "cooperative banks without capital stock organized and operated for mutual purposes and without profit." In 1917, an opinion memorandum from the Office of the Attorney General interpreted this phrase to include credit unions.

The federal credit union charter was created by Congress in 1934. Before the charter, 34 states passed credit union acts.

Challenges to the tax exemption have played out in the courts, Congress and state legislatures throughout credit union history, and the courts have upheld the tax exemption in most cases. The 1988 Sixth Circuit Court of Appeals ruling in United States v State of Michigan upheld the concept of instrumentality and ruled that credit unions adding additional services have no bearing on the tax exemption.

"... because federal credit unions have added other financial services to attract members and remain competitive with other types of financial institutions does not undermine the central fact: federal credit unions were designed and continue to perform important government functions."

As instrumentalities of the government, federal credit unions are subject to federal unemployment and social security taxes, but are exempt from unrelated business income tax (UBIT). State-chartered credit unions are subject to the federal unemployment and social security taxes, but are not exempt from UBIT.

The UBIT status is still being sorted out today by the IRS. UBIT is a tax on "income derived by a tax-exempt entity from a trade or business that is regularly carried on and that is not substantially related to the exercise or performance of the purpose or function constituting the basis for the entity's exemption," said Steven Miller, IRS Commissioner, Tax-Exempt and Government Entities Division, in his testimony before the House Ways and Means Committee, Nov. 3, 2005

What will eventually be interpreted to fall under the UBIT is a source of some conjecture in industry circles. A hint of what might be taxed is provided in Miller's testimony when he said the IRS is "working to determine which of these activities have a substantial relationship to the purposes and function of state credit unions involved, and whether amounts derived from such activities are taxable."

According to Miller, the income derived from the following state-chartered credit union activities is being examined: optional life insurance and credit disability insurance to members who obtain loans from the organization; guaranteed auto protection insurance; automobile warranties; cancer insurance; accidental death and dismemberment insurance; ATM fees charged to non-members; health or dental insurance; marketing of mutual funds to members; marketing of other insurance and financial products.

The attorney general's opinion served as the basis for the state-chartered exemption until the Revenue Act of 1951. The act gave tax-exempt status to state-chartered and federally chartered credit unions. The act also repealed the exempt status of savings and loans, mutual savings banks and cooperative banks. Importantly, the tax code doesn't define credit unions-that's the job of the NCUA.

"There is no definition of what constitutes a credit union in the Internal Revenue Code," said Miller. "The IRS looks to the National Credit Union Administration, which administers the Federal Credit Union Act, to identify credit unions, and to applicable state law to identify state credit unions."

State Charters & Taxes

The IRS will determine what UBIT taxes, if any, will be levied on state-chartered credit unions. Federal credit unions do not pay income taxes; state-chartered credit unions are exempt, with some exceptions, from income taxes.

Forty-seven states and Puerto Rico allow state charters for credit unions. Three states allow federal charters only-Wyoming, South Dakota and Delaware. Three states-Florida, Missouri and Montana-have a franchise tax for state-chartered credit unions; Indiana levies an income tax on credit unions, according to the Profile of State Supervisory Agencies, 2003-2004, published by The National Association of State Credit Union Supervisors. A franchise tax is levied by a government authority for the right to do business.

Australia-Before And After

Australian credit unions are unique because they were taxed, gained a tax exemption, and then were taxed again. It can serve as a "before" and "after" case study. But like the "before" and "after" weight-loss photographs, appearances can be misleading. The tax codes and interpretations of taxable income, for example, differ significantly from the United States. Lessons can be drawn, but a tightly drawn comparison should be avoided. Filene Research Institute is conducting research on Australian taxation of credit unions and its implications for American credit unions that is slated to be available later in 2006.

Until 1973, credit unions were taxed on the same basis as other financial institutions. Credit unions tried and failed to gain a tax exemption under the "mutuality principle," which is a common law principle that exempts from income tax surpluses from mutually owned organizations. The principle holds that funds that are internally produced by mutual organizations shouldn't be taxed.

Australians lobbied the government and received a partial tax exemption in 1973 that applied to loan repayment income and for credit unions that met the government's criteria. The exemption lasted about 20 years and a formula was developed during that time that had the practical effect of exempting an estimated $1 billion in profits, "all of which was capitalized making credit union balance sheets look extremely healthy," said Paul Borg, former CFO of the Credit Union Services Corporation Australia, Ltd., in a speech to the World Council of Credit Unions International Credit Union Forum in Nashville, Tennessee in 2003.

The tax exemption was repealed for three reasons, according to Borg:

* Size of revenue lost to the government.

* Political opposition from banks, finance companies and building societies.

* Governmental policy shifts as a result of a federal government review study that recommended the removal of public subsidies to both public and private enterprises and competitive neutrality.

The Australian movement defended the tax exemption as a means for credit unions to grow and compete and that the effect of the tax would limit capital formation. The movement also argued that banks were increasing fees and closing branches; credit unions were an alternative.

The capital formation argument gains purchase among American credit unions proposing to convert to bank charters during the past few years. These credit unions point to regulatory limitations on capital, especially limiting their business lending, as the reason for converting. Critics of conversions to bank charters say the real reason is enrichment of a small number of individuals.

"I've never seen the members of the cooperative say, let's demutualize," said Paul Hazen, CEO of the National Cooperative Business Association. "It is more top down and enriching a few members."

A Different, Down Under View

After the Australian tax exemption was repealed in 1994, "it's arguable that we won the longer-term competitive war," said Borg. "Once credit unions began, as the Treasurer put it, 'to pay their way like other citizens,' other doors began to open. The commonwealth took us much more seriously than before... we had earned the right to be heard."

After the repeal, Borg said that the government accepted the movement's arguments on checking, bankruptcy and especially their case for non-discriminatory legislation. A key result and one that may resonate with American credit unions is that credit unions are no longer "torn between whether to put a public policy forward or to keep quiet about it because we are afraid of the consequences for our tax-exempt status."

The most significant impact was the effect on capital formation and credit union growth prospects, said Borg. "One thing is mathematically certain: unless new forms of capital are found, movement asset growth at a rate higher than the rate of growth in a generating post-tax surplus will erode the present capital position of the movement."

The Australian government allows risk-based capital under the Basel Accord and allows subordinated debt for credit union capital formation, according to David Grace, senior manager, association services, the World Council of Credit Unions.

Taxation in Canada

Despite Alphonse Desjardins' early efforts in Quebec, credit unions were taxed. There are two distinct credit cooperative systems in Canada, the caisse populaires, which are, for the most part, located in the province of Quebec, and credit unions which are found throughout Canada. The caisse populaire experience is the envy of the international movement-more than 70% of Quebecois are members. Both systems are governed by provincial law, which varies from province to province.

Credit unions in Canada had a tax-exempt status until 1972. The movement argued successfully that economic gains by cooperatives were savings by members and not profits. The Canadian government agreed with this argument and banks didn't view them as competitive threats. Once credit unions grew and expanded their services and products, the arguments were questioned. In 1972, the Income Tax Act removed the tax exemption,

Most credit unions were subject to provincial taxes and income taxes. Credit unions were allowed a deduction for some reserves and member dividends. They were also given an additional deduction, which is similar to a small business deduction on income. The net result of this deduction is that most credit unions are taxed at about the small business rate, which is one half of the rate of chartered banks, according to Taxation of Credit Unions. Similar to the Australian experience, a result of taxation was a weakening of capital structure.

"The main impact of taxing Canadian credit unions was that the cap on additions to reserves caused credit unions to trade off previously higher capital for a lower member tax bill," wrote Burger and Lypny. "Balance sheets are riskier, income has declined, and credit unions are larger."

International Movement Taxation

The World Council of Credit Unions conducted an 81-member country survey of the income tax status for the past several years. According to the survey, some 66% of the countries are tax exempt. The impact of the taxed countries is mixed, but similar to the experience in Australia and Canada in some areas.

"When credit unions are taxed, employees start to lose their understanding of the differences; they take on a different mindset," said David Grace of the World Council. "Tax exemption is not what defines a credit union; member service instead of profit maximization is what defines a credit union."

Grace said that in Australia and Canada consolidation is much greater than in the United States. Margins are squeezed more in both countries as well. A credit union CEO in Australia told Grace that it had a 0.78 return on assets; they would have a 1.0% ROA if they had maintained the tax exemption.

"The issue is not one of U.S. credit unions paying taxes; the issue is what would be the impact on the economy," said Grace. "If credit unions become taxed there would be more demutualization, more mergers, less consumer choice and limited access to financial service."

According to Grace there is a lesson that the United States can take from countries that lost their credit union tax exemption.

"Credit unions were resting on their laurels because of the success of their political advocacy," said Grace. "They didn't think the banks would notice that they were growing. The politically astute countries, like Ireland and Poland, are very cognizant of the need for their political advocacy."

The United Nations recognized the role of credit unions and cooperatives in a January 2006 report, "Building Inclusive Financial Sectors for Development," which emphasized that access to a well-functioning financial system can "economically and socially empower individuals, in particular poor people, allowing them to better integrate into the economy of their countries, actively contribute to their development and protect themselves against economic shocks. Creation and expansion of financial services targeted to poor and low-income populations can play a vital role in enhancing financial access."

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