In anticipation of the removal of federal restrictions on interstate banking this summer, banks are busy carrying out the corporate realignments necessary to establish a multistate branch network.

While bank chief financial officers typically consider the federal tax consequences of these reorganizations, they all too often ignore the state tax picture.

The potential state tax effects of interstate branch banking can be significant. State taxes can, however, often be minimized or avoided through thoughtful state tax planning.

Planning opportunities arise because state bank tax systems are not uniform; they differ from one another in material respects and thus can cause tax gaps or overlaps in the aggregate state tax burden of multistate financial institutions.

By locating assets and operations in states having the most favorable tax systems, banks can realize significant tax savings.

State franchise tax systems differ in four primary respects:

The rate of tax imposed.

The definition of values subject to tax or tax base.

The manner of determining the portion of the tax base locally taxed.

The return-filing requirements applicable to affiliated banking groups.

State tax rates differ greatly. At one extreme, certain states, such as Nevada, do not impose a franchise or corporation income tax at all. Their effective tax rate is zero. At the other end of the spectrum, a bank with operations in New York City pays tax to the city and state at a combined rate in excess of 20%.

States impose their rates with reference to differing measures or tax bases.

They usually start with a nationwide base and then determine a portion of that tax base that can fairly be taxed at the local level.

The starting tax base used in most states is federal taxable income, which individual states then add to or subtract from by varying amounts. For example some states exclude interest on federal obligations from the tax base, while others do not. Some states also have exclusions from the tax base associated with tax incentives, such as the exclusion of interest on loans to enterprise-zone borrowers. Establishment of operations in states with such incentives may result in a reduction of the taxpayer's effective tax rate.

As I mentioned, states generally tax only a portion of a bank's nationwide tax base. That portion is determined under an apportionment formula designed to reflect the local activity of the bank. The particular apportionment factors applied may differ.

Usually, the formula reflects the ratio of the taxpayer's in-state property, payroll, and sales to its nationwide property, payroll, and sales. Some states however, such as Illinois, apply a single-factor sales formula. New York substitutes a deposits factor for a property factor.

Moreover, even under the standard three-factor approach, states may differ in the relative weight accorded each factor. It is increasingly common, for example, for a state to double-weight the sales factor as with a single factor sales formula. This generally increases the tax liabilities of banks headquartered out of state, while favoring local banks.

The apportionment factors may also differ with regard to the type of values they include. For example, some states include intangibles in the property factor, while others do not. The exclusion of a bank's intangibles from the property factor ignores loans, obviously an important element of a bank's income-earning assets.

A bank can often take advantage of this difference by transferring loans from a state that includes loans in the property factor to a state which does not. Other things being equal, this will reduce the bank's taxes in the former state by more than the increase in taxes in the latter state.

States also differ in their determination of where property or receipts are geographically assigned for apportionment factor purposes.

Thus, interest on a loan can be treated as located where the borrower resides, where the lending institution is located, or where the loan is serviced. Because of these differences, a bank can find that its interest is effectively taxed by more than one state - or not taxed at all, depending upon circumstances.

Finally, state tax systems have different return filing requirements that can influence the tax consequences of interstate branching and asset transfers. Some states tax affiliated corporations on a separate-company basis; others require all affiliates be included in a single combined report.

This distinction can be critical. In separate-return states, an asset transfer among affiliates may generate taxable gain. In combined-reporting states, however, no gain is generally recognized, because intercompany transfers among affiliates included in a combined report are usually disregarded.

The conversion from a multicorporate banking configuration to a single interstate branch bank improves the bank's ability to move assets and operations between states to take advantage of these disparate state tax systems. On the other hand, first-time taxability of out-of-state operations conducted by formerly separate corporations in separate-return states can result.

If the bank converts to a branch system, these out-of-state values will be included in the tax return for the first time. It should be noted, however, that their inclusion will not necessarily result in a tax increase, because the new branch bank is taxed only on an apportioned basis. Thus, while its income will be included in the tax base for the first time, its out-of-state property, payroll, and sales will inflate the denominator but not the numerator of the respective apportionment factors.

The state tax consequences of a conversion to a branch configuration must therefore be assessed on a case-by-case basis.

It should be apparent that a thorough review of state tax issues is critical to a comprehensive analysis of the benefits associated with a conversion from multicorporate banking to branch banking configurations. Also, the state tax alternatives should be analyzed in advance of any restructuring, in order to make a timely assessment of the tax ramifications associated with the transfer of assets and operations to various locations.

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