There is no telling how long the Internal Revenue Service will keep in place a new tax change aimed at encouraging bank acquisitions, so banking lawyers are advising their clients to hurry up and deal.
The change, which allows buyers to shelter their own earnings from taxes using an acquired bank's losses, is already considered to have played a role in one big deal — Wells Fargo & Co.'s agreement to buy Wachovia Corp. for $15.1 billion — and many industry watchers say they expect it to spur much more consolidation.
Some even suggest that it could effectively mute the impact of new accounting rules that bankers had said would discourage them from doing deals.
"We think this is massively significant," Neal J. Curtin, co-head of the financial institutions and regulatory practice at the law firm Bingham McCutchen LLP, said of the tax change. "It makes an acquisition of a company with questionable assets a much more attractive proposition."
Before the IRS issued its notice Sept. 30, the built-in loss a buyer could use to offset future income after an acquisition was capped at 5% of the purchase price a year for a five-year period. That limit has been removed for banks, thrifts, industrial loan companies, and trust companies, meaning strong institutions have more of an incentive to buy weaker ones, said Jeffery Harte, an analyst at Sandler O'Neill & Partners LP.
The great unknown is whether the IRS means for the change to be temporary or permanent. There is also the possibility that Congress could intervene. Some lawmakers have questioned whether the Treasury can make such a change and expressed concern that the government could lose billions of dollars in taxes.
The notice from the IRS — quietly issued the day after the House initially rejected President Bush's $700 billion economic rescue plan — had no effective date and no expiration date.
The notice said that it could be relied upon "unless and until" additional guidance is issued, which lawyers say leaves open the possibility that this tax benefit could be modified or reversed later. (When contacted Friday, Treasury would only repeat the wording in the notice, with no further elaboration.)
In a commentary to help explain the notice to its clients, the law firm Jones Day said it would expect any future changes to apply on a prospective basis only. But given that a bank acquisition normally takes three to six months to get regulatory approval, it urged those that want to take advantage of this tax benefit to "accelerate" their plans.
Jones Day estimates that the industry could save up to $140 billion in taxes just on bad housing loans.
Any losses in loan portfolios and investment securities in an acquired bank would count toward tax savings for a buyer, as long as it is making a profit itself.
Jones Day also said that the notice appears to apply even to transactions that have already taken place, meaning that buyers with eligible losses could get a tax refund for at least the past few years.
Most observers agree that the tax break helped Wells to outbid Citigroup Inc. for Wachovia, but it remains to be seen how it might affect consolidation among smaller banks.
Some bankers say the tax break would not be enough to encourage a healthy community bank to buy a troubled one.
"In the community bank space you typically don't see 'Bank A' pick off 'Bank B' when they are weak," said Ron Farnsworth, the chief financial officer of the $8.3 billion-asset Umpqua Holdings Corp. in Portland, Ore. "Typically 'Bank A' is doing good and 'Bank B' is doing good and they think they can do better together."
Dan Rollins, the president and chief operating officer of the $6.8 billion-asset Prosperity Bancshares Inc. in Houston, said his company would like to keep its balance sheet clean.
"We want to make decisions that are rewarding for our shareholders," he said. "Do the accounting rules or regulatory rule changes have an impact? Absolutely. They could raise or lower the price level, but I don't think that in itself increases or decreases M&A activity. I think the market increases or decreases activity, not accounting rules."
But others said they believe banks will recognize the help that the tax benefit offers. "I think what you'll see is that banks in healthy condition will be more inclined to look at banks that are distressed," said Jack Bradley, the president of Bingham Strategic Advisers, a mergers and acquisitions consulting firm owned by Bingham McCutchen, "because even if they have to write down assets, that will generate a future tax deduction they can use to shelter their own earnings."
Several observers said the tax benefit is so attractive that it should offset the unfavorable impact of new accounting rules about to take effect.
The Financial Accounting Standards Board issued Standard 141R last year and it applies to any acquisitions closing after Dec. 31. Among other things, it would require buyers to write acquired assets down to fair value.
Observers said the financial benefit of the tax break, in effect, would help make those writedowns more palatable.
Still, the banking industry would like to do away with the new FASB rules.
Dorsey Baskin, a partner in the professional standards group at Grant Thornton LLP, said that under the new rules the loans must be recorded at fair value and no allowance is added. "So the effect of that is your allowance doesn't change even though your loans have grown substantially," Mr. Baskin said. For a buyer, the ratio of the allowance to the loan portfolio will look "much smaller" than it would under the existing accounting rules, he said.
Donna Fisher, the senior vice president of tax and accounting for the American Bankers Association, said the accounting change could be painful to bankers doing acquisitions. She said the ABA intends to raise the issue during a roundtable the Securities and Exchange Commission is hosting Oct. 29. (The Emergency Economic Stabilization Act required the SEC to study the impact of fair-value accounting, with a report due by Jan. 2.)
The FASB changes also affect the accounting for merger expenses. Now, the cost of a transaction is added to goodwill or accounted for as a one-time charge, but under the new rules the expenses would be charged to earnings as they are incurred. Banks generally complain that this would increase earnings volatility.
Dan Bass, the managing director in the Houston office of Carson Medlin Co., said that while the FASB rule changes are not ideal for the industry, they should not discourage dealmaking.
"If a deal still makes strategic sense, you are not going to not do the deal because you need to run transaction costs through your income statement," he said. "That is like cutting off your nose to spite your face."