An effort by community banks to close a tax loophole that helped Iowa's two biggest banks has collapsed in the state's legislature.

The plan had called for the banks to be taxed based on their deposits rather than their profits. The big sticking point turned out to be whether credit unions should also be taxed in this way.

What played out in Iowa could be a preview of what could happen in other states with franchise taxes.

Legislators found themselves in a tough situation with little room for victory.

Any legislation that included credit unions would have been unpassable because of the powerful credit union lobby. Any legislation that didn't include credit unions became unpassable because of the banking lobby's insistence that community credit unions be taxed like the rest of them.

Plan Is Defended

"I don't know why the thing didn't pass," said one source in the Iowa Division of Banking, the state regulator that had pushed for the change in the law to preserve the integrity of the state's tax base. "It made sense. You'll have to ask the lobbyists."

"One of the reasons we quit actively supporting it was they refused to include credit unions in the bill," said Neil Milner, chief executive of the Iowa Bankers Association. "If the legislature wasn't interested in tax equity to community-based credit unions, why should we be interested in tax equity among banks."

The issue sprang up last year .when Firstar, the second-biggest bank in Iowa, owned by a Wisconsin holding company, applied with the Iowa revenue office to shield its out-of-state bond trading operation from taxation. Under the Iowa franchise tax, all banks are taxed 5% of their income.

Using out-of-state operations, such as in Nevada, which has no income tax, to perform bond operations could shield a significant amount of income from taxation.

After a fire storm of publicity, Firstar said that only its federally chartered banks would use the exemption, according to an account in the Des Moines Business Record.

Norwest, the largest bank in Iowa, acknowledged that it had been using the loophole to shield its bond profits for years. The loophole save the two banks, by one estimate, hundreds of thousands of dollars a year.

But community banks, which conducted their bond operations, along with the rest of their business, in Iowa, were taxed on the profits of their investment subsidiaries. To correct the inequity, legislation was introduced that would tax banks on a sliding scale of up to $1 per $1,000 of deposits.

Legislators sponsoring the bill consciously left credit unions out of it, but the Iowa Bankers Association decided to make it an issue at an April 8 board meeting.

Richard Berglund, executive vice president of the Iowa Independent Bankers, said his group and the IBA had agreed that getting the loophole closed was the first priority, taxing credit unions was the secondary goal.

"Rather late in the session the IBA took a position not to close the loophole unless the community credit unions were taxed," he said. "The minute it looked like credit unions would be taxed, legislators got thousands of calls and letters. The bill just died because of the IBA's position."

Mr. Berglund said he's disappointed because his group spent a year and thousands of dollars trying to get the law changed. He believed it to be in the best interest of the state and community banks.

The legislature adjourned this month without acting on the bill. It could revisit the bill next January, Mr. Berglund predicted, if enough tax revenue takes flight to Nevada.

Iowa could lose a significant amount of tax revenue as a result. In 1994, Iowa is projected to collect up to $34 million in franchise taxes on banks.

"We anticipate that there will be a significant number of banks in the coming months to utilize the exemption for out of state bond operations," Mr. Milner said.

He added that small banks, if the loophole could benefit their bond portfolio, will be served by a number of outside vendors that are moving into the state to take advantage of the business. If any small bank is unserved that wants to take advantage of the loophole, he said the Iowa Bankers Association would arrange to provide the service.

"We don't know if we'll revisit the issue next year," Mr. Milner said. "We might just go into business assisting banks take advantage of it. And unless the state treats community credit unions, which serve the same broad areas as banks, the same way as banks there will be not tax equity in the state."

There is not estimate on how much tax revenue Iowa could lose from banks moving their bond operations out of state.

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