Favorable private-letter rulings that the Internal Revenue Service has started to issue under section 351 of the Internal Revenue Code of 1986 will eliminate tax and accounting problems that have caused a slowdown in mutual holding company transactions this year.
The resolution of this issue will result in a restoration to the capital of institutions that have completed mutual holding company transactions of deferred tax liabilities that had been established to reflect the possible cost if the tax issue had been resolved against them by the IRS.
The American Banker has reported about the tax and accounting issues raised by mutual holding company transactions. This article discusses the tax issue that has now been resolved.
The tax and accounting issues arose because mutual holding company transactions are typically consummated by federally chartered institutions through transfer of the assets of a mutual savings bank to a newly organized subsidiary stock savings bank, which takes the name of the mutual.
The charter of the prior mutual savings bank is restated to be that of a federally chartered mutual holding company.
Technically, a transfer of assets to a controlled subsidiary qualifies as a tax-free transaction for federal tax purposes pursuant to section 351 of the tax code, rather than as a tax-free "reorganization" within the meaning of section 368.
Normally, all of an institution's tax and accounting attributes carry over to a subsidiary corporation in a "reorganization" pursuant to section 381. In the case of a section 351 transaction, however, section 381 does not apply. Only certain tax and accounting attributes of the transferor institution are transferred to its controlled subsidiary.
However, the IRS had ruled in a 1981 private-letter ruling that a subsidiary bank that received assets from a predecessor bank pursuant to section 351 may continue to use the predecessor institution's "base year" bad-debt reserve balance in calculating additions to its own bad-debt reserve in future years.
This relatively arcane tax issue took on magnified importance of several accounting firms' interpretations of Financial Accounting Standard 109.
They interpreted it to require that without a favorable ruling from the IRS, a stock savings bank formed in a mutual holding company transaction consummated pursuant to section 351 would be have to establish a deferred tax liability equal to the federal and state tax liability that would result if essentially all of its bad-debt reserves were recaptured into gross income - although no such recapture would actually be required.
For example, assume that a savings bank had a bad-debt reserve of approximately $29.7 million.
If the savings bank had to recapture, into income the balance of its bad-debt reserve as calculated under the "percentage of taxable income method" of approximately $2.3 million (in excess of the approximate balance of $400,000 that would be permitted under the "experience method"), a hypothetical tax liability would result for the savings bank of approximately $9.8 million.
Deal, Killing Requirement
Accordingly, the savings bank would be required to establish a deferred tax liability in this amount, even though bad-debt reserve recapture would not actually have been required for tax purposes.
The establishment of a deferred tax liability of approximately $9.8 million for accounting purposes would have had a material adverse impact on the savings bank's financial statements and would likely have made it unfeasible to proceed with a mutual holding company transaction.
The submissions to the IRS reviewed all changes in the relevant provisions of the tax law that went into effect after 1981. These submissions demonstrated that no changes since then invalidate the favorable policy conclusion stated in the 1981 private-letter ruling.
Additional lengthy submissions were made that surveyed the carryover of 15 other tax and accounting attributes in section 351 transactions.
The principles derived from the survey of the treatment of these other items lead to the conclusions that no recapture of any portions of a savings institution's bad reserves should be required.
They also led to the conclusion that a stock savings bank that receives all the assets of a predecessor mutual savings institution in a mutual holding hgcompany transaction consummated pursuant to section 351 should:
* Establish a reserve balance in the same amount maintained by the predecessor mutual institution.
* Be permitted to use the base-year bad-debt reserve balance of the predecessor institution.
In the course of its deliberations, the IRS considered whether a mutual holding company transaction should be accomplished as a "triangular reorganization" that would require that the amount of stock sold at the time of the transaction be limited to less than 20% of the resulting number of shares outstanding.
Submissions to the IRS were intended to persuade it that in most instances it would not be viable from a business standpoint for the amount of stock sold in such transactions to be limited in this way.
The IRS did not, however, preclude the consummation of a mutual holding company transactions as a triangular reorganization within the meaning of section 368(a)(1)(a).
Consummation of a mutual holding company transaction in this manner may have important tax advantages for certain thrift institutions.
The IRS did not favor, but has not precluded, an analysis of several alternative scenarios pursuant to which a mutual holding company transaction may qualify as a "reorganization" within the meaning of section 368(a)(1)(d), in which case the 20% limitation would not be applicable.
The agency also considered whether all of a savings bank's bad-debt reserves should be transferred to a subsidiary stock savings bank in transaction consummated pursuant to section 315, or whether a portion or all of the reserves should be recaptured into income.
Detailed legal arguments were submitted to the effect that no portion of an institution's bad-debt reserve should be recaptured into income as a result of its formation of a mutual holding company pursuant to section 315, and that a mutual holding company transaction is the functional equivalent of a tax-free "reorganization."
Delay in resolving the ruling requests arose largely from concern by IRS staff members responsible for rulings on bad-debt reserve issues that a favorable ruling based only on the policy objectives of the bad-debt reserve regulations would have implications in other contexts regarding the distinction between "section 351 transactions" and "reorganizations."
Accordingly, branches of the IRS responsible for "reorganizations" were involved in the regulatory proceedings. The coordination of a response consumed several months.
With the anticipated removal of the tax and accounting problems that had been obstacles to mutual holding company transactions during the summer, interest in such transactions should rise.