Banks, insurance companies, and other financial services firms must consider the impact of taxes - international, federal, value-added, and state - as they make strategic decisions. In particular, banks must base decision-making on their overall domestic or global tax position (the forest) rather than on the tax positions of individual operations within a particular subsidiary, product line, or geographic area (the trees).

That would be difficult enough, but when considered in the context of such market trends as financial services convergence, competition for customer deposits, the Internet, and globalization, effective strategic tax planning is an even bigger challenge.

If done well, however, tax planning can boost earnings and market capitalization. It can also provide the savings needed to make a winning bid or a strategic investment, as well as to improve the bank's regulatory capital position.

The stakes are high indeed. According to the Federal Deposit Insurance Corp., income taxes paid by U.S. commercial banks and savings institutions exceeded $37 billion, or 34% of their net income before income taxes. Taking into account payroll, property, and sales taxes, the banking industry's total tax liabilities exceeded $40 billion in 1998.

With the passage of financial modernization legislation, tax rules and the authorities responsible for applying them are unable to keep pace with the rapidly changing market. Because industry-specific tax rules differ for banks, insurance companies, and other financial intermediaries, this lag will present both opportunities and hurdles to firms striving for effective tax planning.

Banks that typically supply a variety of financial services may have the flexibility to use the tax rules that offer the most tax-efficient answers for specific investments or products. For example, federal rules related to the disallowance of interest-expense deductions for tax-exempt bonds treat banks differently than other taxpayers. If a bank manages its investment portfolio on an organization-wide basis, it can select which entity should hold the tax-exempt bonds so that the organization as a whole increases its after-tax return.

As financial services converge, the hurdles to achieving the optimum tax position loom larger for the inexperienced, and tax inefficiencies may arise when a bank extends its products and services into an area where the rules are different but where it has no expertise. For instance, banks that previously did not engage in extensive investment banking activities (or limited them to a Section 20 subsidiary) will need a deeper understanding of previously inapplicable tax rules related to securities dealers if they expand into investment banking.

Industry-specific tax rules that apply to each traditional segment of financial services, such as banking and insurance, are complex and vary greatly from one to another. In the old world, where the segments were neatly divided, tax departments and professionals specialized in single segments. But a financial supermarket with a variety of delivery channels is now less likely to have the expertise needed to maximize tax efficiency. An expert in, say, taxation of mortgage servicing rights may not be familiar with even the basic rules concerning taxation of insurance premiums. This raises the possibility of omissions and errors in tax-reduction efforts.


State and local tax systems present their own set of opportunities and traps. Like the federal government, states and municipalities have varying tax requirements for different types of companies, as well as different rules for each jurisdiction. This increases the opportunities for tax planning and the potential for tax inefficiencies. The emergence of electronic commerce only worsens the state and local tax issues for banks as they expand into new segments and markets.Financial convergence encompasses not only the aggregating of banking, insurance, and other financial businesses within a single organization but also the merging of capital markets with traditional banking products. Examples include the growing secondary markets for mortgages, commercial loans, auto loans, and other credits originated by banks, as well as the divestment of credit and interest risks through sophisticated hedging techniques.

The tax system still largely applies to financial instruments on a categorical basis, without sufficient regard for the economic similarities and distinctions among the various instruments. As the market merges such financial instruments, uncertainty grows about which set of tax rules should apply. But the confusion also presents opportunities to facilitate a more favorable tax result. Again, given the pace of the introduction of creative financial instruments, it is unlikely that tax rules will catch up.

As banks make their strategic choices, they will need to better understand how current tax law, and possible changes in it, will influence financial products' growth rates.

For instance, in recent years there have been proposals to tax market discount on a current basis, impose state taxes based upon the mere economic (rather than physical) presence of a bank, require the capitalization of loan origination costs, and expand the availability of S corporation status for banks. Such measures would greatly affect the price of financial products and their investment return, which would in turn influence customer demand and profit margins for alternative financial products.


Revision of the Social Security system could prompt the largest partial conversion from a defined-benefit to a defined-contribution plan ever contemplated. Congress is considering different forms of private retirement savings accounts that would supplement or partially replace Social Security. The impact of this reform and its related tax effects on the financial services marketplace could be extensive, with financial intermediaries competing aggressively for new savings dollars.Any discussion of trends today is incomplete without considering the potential effects of the Internet. Congress has imposed a temporary moratorium on new Internet taxes. Yet the Internet may still figure into a bank's tax planning. If, for example, financial services and products are bought over the Internet, a bank may more easily direct the premium or fees to the service provider whose federal or state tax treatment is the most favorable.

The Internet also raises challenging international income tax issues. International tax systems generally put great emphasis on the source of income to determine tax treatment. This determination raises challenging administrative issues for taxing authorities because such sales can be made anywhere in the world without the vendor's physical presence.


In addition, a single transaction may involve the participation of multiple divisions, located in many different countries, of a single organization. The Internet may require governments to fundamentally change their international tax policies, which would have a tremendous effect on financial services.As with other market trends, the globalization of financial services comes with its own set of tax issues. A particular challenge for banks expanding abroad is the deferral of financial services income earned by foreign subsidiaries. Generally, a U.S.-based company may defer federal income tax on income earned by foreign subsidiaries until the earnings are actually repatriated. However, U.S. banks have long been excluded from this rule, requiring them to pay tax on the earnings of foreign subsidiaries as the income is earned.

Some progress has been made in achieving parity for banks and other financial institutions. In 1997 Congress enacted a provision for 1998 permitting U.S.-based financial institutions to defer tax on so-called "active finance income" of foreign subsidiaries. The industry's minimum goal is to see the provision reenacted each year. Ideally, it would be made permanent, a move currently prevented by its substantial tax cost (revenue loss) to the government. This tax deferral will be increasingly important to U.S. banks' ability to compete, especially in countries with lower tax rates than ours.

As is the case with convergence, globalization will require banks to address highly complicated tax issues. Banks will have to develop expertise in-house and/or use outside advisers, either of which may require a major investment. But international tax planning offers numerous savings opportunities, justifying the expenditure.

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