During the last year, the Internal Revenue Service has issued a wave of guidance in response to the credit crisis. This guidance is unprecedented in that it, in effect, relaxes the rules of the Internal Revenue Code to adjust to a changing economy. These changes began in late 2007 with narrow technical guidance aimed at municipal bonds and real estate mortgage investment conduits (REMICs). By late September, the IRS was relaxing the Code's loss trafficking rules apparently in order to encourage the acquisition of failing banks. The following gives a brief description of the significant rulings and other guidance the IRS has issued:

Section 382 Related Guidance-Preservation of Tax Losses

In general, Section 382 of the Code limits the ability of a corporation that undergoes an "ownership change" to utilize its pre-change net operating losses (NOLs) and "net unrealized built-in losses" (NUBILs).1 In general, an ownership change occurs if the percentage (by value) of stock of the loss corporation owned by any one or more 5% shareholders (by value) has increased by more than 50% compared to their lowest percentage ownership in the prior 3 years. Such an ownership change can result from an acquisition of outstanding stock of the loss corporation (whether taxable or in a tax-free acquisition) or an issuance by the loss corporation of new stock for additional capital. If a loss corporation undergoes an ownership change, post change use of its pre-change NOLs and NUBILs is generally subject to an annual limitation (Section 382 Limitation) equal to the product of the fair market value of its outstanding stock immediately before the ownership change multiplied by a statutorily-prescribed interest rate (applicable long-term tax-exempt rate). This interest rate is currently 4.65%, but is adjusted monthly based on market rates.

Two recent Internal Revenue Service (IRS) Notices designed to help failing banks may (1) open the possibility for a corporate acquiror to acquire a bank's built-in loan losses and use those built-in losses against its taxable income, and (2) ease the application of potential tax loss carryover limitations for corporations that raise additional capital by issuing new stock. We expect that these Notices will make significantly more attractive both the acquisition of U.S. banks with underwater mortgages and the furnishing of new capital to distressed banks.

Notice 2008-78 – Capital Contributions to Loss Corporations

As described above, the Section 382 Limitation is determined by valuing a corporation's stock immediately before the ownership change. Capital contributions that increase the total value of the outstanding stock could have the effect of increasing the annual limitation, and, if made ratably by existing shareholders, could reduce the likelihood that other stock transactions would constitute an ownership change. Accordingly, to prevent these potential abuses, Section 382(l) of the Code presumes (except as provided in regulations) that capital contributions made within a two-year period ending on the change date are part of a tax avoidance plan and therefore excludes such capital contributions in determining the Section 382 Limitation.

On September 26, 2008, the IRS issued Notice 2008-78, I.R.B. 2008-41 (Notice 2008-78), in which it announced that it will waive the presumption that a capital contribution within the two-year pre-change period is part of a tax avoidance plan.2 Notice 2008-78 instead provides a facts and circumstances test in determining whether the contribution is for tax avoidance. It also provides four safe harbors under which a contribution will not have a tax avoidance motive. Under the most relevant safe harbors, a contribution will not be considered as part of a plan for tax avoidance if:

  • the contribution is made by a person who is neither a controlling shareholder3 (determined immediately before the contribution) nor a related party,4 (ii) no more than 20% of the total value of the loss corporation's outstanding stock is issued in connection with the contribution, (iii) there was no agreement, understanding, arrangement, or substantial negotiations at the time of the contribution regarding a transaction that would result in an ownership change, and (iv) the ownership change occurs more than six months after the contribution; or
  • the contribution is made either by a related party provided that no more than 10% of the total value of the loss corporation's stock is issued in connection with the contribution, or by a person other than a related party, and (ii) in either case there was no agreement, understanding, arrangement, or substantial negotiations at the time of the contribution regarding a transaction that would result in an ownership change, and (iii) the ownership change occurs more than one year after the contribution.

Notice 2008-83 – Built-in Loss Limitations of Banks

On September 30, the IRS issued Notice 2008-83, 2008-42 I.R.B. 1 (Notice 2008-83), in which it announced that losses and deductions attributable to loans or bad debts5 of a bank6 (including any deduction for a reasonable addition to a reserve for bad debts by a bank) after the date of an ownership change under Section 382 of the Code and which are otherwise allowable, will not be treated as built-in losses or deductions attributable to a pre-change period.7 Accordingly, Notice 2008-83 effectively removes a potential barrier to acquisitions of struggling banks that have unrecognized loan losses and to equity infusions by prospective investors by assuring that the IRS does not intend to challenge the use of unrecognized losses to offset future taxable income after an ownership change occurs.

Impact of Notice 2008-78 and Notice 2008-838

Capital Raising. Notice 2008-78 means that a bank (as well as other corporations) may now raise capital without creating a concern for existing stockholders and potential investors that the value of the corporation's tax "assets" (i.e., the built-in losses) automatically will be impaired by excluding the new capital from the Section 382 Limitation calculation if circumstances should force a change in ownership within the following two years. Notice 2008-83 means that banks can feel free to issue stock to raise new capital without a concern that losses subsequently recognized on troubled mortgages, including those arising from sales under the TARP, will be treated as NUBILs for purposes of Section 382 of the Code.9

Acquisitions. In practice, Notice 2008-83 means that an acquiring corporation, e.g., a bank holding company (Acquiror) can acquire a bank owning underwater mortgages in a basis preservation transaction (e.g., a stock sale or tax-free reorganization), sell the mortgages (including to Treasury under the TARP), and then use those losses recognized on the sale to offset future income of the Acquiror or other members of its affiliated group.10

Additional Provisions Modifying Section 382 Treatment (Notice 2008-76, Notice 2008-84 and Notice 2008-100).

On September 29, 2008, the IRS and Treasury announced in Notice 2008-76 that they will issue regulations under Section 382(m) providing that the "testing date" (as defined in Regulations Section 1.382-2(a)(4)) does not include any date on or after the date on which the United States (or an agency or instrumentality thereof) acquires, in a "Housing Act Acquisition," stock or an option to acquire stock in a corporation. The regulations apply after September 6, 2008.

On the same day, the IRS and Treasury issued Notice 2008-84, in which they announced that they will issue regulations under Section 382(m) providing that the "testing date" does not include any date as of the close of which the United States owns a more-than-50 percent interest in a Section 382 loss corporation. The regulations will apply to any taxable year ending after September 25, 2008. Finally, on October 14, 2008, the IRS and Treasury issued Notice 2008-100, providing very favorable guidance regarding the application of Section 382 to loss corporations whose instruments are acquired by Treasury pursuant to the Capital Purchase Program (CPP) under the Act. The Notice generally provides (1) that shares of stock of a loss corporation acquired by Treasury pursuant to the CPP shall not be considered to have caused Treasury's ownership in the loss corporation to have increased over its lowest percentage owned on any earlier date, but subject to certain exceptions, are considered outstanding for purposes of calculating the ownership percentage of other 5 percent shareholders on a testing date; (2) that once shares of stock acquired by Treasury pursuant to CPP are redeemed by the corporation, such shares are not treated as having ever been outstanding for purposes of measuring ownership shifts of any 5 percent shareholder on any testing date on or after the redemption; (3) that any preferred stock acquired by Treasury pursuant to CPP is treated as stock described in Section 1504(a)(4) for all Federal income tax purposes (and is therefore carved out of the definition of "stock" for purposes of Section 382(k)(6)(A); (4) that warrants acquired by Treasury pursuant to CPP shall be treated as options (and not as stock) for all Federal income tax purposes and that options acquired by Treasury will not be deemed exercised for purposes of Section 382; and (5) that capital contributions made by Treasury to a loss corporation pursuant to the CPP shall not be considered to have been made as part of a plan for purposes of Section 382(l)(1) of the Code.

The Notice states that Treasury and the IRS intend to issue regulations setting forth the rules provided in the Notice, but that taxpayers may rely on the Notice unless and until there is additional guidance. Additionally, the Notice states that any future guidance issued contrary to that provided in the Notice will not apply to instruments acquired by Treasury (1) prior to the publication of the contrary guidance or (2) pursuant to binding written contracts entered into prior to the publication of the contrary guidance.

Money Market Share-Price Guarantee

As previously noted, in Notice 2008-81, Treasury announced a Temporary Guarantee Program to enable money market funds to maintain stable $1 per share net asset values, and said that participation in the program will not be treated as a federal guarantee that jeopardizes the tax-exempt treatment of payments by "tax-exempt money market funds" (i.e., money market funds holding enough of their total assets in tax-exempt bonds to be eligible to pay Section 852(b)(5) exempt interest dividends).

In Notice 2008-92, the IRS and Treasury announced that they will not assert that participation in the Temporary Guarantee Program by an "insurance-dedicated money market fund" (a fund with beneficial interests held by investors permitted under Regulations Section 1.817-5(h)(1)) causes a violation of the Section 817(h) diversification requirements in the case of a segregated asset account investing in the fund, or that the fund's participation causes the holder of a variable contract supported by a segregated asset account investing in the fund to be treated as an owner of the fund.

Borrower's Default on Securities Loan Doesn't Trigger Taxable Event to Lender (Notice 2008-63)

Under a securities loan agreement, a borrower typically borrows securities from a lender and posts collateral to secure its obligation to return identical securities. The initial transfer of securities to the borrower and the return of identical securities to the lender upon termination of the securities lending agreement generally do not result in any gain or loss to the lender for U.S. federal income tax purposes, provided the loan agreement meets certain specified requirements under Section 1058. If, upon a borrower default, the lender applies the collateral to purchase securities that are identical to the securities borrowed, the lender would be required to realize gain, if any. In most situations, losses would be expected to be disallowed as a result of the application of the wash sale rules. On September 29, 2008, the IRS published Revenue Procedure 2008-63 to preserve non-recognition treatment and restore symmetrical results in the case of gains and losses. The Revenue Procedure, effective for taxable years ending on or after January 1, 2008, provides that if a borrower defaults under a securities loan agreement as a direct or indirect result of its bankruptcy (or the bankruptcy of an affiliate) and the lender applies the collateral to purchase identical securities as soon as is commercially practicable after the default (but not more than 30 days following the default), then the transaction will not be a recognition event for U.S. federal income tax purposes to the lender.

Relief for Auction Rate Securities

Since the 1980s, closed-end funds, corporations, municipal authorities and student loan organizations have issued auction-rate securities (ARS), typically in the form of bonds with long-term maturities or as preferred stock. The interest or dividend rate on ARS is determined by a Dutch auction mechanism through which investors already holding ARS and investors seeking to acquire ARS indicate their interest in holding, purchasing or selling the ARS at specified rates. Auctions are typically held every seven, twenty-eight, thirty-five or forty-nine days, but with respect to some ARS the auctions can occur daily or at longer intervals such as every six months. For issuers, ARS are beneficial as they can provide financing at rates that are lower than variable rate debt instruments. To investors, ARS are attractive as their yield is typically higher than the yield on deposits or money market funds. The ARS market currently has an estimated size of a few hundred billion dollars. Lately, as a result of the current credit crunch, there has been little or no interest in purchasing ARS resulting in wholesale auction failures. Upon an auction failure, the interest or dividend rate on the ARS defaults to a maximum rate which, generally, is intended to be an above-market rate at original issuance that is intended to compensate holders of the ARS for the illiquidity of the securities. However, due to the credit crisis, some of these rates are now viewed as below market, causing ARS to become even more illiquid.

In response to the illiquidity problem, the IRS issued Notices 2008-27 and 2008-41, providing guidance to issuers of tax-exempt bonds that wish to either convert their outstanding bonds from ARS to bonds with a fixed or floating interest rate to maturity or to purchase their own ARS from the market. Pursuant to these notices, under certain limited circumstances, the conversion of a tax-exempt ARS to a bond with a fixed or floating interest rate will not result in a reissuance for U.S. federal income tax purposes, and, in applying the tax-exempt bond rules, an issuer may purchase its own tax-exempt ARS without such purchase resulting in a retirement of the bonds for U.S. federal income tax purposes, which could potentially result in adverse tax consequences to the issuer.

With respect to ARS issued as preferred stock, in order to preserve their status as "equity" for tax purposes, it is particularly important that investors not be viewed as having the right to put the ARS to the issuer on demand. Notwithstanding, some had proposed that holders of such ARS be permitted to sell, pursuant to a liquidity facility agreement, their shares to a liquidity provider upon a failed auction. This would broaden the market for potential ARS investors as tax exempt money market funds (frequently referred to as 2a-7 funds) would subsequently be allowed to purchase ARS under the '40 Act from issuers that are themselves RICs. Under the proposal, the liquidity provider would try to sell the ARS (including by participating in subsequent auctions). Further, the issuer would be required to redeem the stock after a specified period of time if the liquidity provider is unable to sell the ARS. The proposal was designed to permit new investors to invest in ARS.

In response, the IRS issued Notice 2008-55, confirming that it will not challenge the equity characterization of the ARS if a liquidity facility agreement such as the one described above were entered into. As a result, payments on the ARS should still be characterized as exempt-interest dividends (to the extent of the issuer's exempt interest) and not as taxable interest, which would have been the consequence if the ARS were instead treated as debt for U.S. federal income tax purposes. In general, the notice only applies if, among other requirements, the ARS are issued by closed-end funds that are RICs and that invest exclusively in taxable or tax-exempt bonds, the ARS were outstanding on February 12, 2008 (or issued after that date to refinance ARS that were outstanding on that date) and the liquidity provider is unrelated to the issuer.

The IRS' latest installment of relief provisions for the ARS market provides guidance to holders of ARS in light of recent announcements by Wall Street firms that they will buy back billions of dollars worth of ARS from aggrieved investors. On September 29, 2008, the IRS issued Revenue Procedure 2008-58 (Rev. Proc. 2008-58), providing assurance to investors in the auction rate securities market that the IRS will not challenge certain tax positions taken with regard to settlement of potential legal claims related to such securities.

Rev. Proc. 2008-58 focuses on ARS holders that have the right during a specified "window period" to cause an issuer to buy back the ARS for par amount in order to settle potential legal claims against the issuer (e.g., that the issuer did not properly disclose the potential that the ARS would become illiquid). Alternatively, the ARS holder may borrow the par amount of the ARS from the issuer prior to the window period while securing the "loan" with the ARS. Rev Proc 2008-58 also contemplates a scenario in which the ARS holder does not exercise the settlement right, in which case the ARS holder would continue to receive payment under the maximum penalty rate upon a continued auction failure or receive a return that would fluctuate based on the auction rate-setting process, ultimately affecting the holder's economic return. If the ARS holder were to hold the security after the window period, the ARS holder would continue to be entitled to exercise all voting rights associated with the security and to sell the security to a third party.

The IRS stated that it will not challenge the following positions: (1) that the taxpayer continues to own the auction rate security upon accepting (or "opting into") the settlement offer until the tender of the security; (2) that the taxpayer does not realize any income as a result of accepting the settlement offer and does not reduce the basis of ARS from its original purchase price; and (3) that the taxpayer's amount realized from the sale of ARS during the window period to the party offering the settlement is the full amount of the cash proceeds received from that party.

Rev Proc 2008-58 applies to taxpayers that accept settlement offers prior to June 30, 2009 and have such settlement offers in which the window period does not extend beyond December 31, 2012, where such relevant ARS were purchased prior to February 14, 2008. Significantly, a revision to Rev. Proc. 2008-58 on September 29 clarifies that the relief provisions would still apply even if an ARS holder is not required to release claims in connection with the settlement. The new Rev. Proc. serves to eliminate some uncertainty for the throngs of ARS investors that will face various tax issues as a result of these settlements.

Facilitating Intercompany Liquidity

In general, the provisions in the Code applicable to a controlled foreign corporation (CFC) may result in phantom income inclusion to a U.S. shareholder that owns 10% or more of the voting stock of the CFC under certain circumstances. Code Section 956 provides for such an income inclusion when a CFC makes an investment of earnings in U.S. property, which includes certain loans by the CFC to related U.S. persons. The IRS and Treasury had previously announced in Notice 88-108 that final regulations issued under Section 956 will exclude an obligation from the purview of Section 956 where the obligation is collected within 30 days from the time it is incurred. To facilitate liquidity in the near term, on October 10, 2008, the IRS and Treasury announced in Notice 2008-91 that they will issue regulations providing that, for Section 956 purposes, a CFC may choose to exclude an obligation held by the CFC that would otherwise be an investment in "United States property" if the obligation is collected within 60 days from the time it is incurred. The exclusion does not apply if the CFC holds for 180 or more calendar days during its taxable year obligations that would be an investment in "United States property" without regard to the new 60 day rule. Additionally, a CFC may apply Notice 2008-91 or Notice 88-108, but not both. Notice 2008-91 applies for the foreign corporation's first two taxable years ending after October 3, 2008.

Footnotes

*. See Morrison & Foerster LLP's "Tax Talk" Volume 1, Issue 3 at http://www.mofo.com/news/updates/files/080930TaxTalk.pdf .

1. NUBILs are generally losses recognized in the 5-year period after the ownership change, but that are attributable to unrealized pre-change declines in asset values. Certain deductions during post-change periods that are attributable to periods before the change date are treated as recognized NUBILs under Section 382(h)(6)(B), and therefore limited.

2. Notice 2008-78 states that the IRS and the Treasury intend to issue regulations to implement the rules described in the Notice. Taxpayers may rely on the Notice until further guidance is issued.

3. With respect to a public company, a controlling shareholder is a shareholder that owns at least 5% (directly or indirectly) of any class of stock outstanding and who actively participates in the management or operation of the corporation (e.g., a corporate director).

4. A related party generally would include (but would not be limited to), as determined immediately after the capital contribution: (1) an individual or trust owning more than 50% of the stock (by value) of the loss corporation, (2) a corporation that is a member of the same "controlled group" (meaning generally 50% affiliation by vote or value) as the loss corporation, and (3) a partnership or an S corporation if the same persons own a greater than 50% interest in both such partnership or S corporation and the loss corporation. A related party may include certain coordinated groups.

5. The Notice does not define the term "loans," however it should be broad enough to include debt interests in securitization vehicles as well as direct interests in residential or commercial mortgages. It does not appear that the Notice would apply to most derivative positions.

6. In order to qualify for the treatment described in Notice 2008-83, the taxpayer must be a bank as defined in Section 581 of the Code immediately before and immediately after the ownership change.

7. No effective date is specified in the Notice, so it appears that it may also benefit banks that have already had an ownership change.

8. See Morrison & Foerster LLP's News Bulletin "Notice 2008-83: The IRS Offers Reassurance to Troubled Banks" at http://www.mofo.com/news/updates/files/14544.html .

9. Of course, pre-existing NOLs would be subject to the Section 382 Limitation if sufficient shares to constitute an ownership change were issued.

10. Pre-existing NOLs of the target would still be subject to the Section 382 Limitation (assuming that the acquisition results in a greater than 50 percent shift in the ultimate equity ownership of the target). Section 382 of the Code should displace the consolidated return regulations' limitation on built-in-losses (via the separate return limitation year rules), so that the treatment provided by Notice 2008-83 should apply whether the target bank is merged into the Acquiror (or a disregarded entity of the Acquiror) or remains in existence as a consolidated subsidiary of the Acquiror.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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