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BANK AVOIDS DEDUCTION HAIRCUT ON MUNI BONDS HELD BY INVESTMENT SUBSIDIARY

November 02, 2007

The tax law has two provisions that require banks to reduce their interest expense deduction in proportion to their tax-exempt income from municipal bonds. In a reviewed decision yesterday the Tax Court ruled that this expense disallowance -- commonly known as the "TEFRA disallowance" -- doesn't apply to municipal bonds held by a non-bank subsidiary of a C corporation bank.

In the early 1990s many banks created "investment subsidiaries" to hold municipal bonds and other investments; under the laws that applied at the time, this maneuver often reduced state taxes for the bank (most states, including Iowa, have since changed their laws to tax this income).

Peoples State Bank of Wausau, Wisconsin, used this technique, and they excluded the investment subsidiary's muni bonds from the bank's TEFRA disallowance computation. The IRS balked. The Tax Court yesterday said the bank was right because the Internal Revenue Code says they are:

Congress knew how to require a taxpayer to take into account the assets of another taxpayer had Congress intended to include respondent's "look-through" approach in the applicable statutes. See, e.g., sec. 265(b)(3)(E). Congress, however, did not in those statutes provide any aggregation or indirect ownership rule that would apply to the numerator. Instead, Congress referred simply to the obligations of the "taxpayer" for purposes of making that calculation. "'[W]here Congress includes particular language in one section of a statute but omits it in another section of the same Act, it is generally presumed that Congress acts intentionally and purposely in the disparate inclusion or exclusion.'" Russello v. United States, 464 U.S. 16, 23 (1983) (quoting United States v. Wong Kim Bo, 472 F.2d 720, 722 (5th Cir. 1972)).

In short - if Congress writes the law with a loophole, it's not up to the IRS to fix it.

The ruling bodes well for a similar issue affecting S corporation banks. The Code provides that one form of TEFRA disallowance doesn't apply once a corporation has been an S corporation for three years. The IRS has attempted to make banks continue to apply this disallowance even after the three-year period expires, saying that Congress really didn't mean to apply the law that way. While this case doesn't directly address the S corporation issue, the court's insistence that the Code means what it says makes me optimistic that we will see a pro-taxpayer ruling when it rules on a now-pending S corporation bank case.

Cite: PSB Holdings, Inc., 129 T.C. No. 15

Tags: bank tax.TEFRA disallowance.