The Rising Cost of Funds Has a Potential Tax Impact for Banks

Certain municipal bonds can provide a tax-efficient investment opportunity because the interest is generally exempt from federal income tax. However, with this tax benefit comes a potential deduction limitation.

To prevent a double tax benefit, Internal Revenue Code (IRC) 265(a) fully disallows a deduction for the costs to acquire or carry tax-exempt investments (i.e., the interest expense associated with purchasing or owning the municipal bonds.) This disallowance may reduce the overall tax benefit. Banks, however, may receive a special exemption from this limitation by purchasing “bank-qualified securities.”

What is a Bank-Qualified Security?

Banks have historically been one of the largest purchasers of tax-exempt debt. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) created a special exception to incentivize banks to continue to invest in their communities.

Banks may deduct 80 percent of the interest expense allocated for carrying bank-qualified securities on their balance sheets. This provision provides banks a tax incentive to purchase tax-efficient bonds from smaller municipalities that may otherwise have difficulty finding investors because of smaller loan sizes and lower yields.

Bank-qualified securities must meet all the following criteria:

• Debt issued after August 7, 1986, by a “qualified small issuer.” A qualified small issuer is generally an issuing government with $10 million or less in bonds per calendar year.
• Debt that is not a private activity bond or used to fund private projects.
• Debt designated by the issuer for purposes of IRC Section 265.

Qualified Small Issuer Threshold

The American Recovery and Reinvestment Tax Act of 2009 (the Stimulus Act) temporarily increased the threshold for a qualified small issuer from $10 million to $30 million in 2009 and 2010. The Stimulus Act also included a two percent de minimis safe harbor exception. This allowed banks to deduct 80 percent of interest expense from all tax-exempt securities if the bases of tax-exempt securities did not exceed two percent of the average bases of all the bank’s assets.

TEFRA Adjustment Example

Banks investing in non-bank qualified tax-exempt securities do not receive an interest expense deduction for the interest that is deemed allocated to carrying those bonds.

Assume a bank has a 21-percent corporate tax rate and 1.5-percent cost of funds. If the bank’s entire investment portfolio is comprised of bank-qualified securities, the allowed interest expense deduction is 25.2 bp (21% * 1.5% * 80%). With the same facts, if a bank’s entire investment portfolio is comprised of non-bank qualified securities, the interest expense deduction is zero.

Banks that own both tax-exempt and non-exempt bonds must first prorate interest expense based on the average tax bases of the tax-exempt assets to the average tax bases of total assets.

Now assume that 30-percent of the bank’s securities are tax-exempt bonds. The bank’s allowable interest expense deduction is immediately reduced by 30-percent because of the bank’s ratio of tax-exempt to non-exempt securities. The TEFRA adjustment follows this allocation if applicable.

Alternatives to purchasing bank-qualified securities

Banks may be looking for alternatives due to interest rate increases, excess cash reserves and the relatively high demand for bank-qualified securities.

One alternative may be to purchase tax-exempt securities in an investment subsidiary. For example, PSB Holdings, Inc., a Wisconsin holding company, took this position by forming a wholly owned investment subsidiary to manage and safeguard the bank’s (Peoples State Bank) investment portfolio. The subsidiary’s investment portfolio included cash, tax-exempt securities, and non-exempt securities.

When calculating the bank’s interest expense allocation, the denominator included the investment subsidiary’s stock, but excluded the investment subsidiary’s tax-exempt assets from the numerator. This resulted in a lower ratio of tax-exempt to non-exempt securities, increasing the bank’s interest expense deduction.

The IRS challenged this position in Tax Court, arguing the numerator needed to include tax-exempt assets held by the entire consolidated group. The court ruled in favor of PSB Holdings, Inc., indicating there are no aggregation or indirect ownership rules applying to the numerator.

Additional Considerations

Banks considering a structure similar to PSB Holdings, Inc. can consider the following:

• Stringent qualifications and business purpose requirements.
• The costs involved in operating the subsidiary and whether the IRS will consider the subsidiary appropriately “separated” from the bank.
• Whether the volume of tax-exempt municipals and the cost of funds are substantial enough for the structure to be a feasible alternative for a community bank.

What’s Next?

Due to current market conditions, more banks may explore tax-efficient investment options. Leaning on a trusted banking industry advisor will help you take advantage of these opportunities.

Eide Bailly’s advisors can help navigate the complexities of tax-efficient investing for your bank.

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