The Imperfect Storm For Bank Acquisitions – Treasury's Tarp, Troubled Assets And Tax Benefits
11/5/2008
Through a variety of actions by the federal government, commercial banks that have best been able to survive the current mortgage and real estate crisis and are interested in expanding through acquisition are in a position to use government programs to acquire troubled institutions.
As one of the first pieces of the Troubled Asset Relief Program ("TARP"), the Department of Treasury has quickly rolled out the Capital Purchase Program ("Program"), which permits Treasury to purchase senior preferred stock and warrants in many banks. In addition to the "Big Nine" banks that signed on at the inception of the Program, local and regional banks have until November 14, 2008, to submit applications for additional capital under the Program, and Treasury has stated that they intend to fund the purchases by December 31, 2008. It is also becoming increasingly clear that the Capital Purchase Program is targeted at the healthier institutions and is not intended as a bailout for weaker institutions that are burdened with substantial troubled assets. Since the Program does not require the banks to lend the additional capital to borrowers, many banks are looking at the additional capital as an opportunity to acquire other institutions and consolidate the industry.
It is well known that one of the impediments to acquiring a troubled bank is taking both the good deposits and loans while also taking over the target bank's troubled loan portfolio. The drop in the real estate market, the slowdown in the housing industry and concerns over the ability of borrowers to repay on many of these loans has forced target banks to write down the loans on their books. While many of these banks, which only several years ago were selling for multiples of their book value, are now struggling to survive and are opportunities for acquisition, I.R.C. Section 382 has limited the ability of an acquiring institution to deduct for tax purposes the unrealized built-in losses that many of the target banks are carrying on their balance sheets. Specifically, in an acquisition where the percentage of the stock of the target entity which holds the unrealized built-in losses shifts by more that 50 percent during the three-year testing period, Section 382 provides that an unrealized built-in loss that is recognized during the five-year post-acquisition period will be treated as a pre-acquisition net operating loss. The use of pre-acquisition net operating losses against post-acquisition income is limited to the fair market value of the stock of the target immediately prior to the ownership change, multiplied by the applicable long-term tax-exempt rate.
It what appears to be part of a coordinated effort to encourage acquisitions of weaker banks, in addition to the TARP Capital Purchase Program, the Internal Revenue Service issued Notice 2008-83 on September 30, 2008 ("Notice"). By addressing the limitations on Section 382, the Notice provides a substantial tax benefit to an institution that acquires control of a target bank that has substantial net unrealized built-in losses. Specifically, the Notice provides that recognized losses on loans or bad debts (including any deduction for a reasonable addition to reserve for bad debts) during the five-year post-acquisition period will not be treated as a built-in loss or a deduction attributable to a period prior to the date of ownership change. Consequently, the acquirer is now permitted to offset the entire loss against its income once the loss is recognized, thereby creating what could be a substantial tax benefit that was not available prior to the issuance of the Notice. The ability to make current use of the tax deduction that results from the recognition of the unrealized losses, also substantially reduces the adverse effect of the "mark-to-market" rule required by FASB Statement No. 141R.
The result of the actions of the federal government is an opportunity for healthy banks to expand. Not only is the government providing the capital necessary for acquisition via the TARP Capital Purchase Program, but through the Notice it is also providing a substantial tax benefit to subsidize the purchase and subsequent disposition of the troubled assets. It is also important to note that Notice 2008-83 focuses only on the provisions of I.R.C. §382, which covers equity acquisitions through an ownership change of more then 50 percent of the target institution. It would not apply to asset acquisitions. Nevertheless, the combination of the TARP capital program and the tax benefits provided by Notice 2008-83, provide a unique opportunity to many banks seeking to expand their business.
Edward H. Brown is a Member of the Firm in the Business Law practice as well as the Tax Law and Estate Planning practices in the Atlanta office.