Should Banks Be Entitled To Tax Deductions For “Dividends” On TARP Stock?
Four years have passed since Congress enacted the Troubled Assets Relief Program, better known as TARP. After Treasury determined that frozen credit markets were threatening the U.S. financial industry and even the entire economy, it asked Congress to authorize the purchase of illiquid mortgages from banks. Congress obliged, authorizing Treasury to purchase up to $700 billion of these so-called “toxic assets.”
Soon after the enactment of TARP, Treasury Secretary Henry Paulson changed course and decided that investing directly in the banks would better serve TARP’s goals than would buying illiquid mortgages. Readers may remember Paulson’s next extraordinary and unprecedented move: summoning the CEOs of our country’s nine largest banks to Washington, the Secretary informed each of them that they must accept $25 billion worth of TARP investments—no questions asked. As one observer told the New York Times, Paulson’s “was a take it or take it offer. . . . Everyone knew there was only one answer.”
Paulson’s historic meeting concludes Andrew Ross Sorkin’s influential book Too Big To Fail, which chronicles the turmoil in the markets that eventually led to TARP’s enactment. It also begins an article that we published in the latest issue of the Journal of Taxation and Regulation of Financial Institutions. Our article considers the tax consequences of the Treasury’s TARP investment.
The article is bookended by two sections that assume the nominal form of the TARP investments – i.e., preferred stock – would be respected for tax purposes. The first part chronicles the tax treatment of the TARP investments under guidance issued by Treasury. The third part explains why Dodd-Frank, legislation ostensibly enacted to limit taxpayer-funded investments in financial institutions, would not prevent Treasury from making similar investments in the future.
In the heart of the article, we question the nominal form of the TARP investments and demonstrate why, for tax purposes, they should be characterized as debt instead of stock. The implicit and explicit terms of Treasury’s investment more closely resembled a borrowing relationship and, for tax purposes, should have been treated as such. Several tax consequences flow from this conclusion, the most important of which is the banks’ ability to treat the “dividends” paid to Treasury as interest and claim corresponding deductions (amounting to many billions of dollars) under Section 163.
Most of the common law factors traditionally employed to differentiate debt from equity for tax purposes counsel towards treating the TARP instrument as debt. Treasury’s own statements indicated that the government never intended TARP to be more than a short-term loan to keep the banks solvent and liquid until the credit markets thawed. Consistent with this approach, all but one of the banks represented at Secretary Paulson’s October 2008 meeting repaid their TARP investments by the end of 2009. The last would repay Treasury by the end of 2010.
Although we presume that none of the banks treated the TARP investment as debt on their tax returns, for an enterprising bank, the statute of limitations remains open to seek the refund that they are rightfully owed.Explore posts in the same categories: Corporate, Financial Products comment below, or link to this permanent URL from your own site.