Current Tax Issues for Community Institutions

Transcription

1 Current Tax Issues for Community Institutions Monday, June 17, :15 AM 12:15 PM Presented by: David A. Thornton, CPA Partner Crowe Horwath LLP 488 Madison Ave., Floor 3 New York, NY P: (212) E: david.thornton@crowehorwath.com slide 1

2 Agenda: IRS Audit Initiatives Aimed at the Financial Services Industry Recent Tax Regulations and Administrative Pronouncements Tax Benefit Limitations and Potential Hidden Tax Costs Associated with Acquisitions slide 2

3 IRS Audit Initiatives Aimed at the Financial Services Industry slide 3

4 Current Target Issues for the IRS Bad debt deductions for loan losses (i.e. charge-offs) Non-performing loan interest exclusion Foreclosure transactions and OREO Success-based fees paid to consummate merger and acquisition transactions Recent IRS challenge to certain historic tax credit partnership structures slide 4

5 Bad Debts and Non-Performing Loans Both areas have historically been the subject of significant disagreement between taxpayers and the IRS The issue centers on the timing of the deduction for worthless loans and worthless accrued interest Thus, the issue is a temporary difference that generally only impacts the deferred tax asset However, for banks with a valuation allowance against their recorded deferred tax asset, the effect of lost deductions could directly impact income tax expense slide 5

6 Bad Debts and Non-Performing Loans The bad debt conformity election found in Regulation (d)(3) offers banks a safe harbor for deducting worthless loans If elected, the bank must conform its bad debt deduction to loans classified as loss assets for regulatory purposes In order to elect the safe harbor, the bank must secure an Express Determination Letter from its primary federal regulator and must continue to do so for each subsequent examination cycle slide 6

7 Bad Debts and Non-Performing Loans While most banks would benefit from the IRS audit protection secured under the election, there may be circumstances under which banks do not want to conform their tax deductions to regulatory charge-offs These circumstances typically involve scenarios where the bank would prefer to defer the deduction until later years (can easily be done for partial charge-offs) Expiring net operating loss or tax credit carryforwards, so bank is seeking to maximize current taxable income IRC 382 limitation placed on built-in losses related to loans, so bank may potentially mitigate the limitation by delaying the bad debt deduction until after the built-in loss window closes slide 7

8 Bad Debts and Non-Performing Loans Revenue Ruling extends the safe harbor provided by the bad debt conformity election to cover the write-off of non-performing loan interest This protection is significant because it often results in a more beneficial treatment of non-performing loan interest than would otherwise be available outside the scope of the bad debt conformity election If elected, the bank is still required to pay tax on interest collected while the loan remains in nonperforming status (even if this interest is not recorded to book income) slide 8

9 OREO Foreclosure Issues Foreclosed property is required to be taken into possession with a tax basis equal to its FMV Once OREO is taken into possession, subsequent write-downs to FMV are not deductible for tax purposes until the property is sold Under examination, there is often disagreement about what the FMV of the OREO was at the foreclosure date based upon the timing of appraisals slide 9

10 OREO Foreclosure Issues Post-foreclosure appraisals: Any attempt to argue that OREO write-downs resulting from post-foreclosure appraisals represent deductible losses retroactive to the foreclosure date are likely to be challenged by the IRS The IRS often argues that such losses represent post-foreclosure declines in fair market value and are therefore not deductible until the OREO property is sold Ideally, appraisals dated on, or very close to, the foreclosure date should be used to support the amount of the charge-off claimed upon foreclosure slide 10

11 OREO Foreclosure Issues Inclusion of selling costs in foreclosure date FMV: This reduction is required for regulatory and GAAP accounting purposes In recent years the IRS has challenged taxpayers who reduce the FMV of OREO at foreclosure by anticipated selling costs, arguing that there is no basis in tax law for allowing this reduction to FMV There is an old district court case addressing this issue - Bank of Kirksville which is taxpayerfavorable but the IRS had indicated they will not follow the decision slide 11

12 OREO Foreclosure Issues Inclusion of selling costs in foreclosure date FMV: If the taxpayer is under the bad debt conformity election and the bad debt deduction claimed matches the portion of the loan classified as a loss asset for regulatory purposes, the taxpayer should be protected against any potential examination adjustment slide 12

13 OREO Foreclosure Issues Inclusion of selling costs in foreclosure date FMV: On an informal basis, the IRS has recently expressed an inclination to abandon its position on this issue, but nothing official has yet been released Taxpayers under examination may want to defer conceding this issue, pending forthcoming guidance from the IRS slide 13

14 Deducting OREO Carrying Costs In recent years, there has been a coordinated effort by the IRS to require capitalization of carrying costs on non-income producing OREO property The IRS argument was based upon an assertion that the OREO property is inventory acquired for resale and, consequently, 263A requires all carrying costs to be capitalized to the basis of the individual properties (which would permit them to be deducted upon disposal of the applicable properties) Numerous taxpayers conceded this issue under examination because the IRS would not settle the issue in Appeals slide 14

15 Deducting OREO Carrying Costs On 3/1/2013, the IRS released a memorandum indicating a reversal of their position on this issue The memorandum holds that OREO acquired through foreclosure proceedings or by deed-in-lieu of foreclosure by the bank that originated the loan is not inventory, but instead represents an extension of the lending transaction Consequently, the memorandum holds that carrying costs are currently deductible because they represent an ordinary and necessary cost of carrying on the banking business slide 15

16 Deducting OREO Carrying Costs While the IRS memorandum does not represent citable precedent for other banks to follow, the IRS is in the process of finalizing formal industry guidance Nevertheless, this pronouncement does indicate the current view of this issue by the IRS National Office and should be raised by any bank facing an IRS challenge on this issue Furthermore, the issuance of this pronouncement should be considered a new development by any bank that currently maintains an unrecorded tax benefit (FIN 48 / ASC reserve) for this issue slide 16

17 Deducting OREO Carrying Costs Unanswered questions that may be resolved when formal IRS guidance is issued: The memorandum addresses the bank that originated the loan. What about Loans purchased from another bank? Non-bank lenders? What happens to taxpayers who conceded this issue under examination, or might otherwise be capitalizing OREO carrying costs? Reversal of examination adjustments? Refund of interest? Accounting method change (i.e. IRS form 3115)? slide 17

18 Deducting Success-Based Fees in M&A Transactions In 2011, the IRS issued Revenue Procedure which provides an elective safe harbor to deduct 70% of any success-based fee associated with most merger and acquisition transactions This protection is substantial, as it eliminates what is likely a significant tax uncertainty regarding the deductible portion of these fees (if elected) Requires a formal election IRS also indicated that they will generally allow prior year deductions under audit if they did not exceed 70% (LB&I ) slide 18

19 Deducting Success-Based Fees in M&A Transactions In July 2012, the IRS ruled (CCA ) that nonrefundable milestone payments that are due under a service agreement cannot qualify as contingent fees for purposes of the 70% deduction safe harbor election because they are not contingent upon the successful completion of the transaction Even if these fees can be credited against the successbased fee charged for the successful completion of the transaction, the fact that they relate to milestone events other than the transaction closing causes them to fall outside the scope of the safe harbor election The deductible portion of these amounts can still be supported in the traditional manner with no safe harbor slide 19

20 Deducting Success-Based Fees in M&A Transactions On April 30, 2013, the IRS issued audit guidance (LB&I ) reversing this position and instructing its agents not to disallow the application of the 70% deduction safe harbor to eligible milestone payments The guidance specifically applies to eligible milestone payments for investment banker fees that are part of a success-based fee arrangement No mention of other types of success-based fee arrangements (i.e. legal or other) slide 20

21 Deducting Success-Based Fees in M&A Transactions Eligible milestone payments include non-refundable payments that are creditable against a successbased investment banking fee and are: Contingent upon the execution of a letter of intent, exclusivity agreement or similar written communication; Contingent upon the authorization or approval of the material terms of the transaction by the board of directors Contingent upon any other specified event occurring in the course of the transaction that does not occur prior to the first occurrence of one of the above events slide 21

22 Deducting Success-Based Fees in M&A Transactions Example 1: Investment banker charges Seller a $1 million success-based fee payable upon the successful closing of its acquisition by Buyer If the safe harbor is elected, $700,000 of the success-based fee qualifies for deduction without any need to gather supporting information and this deduction is guaranteed slide 22

23 Deducting Success-Based Fees in M&A Transactions Example 2: Investment banker charges Seller a $100,000 nonrefundable fee for issuing the fairness opinion (assume after the board approves the transaction) plus a $1 million success-based fee payable upon the successful closing of its acquisition by Buyer The $100,000 is credited against the $1 million fee, so $900,000 is paid at closing The safe harbor deduction would amount to $700,000 ($1,000,000 x 70%) slide 23

24 Deducting Success-Based Fees in M&A Transactions Example 3: Investment banker charges Seller a $1 million fee related to its acquisition by Buyer payable as follows: $300,000 non-refundable installment payable upon the signing of the definitive agreement $300,000 non-refundable installment payable upon mailing the proxy solicitation to shareholders $400,000 non-refundable installment payable upon the successful closing of the transaction ($1 million fee less credit for the $600,000 milestone payments applied) The safe harbor deduction would amount to $700,000 ($1,000,000 x 70%) slide 24

25 IRS Challenge of Certain Historic Tax Credit Partnerships In a reversal of an originally taxpayer-favorable decision by the Tax Court, the U.S. Court of Appeals for the Third Circuit recently ruled in Historic Boardwalk Hall that historic rehabilitation tax credits could not pass through to one of the partners The basis for denying the pass through of the tax credits centered on the partnership agreement The taxpayer was found not to be a true partner for tax purposes due to the limitations placed on the taxpayer s downside risk and upside potential under the terms of the partnership agreement slide 25

26 IRS Challenge of Certain Historic Tax Credit Partnerships Some of the terms in this particular partnership agreement are commonplace in these types of historic tax credit partnerships out in the marketplace Going forward, care must be taken to distinguish the terms of the partnership agreement from those presented in the Historic Boardwalk Hall case Investor/partners may want to seek a formal tax opinion to evaluate the likelihood of successfully defending against a similar challenge Can an uncertain tax position reserve be avoided? If not, may have to disclose to IRS on Schedule UTP slide 26

27 Recent Tax Regulations and Administrative Pronouncements slide 27

28 Limitations on Prepaid Expense Deductions The IRS issued Revenue Ruling to clarify which short-term prepaid expenses qualify for the advance deduction under Reg (a)-4(f) The clarifications limit the application of the recurring item exception for prepaids that are capitalized for book purposes and prevent the advance deduction for prepaid service contracts that represent routine service agreements as opposed to services to be provided under unique and irregular circumstances (i.e. disaster recovery, unexpected breakdowns, etc.) Prepaid insurance and regulatory assessments are still valid deductions under these rules slide 28

29 Limitations on Prepaid Expense Deductions On November 7, 2012, the IRS issued a ruling (CCA ) formally stating its objection to an advance deduction for any portion of the 36 month prepaid FDIC assessment paid in 2009 under the 12 month rule of Reg (a)-4(f) The IRS ruled that the entire assessment was a single prepaid amount and not 13 separate prepayments of quarterly FDIC assessments Consequently, no portion of the prepayment would qualify for advance deduction under the 12 month rule Most banks had already given up on this position slide 29

30 Foreign Account Tax Compliance Act FATCA Enacted in 2010 as part of the Hiring Incentives to Restore Employment ( HIRE ) Act Seeks to address U.S. tax evasion through the use of foreign bank accounts and other foreign financial interests Generally applicable to payments made by U.S. taxpayers to foreign financial institutions Imposes a 30% withholding requirement on payments of interest, dividends, rents, royalties and other non-business income unless the recipient certifies compliance with U.S. requirements to identify U.S. account holders slide 30

31 Foreign Account Tax Compliance Act FATCA Generally applicable to withholdable payments made after 12/31/2013 However, no withholding is required for payments on any obligation outstanding on 1/1/2014 The payor has the obligation to identify applicable payments to foreign financial institutions (certification will be available) Model agreement for government-to-government exchange of information issued recently Final regulations were recently issued slide 31

32 Expanded Reporting of Nonresident Deposit Interest On April 17, 2012, Treasury issued final regulations requiring domestic banks to report U.S. deposit interest to nonresident alien individuals on form 1042-S The regulations apply to interest paid on or after 1/1/2013 to individuals from countries with which the U.S. has an information exchange agreement Revenue Procedure provides a list of these countries Both the Texas and Florida Bankers Associations recently filed a lawsuit in federal district court seeking to eliminate this expanded requirement slide 32

33 FICA Tax on Severance Payments The issue of whether severance payments are subject to FICA has been recently debated in the courts with no consistent result In the recent Quality Stores case, the U.S. Court of Appeals for the Sixth Circuit ruled for exemption However, the U.S. Court of Appeals for the Federal Circuit had previously ruled them taxable - CSX Corp. The Quality Stores case is currently pending appeal to the U.S. Supreme Court Taxpayers may be advised to consider filing protective refund claims for years with significant severance payments, pending the outcome of this issue slide 33

34 Tax Benefit Limitations and Potential Hidden Tax Costs Associated with Acquisitions slide 34

35 Can We Acquire Target s Tax Benefits? Yes, provided the acquisition is properly structured Generally requires: A tax-free reorganization or merger transaction with the purchase consideration consisting of the requisite percent of Acquiror stock; OR A taxable purchase of Target stock for cash and/or other consideration Acquiror succeeds to these Target tax benefits regardless of whether they are recorded on the GAAP books of Target (they may be offset by a valuation allowance) slide 35

36 Are There Limitations Placed on the Use of These Benefits? Potentially, depending on the size of the acquired benefits, the purchase price paid for Target, and the remaining life of any tax loss or credit carryforwards acquired from Target IRC 382 applies an annual limitation on Acquiror s use of Target tax benefits when there has been an ownership change with respect to Target The annual limitation is applied to: Tax loss and credit carryforwards acquired from Target; and Certain built-in losses triggered through sale of acquired Target assets within 5 years of the ownership change date (one year for loan charge-offs) slide 36

37 How is the Limitation Applied? The annual limitation is calculated by multiplying the purchase price paid for Target stock by an IRS published interest rate (2.70% for May 2013) The annual limitation generally represents the extent to which acquired Target tax benefits can be deducted or credited in any post acquisition year Deductions and credits in excess of the annual limitation can be claimed in future years, but most of them have a limited carryforward life (i.e. NOLs, tax credits and certain built-in losses have a 20 year carryforward life) slide 37

38 How is the Limitation Applied? Thus, if the limitation is small enough compared to the size of the acquired Target tax benefits subject to the limitation, some of the tax benefit can be permanently lost Example: Annual limitation = $1 million Target NOL acquired = $30 million (generated in the year of acquisition, so it has a 20 year carryforward life) Mathematically, a maximum $20 million of the acquired Target NOL will ever be used, and it will take 20 years to fully use it slide 38

39 Can We Plan Around the IRC 382 Limitation? In an acquisition setting, it may be difficult or impossible to completely plan around the limitation The best planning is to recognize the extent of the limitation in advance of pricing the transaction, so that Acquiror does not pay for tax benefits that it can never realize Acquiror may have control over when built-in losses on the sale of Target assets are triggered, so delaying these triggers beyond the built-in loss windows can preserve these benefits (i.e. defer loan charge-offs beyond the first anniversary of the acquisition / defer sales of other built-in loss assets beyond the fifth anniversary) slide 39

40 What if We Just Want to do a Stock Issuance? The IRC 382 limitation applies to any ownership change, not just those resulting from an acquisition Significant capital raises can also trigger an ownership change and the issues / limitations discussed previously An ownership change results when the stock ownership of 5% shareholders increases by >50% over a 36 month period For this purpose, all <5% shareholders are aggregated and viewed as a single shareholder, but different groups and sub-groups are segregated based upon discrete transactions and events slide 40

41 What Warning Signs Should We Look For? Large net operating loss and tax credit carryforwards on Target s tax returns Significant deferred tax assets on the books of Target (whether recorded or offset by a valuation allowance): Net operating loss and tax credit carryforwards Allowance for loan losses Other-than-temporary impairment of securities OREO write-downs slide 41

42 What Warning Signs Should we Look For? Market value of stock is significantly below book value i.e. would result in sizeable downward purchase accounting adjustments to acquired assets Same concerns with a corporation raising capital slide 42

43 Potential Limitations on Compensation Deductions IRC 280G: Applies if Target is a public company; OR To certain other non-public companies if shareholder approvals requirements are not met Imposes a combination of excise taxes and deduction limitations if change-in-control payments to officers, significant shareholders and certain highlycompensated individuals equal or exceed 3x a computed base amount The base amount is the average taxable compensation for the 5 calendar years preceding the year in which the change-in-control occurs slide 43

44 Potential Limitations on Compensation Deductions IRC 280G: If the 3x trigger is tripped: A 20% excise tax on all compensation deemed to be contingent on the change-in-control over 1x the base amount is levied against the employee All amounts subject to the 20% excise tax are nondeductible to Acquiror / Target The effect of tripping the trigger is especially onerous due to its retroactive application slide 44

45 Potential Limitations on Compensation Deductions IRC 280G - Example Base amount = $100,000 Therefore, up to $299,999 of compensation can be paid that is deemed to be contingent on the changein-control with no IRC 280G consequences However, if $1 of additional contingent compensation is paid: Excise tax of $40,000 [($300,000-$100,000) x 20%] to employee Lost deduction of $200,000 to employer Total combined cost of the additional $1 = $110,000 slide 45

46 Potential Limitations on Compensation Deductions IRC 280G: There are numerous rules and special treatments to determine when / how compensation is considered contingent on a change-in-control Focuses more on accelerated vesting than on accelerated payment Potential tax planning strategies: Increase the base amount where possible (stock option exercises are a common strategy) Restructuring compensation arrangements, but this requires extreme care and often requires the employee to make concessions slide 46

47 Potential Limitations on Compensation Deductions IRC 280G: Contractual terms that address the application of IRC 280G: Cut-back favors the employer at the expense of the employee (makes it the employee s problem ) Gross-up - favors the employee at the expense of the employer (makes it the employer s problem ) No provision offers potential for planning Gross-up provisions can make the IRC 280G issue exponentially expensive for Acquiror slide 47

48 Potential Limitations on Compensation Deductions IRC 162(m): Applies to public companies Applies to the CEO and the top three most highlycompensated officers other than the CEO and the CFO (CFO is effectively exempt from the limitation under current law) Limits deductible compensation for the tax year for any of these officers to $1 million Exceptions for qualified performance-based compensation such as stock options and incentive bonus plans approved by an independent board compensation committee slide 48

49 Potential Limitations on Compensation Deductions IRC 162(m): The limitation only applies if: The compensation is required to be reported in the summary SEC compensation table in the proxy filing and The officer holds his/her position as one of the affected officers as of the end of the tax year These conditions are often avoided in Target s final pre-merger period, but care should be taken to ensure that any potential limitation is identified and factored into Acquiror s purchase accounting entries slide 49

50 Nondeductible Transaction Costs Reg (a)-5 provides that transaction costs incurred in the timeline of evaluating an acquisition must be divided into investigatory (deductible) and facilitative (capitalized) amounts based upon an identified brightline date Bright-line date is typically the earlier of the date any letter of intent or exclusivity agreement is executed (if applicable) or the date the board formally approves the material terms of the transaction An exception applies for inherently facilitative costs that are so closely associated with facilitating the transaction that they are capitalized no matter when they are incurred slide 50

51 Nondeductible Transaction Costs Another exception applies to success-based fees discussed previously (refer to 70% safe harbor election) Acquiror s costs must be expensed for book purposes To the extent these costs are found to be nondeductible, no associated tax benefit can be recorded if the capitalization is permanent (which it is in most cases) Consequently, a large amount of these non-deductible costs can drive up the effective tax rate for the year in which the costs are incurred slide 51

52 Disclaimers The views expressed do not necessarily represent those of Crowe Horwath LLP. This material is for informational purposes only and should not be construed as legal, tax, accounting or other professional advice. Please seek guidance specific to your organization from qualified advisers in your jurisdiction. slide 52

53 Questions? slide 53