IRS Not Appealing PSB Ruling

WASHINGTON - Rather than appeal a recent U.S. Tax Court's ruling that a bank can deduct the interest expenses of tax-exempt bonds held by a subsidiary investment company, the Internal Revenue Service is expected to try to write rules prohibiting the practice, a lawyer said yesterday.

But some members of the tax community are skeptical about whether the IRS would be able to write rules sidestepping existing tax law language and warn the agency may instead have to ask Congress to change the law.

The ruling has received significant interest from the banking community since it was handed down by the court in November, said Debra Sadow Koenig, an attorney at Godfrey & Kahn SC in Milwaukee, who represented PSB Holdings, the parent company of Peoples State Bank in Wisconsin, that sued the IRS over the issue.

"My understanding is that even though many of the banks that have been audited on this issue are in Wisconsin, there are banks all over the country that are affected by this decision," she said.

The IRS had until March 11 to appeal the ruling, but let the deadline pass without taking any action. Koenig learned from her discussions with IRS officials in Wisconsin that the agency plans to soon release regulations that would prohibit the practice that would be effective on a prospective basis. The IRS has already agreed to refund the excess taxes already collected from banks with investment subsidiaries holding tax-exempt bonds.

The case centers around provisions within the tax code that prevent a bank from taking interest expense deductions for tax-exempt bonds purchased during the past two decades.

People State Bank disputed the IRS' claim that it owed more than $100,000 in taxes from 1999 to 2002 as a result of deductions it allegedly improperly took for interest expense on tax-exempt bonds purchased by the bank and held by its subsidiary, PSB Investments Inc.

The subsidiaryheld between $14 million and $17 million of tax-exempt bonds during that time. The bank had purchased the bonds after 1986.

The IRS said the bank underpaid its taxes because, under Section 265(b) of the tax code, a "financial institution" is not eligible for an interest expense deduction for any tax-exempt bonds purchased after Aug. 6, 1986. The bank disputed the agency's allegations by claiming that the subsidiary is not a financial institution and that it and the subsidiary are two separate and distinct taxpayers, despite their having filed a consolidated return.

The IRS argued that its 1990 Revenue Ruling 90-44 requires the inclusion of subsidiary holdings in the calculations, and that PSB was simply using the subsidiary as a way to circumvent the tax code.

The court agreed with PSB that the two entities were separate taxpayers for purposes of the deduction.

"Nothing that we read in the statutes ... directs us to ignore the separate existence of [the subsidiary and the bank] or otherwise to treat [the subsidiary's] self-purchased tax-exempt obligations as owned by [the bank]," the ruling stated, adding, "We apply the law as written by Congress and leave it to Congress or to the Department of the Treasury ... to address any gaps in the statutes as written."

Koenig said the IRS may have declined to appeal the ruling because it strongly favored the bank on all counts.

"I assume that it was a policy decision on the IRS' part, that they would rather devote their scarce resources to solving this problem globally, rather than by litigating the issue with the multitude of banks affected by this issue, especially in light of the Tax Court's opinion," she said.

While the IRS has given up its court battle and is opting to write regulations, Koenig said the wording of the statute may make it difficult for the agency to do so.

"The real question here is: Is the statute so clear on its face that there would be no regulatory fix that the IRS could do?" she said. "The tax bar is somewhat skeptical that the result of the PSB case can be reversed merely by regulations. It may be that the IRS will have to go to Congress to change the statute."

While the IRS would maintain more control over the process by issuing regulations, some tax experts think the only way to make banks include subsidiary holdings for purposes of taking such deductions would be by changing the statute.

W. Eugene Seago, a professor of accounting at Virginia Polytechnic Institute and State University who wrote a February Journal of Taxation article on the case, said regulations may not be sufficient because the statute is too narrowly defined.

"The wording of the statute is such that if you look at a single entity and you don't have a direct relationship between the borrowing and the investing, then the interest deduction is going to be allowed," he said. "The statute's too specific."

But Tom Vander Molen, a tax attorney with Dorsey & Whitney LLP in Minneapolis, said other sections of the tax code may give the IRS the ability to address the issue through regulation.

"Although the case focused on interpreting the language of the statute, the court did point out that the IRS has broad powers to adapt consolidated return regulations to affect consolidated groups," he said.

A section of the tax code that might provide such that authority, he says, is Section 7701(f), which states, "The secretary shall prescribe such regulations as may be necessary or appropriate to prevent the avoidance of those provisions of this title which deal with (1) the linking of borrowing to investment, or (2) diminishing risks, through the use of related persons, pass-thru entities, or other intermediaries."

The consolidated return regulations, he added, are historically given broad deference by the tax courts, and likely would only be struck down if they were found to be in direct contradiction with an existing statute or regulation.

IRS officials declined to comment on the case.

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