The American Bankers Association has urged the Treasury Department not to draft overly broad regulations to overturn a recent tax court case involving PSB Holdings Inc., warning the rules could effectively impose a new tax on banks for investing in tax-exempt securities.

In a letter sent to the department last week, the group also cautioned that if the rules are not narrowly targeted, they could create a "distinct disadvantage" for banks when it comes to investing, and would go against the intent of the section of the tax code the regulations are intended to implement.

Meanwhile, Treasury officials confirmed yesterday that they are in the process drafting regulations in an attempt to close a perceived loophole in the tax code that allowed the tax court to conclude banks could take certain tax deductions that normally would be unavailable to them by shifting their tax-exempt holdings to a wholly owned non-bank subsidiary.

Section 265(b) of the tax code stipulates that a "financial institution" is not eligible for an interest expense deduction for any tax-exempt bonds purchased after Aug. 6, 1986. As a result, several banks across the country have shifted tax-exempt holdings to non-bank subsidiaries to preserve such deductions.

In November, the U.S. Tax Court ruled that PSB Holdings, the parent company of Peoples State Bank in Wisconsin, did not owe the Internal Revenue Service more than $100,000 in taxes from 1999 to 2002. The IRS claimed the bank improperly took interest-expense deductions on tax-exempt holdings purchased by the bank and held by its subsidiary, PSB Investments Inc.

The IRS argued its regulations require that subsidiary holdings must be included in calculating the deduction, but PSB contended that the bank and subsidiary were separate taxpayers, subject to separate tax code requirements, despite filing a consolidated tax return. The case reached the court after the bank sued the IRS.

But after the court strongly ruled in PSB's favor and said that, under the statute, the bank and subsidiary are separate taxpayers and should be treated as such, the IRS declined to appeal the ruling, allowing the March deadline to pass without taking action.

Instead, Treasury officials have been drafting regulations to address the situation. They declined to offer a timeframe, but Debra Sadow Koenig, an attorney at Godfrey & Kahn SC in Milwaukee, who represented PSB Holdings, said she does not expect to see them any time soon.

"Given the internal review process at IRS and Treasury for issuing proposed regulations ... this will be a long-term process," she said. "I don't foresee any regulations being published in the near future."

In its letter, the ABA warned that if the proposed regulations require banks to include any non-bank subsidiary holdings, it would place banks at a disadvantage and ignore the intent of Congress when it enacted the relevant Section 265(b) of the tax code.

"Any proposed regulations issued under Section 265(b) that consolidate a bank with its non-bank subsidiaries would mean that even a non-bank subsidiary that has independently earned income and has no debt would be unable to purchase or carry tax-exempt assets without causing its parent bank to suffer an interest expense disallowance ... In fact, new regulations requiring consolidation ... would put banks at a distinct disadvantage compared to non-banks," the letter stated.

"The irony of issuing regulations requiring consolidation for banking groups is that such a rule would create the reverse problem Congress intended to correct in enacting Section 265(b). Before Section 265(b) was enacted, Congress viewed non-banking groups to be disadvantaged compared to banks, and Section 265(b) was passed to level the playing field. New consolidating regulations would turn this situation on its head by continuing to benefit non-banks while unfairly placing banks in a disadvantageous position."

As Treasury is drafting rules in this area, it should keep Congressional intent in mind, the letter said. The letter offered a "safe harbor" example, under which tax-exempts held by a subsidiary could be excluded from consolidation with the parent bank, if the amount of tax-exempts does not exceed the subsidiary's retained earnings.

"It would satisfy Congress' intent to maintain equality between banking and non-banking groups, by allowing banks to purchase or carry tax-exempt assets with non-borrowed funds (i.e. the non-bank subsidiary earnings) without suffering an interest expense disallowance in the same way that non-banking groups can," the letter stated.

The ABA intentionally did not weigh in on whether or not the Treasury would even be able to address the perceived loophole through regulatory changes. Some tax experts have said in the past that the IRS may need to ask Congress to change the tax code to require banks to include subsidiary holdings in their returns.

The group said its letter was not intended to say whether regulations would be sufficient, but simply to ensure that the IRS and Treasury understand the situation and Congress' original intent.

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