Federal lawmakers and a commercial banking group are warning the Treasury Department that, due to struggles in the financial and municipal bond markets, they should avoid any rule-making that could further restrict banks from purchasing tax-exempt bonds.

A group of five representatives, including House Financial Services Committee chairman Barney Frank, D-Mass., and theClearing House Association, the nation's oldest bank association, sent letters to the Treasury this month requesting that officials use caution in writing regulations designed to close a perceived loophole in the tax code regarding banks with tax-exempt debt holdings.

Treasury is reportedly considering issuing rules that would effectively overturn a November 2007 U.S. Tax Court ruling that determined a bank did not need to account for the tax-exempt holdings of its subsidiary when calculating its interest expense deductions.

In that case, the tax court strongly sided with PSB Holdings, the parent company of Peoples State Bank in Wisconsin, which sued the Internal Revenue Service over its claim that the bank owed more than $100,000 in back taxes.

The court ruled that the bank's wholly owned subsidiary, PSB Investments Inc., should be treated as a separate taxpayer, and as a result its tax-exempt holdings would not count against the parent bank's interest expense deductions. Such deductions are taken on interest paid for money borrowed to purchase investments. The IRS declined to appeal the ruling, instead opting to draft new rules to prevent the practice in the future.

However, in a letter dated Aug. 1 but released yesterday, lawmakers warned that overly restrictive regulations could place additional burdens on municipal issuers already struggling in the wake of the credit crisis.

"For state and local bond issuers seeking to finance critical infrastructure projects, the credit crisis has meant less access to financing, increased interest costs, and a shrinking universe of available investors," the letter stated. "This marketplace needs assistance."

Frank was joined in signing the letter by Reps. Dave Camp, R-Mich., Phil English, R-Penn., Richard Neal, D-Mass., and Sander Levin, D-Mich.

As examples of such assistance, the letter cited the recently enacted housing law, which permitted the Federal Home Loan Banks to provide letters of credit for tax-exempt bonds, in an attempt to address credit enhancement shortages brought on by struggles of the major bond insurers.

The letter also noted legislation introduced by Frank, HR 6333, that would attempt to increase demand for munis by modifying the tax code to allow more investment by financial institutions. Among others, that bill would change Section 265(b) of the code, which was the section debated in the tax court in the PSB ruling, to allow banks to purchase more muni bonds. The bill is currently pending before the House Ways and Means Committee.

While the lawmakers stopped short of calling into question the regulations, they requested, at least, that any new regulations permit banks to keep the muni bonds they currently own.

"At a minimum ... we would ask that any proposed effective date be prospective and applicable only to future purchases of municipal bonds," it stated. "This approach would avoid the further disruption that would accompany a forced sale of significant quantities of municipal debt."

The Clearing House, however, did call into question the need for such regulations, arguing that a statutory change would be a better way to alter the code.

"Legitimate questions about Treasury's existing regulatory authority will surely be raised if the Treasury were to propose a rule aggregating a bank and its non-bank subsidiaries for purposes of section 265(b)," the letter stated. "Legislation would avoid a protracted battle between taxpayers and the IRS."

The group went on to throw its support behind Frank's bill, saying: "The regulations ... could only work in the opposite direction, by closing off investment by a significant class of potential bond buyers."

They also reiterated the lawmakers' request that if regulations are adopted, they only function prospectively, to minimize market disruption.

Debra Sadow Koenig, an attorney at Godfrey & Kahn SC in Milwaukee, who represented PSB before the tax court, said yesterday she expects the regulations to be strictly prospective.

No time frame has been given on the potential regulations.

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