WASHINGTON — In a little noted opinion that could have substantial implications for banks, the U.S. Tax Court recently ruled against the Internal Revenue Service, determining that a bank does not lose its deduction for interest expenses due to the tax-exempt bonds held by its subsidiary investment company.

“It’s a very significant ruling for bank holding companies and banks with affiliates, because this opinion basically helps them out on an issue that concerned them,” Tom Vander Molen, a tax attorney with Dorsey & Whitney LLP in Minneapolis, said about the Nov. 1 ruling and its effect on the growing number of banks that have set up such subsidiaries. “They’ll certainly feel more comfortable doing what they’re doing.”

“It’s really a big win for the taxpayers,” said Francisca Mordi, tax counsel for the American Bankers Association. “Obviously, banks that have subsidiaries are pleased with this ruling because it took off the burden that they had to prove the subsidiary wasn’t a sham.”

The IRS, which claimed the bank took advantage of a loophole in the tax law to reduce its taxes, have not yes appealed the ruling. The agency has until March 10 to file an appeal. The tax court said in its opinion that if the IRS is unhappy about such practices, it should ask Congress to amend the tax code to abolish the practice or adjust its own regulations.

But ABA officials say banks are not creating investment subsidiaries to take advantage of a tax code loophole. Mordi said many banks have set up such subsidiaries and they are fully within the boundaries of the tax law. She could not provide the number of banks.

The case, PSB Holdings Inc. v. Commissioner, focuses on provisions of the tax code that prevent a bank from taking interest expense deductions for tax-exempt bonds purchased during the past two decades.

In the case, Peoples State Bank disputed the IRS claim that it owed more than $100,000 in taxes from 1999 to 2002. A wholly owned investment subsidiary of the bank, PSB Investments Inc., held between $14 million and $17 million of tax-exempt bonds during that time. The IRS said the bank underpaid its taxes because, under Section 265(b) of the tax code, a bank is not eligible for an interest expense deduction for any tax-exempt bonds purchased after Aug. 6, 1986. The bank disputed the claim, arguing that it and its subsidiary were two separate and distinct taxpayers.

However, the IRS pointed to its Revenue Ruling 90-44, which was issued in 1990, that states it can include subsidiary holdings in determining the interest expense deduction of a parent company. The agency argued in the case that investment subsidiaries are simply used by banks to circumvent the tax code.

“The IRS’ initial contention was that the subsidiary didn’t really do anything other than hold the securities, and I believe that was a strong basis for their position,” ABA’s Mordi said.

The tax court disagreed, saying that even though the bank and the subsidiary filed a joint tax return, under the law they are deemed to be separate taxpayers for purposes of the interest expense deduction.

“Nothing that we read in the statutes or in the consolidated return regulations directs us to ignore the separate existence of investments and peoples or otherwise to treat investments’ self-purchased tax-exempt obligations as owned by peoples,” it said.

The court added that it is the responsibility of Congress or the Treasury Department, not the court, to close any perceived loopholes.

“We apply the law as written by Congress and leave it to Congress or to the Department of the Treasury, the latter through and to the extent of its regulatory authority, or by other permissible means, to address any gaps in the statutes as written,” it said.

If the court had agreed with the IRS, the bank would have lost some of its interest expense tax deduction proportional to the percentage of the bonds that made up its total assets.

The only exception is “bank-qualified bonds,” which are public purpose bonds sold to banks by issuers that sell $10 million or less of debt a year. To ensure small issuers would find buyers for their bonds, Congress, in the 1986 Tax Reform Act, said banks could deduct 80% of the costs of purchasing and carrying the bonds.

Vander Molen said the court’s ruling is very favorable to banks because it allows them to account for the money they give a subsidiary for investments when determining their total assets, but excuses them from having to include that subsidiary’s tax-exempt holdings when determining the amount of tax-exempt bonds held by the bank.

“It’s kind of the best of both worlds. They don’t have the negative of accounting for the subsidiary's tax-exempt bonds, but they have the positive of including their investment in the subsidiary as an asset,” Vander Molen said.

He added, however, that the ruling does not necessarily mean that banks can create subsidiaries for the sole purpose of avoiding the loss of the tax deduction for the interest rate expenses associated with tax-exempt bonds.

If the IRS could prove that a bank borrowed money, then transferred it to a subsidiary specifically for the purchase of bonds, the bank could still lose the ability to take the tax deduction, Vander Molen said.

Mordi said that while the court ruling validated a practice already shared by many banks, it is not advantageous enough to make banks more interested in tax-exempt bonds.

“The banks that have tax-exempt bonds already are happy with the decision, but I don’t think that’s going to make banks go out and buy them,” she said.

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