C. Special Rules for Net Operating Losses of Financial Institutions (Sec. 903 of the Act and sec. 172 of the Code) 24 Prior Law Under prior law, commercial banks or thrift institutions (mutual savings banks, domestic building and loan associations, and cooperative banks) may carry net operating losses (NOLS) back to the prior 10 taxable years and forward to the succeeding five taxable years. Under both present and prior law, other taxpayers generally may carry net operating losses back to the prior three taxable years and forward to the succeeding 15 taxable years. Reasons for Change The Congress believed that net operating losses incurred by financial institutions, such as commercial banks and thrift institutions, should be treated in the same manner as net operating losses incurred by other taxpayers. However, the Congress was aware that the immediate application of such a change to commercial banks in concert with the repeal of the reserve method of computing a deduction for bad debts could have an unnecessarily adverse impact upon the deferred tax accounts that such taxpayers keep for financial and regulatory accounting purposes. Accordingly, the ten year carryback period of prior law is retained for such taxpayers for taxable years beginning before 1994 for the portion of a net operating loss attributable to deductions for bad debts. The Congress was concerned that thrift institutions that had incurred large net operating losses in years prior to the Act not be encouraged to engage in overly risky activities or to reorganize with other taxpayers in order to use the net operating losses within the prior law carry forward period. The Congress believed that an extension of the carryforward period by an additional three years is a preferable approach to encouraging overly risky activities or reorganizations that are motivated by tax rather than economic considerations. The Congress believed that an additional three-year carryforward period for such losses was appropriate because the three additional years permit a total carryover period (i.e., 18 years) equal to that available to taxpayers generally. The Congress believed that the potential inability to use net operating losses is most pronounced for losses incurred during taxable years beginning during the period 1982 to 1985, and that it is appropriate to limit the additional carryforward period to those taxable years. 24 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 803; H. Rep. 99-426, p. 592; H.R. 3838 as reported by the Senate Committee on Finance on May 29, 1986, sec. 802; S. Rep. 99-313, pp. 289290; and H. Rep. 99-841, Vol. II (September 18, 1986), pp. 335-336 (Conference Report). Explanation of Provision The Act repeals the special rules permitting financial institutions to carry net operating losses back to the prior 10 taxable years and forward to the succeeding five taxable years. Thus, financial institutions generally are subject to the general rule allowing taxpayers to carry net operating losses back to the preceeding three taxable years and forward to the succeeding 15 taxable years. Net operating losses incurred by a thrift institution in taxable years beginning after December 31, 1981, and before January 1, 1986, may be carried back to the prior 10 taxable years and carried forward to the succeeding eight taxable years. A special 10-year carryback provision is provided for commercial banks that are required to compute their deduction for bad debts using the specific charge-off method as a result of the Act. The portion of net operating losses for any taxable year beginning after December 31, 1986, and before January 1, 1994, that is attributable to deductions for bad debts is carried back to the prior 10 taxable years and carried forward to the succeeding five taxable years. The portion of the net operating loss of a commercial bank attributable to deductions for bad debts is the excess of the net operating loss for the taxable year over the net operating loss for such taxable year computed without regard to any deductions for bad debts. The special 10-year carryback provision does not apply to either a commercial bank that continues to compute its deduction for bad debts using the reserve method or to a thrift institution. An entity that was previously treated as a thrift institution now treated as a large commercial bank (and thus not allowed to use the reserve method of computing a deduction for bad debts) is subject to this special 10year carryback provision. The special 10-year carryback provision is provided in place of the normal rules requiring a net operating loss to be carried back three years and carried forward 15 years. A commercial bank subject to the special 10-year carryback provision may elect to relinquish the entire carryback period as part of an election to relinquish any carryback for all net operating losses arising within a taxable year. The availability of criteria of these provisions is determined by the status of the entity in the year in which the net operating loss arises. Revenue Effect The provision is estimated to decrease fiscal year budget receipts by $59 million in 1988, $93 million in 1989, $92 million in 1990, and $77 million in 1991. D. Repeal of Special Rules for Reorganizations of Financially Troubled Thrift Institutions (Sec. 904 of the Act and secs. 368, 382, and 597 of the Code) 25 In general Prior Law Prior law provided special rules designed to provide relief to financially troubled thrift institutions. These provisions, added by the Economic Recovery Tax Act of 1981,26 provided that the continuity of interest requirement was met if the depositors of the financially troubled thrift institution were depositors of the surviving corporation, allowed the carryover of net operating losses of a financially troubled thrift institution where its depositors continued as depositors of the acquiring corporation, and exempted certain payments from the Federal Savings and Loan Insurance Corporation (FSLIC) to financially troubled thrift institutions from income and the general basis reduction requirement of the Internal Revenue Code. Tax-free reorganization status Under both present and prior law, in order for a combination of two corporations to be a tax-free "reorganization" within the meaning of section 368(a), a judicially created continuity of interest rule must be satisfied. The continuity of interest rule generally requires that the shareholders of an acquired corporation retain a meaningful ownership interest in the acquiring corporation.27 If the transaction fails to qualify as a tax-free reorganization, the acquired corporation and its shareholders may recognize gain or loss on the transaction, and the acquiring corporation generally takes a cost basis in the acquired corporation's assets. If the transaction qualifies as a tax-free reorganization, the acquired corporation and its shareholders generally recognize no gain and the acquiring corporation assumes the acquired corporation's basis. It was unclear prior to the 1981 Act whether a merger of an insolvent thrift institution into a solvent thrift institution could comply with the "continuity of interest" rule, expecially where one of the institutions was mutually owned. For example, in Rev. Rul. 69-3, 1969-1 C.B. 103, the Internal Revenue Service ruled that a merger of a mutual savings and loan association into another mutual savings and loan association qualified as a tax-free reorganization. Nonetheless, a case decided by the Supreme Court after 25 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 804; H.Rep. 99-426, pp. 593-595; and H.Rep. 99-841, Vol. II (September 18, 1986), p. 336 (Conference Report). 26 Pub. L. 97-34, 97th Cong., 1st Sess. (1981); referred to as the "1981 Act". 27 See Penellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462, 468-470; Treas. Reg. secs. 1.368-1(b), 1.368-2(a). the 1981 Act, but relating to facts occuring prior to the 1981 Act, held that a merger of a stock savings and loan into a mutual savings and loan failed to qualify as a tax-free reorganization. The Court held that continuity of interest did not exist because the depositors in the acquired institution (whose savings accounts were converted into accounts in the acquiring institution) received essentially cash plus an insubstantial equity interest.28 Under the 1981 Act, the continuity of interest requirement need not be satisfied in the case of a merger involving a thrift institution, provided certain conditions are met. First, the acquired institution must be one to which section 593 applies, namely, a savings and loan association, a cooperative bank, or a mutual savings bank. Second, the FSLIC or the Federal Home Loan Bank Board (FHLBB) (or, if neither has jurisdiction, an equivalent State authority) must certify that the thrift institution is insolvent, that it cannot meet its obligations currently, or that it will be unable to meet its obligations in the immediate future. Third, substantially all of the liabilities of the transferor institution (including deposits) must become liabilities of the transferee. If these conditions are satisfied, the acquired institution need not receive or distribute stock or securities of the acquiring corporation for the transaction to qualify as a tax-free reorganization (sec. 368(a)(3)(D)). The legislative history of the 1981 amendments made it clear that the provision covered all possible combinations of stock and mutual thrift institutions, including stock acquiring mutual, stock acquiring stock, mutual acquiring mutual, and mutual acquiring stock. Net operating loss carryovers Where a tax-free reorganization of two corporations occurs, the acquiring corporation generally succeeds to the tax attributes of the acquired corporation, including its net operating loss carryovers, subject to certain limitations in section 382. Under prior-law section 382, the ability of an acquiring corporation to succeed to the net operating loss carryovers of a corporation acquired in a taxfree reorganization was limited to the extent the owners of the acquired corporation fail to acquire stock in the acquiring corporation representing at least 20 percent of the value of the latter's stock (sec. 382(b)). The 1981 Act provided that depositors in a thrift institution that had been certified as financially troubled whose deposits carry over to the acquiring corporation would be deemed to have continued an equity interest in the thrift inastitution to the extent of their deposits. Thus, any losses of the thrift institution were less likely to be reduced under the loss limitation provisions of section 382. FSLIC contributions Under both present and prior law, although contributions to capital by nonshareholders are excluded from the income of the recipient corporation (sec. 118), the basis of property normally must be reduced by such contributions (sec. 362(c)). The status of contributions from the FSLIC as either taxable income or as a contribution 28 Paulsen v. Commissioner, 105 S. Ct. 627 (1985). to capital was unclear prior to the 1981 Act. The 1981 Act provided that certain financially troubled thrift institutions need not reduce their basis for money or property contributed by the FSLIC under its financial assistance program, and such amounts were not includible in income (sec. 597). Reasons for Change The stated purpose of the special rules in the 1981 Act relating to financially troubled thrift institutions was to provide favorable tax rules to aid those institutions, their depositors, and the institutions that insure their deposits. The Congress believed that these 1981 Act rules were inconsistent with the policies of normal tax rules that otherwise would apply to those institutions. Moreover, the Congress believed that these special rules were unfair since they provided beneficial treatment to a selected class of beneficiaries. Accordingly, the Congress believed that, after a two-year transitional period, financially troubled thrift institutions should no longer receive the preferential tax treatment accorded by the 1981 Act. Explanation of Provision The Act repeals the special provisions enacted in the 1981 Act relating to acquisitions of financially-troubled thrift institutions, and the exclusion from income and the basis reduction requirement of FSLIC payments to such thrift institutions, effective after December 31, 1988.29 Accordingly, acquisitions and reorganizations after that date involving financially troubled thrift institutions will be subject to the generally applicable rules. The Act also provides that no deduction may be disallowed under section 265(a)(1), relating to expenses allocable to tax-exempt income, for any amount paid or incurred by a taxpayer on the ground such amount is allocable to amounts excluded under section 597. Effective Date The repeal of the special reorganization rules is effective for acquisitions or mergers occurring after December 31, 1988. The exclusion for certain FSLIC payments is repealed for payments received in taxable years beginning on or after the same date. An exception is provided, however, for payments made pursuant to an acquisition or merger that occurs before January 1, 1989. Revenue Effect The provision is estimated to increase fiscal year budget receipts by $46 million in 1989, $105 million in 1990, and $164 million in 1991. 29 For discussion of amendments to Code section 382, see Title VI., Part F., supra. |