There is a current earnings improvement opportunity associated with existing tax-exempt municipal bond portfolios held by banks. It may come as a surprise to some, but most “tax-exempt” municipal bonds are not fully exempt from Federal Tax. There is a seldom-discussed Federal Tax liability that comes from interest expense disallowance rules established by the Tax Equity and Financial Responsibility Act of 1982. With interest expense on the rise, this added tax has become a meaningful drag on earnings for some institutions. Below, we discuss a strategy employed by many banks over multiple decades that aims to improve after tax income from existing (and new) tax-exempt municipal bond investments.
Tax Treatment of Municipals – The TEFRA “Penalty”
Originating in 1982 from the Tax Equity and Fiscal Responsibility Act, the most relevant part of TEFRA relates to the ability to deduct interest expense for banks with tax-exempt securities (i.e. municipal bonds). The tax code does not allow banks to deduct interest expense on liabilities associated with tax-free securities. The TEFRA penalty depends on three factors: a bank’s interest expense (cost of funds), the tax rate, and the disallowance percentage.
Now, with cost of funds rising significantly, the interest expense disallowance has increased exponentially affecting the bank’s federal tax liability and after-tax income. The good news is there is a strategy component that enables banks to own tax-exempt municipals without being subject to interest expense disallowance.
Establishing a Subsidiary to Efficiently Own Tax-Exempt Municipals
With interest expense disallowance potentially reducing after tax returns of tax-exempt municipal bonds, many years ago banks began exploring ways to most efficiently own and manage these assets. The answer was to establish a wholly owned subsidiary of the bank to hold tax exempt municipals. This element of the strategy was validated by the courts in 2007, when PSB Holdings, a subsidiary of Peoples State Bank (Wisconsin), brought a case against the IRS and prevailed in court. The issue was whether tax-exempt obligations held by investment subsidiary of a bank, must be included in the bank’s interest expense disallowance (TEFRA) calculation. The court ruled in favor of the Bank, and in 2008 the IRS declined to appeal the ruling. It has not been challenged since.
Business Purpose of the Subsidiary
One necessary step to take when establishing a subsidiary is to have a valid non-federal tax business purpose to provide substance and support. When it comes to business purpose, the bank needs to have a defendable answer to this key question: “What are you doing differently at the subsidiary vs. what you are currently doing at the bank?” Business purpose weakens without the use of a third party who has expertise in the municipal market and can assist in the management and monitoring of this asset class. For example, the bank’s portfolio manager also performing credit analysis and surveillance of the subsidiary’s portfolio is not likely to be deemed an acceptable business purpose. The need to fundamentally change how this segment of the portfolio is managed and monitored remains central to the strategy, but it is important to note the bank does not have to give up transaction control of the portfolio.
Conclusion
The investment subsidiary strategy is a way to optimize your tax-exempt holdings by efficiently owning them to maximize after-tax returns with effective risk oversight and sound business purpose.
The best way to learn more about the strategy is through a short presentation offered by HUB | Taylor Advisors to determine if your institution would be a good candidate. This discussion would also review the elements of the strategy mentioned above, including a review of the earnings enhancement potential, TEFRA penalty quantification, business purpose, accounting implications, implementation and operational best practices.