Wouldn’t it be nice if the Internal Revenue Service issued a new tax rule that applied just to your company to help it retain all the net-operating losses it could? In that way, the NOLs could be used over the next 20 years to offset income, and reduce the company’s tax bill.
That’s what Treasury Secretary Henry Paulson did for Fannie Mae and Freddie Mac on Monday, when he had the IRS issue Notice 2008-76, which essentially allows the two government-sponsored enterprises to retain all of their NOLs, despite a change of control of ownership, tax expert Robert Willens told CFO.com.
Under the tax code — specifically Section 382 — NOLs are severely limited when there is a change of control. The rule is in place to prevent acquiring companies from buying up targets just to gain access to their NOLs. The NOLs for Fannie and Freddie are substantial. Over the last four quarters, Fannie and Freddie recorded about $14 billion in aggregate losses.
In essence, Paulson changed tax law so that the two lenders aren’t paying more in taxes to the government as a result of that same government becoming their controlling investor. When the government structured its bailout of the two mortgage lending giants, it seized control of Fannie and Freddie by buying up $1 billion worth of senior preferred stock in each GSE. The plan also stipulates that Fannie and Freddie will pay a 10 percent annual dividend on the preferred stock owned by the government; and no other dividend can be paid out without the permission of the Treasury Department.
If the Treasury Department were simply another company, such a takeover would constitute a change of control under the tax code. But the new ruling creates a big exception for the two mortgage lenders. And while the IRS ruling was issued without any basis in law, says Willens, the NOL provision of the bailout was done “very effectively.” He explains that the new rule eliminates the “testing dates” that normally would have applied to Fannie and Freddie, or any other company, in the event of a takeover.
The testing date is used to determine when a change of control takes place, and the stock price of the target company on that day. The stock price is used to calculate the target company’s market capitalization (share price times shares outstanding), and then the market cap is plugged into a formula to figure out how much of the target company’s losses the new parent can claim as its own NOLs.
The formula is straightforward. The change-of-control NOL limit is calculated by multiplying the target company’s market capitalization on the day of the acquisition by the IRS’s long-term tax-exempt rate – which is currently 4.6 percent.
With Fannie and Freddie’s market caps at all time lows, the government would have been able to claim only a fraction of the original NOLs, opines Willens. However, by eliminating the testing date, the IRS also eliminates the question of whether the bailout constituted a change-of-control under the tax law. “It becomes a moot point,” says Willens.
Nevertheless, under the bailout deal, the government is forcing Fannie and Freddie to contribute to federal coffers through the annual 10 percent dividend payout. Further, Willens points out that by giving the mortgage lenders a way to reduce their future income tax bills, the plan frees up more cash so Fannie and Freddie can meet the dividend requirements. To be sure, NOLs do not offset the dividend payout, NOLs only offset pre-dividend, pre-tax income.
“I am not saying that the IRS ruling is a good thing, or a bad thing, it is just unusual,” asserts Willens. “Then again, this is a very unusual situation.”