How Bailout Loosens Accounting, Tax Rules

While the new law works to ease the credit crisis, it lets banks sidestep tax and accounting rules.

Banking regulators may not have suspended fair-value accounting to benefit the balance sheets of ailing financial institutions. But they did bend generally accepted accounting principles in the name of increased liquidity and the public good. What’s more, Congress gave banks permission to ignore a tax code provision for the same reason.

The rule-bending stands to benefit a wide swath of corporations by pushing banks to build up cash cushions and start lending again, at least one tax and accounting expert says.

Tucked into the Emergency Economic Stabilization Act of 2008, the rule relaxation could increase their banks’ regulatory capital, also called Tier 1 capital. “I suppose I’m in the camp that believes some relaxation of the rules was necessary in order to help cure the liquidity crisis,” says tax expert Robert Willens. “That said, it strikes me as a dangerous precedent to set. If the rules can be ignored, or reshaped, based on a Treasury or IRS or Fed official’s perception of ‘exigent circumstances,’ then it will be difficult to reinstate the rules &#8212 that were reshaped or ignored — once the crisis passes.” adds Willens.

One provision of EESA is designed to bolster failing mortgage finance companies Fannie Mae and Freddie Mac, two federally backed mortgage-finance companies severely hampered by subprime mortgage. Congress, through EESA, permitted “applicable” financial institutions to invest in Fannie and Freddie preferred stock to help the mortgage lenders raise much needed capital.

The law relies on the U.S. tax code’s definition of a financial institution, which includes any bank, mutual savings bank, domestic building and loan association, cooperative bank, small business investment company, and business development corporation. Further, the law requires that the Fannie and Freddie preferred stock had to be in the hands of the participating bank on or after January 1, 2008 and before September 7, 2008.

But holding the Fannie and Freddie shares in the current bear market could prove dangerous to banks that are suffering through liquidity problems of their own. So as an incentive, EESA allowed qualified banks to sidestep U.S. tax code provisions and GAAP in exchange for pumping capital into Fannie and Freddie, says a new report by Robert Willens LLC. On the tax side, EESA permits any gain or loss from the sale or exchange of the preferred shares to be treated as ordinary loss or ordinary income.

Under normal circumstances, the owners of the Fannie and Freddie preferred shares would treat the income or loss as a capital asset or liability, respectively, notes Willens. Further, he says, the switch from capital to ordinary losses is good news for companies because capital losses are “exceedingly difficult” to offset.

Indeed, capital losses may only be offset against capital gain income. But ordinary losses — also known as net operating losses — may be offset by any income generated by the company’s business. In fact, the Internal Revenue Service allows companies that have posted an NOL to save up to two years’ worth of the losses and use them to offset income generated over the next 20 years. By applying the NOLs to future periods, a company’s taxable income is decreased, and the corporation pays less to Uncle Sam. Essentially, the NOL rule takes some of the sting out of current losses.

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