On March 3, the U.S. Internal Revenue Service suffered a devastating loss to Washington Mutual in a U.S. Appeals Court decision in a tax-refund case concerning the basis of intangible assets acquired in a reorganization.
Recent as the decision is, the case arose in the long aftermath of the federal government’s efforts to contain the savings-and-loan crisis more than three decades ago.
The case originated in 1981. Home Savings of America agreed to acquire three failing savings-and-loan associations, or thrifts: Southern Federal S&L, Hamiltonian Federal S&L, and Security Federal S&L. The Federal Savings and Loan Insurance Corp. (FSLIC) and Home Savings agreed that the acquisition would be structured as two separate mergers: Hamiltonian and Security Federal would first merge into Southern Federal and Southern Federal would then merge with and into Home Savings.
Although bank regulators tried to mitigate the crisis through deregulation, the liabilities of many already-failed thrifts threatened to exhaust FSLIC’s insurance reserves. To avoid further insurance liability, the Federal Home Loan Bank Board, which chartered and regulated federal thrifts, decided to induce healthy financial institutions to take over troubled thrifts in a series of “supervisory mergers.”
Such transactions, in which the acquiring parties assumed the obligations of thrifts with liabilities that far exceeded their assets, were not alluring to healthy institutions. Further, the FSLIC lacked the cash to promote such acquisitions through direct subsidies alone.
Deals like the one Home Savings enjoyed thus became typical. In exchange for agreeing to do the mergers and accept the liabilities in excess of the assets of the failing thrifts, the FSLIC gave Home Savings a rich package of incentives that included the right to maintain branches in other states (the “branching rights”) and the right to use the purchase method of accounting for regulatory capital reserve purposes (the “RAP rights”).
Later the FSLIC and Home Savings entered into an “Assistance Agreement”(AA) under which the Home Savings-Southern Federal merger would be “. . .a tax-free reorganization. . . .”
Washington Mutual, which later acquired Home Savings, filed amended tax returns with the IRS, seeking refunds for 1990, 1992, and 1993 based on the amortization of the RAP rights and the abandonment of the branching rights. The company claimed that the IRS failed to allow Home Savings amortization deductions for the RAP rights and loss deductions for its abandonment of the Missouri branching rights.
The IRS denied the claims, and Washington Mutual sued in U.S. District Court. The District Court ruled on summary judgment that Home Savings did not have a “cost basis” in the RAP rights and the branching rights. It also rejected Washington Mutual’s amortization and loss deduction-related refund requests.
Washington Mutual appealed the decision in the U.S. Court of Appeals for the Ninth Circuit. In its March ruling, the Appeals Court held that Home Savings did have a cost basis in the RAP rights and the branching rights equal to some part of the excess of the three acquired thrifts’ liabilities over the value of their assets.
Generally, a taxpayer’s basis in an asset is equal to the cost to the taxpayer of acquiring the asset. The term cost generally includes any assumption of the seller’s liabilities. The Appeals Court found that the merger and the AA were integral parts of one all-encompassing transaction in which Home Savings acquired Southern Federal’s excess liability in exchange for a complex consideration package that included structuring the merger as a tax-free “G” reorganization. (A “G” reorganization is a court-approved transfer by a corporation of assets to another corporation in a bankruptcy, receivership, or foreclosure, provided that the owners of the transferor get stock or securities of the transferee corporation as part of the deal.)
The United States had argued that recognizing a Home Savings cost basis in the rights based on its assumption of FSLIC’s liabilities required characterizing some of the acquired thrifts’ liabilities as FSLIC’s liabilities. That’s because Home Savings did not pay the FSLIC separate consideration for the rights, the United States argued. In the IRS’s view, that would be inconsistent with the supervisory merger’s treatment as a tax-free “G” reorganization, which requires, among other conditions, that Home Savings assume “substantially all” of Southern’s liabilities as a result of the merger.
In its conclusion, the Appeals Court quoted a 1971 decision, Lewis & Taylor, Inc. v. Comm’r: Where “a transaction has economic substance and is economically realistic, it should be recognized for tax purposes, and the fact that a transaction is so arranged that the tax consequences are highly favorable to one of the parties affords the Commissioner no license to recast it into one of less advantage.”
Home Savings had agreed to acquire the three failing thrifts, “whose liabilities far exceeded their assets, in exchange for a complex consideration package including, among other items, cash, indemnities, the branching and the RAP rights, and the structuring of the merger as a tax-free ‘G’ reorganization,” the Appeals Court noted. “This leads us to hold that Home Savings had a cost basis in the Rights equal to some part of the acquired thrifts’ excess of liabilities over the value of their assets.”
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.