On November 1, 2007, Judge Laro of the United States Tax Court, in a strongly-worded opinion, ruled in favor of the banks on the TEFRA interest disallowance issue in PSB Holdings v. Commissioner of Internal Revenue (129 T.C. No. 15). PSB Holdings is the holding company for Peoples State Bank, Wausau. The issue in PSB Holdings was whether tax-exempt obligations, purchased and owned by an investment subsidiary of a bank, must be included in the bank’s TEFRA interest disallowance calculation under Section 291 of the Internal Revenue Code. PSB Holdings is represented by Debra Koenig and Sarah McNally of Godfrey & Kahn, S.C. in this litigation.

The court challenge was funded by an industry-supported legal defense fund through the Wisconsin Bankers Association and the Community Bankers of Wisconsin. The legal victory is considered a major victory for C Corporation banks nationwide.

The IRS took the position that the tax-exempt assets of the bank’s investment subsidiary must be included in the bank’s interest disallowance calculation. By including the investment subsidiary’s tax-exempt assets in the calculation, the interest expense deduction of the bank decreased, thus increasing the federal taxes owed.

Judge Laro disagreed with the IRS in every instance and found that the calculation does not include the tax-exempt obligations purchased and held by the investment subsidiary.

“We read the text [of Section 291] to refer to the tax-exempt obligations and assets owned by [the Bank] alone . . We do not read the text to provide that a taxpayer such as [the Bank] must include in its tax-exempt obligations any tax-exempt obligation purchased and owned by another taxpayer, whether the taxpayers be related or not.”

The Court continued:

"[The IRS] has not identified, nor are we aware of, any provision in the consolidated return regulations that would require the tax-exempt obligations purchased and owned by [the investment subsidiary] to be taken into account in the calculation of [the Bank's] interest expense deduction. Nothing that we read in the statutes or in the consolidated return regulations directs us to ignore the separate existence of [the investment subsidiary] or [the Bank] or otherwise to treat [the investment subsidiary’s] self-purchased tax-exempt obligations as owned by [the Bank] for purposes [of the Section 291 calculation]."

The Tax Court also dismissed the IRS’ argument that Revenue Ruling 90-44 gives the IRS the power to allocate the tax-exempt obligations of the investment subsidiary to its parent bank (referred to as “the exception”).

“In accordance with the analysis under [the U.S. Supreme Court’s decision in the Mead case], we decline to adopt the exception set forth in Rev. Rul. 90-44. First, as we have discussed, the exception does not properly interpret the text of the statute as written. Second, we find in the ruling neither adequate ‘thoroughness evident in its consideration’ nor adequate ‘reasoning’ as to the presence of the exception in the statutes. . Third, the revenue ruling was issued many years after the enactment of [Section 291] . .”

It is important to note that the Tax Court emphasized in several instances that it was not deciding the issue of whether tax-exempt obligations purchased by the bank and contributed to the investment subsidiary could be excluded from the bank's TEFRA calculation, since that issue was not before the Court in the PSB Holdings case. In addition, the Tax Court reminded the IRS that if it is not happy with the result in this case, it can issue regulations or convince Congress to amend the statute. New regulations or legislation are almost always prospective in their application, and if this were the case, would not affect tax years that ended prior to their enactment.

While we are obviously pleased with the Tax Court victory, this may not be the final development. The IRS may appeal the matter to the Seventh Circuit Court of Appeals in Chicago. While a victory at the Tax Court level adds weight to the banks’ arguments, this does not foreclose the Seventh Circuit from taking a fresh look at the legal arguments in the case, if the IRS appeals.

The IRS must make a decision regarding a potential appeal to the Seventh Circuit during the upcoming months. If the IRS appeals, it may be many months, if not years, before we receive a final decision with respect to the TEFRA interest disallowance issue. We will continue to monitor the status of the PSB Holdings case and publish updates with any new developments.

Given the reasoning of Judge Laro's decision, we hope, at the very least, that this ends the IRS’ practice of assessing penalties against banks when they are audited on this issue. We have always felt that assessing penalties in this case was patently unfair given the statutory language in Section 291 and the lack of any authority supporting the IRS’ position. Debra Koenig (dkoenig@gklaw.com) and Sarah McNally (smcnally@gklaw.com) are interested in hearing from banks that, in future audits or in audits that have not been concluded, receive disallowances on the TEFRA issue, and whether such disallowances include penalties.