Alert August 05, 2008

American Bankers Association Seeks to Protect Bank Interest Expense Deduction

The Treasury Department recently released to the public a letter from the American Bankers Association (the “ABA”) that urged the Treasury Department to carve out an exception for banks if it proposes rules that would bar the tax treatment allowed by the Tax Court in PSB Holdings Inc. v. Commissioner, 129 T.C. 131 (2007).  The ABA’s letter was prompted by the Treasury Department’s release of its periodic update of the 2007-2008 Priority Guidance Plan, indicating that it is considering issuing proposed regulations that would seek to overturn the PSB Holdings decision.

The issue in PSB Holdings was whether the tax-exempt assets held by an investment subsidiary of a bank have to be counted as the parent bank’s assets in computing the amount of interest expense disallowed under Section 265(b) of the Internal Revenue Code.  The Tax Court ruled that they do not.  The Tax Court’s holding in PSB Holdings rejected the position the IRS had announced in Revenue Ruling 90-44 and represented a major victory for the banking industry.  Under Section 265(b), a bank generally may not deduct interest expense allocable to tax-exempt interest from tax-exempt obligations.  The IRS issued Revenue Ruling 90-44 to simplify the application of Section 265(b) and to prevent banks from transferring tax-exempt obligations to wholly owned subsidiaries and replacing the tax-exempt obligations with the stock of the subsidiary as the asset of the bank that bears the interest expense.

In its letter to the Treasury Department, the ABA raised the concern that the Treasury Department may be drafting a rule that would require a consolidated approach to deductions.  It urged the Treasury Department to provide an exception that would allow banking firms to carry or purchase tax-exempt obligations as long as no borrowed funds are used to do so and stated that such an exception would be consistent with the Congressional intent to maintain equality between banks and non-banks in the application of the interest expense disallowance rules relating to tax-exempt obligations.