The Treasury intends to issue regulations that may provide that a bank is required to include the investments of its non-bank subsidiary in calculating its interest expense disallowance under IRC section 265(b). These regulations would overturn the Tax Court's decision in PSB Holdings, Inc. v. Commissioner.
ABA supports the Tax Court's ruling in PSB Holdings, Inc. v. Commissioner, where the Court rejected the IRS's position that a bank is required under sections 265(b) and 291 to include a non-bank subsidiary's tax-exempt obligations that were purchased and owned by the subsidiary, in calculating the bank's average adjusted bases of tax-exempt obligations for purposes of determining the bank's interest expense disallowance.
In the PSB Holdings case, PSB Investments is a subsidiary of Peoples State Bank. The IRS issued a notice of deficiency indicating that the bank should have included tax-exempt obligations purchased by the investment company in the calculation of its tax-exempt obligations, which then increased the bank's taxable income.
The Tax Court rejected the IRS's position and ruled that nothing in the text or legislative history of section 265(b) indicates that the language referring to "the taxpayer's average adjusted bases" refers to the bank and other entities. According to the bank, the text of section 265(b) refers to the taxpayer only, in this case, the bank, and does not include its investment subsidiary. Thus, the court rejected the IRS's position that the assets of the investment subsidiary were also the assets of the bank, and held that the bank had no adjusted bases in the tax-exempt obligations purchased and owned by the investment subsidiary. The Court stated that the bank and investment company are separate taxpayers, even though they file consolidated returns.
ABA sent a letter to the Treasury requesting that it take certain issues and concerns into account as it works on this project. The letter specifically noted that, "in drafting regulations under Section 265(b), Treasury should consider Congress' desire to maintain equality between banks and non-banks in the application of the interest expense disallowance rules relating to tax-exempts." Thus, a rule that would disadvantage only banks would not achieve Congress' purpose in enacting section 265(b), and should be avoided by the Treasury.
Any proposed regulations issued under Section 265(b) that consolidates a bank with its non-bank subsidiaries would mean that even a non-bank subsidiary that has independently earned income and has no debt would be unable to purchase or carry tax-exempt assets without causing its parent bank to suffer an interest expense disallowance. Such a rule would mean banks would no longer be on "equal footing with other taxpayers" as intended by Congress. In fact, new regulations requiring consolidation under Section 265(b) would put banks at a distinct disadvantage compared to non-banks. This is because an affiliated group that includes a bank would always have an interest expense disallowance under Section 265(b) resulting from the bank's business of taking deposits. In contrast, affiliated groups that do not include a bank could avoid an interest expense disallowance by ensuring that there is not the requisite connection between borrowings and the purchase or carry of tax-exempts that is required by Section 265(a)(2).