New Tax Rules: The Hidden Corporate Bailout

By Stephen Gandel

Corporate America has a new Santa Claus — the taxman. And this year he is bringing bags of cash, billions of dollars' worth, to all the suited boys and girls.

While the $700 billion bailout has been the focus of attention and scrutiny, the Internal Revenue Service and lawmakers have been quietly making changes to the tax code and how it is followed in an effort to further boost the financial strength of ailing companies. At the same time, though, the changes drain billions of dollars of badly needed tax revenue when the federal deficit is mushrooming. Many of the changes may lower corporate-tax revenue for years to come.

"The IRS has spent the past few months trying to make the rules as liberal as possible," says Robert Willens, an accounting and tax expert in New York. "They have been decreasing corporate taxes pretty consistently." (See pictures of the recession of 1958.)

The IRS this year has issued 113 notices, many of which will lower the taxes companies will pay this year and in the future. That breaks the previous record of 111 in 2006, and is nearly double the 65 issued in the last year of Bill Clinton's presidency. Lawmakers, too, have passed tax changes and are pushing for more, which will save corporations billions of dollars this year. One of the biggest windfalls could come from a proposed change in the so-called carryback rule, which would fatten the tax rebate companies get when they have losses. The extension would be similar to one that was passed after 9/11.

"I think the carryback extension is a good idea," says Mark Silverman, a prominent tax lawyer at Steptoe & Johnson. "It's been done in the past, and it ought to be done again."

Of course, some IRS notices raise taxes, and not all of the tax-relief measures pertain to what corporations pay. For example, the IRS has passed notices this year that give tax relief to hurricane and flood victims.

But in the past few months, experts say, the IRS has been unusually aggressive in doing what it can to lower corporate taxes, going above and beyond what has been allowed in the past. The result is that the IRS has become, in effect, a much less public arm of the federal-bailout machine. "There have been all sorts of Administration announcements that relax the tax law," says Thomas Humphreys, an attorney at Morrison and Foerster. "I don't remember a wave of provisions like this." (See pictures of the global financial crisis.)

The IRS has numerous stocking stuffers planned for corporate America this year. Here are some of the biggest ones:

Merger Tax Windfall

In the past, corporations could deduct from their taxes only a small portion of the losses incurred by a company they acquire. The rule, commonly called Section 382, eliminated the practice of companies' avoiding taxes by buying failing corporations just for their losses.

But in late September, just after Congress defeated the first bailout bill, the IRS issued a notice to change that rule to allow banks to significantly lower their taxes when they purchase other banks. Now, after an acquisition, a bank can reduce its IRS bill by claiming that loans on the books of an acquired rival are worth far less than the previous owners thought, not a hard claim to make these days. The acquirer can deduct from its taxes the full amount of the write-down. Before it could only lower its taxable earnings by a small percentage of the write-down of the preacquisition loans. (Read "Can Congress Pass an Auto Bailout Bill Nobody Likes?")

Jones Day lawyers estimate that the rule change could cost the Federal Government up to $140 billion in revenue during the next few years. But it would only get that high if every bank in the U.S. were sold and troubled mortgage assets were all written down to zero. Still, a number of banks have made acquisitions since the rule change and are already benefiting. Wells Fargo will book an estimated $25 billion tax credit from its November acquisition of Wachovia. PNC, which bought National City in October, could get as much as $5 billion in tax benefits from that merger. And Capital One, which bought Chevy Chase Bank earlier this month, is looking at a $500 million tax windfall.

Investment Losses Now Count for More

Here's one change that every investor in America would like this year. Typically, investment losses, when it comes to taxes, can be deducted only against investment gains. The tax you pay on regular income is not affected. And that's generally true for individuals as well as corporations, unless of course investing is your job.

But in October, Congress passed a law that said banks who held Fannie Mae and Freddie Mac preferred shares, which were essentially rendered worthless when the government took over the two large mortgage guarantors, can count the loss on that investment as a regular business loss, not an investment loss. The Federal Government has estimated the change will save banks as much as $3 billion in tax payments this year.

Improved Tax Break on Foreign Operations

Corporations have been able to postpone taxes on profits earned overseas so long as those profits remain overseas, and borrowing from a foreign subsidiary has been strictly limited to 30 days or less, lest the money be seen as repatriated profits and taxed accordingly. An IRS notice in October, though, allows companies to receive loans from their overseas businesses for up to 60 days and not have to pay taxes on the profits, so long as the loan is paid back in 60 days. Pay it back in 59 days, and you can roll the loan over three times in one year, tax-free. Willens says it's hard to put a number on how much the change will save companies but that it is substantial. "It's quite a large savings," says Willens. "Not only does it lower taxes, but it also allows companies to borrow more cheaply from their subsidiaries."

Saba Ashraf of law firm Troutman Sanders wrote in a notice to clients that the IRS's relaxation of overseas borrowing rules "continues the trend of taxpayer friendly guidance in light of the credit difficulties and economic downturn."

Federal Assistance, Tax-Free

Under the law, companies have to pay taxes on any money they receive in federal aid, just like any other income. But don't worry, corporate America, the Treasury's Troubled Asset Relief Program won't trigger a tax bill. In October, the IRS said it doesn't consider money given by the government to the ailing banks as part of the TARP program financial aid. Call it a financial encouragement to stay in business, but not aid.

Tax-Loss Carrybacks

Perhaps the biggest tax windfall that corporations will get this year and next is from a proposed change in the long-standing rule on tax rebates for losses. What's more, companies that don't, or can't, use the losses for rebates now will be able to significantly lower their taxes for as long as 20 years, when they return to profitability.

Here's how it stands now: companies that lose money in any given year are entitled to a rebate on money they have paid in taxes for the prior two years. So if you made a million dollars for each of your past two years, and lost 2 million this year, your company would be allowed to get back all of the taxes paid for the past two years. This could result in huge corporate-tax rebates in 2008 and 2009. For instance, in 2008 there are projected to be 107 companies in the S&P 1500 that will lose money, as much as $80 billion. About half those companies were profitable in 2007, making nearly $30 billion as a group. That means, based on an average corporate-tax rate of about 30%, those companies could receive as much as $10 billion in tax rebates from last year alone.

And the companies could soon be eligible for billions of dollars more. A bill was proposed in the House of Representatives in late November by Congressman Steve King, a Republican from Iowa, that would extend the tax-carryback rule to five years, which means companies could get their tax payments refunded all the way back to 2003. And the rule would be eligible for losses that occurred in 2008 or 2009. That means a company with a large enough loss, after the proposed rebate, could effectively not pay taxes for seven years. Senator Olympia Snowe, a Republican from Maine, has proposed a similar change to the tax code in the Senate, but only for small businesses.

"All of these tax moves are being done to help address the liquidity issues of corporate America," says Willens. "The collateral effect is that they will reduce taxes."

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