A strategy for C-corp banks
It is not unusual for a community bank to incur a capital loss. For instance, many community banks invest in, and lend to, tax credit-financed projects (low-income, historic, etc.) because this can help them meet the credit needs of the areas in which they operate and, importantly, a bank can receive Community Reinvestment Act consideration for doing so. Banks often can earn reasonable rates of return on these investments, which also can provide a platform to leverage other tax credit investments.
These investments, however, also can generate capital losses. For C-corp banks, capital losses are deductible only against capital gains. If a bank is not able to generate sufficient capital gain during the tax year the loss was realized, the capital loss can be carried back three years and then forward five years, at which point the loss will expire worthless if sufficient gain has not been realized to absorb the loss.
Not surprisingly, banks that have incurred capital losses often are not in a position to generate sufficient capital gains to fully utilize the losses. Unfortunately, many of the possible “solutions” proposed to management by legal, tax and accounting advisors to absorb the losses are highly structured transactions that may lack a meaningful business purpose and economic substance. Therefore, for financial reporting purposes, management often takes a valuation allowance against the losses, meaning management has made the determination it is more likely than not that such losses will expire worthless after five years.
Since the presidential election, interest rates in the United States have risen all along the yield curve. Perhaps that’s not terribly surprising, given that Mr. Trump’s victory has increased expectations of fiscal stimulus, inflation and continued heavy issuance of U.S. Treasury debt. Many corporate executives, investors and economists are starting to suspect this may finally be the beginning of the long-anticipated “normalization” of the U.S. Treasury yield curve. There are, of course, many reasons why a sustained rise in U.S. interest rates may not occur, or occur as quickly and substantially as some expect. For instance, in Europe and Japan pensions and insurance companies remain starved for yield, which could help keep a lid on U.S. rates. And it’s not yet clear how much of President Trump’s policy agenda will be enacted, and any backtracking, for instance, on proposed fiscal stimulus might send yields tumbling down once again.
Nonetheless, the senior executives and board of directors of most banks are well aware of the possibility (and perhaps probability) of a rising rate scenario, and some wish to protect against the prospect of inflation, as well as the business risks and other deleterious effects to their businesses, which could accompany a rising interest rate environment. For instance, a bank’s capital structure might include debt or other liabilities that are tied to a floating rate; should interest rates increase, the cost of these liabilities also will rise. Or a bank might hold financial assets or investments that pay a fixed return; a rise in rates will likely negatively impact the asset’s value. Of course, rather than seek protection from rising rates, others view this as an opportune time to instead seek to profit from the normalization of the yield curve.
In any event, if senior management does expect interest rates to rise, there are many tools a bank might use to help guard against, or take advantage of, rising interest rates; however, each can have very different tax implications for the bank.
ABC Bank, a publicly-traded, C-corp community bank, has a capital loss carryforward of $2.5 million. ABC Bank is profitable, generating net income of $2.5 million per annum, and pays federal tax at the 35 percent rate. ABC Bank realized its capital loss in December 2013, and the loss will, therefore, expire in December 2018 unless sufficient gain can be utilized to absorb the loss, which appears unlikely. ABC Bank’s capital structure includes a considerable amount of floating rate debt, and it holds a sizeable portfolio of fixed income investments.
Since early 2014, senior management has explored potential solutions that have been proposed by ABC Bank’s legal, tax and accounting advisors; however, senior management concluded that most of these strategies did not have a meaningful business purpose and lacked economic substance. Therefore, for financial reporting purposes, senior management took a valuation allowance against those losses, having determined it was more likely than not that the losses will expire worthless in December 2018.
Nevertheless, the investment community remains mindful of ABC Bank’s capital loss carryforward, because many sophisticated institutional investors logically believe public companies that actively plan for and manage their tax attributes, by improving future after-tax cash flows, enhance shareholder value. Not surprisingly, during quarterly conference calls, shareholder meetings, investor conferences and other meetings with investors, institutional investors ask detailed questions to gain insight into what senior management’s plan is, if any, with respect to the potential utilization of its capital loss carryforward.
Senior management has become confident the U.S. yield curve will normalize, with the potential to significantly increase the cost of the bank’s floating rate debt, and reduce the value of its fixed income securities portfolio. Senior management recently met with its financial, legal and tax advisors to explore how the bank might position itself to guard against the risk of rising rates in the most cost-effective and tax-efficient manner. Along these lines, senior management explored numerous tools that could be employed such as options, forwards, futures and swaps, among others. Each of these tools can deliver the desired protection against rising interest rates, but they can have differing tax consequences for the bank.
Given ABC Bank’s circumstances, senior management decided the most straight-forward, cost-effective and tax-efficient strategy is to establish a short position in U.S. Treasury Bonds with a fairly short duration (approximately 24 months). With interest rates still near historic lows, ABC Bank’s “worst case” scenario can be defined with a fair degree of precision, and the potential maximum loss is limited. That is, the bank can benefit from what is effectively free “put protection” currently offered by the market.
For instance, in a “worst case” scenario (i.e. interest rates decrease), if the bank establishes a short position in a two-year UST Bond, it can keep the short position open until just before maturity of the UST Bond. In that event, assuming the yield-to-maturity on the UST Bond is 1 percent on the date the short position is established, the bank would be required to pay the YTM of the UST Bond for two years (i.e. a total of 2 percent of the principal amount of the bonds shorted). During this period the bank will earn interest on the short sale proceeds and cash margin held by the bond dealer. Therefore, the bank’s maximum loss is 2 percent less the amount of interest earned on the short sale proceeds and cash margin held with the dealer. However, in the event that rates do begin to normalize, as senior management expects, the bank will be in a position to benefit handsomely.
This strategy is intriguing to senior management for another important reason: the bank’s non-deductible capital loss carryforward. Given current interest rate levels, if structured and implemented properly, establishing a short position in a two-year UST Bond will generate both capital gain and interest expense.
Interest rates in the U.S. are currently near historic lows, but many UST Bonds were issued years ago when interest rates were much higher. These “seasoned” UST Bonds, often referred to as “off-the-run” UST Bonds, currently trade at a significant premium over par because today’s interest rates are significantly lower than when they were issued. By shorting UST Bonds that are currently trading at a significant premium to par, the bank will generate both capital gain (as rates begin to rise and the UST Bond is “pulled to par”) and interest expense (as the bank makes the “in lieu of” coupon payments to the lender of the UST Bond).
The gain generated on the closing out of the short UST Bond position is short-term capital gain. The “in lieu of” coupon payments are treated as interest expense. For a C corporation such as ABC Bank, interest expense is deductible without limitation against any form of income, including operating income. Therefore, the bank’s capital loss will be deductible against the capital gain generated by closing out the short UST Bond position, while the interest expense generated by the strategy will be deductible against the bank’s ordinary income. Therefore, this strategy effectively converts ABC Bank’s otherwise non-deductible capital loss carryforward into currently deductible interest expense.
Senior management made the decision to implement this strategy. ABC Bank established a short position in a UST Bond with a two-year maturity that was executed through a Primary U.S. Government Bond Dealer on exactly the same pricing, terms and conditions that were then available in the marketplace to any sophisticated institutional investor. Senior management entered into this strategy with the belief that the one-year U.S. Treasury rate was likely to rise significantly during the next 12 months.
The short position was closed out approximately one year later, management’s view on rates was correct, and the results were attractive. As stated above, the bank has a $2.5 million capital loss carryforward, and generates $2.5 million of taxable operating income per year. The transaction generated $2.75 million of capital gain and $2.5 million of net interest expense, resulting in a profit of $250,000. The $2.5 million capital loss carryforward is deductible against $2.5 million of capital gain and is thereby fully utilized. The $2.5 million of net interest expense is currently deductible against $2.5 million of ordinary income. ABC Bank earned a profit of $250,000 on a cash investment of $750,000 (the cash margin typically required for a transaction of this size and duration, which is not capital intensive) to generate a 33 percent pre-tax return and, due to the net interest expense, an even greater after-tax return. The bottom line is that ABC Bank earned an attractive return on its investment while effectively converting its otherwise non-deductible capital loss carryforward into currently deductible investment interest expense which would have otherwise expired worthless.
In addition to helping ABC Bank protect against inflation and business risks caused by rising interest rates, implementation of this strategy has two other important business purposes. First, sound corporate governance policy recognizes that senior management has a duty to prudently manage a company’s assets, which includes determining if deferred tax assets such as capital losses can be utilized in the interests of shareholders, creditors and other stakeholders. Implementation of this capital markets-based solution enabled ABC Bank to more efficiently and effectively utilize its deferred tax assets, and aided senior management to satisfy and maintain, respectively, its corporate governance obligations and best practices.
The implementation of this strategy by senior management enabled ABC Bank to more efficiently and effectively utilize its deferred tax assets and thereby increase its after-tax cash flows. Through its investor relations function, the bank communicates its actions and strategy to the investing public and enhances its value in the stock market.
Tom Boczar is CEO of Intelligent Edge Advisors and can be reached at [email protected]
Jeff Markowski is Managing Director at Intelligent Edge and can be reached at [email protected]