Financial services companies across the country increasingly are exploring the possibility of abandoning their holding company structures. Such explorations are incomplete, though, without consideration of the potential tax consequences.
The motivations behind financial services companies abandoning their holding companies include the desire to achieve cost efficiencies, reduce regulatory burden, and eliminate redundant management activities. In some cases, the perceived advantages of eliminating the holding company are compelling enough for institutions to implement the strategy. In others, the holding company format is retained due to operating flexibilities that holding companies enjoy compared to insured depository institutions. Flexibility in being able to use a holding company for some merger and acquisition (M&A) transactions and the consequences of potentially becoming a public business entity are additional considerations that might lead to retaining the holding company structure.
While corporate tax consequences generally are not the primary factor in determining whether to eliminate a holding company structure, financial services companies should weigh the potential tax consequences related to several critical areas in their overall decision process.
The Transaction Itself
Initially, the consequences of the transaction that eliminates the holding company warrant consideration. In a normal scenario, the transaction itself is a downstream merger of the holding company into the bank. If the merger is valid under state law, and the holding company shareholders receive an equity interest in the bank that is identical to their equity interest in the holding company, the transaction should be tax-free at the corporate level. For federal purposes, tax-free treatment will result in basis carryover of any assets or liabilities transferred to the bank, as well as carryover of any unused tax credit or net operating losses. If the merger is not accorded tax-free treatment, though, the resulting tax liabilities could render the entire process unjustifiable.
Generally, the elimination of the holding company should not have a negative impact on M&A-related activities. Acquisitions, whether taxable or tax-free, would continue to be allowable for any target considered a permissible investment. Stand-alone banks seeking to acquire other bank targets will, however, need to take heed of regulatory restrictions on bank ownership of another bank. Banks with less than $1 billion in assets might find more value in retaining the holding company due to the flexibility it can provide in transaction structuring and financing.
Treatment of Gain or Loss on Debt Securities
Debt securities held by a bank always will produce ordinary gain or loss. Ordinary losses are deductible in full against other types of income, but capital losses are deductible only to the extent of capital gains. Thus, a bank that generates a capital loss from the sale of, for example, an equity security, partnership interest, or real estate property typically will find it difficult to generate sufficient, if any, capital gain to absorb those losses.
Holding companies, on the other hand, report capital gain or loss on the sale of virtually any asset they own, providing flexibility when determining whether a tax benefit from capital losses could or should be recognized. For those consolidated groups with capital loss carryforwards, this particular issue merits careful consideration.
Notably, holding companies have more flexibility than banks regarding the types of assets they can own, which is critical from a tax planning perspective. Not only can holding companies hold more types of equity securities as investments, they also can own subsidiaries that a bank cannot. For example, holding companies are permitted to own captive insurance subsidiaries that insure the identified risks of the bank subsidiary. Under some limited situations, banks also can own captive subsidiaries, but those captives cannot insure the risks of the parent bank for federal income tax purposes, thereby greatly limiting the overall risk management strategy.
State taxation can vary dramatically by jurisdiction, and the consequences of eliminating the holding company should be carefully reviewed in light of the relevant laws, rules, and regulations. Some states require separate filings, while others mandate combined unitary filings. Others apply different taxation schemes to holding companies and to banks. Given the wide differences in tax treatment, detailed analysis is required to determine the state tax impact.
Look Before You Leap
Financial services companies must weigh a variety of tax consequences when determining whether to eliminate or retain a holding company structure. A holding company’s increased ability to generate capital gain, as well as the flexibility in the types of assets it can hold, represents valuable tax benefits that could help sway the ultimate decision.