AIG bailout and the tax code

Remember when Fannie Mae and Freddie Mac were taken over by our government?  Specifically, remember how Treasury Secretary Paulson directed the IRS to issue a notice allowing Freddie and Fannie to retain all of their net-operating losses, despite a change of control of ownership? As discussed in this blog item, the change was made to ensure that the two lenders don’t pay more in taxes to the government that now controls them.

Now, in the wake of the government bailout of insurance giant AIG, comes another tax component to the current financial crisis.

Adam Levitin, blogging at Credit Slips, writes:

A small but unexplained detail in the federal government’s
nationalization of Fannie, Freddie, and AIG has been that the deals
have been structured so that the Fed or Treasury ends up owning no more
than 79.9% of the nationalized entities’ stock (or having warrants
that, if exercised, would produce the same result). So what is the
source of the 79.9% threshold? Why didn’t the government do a 99.99%
dilution of shareholders (and thereby a full de facto taking)? 

The answer, says Levitin, is Internal Revenue Code Section 163, the portion of federal tax law that governs loan interest deductibility. But if the interest is paid on a loan from an entity that has "controlling interest,"
notes Levitin, then the interest is not tax-deductible.

Here’s the applicable language (emphasis mine):

For purposes of sub clause (II), except as provided in regulations, the term “a controlling interest”
means direct or indirect ownership of at least 80 percent of the total
voting power and value of all classes of stock of a corporation, or 80
percent of the profit and capital interests in any other entity. For purposes of the preceding sentence, the rules of paragraphs (1) and (5) of section 267(c) shall apply; except that such rules shall also apply to interest in entities other than corporations.

"Because the bailout deals were structured so that the Fed or Treasury
will make sizable loans to the nationalized entities, they had to be
careful not to reach the 80% threshold, lest the nationalized entities
(which still pay taxes) lose their tax deduction for the interest paid
on the Fed/Treasury loans (LIBOR +850 on $85BN for AIG–that’s a lot of
interest)," writes Levitin.

Read the full Credit Slips item here, and be sure to check out the comments.

Maybe it’s just my perverse sense of humor, but I particularly love one commenter’s proposed new national slogans. Hey, in situations like our financial sector meltdown, you either laugh, cry or mock. Or, my personal preference, a combination of all three!