Deciphering the Code

BY EDWARD J. SCHNEE

A recent case that ostensibly dealt with a bank’s deductions for interest and other expenses associated with tax-exempt income could affect how advisers approach interpretation of the Code and revenue rulings generally.

PSB Holdings is the parent of an affiliated group that includes Peoples State Bank, which is based in Wausau, Wis. It also includes Peoples’ wholly owned subsidiary, PSB Investments Inc., which handles investment of the bank’s stock and bond portfolio. Code section 265(b) requires financial institutions to allocate a pro rata portion of their interest expense to the average adjusted bases of their tax-exempt obligations acquired after Aug. 7, 1986. In calculating its nondeductible interest under the section, Peoples included in its consolidated returns for 1999 through 2002 the value of the stock of PSB Investments in its assets but excluded the tax-exempt obligations purchased and owned by PSB Investments. The government asked the Tax Court to include the tax-exempt investments owned by the subsidiary in the pro rata computation. The court ruled for the bank, saying it had no adjusted bases in the tax-exempt obligations of its subsidiary.

The court noted that the subsidiary was formed to improve efficiency, safeguard and manage the investment portfolio, and—organized in Nevada—minimize state taxes. The court also noted the IRS accepted these reasons as reflecting a sufficient business purpose to avoid any sham or economic substance arguments.

In applying section 265(b), the court said the wording of the Code shall be followed directly unless the wording is ambiguous or the result would be absurd or thwart congressional intent. The congressional intent behind section 265(b) was to raise revenue, prevent abuse and provide certainty and reasonableness in calculating an interest deduction, which the taxpayer’s narrow reading of the section did not thwart, the court said. The court also pointed out that Congress used the singular noun “taxpayer,” which limits the computation solely to the bank corporation’s assets. The court also noted a subparagraph of § 265(b) refers to a corporation and its affiliates, thus proving, the court said, that Congress was aware of the correct wording to combine corporations.

Perhaps most significantly, the court refused to follow Revenue Ruling 90-44, which provides guidance on section 265(b). According to the court, revenue rulings are entitled only to the deference paid them under Skidmore v. Swift & Co. , 323 U.S. 134 (1944): The court will honor the government’s interpretation only to the extent its reasoning is persuasive, analysis complete and results consistent with prior rulings and decisions. In effect, the Tax Court treated the revenue ruling as the government’s litigation position.

This decision can have far-reaching implications, given the change in section 6694 to requiring a more-likely-than-not standard of tax return preparers for undisclosed items. It authorizes minimizing the weight given to revenue rulings and permits taxpayers to argue that where the words of the Code are not ambiguous they can be followed exactly as written, even if the results are not completely in step with the broadest interpretation of congressional intent. It may also permit taxpayers to argue that state tax savings are a valid business purpose to avoid sham transactions and economic substance issues.

PSB Holdings Inc. v. Commissioner , 129 TC no. 15

Prepared by Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

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