Industry Insights

Financial Institutions May Structure to Avoid Interest Expense Disallowance Rules

September 2012
Author:  John Wright

John Wright

Managing Director


Manufacturing & Distribution

400 Cross Pointe Boulevard
P.O. Box 628
Evansville, IN 47704-0628 (47715)


The Internal Revenue Code requires financial institutions, as defined, to allocate a portion of their interest expense to tax-exempt interest debt instruments held. The interest so allocated is a permanent difference between tax and book income and is never deductible for federal income tax purposes. Consequently, as the maximum federal income tax rate is currently 35 percent, a potentially significant permanent tax savings opportunity exists if the amount of this disallowance can be reduced or eliminated. To the extent of the mitigation of the interest expense disallowance, the tax equivalent yield on the institution’s tax-exempt obligations is increased. In today’s low-interest rate environment, even an increase of a few basis points in the taxable equivalent yield is beneficial.

Interest expense disallowed is calculated using a statutory formula that incorporates tax-exempt securities and total assets. Depending on the obligation, the disallowance is either 100 percent or 20 percent of the amount calculated.

In PSB Holdings, Inc. v. Commissioner of Internal Revenue, the U.S. Tax Court determined how this formula is to be applied to a corporation filing a consolidated return. PSB Holdings, Inc. was a bank holding company that owned Peoples State Bank (Peoples). Peoples formed a nonbank subsidiary, PSB Investments, Inc. (Investments), by transferring cash, taxable securities, tax-exempt securities and loan participations as paid-in-capital. Investments’ activities were limited to holding and managing these assets. It was not a financial institution, as defined. Investments purchased securities from cash flow it received from interest, sales and maturities; it had no debt and, therefore, no interest expense.

The court held the tax-exempt securities held by Peoples’ wholly owned subsidiary, Investments, were not to be taken into account when applying the statutory formula for calculation of interest expense disallowance for Peoples. Had the tax-exempt securities held by Investments been held directly by Peoples, interest expense would have been allocated to those securities; at least a portion would have become a permanent, nondeductible expense.

Based on this holding, financial institutions can use valid separate entities to decrease the amount of interest expense disallowance that would result in applying the statutory formula to a single entity. Given the potentially significant and permanent tax savings, financial institutions with tax-exempt debt instruments should evaluate the benefits of creating an investment subsidiary. For more information, contact your BKD advisor.

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