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Earlier this year, my former colleague Jonathan Prokup and I published an article in the Journal of Taxation and Regulation of Financial Institutions. In the article, we considered the federal tax consequences of Treasury's capital purchase program – the centerpiece of TARP. Under the program, Treasury invested several hundred billion dollars into hundreds of our country's banks to alleviate their perceived liquidity problems, which many believed to be the cause of the unfolding financial crisis.
Our article concluded that, even though most TARP instruments were nominally designated as preferred stock, the instruments actually constituted debt for tax purposes. We reached this conclusion by applying the debt-equity factors that are classically used to classify hybrid instruments for tax purposes. Most of these factors strongly support the classification as debt. As a result, the tens of billions of dollars repaid on TARP investments could have been deducted by the banks as interest on their federal tax returns.
As new details continue to emerge about the October 2008 meeting that gave rise to TARP, our argument appears even more compelling. In the article, we acknowledged that perhaps the most significant impediment weighing against debt characterization was that the TARP instrument was nominally designated as "preferred stock." As a general rule, courts are reluctant to allow taxpayers to determine the tax consequences of a transaction in a manner inconsistent with its papered form. TARP was not, however, the product of arms-length negotiations. Rather, Treasury mandated all of the terms of the TARP instrument each bank was pressured to accept, including its nominal form as preferred stock. Given the duress placed upon the banks to accept the TARP investment, the banks may be able to disclaim the form of the TARP instrument even under the most restrictive interpretation of the general rule. See Commissioner v. Danielson, 378 F.2d 771 (3rd Cir. 1967) (allowing taxpayer to disclaim the form of a transaction if the transaction would be unenforceable under common law contractual defenses such as duress).
In a speech this past June, former Wells Fargo CEO Richard Kovacevich recounted that fateful October 2008 meeting. As described in the San Francisco Business Times, Mr. Kovacevich's description of the meeting confirms the duress experienced by the banks to accept TARP investments. In speaking to an audience at Stanford University, he said:
"Why didn't I just say no and not accept the TARP money?"
"As my comments were heading in that direction in the meeting, Hank Paulson turned to Fed Chairman Ben Bernanke sitting next to him and said, 'Your primary regulator is sitting right here. If you refuse to accept these funds, he will declare you 'capital deficient' Monday morning,'" Kovacevich recalled. "'Is this America?' I asked myself."
"This was truly a 'godfather moment.' They made us an offer we couldn't refuse," Kovacevich said, adding that he might have put up more of a fight if the San Francisco bank … had not been trying to acquire troubled Wachovia at the time.
We are not aware whether any bank that accepted the TARP instrument in its nominal preferred stock form actually deducted "interest" paid on the instrument on its tax return. Banks that did not originally claim the interest deduction may now pursue the interest deduction by filing a claim for refund. Pursuing such a claim would incur small costs and create little risk, which would be far outweighed by the potentially hefty rewards. However, despite the legal merits and potential rewards of such a refund claim, the statute of limitations has nearly expired for many banks to file one; by March 2011, banks had repaid Treasury over ninety-nine percent of invested funds.