Banks could end up paying millions of dollars in penalties for peddling auction-rate securities, the irredeemable assets once billed to be as good as cash. But tax deductions are likely to reduce their pain, putting some of the burden back on taxpayers.
That possibility rankles Iowa Sen. Charles Grassley, a senior Republican on the Senate Finance Committee, who raised a fight five years ago when banks got a tax windfall out of the $1.4 billion settlement they made amid allegations of misleading investors. In a letter last week to Christopher Cox, chairman of the Securities and Exchange Commission, Grassley argued that the regulator should consider “grossing up” any penalties that it imposes on banks.
“If the SEC determines that monies should be paid by Citigroup or other financial institutions as a result of these allegations, the SEC should consider the potential tax deductibility of these payments by Citigroup or other financial institutions when determining the appropriate amount of such payments,” Grassley wrote.
Grassley calculates that if Citigroup, for example, were asked to pay $600 million in penalties, it could deduct that from its taxable income and save $210 million. To truly impose a $600 million penalty, assuming they would utilize the deduction, the SEC would have to fine them $923 million.
“The standard practice is to settle the matter by a payment which is not delineated at a penalty and does not acknowledge it is a penalty — merely a settlement of the claim by the regulator,” says Sheldon S. Cohen, a director of Farr, Miller & Washington LLC, an investment management firm. “Those payments are deductible for tax purposes and the regulators like it that way as it makes it easier to settle the matter.”
Penalties in legal settlements are not supposed to be tax deductible, but restitutions — compensation for financial losses — can be deducted, according to Sarah Lawsky, a tax law professor at the George Washington University Law School.
“Banks are claiming some portions are restitution,” says Lawsky. “As part of the settlement you have to pay a certain amount, but they’re not laying out which part of that is restitution or fines. The banks can decide by themselves.”
Since many banks have already agreed to repurchase auction-rate securities from investors and compensate them for any losses they incurred by selling them on secondary markets, additional fines would likely be seen as punishment and would be difficult to write off. In 2003 Grassley criticized the SEC for allowing settlements be structured so that penalties were treated as restitution, taking advantage of some fuzziness in the legal definition of the word “penalty.”
“Companies will have an incentive to push for settlements that favor their ability to deduct whatever payment they have to make, thus reducing the overall impact on the company, by making sure that the payment amounts are not described as a fine or similar penalty paid to the government for violation of any law,” says Linda Beale, an associate professor at Wayne State University Law School.
In 2003, Grassley was among a group of senators who proposed the Government Settlement Transparency Act, which would have clarified that penalties were not tax deductible, but Congress did not pass it.
Citigroup, UBS, Wachovia, Morgan Stanley, Merrill Lynch, and J.P. Morgan Chase & Co. have agreed to buy back more than $40 billion of auction-rate securities from investors and regulators are considering additional punishment.
“The SEC needs to do what it can to make sure that the after-tax amount of the payment reflects the amount that the SEC actually intends to be paid by the financial institution,” Grassley said.