Banks Win Tax Battle Over Loan Fees Deduction

By John J. Mueller, J.D., LL.M., Managing Editor and Tax Law Analyst for CCH's Federal Tax Guidance Group, contributing author, CCH FOCUS.

The banking industry won the latest round in an important battle waging on an unlikely front—the Internal Revenue Service’s treatment of loan origination costs. The U.S. Court of Appeals for the Third Circuit recently entered the fray and decided in favor of banks being allowed to deduct these expenses in the year incurred, rather than having to capitalize them over the life of the loans (PNC Bancorp, Inc. v. Commissioner, CA-3, 2000-1 USTC 50,483, rev’g 110 TC 349, CCH Dec. 52,729). This ruling overturns an IRS victory in the Tax Court, distinguishes two Supreme Court cases and runs counter to established financial accounting standards.

The decision hinged on whether the loan origination costs were “ordinary” business expenses of the banks. If the costs were ordinary, they were deductible in the year they were incurred. If not, the costs would be deemed “capital expenditures” and have to be spread out over the life of the associated loans. For now, banks come away as winners because the loan costs were found to be ordinary and, therefore, currently deductible.

SETTING THE STAGE

PNC Bancorp (PNC) is a bank holding company that succeeded to the liabilities of two banks that merged into PNC, namely First National Pennsylvania Corporation and United Federal Bancorp, Inc. The loan activity at issue took place before the mergers of the two banks into PNC. The costs involved included payments to third parties for loan approval activities, such as credit screening, property reports and appraisals, as well as recording security interests. The costs also included internal costs associated with time spent completing and reviewing loan applications and other expenses associated with loan marketing and origination.

The banks deducted these costs in the year in which the associated loan closed. The IRS denied these deductions, claiming that they needed to be capitalized over the life of the loans. The Tax Court found in the IRS’ favor, which set the stage for the appeal to the Third Circuit.

WHAT IS ORDINARY?

The Third Circuit delved into the issue of “ordinary” versus “capital” expenses as pertaining to the unique nature of the banking industry. Interest paid on loans is a bank’s largest revenue source, while interest paid on deposits is the largest expense. That being noted by the appellate court, the nature of the costs being routinely incurred in a bank’s production of income seemed to clearly indicate current deductibility (IRC Sec. 162). If loans produce the bank’s income, loan origination costs are the ordinary expenses associated with that production of income. However, the Third Circuit also needed to overturn the Tax Court’s determination that the costs were capital expenses.

An expense is capitalized if it is paid for “permanent improvements or betterments made to increase the value of property” (IRC Sec. 263). If it can be shown that costs expended today will have lasting effects, then the costs must be capitalized over time. The Supreme Court has ruled that payments made by a bank to a secondary reserve fund at the FSLIC were capital expenditures, while payments made to a primary reserve were currently deductible (Commissioner v. Lincoln Savings and Loan Ass’n, 71-1 USTC 9476, 403 U.S. 345). The Court distinguished between the two reserves by stating that the payments to the secondary reserve created a separate and distinct asset. Lincoln Savings had a property interest in the reserve that was carried as an asset on their books, payments to the reserve were outside their normal banking activities, and the FSLIC kept the reserve separate from its other revenues.

The Tax Court followed this approach in the present case and found that the loan origination costs were directly related to the creation of the loans. The Third Circuit reached the opposite conclusion. It rejected the Tax Court’s interpretation of Lincoln Savings, claiming that it went too far by focusing on whether the costs were incurred “in connection with” the loans rather than “in creation” of the loans. According to the appellate court, in Lincoln Savings, the payments themselves formed the corpus of the reserve. They created the reserve asset. With PNC, the loan origination costs did not create new loans and the expenses did not become part of the loan balance. Therefore, the Third Circuit found that they were not capital expenses.

FUTURE BENEFITS

The Third Circuit continued its analysis of this case by tackling, and ultimately distinguishing, another Supreme Court decision in favor of capitalizing expenses (INDOPCO, Inc. v. Commissioner, 90-1 USTC 50,113, 503 U.S. 79). In INDOPCO, the High Court required capitalization of expenses incurred by a target company during a planned friendly takeover. While downplaying the importance of the creation of a separate and distinct asset, the Court focused on the importance of how the expenses related to the future benefits of the post-takeover company. The Supreme Court found that the expenses incurred as part of the takeover were spent primarily for future benefits that extended beyond the current tax year, rather than for the needs of the current production of income.

Applying this test to the loan costs at issue, it is easy to make an argument that since the life of the loans extended into the future, the associated costs were tied to a future benefit of the banks. However, the Third Circuit dismissed this line of reasoning by relying on its determination that the loan origination costs did not create a separate and distinct asset. Without an asset, there was no future benefit. These were the costs associated with a bank’s day-to-day business of producing income, namely issuing loans.

TAX VS. FINANCIAL ACCOUNTING

The Third Circuit had one last obstacle to overcome—Statement of Financial Accounting Standards No. 91 “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases” (SFAS 91). SFAS 91 was established by the Financial Accounting Standards Board and provides that loan origination costs must be deferred and amortized over the life of the loan. However, it is important to note that SFAS 91 applies only to financial accounting, not tax accounting. The Supreme Court has held that financial accounting standards do not dictate the tax treatment of income and expenses (Thor Power Tool Co. v. Commissioner, 439 U.S. 522).

With PNC, the Third Circuit summarily rejected any intimation from the IRS or Tax Court that SFAS 91 was a factor in determining that the loan origination costs were capital expenses. The banks in question deducted the loan costs for tax purposes, but also kept separate books for financial accounting purposes and applied the SFAS 91 treatment for the loan costs. There was no crossover from the financial accounting realm into the tax accounting realm.

INDUSTRY REACTION

News of this decision was met with a sigh of relief throughout the banking industry. Millions and millions of dollars are spent every year in loan origination costs, so upholding the IRS victory would have had a sizable impact on banks’ bottomlines. While there still remains the possibility that the IRS will appeal, for now, the costs are currently deductible. The American Bankers Association released a statement from Executive Vice President Donald Ogilvie, in response to the Third Circuit’s decision:

“The ABA applauds this landmark decision upholding the historic tax treatment of loan origination costs. This decision confirms the industry’s long-standing position that normal and routine costs incurred in the particular business of banking are tax deductible in the year incurred. We hope the IRS will broadly apply the decision in a uniform manner from this point forward.

“This issue, which has a wide-ranging impact on all banking institutions, has been a high priority for the American Bankers Association for many years. The ABA filed amicus briefs in both the Tax Court and Appeals Court in support of PNC’s position. We hope that this decision puts an end to uncertainty in an area of tax law that has become unnecessarily controversial.”