06-68 | Virginia Tax

Tax Type

Bank Franchise Tax

Description

Deduction disallowed for goodwill on bank franchise tax returns

Topic

Appropriateness of Audit Methodology

Assessment

Date Issued

08-18-2006

August 18, 2006

Re: § 58.1-1821 Application: Bank Franchise Tax

Dear *****:

This will reply to your letter in which you seek correction of the assessment of bank franchise tax issued to ***** (the "Taxpayer") for the 2001 through 2003 taxable years. I apologize for the delay in responding to your letter.

FACTS

In 1997, the Taxpayer purchased the stock of both ***** ("Bank A") and ***** ("Bank B"). Neither Bank A nor Bank B operated in Virginia prior to their acquisition by the Taxpayer. In both cases, a combination of stock and cash was exchanged with the shareholders to consummate the purchase, and the purchase price paid by the Taxpayer exceeded the fair market value of the acquired banks. The Taxpayer recorded the assets and liabilities of Bank A and Bank B at their fair market value, and the premium paid in excess of the fair market value was recorded as goodwill.

On the bank franchise tax returns filed by the Taxpayer for the 2001 through 2003 taxable years, taxable capital was reduced by goodwill deductions attributable to the acquisitions of Bank A and Bank B. On audit, the Department's auditor disallowed these deductions for goodwill on the basis that such deductions are not permitted under the Virginia statutory and regulatory provisions. This resulted in the assessment of additional tax and interest.

The Taxpayer believes that the assessments are inequitable and unjust because the increase in capital is not attributable to an increase in economic activity or the deployment of incremental capital in Virginia. The Taxpayer asserts that the goodwill deductions were appropriate because they eliminated purchase accounting adjustments made for book purposes. The Taxpayer maintains that these accounting adjustments reflected acquisitions that did not represent increases in capital deployed and utilized in Virginia.

DETERMINATION

Virginia Code § 58.1-1202 imposes a franchise tax on the net capital of banks and trust companies as computed pursuant to Va. Code § 58.1-1205. Pursuant to Title 23 of the Virginia Administrative Code 10-330-20, the computation of the Virginia bank franchise tax starts with capital as reported on the report of condition (the "Call Report"). The Call Report is based on authoritative federal banking laws and regulations, as well as Generally Accepted Accounting Principles ("GAAP").

For accounting purposes there are two methods for recording mergers and acquisitions. These two methods are either a "pooling" of interests or a "purchase" of assets. In a pooling, assets and liabilities are transferred at book value, whereas in a purchase the assets and liabilities are transferred at fair market value. Because the value of balance sheet items does not change in a pooling, no intangible assets are created. Under the purchase method, however, any value given that exceeds the fair market value of assets less liabilities is treated as an intangible asset (usually goodwill).

In most cases, an acquisition accounted for under the purchase method will result in more capital than if the transaction were accounted for as a pooling. In accordance with GAAP, an acquisition including cash consideration is required to be accounted for as a purchase rather than as a pooling.

As such, the construction of merger transactions can affect the bank franchise tax liability. The difference between an acquisition accounted for under the pooling method versus the purchase method can have an effect on capital subject to bank franchise tax. Two otherwise identically situated banks could pay different amounts of tax based upon the method of recording the acquisition required for accounting purposes. Any resulting disparity in the tax liability is a function of the underlying computation of the banks' capital and is not created by the computation of the bank franchise tax.

Historically, when changes to bank reporting requirements have occurred, the General Assembly, at its discretion, has amended the bank franchise tax statutes to limit their effect. For example, the General Assembly took action as a result of the issuance of Financial Accounting Standards Board ("FASB") Statement 141. Effective for business combinations initiated after June 30, 2001, FASB 141 requires that all business mergers and acquisitions be accounted for using the purchase method. As such, the pooling of interests method can no longer be used. The General Assembly acted to reduce the effect of this change on banks.

Senate Bill 174 (Chapter 667, 2002 Acts of Assembly) established a deduction equal to 90% of goodwill created in connection with the acquisition or merger of a bank on or after July 1, 2001 for purposes of determining a bank's capital subject to the Virginia bank franchise tax. This legislation, codified at Va. Code § 58.1-1206 A 5, was enacted to relieve banks of an unintended increase in a bank's capital subject to the bank franchise tax from mergers or acquisitions occurring on or after July 1, 2001.

The Taxpayer cites Senate Bill 174 to support its position that the Department should allow the deduction for the premium it paid for Bank A and Bank B. The Taxpayer asserts that the Virginia General Assembly recognized the distortion created by use of the purchase method as the result of FASB 141. The Taxpayer contends that the provisions of Senate Bill 174 should apply to acquisitions occurring prior to the effective date of the bill.

Further, the Taxpayer asserts that situations where two identically situated banks are treated differently based on the accounting method used to account for a merger or acquisition creates an inequitable result. For example, assume that Bank C made an acquisition using the purchase method on June 30, 2001, while Bank D made an identical acquisition on July 1, 2001. The Taxpayer asserts that Bank C's capital would be artificially inflated for the 2002 taxable year and all subsequent taxable years, while Bank D would see a lower increase to its capital resulting from the adjustment allowed under Va. Code § 58.1-1206 A 5.

In recognizing the burden created by FASB 141, the General Assembly also recognized that, while most mergers and acquisitions were accounted for as a pooling, some bank mergers were accounted for under the purchase method prior to the promulgation of FASB 141. Accordingly, the deduction has been limited to 90% of the goodwill created by mergers and acquisitions occurring after the issuance of FASB 141. Limiting the deduction to 90% is intended to approximate the total bank franchise tax that would be imposed if banks were permitted to continue to choose either the pooling of interests or purchase method to account for mergers and acquisitions. In other words, the General Assembly's intent in passing Senate Bill 174 was to maintain the status quo or continue to tax, in approximation, the same amount of acquisition capital created by the purchase method as was taxed prior to the issuance of FASB 141.

In doing so, the General Assembly's purpose was to equalize the treatment of mergers and acquisitions for the bank franchise purposes. As a result of the General Assembly's actions, all additional capital resulting from mergers and acquisitions occurring on or after July 1, 2001, will be taxed to approximately the same extent as mergers and acquisitions occurring before July 1, 2001.

Further, prior to July 1, 2001, an acquiring entity had the opportunity to structure a merger so that the transaction could be treated as a pooling or a purchase. In this case, the Taxpayer negotiated for the acquisition of Bank A and Bank B, was fully aware of the accounting rules governing mergers and acquisitions, and should have known the impact that the method of accounting for the acquisitions would have on its Virginia bank franchise tax liability. Even with this knowledge, the Taxpayer decided that it would be in its best interest to acquire Bank A and Bank B using the purchase method.

The Code of Virginia does not provide an adjustment for goodwill resulting from mergers and acquisitions occurring before July 1, 2001. The Taxpayer had control as to the method of accounting that would be used to account for the acquisitions of Bank A and Bank B. Consequently, the inclusion of the goodwill created by the acquisitions of Bank A and Bank B is correct. The auditor properly disallowed the deduction for goodwill claimed on the Taxpayer's 2001 through 2003 bank franchise tax returns, and the Department's assessments are upheld.

The Taxpayer should remit payment for the total outstanding balance in accordance with the attached schedule within 30 days from the date of this letter to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attention: *****. Failure to remit full payment within the 30-day period may result in the imposition of additional interest and an additional 20% penalty on the tax due under the terms of Virginia's recent Amnesty program. See the enclosure entitled "Important Payment Information." If you have any questions concerning payment of the assessment, you may contact ***** at *****.

The Code of Virginia sections and regulations cited, and other reference documents, are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.

- - - - Sincerely,

- - - - Janie E. Bowen
        Tax Commissioner

AR/51317O

Rulings of the Tax Commissioner