Minimizing financial institution taxes.
Financial institution, like all taxpayers, are constantly searching for opportunities to reduce their tax burden. One opportunity for tax reduction is the amortization of the core deposit intangible asset, which is created when a financial institution pays a premium above the outstanding account balances to acquire the core deposits of a bank or thrift institution. The acquisition premium paid above the outstanding account balances for the core deposits is considered as paid for goodwill unless the taxpayer can demonstrate the existence of an intangible asset whose value is separable from goodwill and whose life is of a limited duration. For tax purpose goodwill is not depreciable; however, an intangible asset with a limited useful life and a value distinct from goodwill is depreciable. Therefore, a financial institution seeking to minimize its tax exposure will identify any amortizable intangible assets associated with a core deposit account portfolio acquisition.
The core deposit intangible asset has historically been the most significant intangible asset that has been acquired with the purchase of core deposit accounts. Opportunities to amortize the core deposit intangible asset arise because core deposit balances represent a low cost funding source for financial institutions when compared to alternative funding sources. If a financial institution is unable to maintain substantial core deposit account balances, it will be forced to obtain financing from more expensive alternative funding sources. Obtaining the expensive financing will increase the financial institution's overall cost of funds and thereby reduce its profitability. Therefore, because the acquisition of a core deposit account population generally enables a financial institution to obtain funds at favorable interests rates, the core deposits will sell at a premium above face value since a financial institution recognizes the benefit to itself in acquiring this attractive financing source. The benefit received by the acquiring financial institution is quantified as the core deposit intangible asset. Because of the potential tax savings, many financial institutions have attempted to amortize the core deposit intangible asset. However, legal response to the core deposit intangible asset amortization issue has been inconsistent so that a brief examination of the legal history relating the amortization of the core deposit intangible asset is necessary.
Sec. 167 permits a depreciation deduction when there is exhaustion of property used in a trade or business or the property is held for the production of income. Sec. 167 paces the burden of proof on the taxpayer to demonstrate that the intangible asset possesses a limited useful life that can be ascertained with reasonable accuracy and a value separate and distinct from goodwill. Rev. Rul. 74-456(2) further clarified this position by requiring the taxpayer to provide sufficient evidence to support the amortization claim. In all cases, the amortization issue is a factual one, with the taxpayer bearing the burden of proof.
The courts have responded in various ways to the core deposit intangible asset amortization issue. Judicial rulings have varied depending on the facts presented in each case. The amortization deduction was permitted in four Tax Court decisions. Most recently, in People's Bancorporation, the Tax Court held that some of the core deposits were amortizable because they were separate from goodwill and going concern value. In IT&S of Iowa, Inc., the Tax Court also ruled that the taxpayer satisfied the burden of proof so that the core deposit intangible asset was separate and distinct from goodwill and therefore could be depreciated under Regs. Sec. 1.167(a)-3. Previously, in Colorado National Bankshares, Inc. and Subsidiaries,(3) the Tax Court held that the core deposit intangible asset had a value separate and distinct from goodwill and going concern value, and a limited useful life that could be ascertained with reasonable accuracy, so that the taxpayer was entitled to an amortization deduction. Similarly, in Citizens and Southern Corp. and Subsidiaries,(4) the court decided that the taxpayer had satisfied the burden of proof by satisfying the requirement that the core deposit intangible asset possessed an ascertainable value separate and distinct from goodwill and it possessed a limited useful life the duration of which could be ascertained with reasonable accuracy. Thus, the taxpayers in these four cases were permitted to amortize the value ascribed to the core deposit intangible assets.
Conversely, an amortization deduction has been denied in several court decisions involving core deposits. In Banc One Corp.,(5) the amortization deduction was denied because the taxpayer failed to establish a reasonably determinable life based on the facts available at the acquisition date. In AmSouth Bancorporation & Subsidiaries,(6) the court decided that the core deposit intangible asset value was not separate from goodwill, and thus denied the amortization of the core deposit intangible asset.
Based on these court decisions, it is evident that the judicial response has varied depending on the facts presented in each specific case. Therefore, the taxpayer must be diligent in collecting the necessary information to support his position concerning the amortization of the core deposit intangible asset. In the Tax Court decisions in which the core deposit intangible asset was determined to be amortizable, the taxpayer established the amortizable value based on the present value (PV) of the difference in cost between the market alternative and the acquired core deposits. The limited useful life for the core deposit intangible asset was estimated through a statistical analysis of historical account retirement activity prior to the acquisition date (otherwise known as survival analysis). The cost savings approach and survival analysis have been recognized as accepted methods to use when valuing the core deposit intangible asset.
Survival analysis of the core deposit accounts is essentially an actuarial study. The objective is to determine a pattern of core deposit account retirement activity. The first step in the survivor analysis process is the estimation of the survivor curve from the observed retirement activity. The observed survivor curve depicts the relationship between the percent of core deposit accounts surviving and the length of time the accounts have maintained their business relationship. After the survivor curve has been generated, it is compared to various mathematical models such as the Iowa curves, the exponential distribution and the Weibull distribution. The comparison determines the model that best describes the historical retirement behavior using a least squares analysis. The mathematical model, which minimizes the squared differences between itself and the observed survivor curve, is selected as the model that best describes the core deposit retirement activity. The mathematically modeled survivor curve is then used to forecast future core deposit account retirement activity and estimate the life characteristics for the core deposit population. In performing this analysis the limited useful life of the core deposit intangible asset will be established.
Discounted Cash Flow Analysis
Once the limited useful life has been calculated, the value of the core deposit intangible asset can be determined. A discounted cash flow analysis of the expected cost savings associated with the core deposits is the accepted method used to value the intangible asset. The discounted cash flow approach measures the expected future economic benefits associated with ownership of the core deposit intangible asset.
The first step in performing the discounted cash flow analysis of the core deposit intangible asset is to estimate the number of surviving core deposit accounts in future years. An estimate of future survivor expectancy can be forecast for each age group of the population by applying the mathematically modeled survivor curve to the active acquired core deposit accounts. Totaling the surviving accounts for each vintage age group generates a forecast of the total surviving accounts for the core deposit account population in future years.
Having estimated the future surviving accounts, a pro forma analysis of the expected future benefits of the core deposit accounts is performed next, to calculate the value of the core deposit intangible asset. This analysis estimates the available cash flow associated with cost savings by comparing the difference between the cost of the market alternative and the actual cost of the acquired core deposit accounts, including the amortization benefit.
The cost savings attributable to the core deposit accounts is a function of the outstanding balances associated with the core deposit population and the relative cost savings associated with the core deposit accounts. The available cost savings is calculated by first determining the cost of the market alternative funding source. The interest and servicing costs paid on the core deposit accounts are then totaled to calculate the actual core deposit cost. Subtracting the core deposit cost from the market alternative cost yields the cost savings from ownership of the core deposit account population.
Applying the estimate of the future surviving core deposit accounts from the survival analysis to the forecasted average balance per account will estimate the expected future total account balances for the deposit population. Once the average balances have been estimated for each year, the expected cost savings associated with the core deposit accounts can be projected. Applying the cost savings associated with the core deposit balances to the quantity of balances outstanding will produce the expected annual cost savings for the core deposit population. The available cash flow from the core deposit population is calculated from the cost savings attributable to the favorable financing and the amortization tax benefit. A present value for each annual cash flow can be calculated by discounting the annual cash flows at a discount rate that provides a satisfactory return of capital. Totaling the individual present values yields an estimate of the core deposit intangible asset value. An example of these valuation principles follows.
Example: A bank has acquired a portfolio of core deposit accounts consisting of the following account classifications: demand deposit, savings and certificates of deposit
A compilation of the active and retired accounts results in a calculation of the observed retirement activity of the savings type core deposit accounts. The mathematical model describing the observed survivor curve can be estimated from the retirement activity. The mathematically modeled survivor that best describes the retirement activity is the exponential distribution with an average life of six years. The average outstanding balance is $3,000 per account with 1,000 active accounts. The market alternative cost of funds is 8%, the savings account interest expense is 4% and the service expense is 2%, representing a cost advantage of 2% (8% - (4% + 2%)). The value of the savings account core deposit intangible asset can then be calculated using the cost savings approach, a 40% tax rate and 15% discount rate. The table (page 606) shows the cost savings approach to value the intangible asset.
A value of the savings account core deposit intangible asset can be estimated by summing the present value of the annual pro forma cash flows. Thus, the core deposit intangible asset is $182,000.
[TABULAR DATA OMITTED]
A financial institution can minimize its tax liabilities by successfully amortizing the core deposit intangible asset. A successful amortization position is possible only by determining the value and remaining useful life of the core deposit intangible asset through the use of accepted valuation methods. Statistical analysis of the core deposit account population provides the necessary foundation for projecting the number of surviving future accounts and determining the remaining useful life of the core deposit intangible asset. Application of a discounted cash flow approach to estimate the expected future cost savings establishes the value of the core deposit intangible asset. A financial institution may amortize the core deposit intangible asset by demonstrating that it possesses a remaining useful life and a value separate from goodwill. Although the IRS may challenge the amortization deduction, recent judicial decisions support the amortization of the core deposit intangible asset. The application of sophisticated valuation techniques will enable a financial institution to improve its prospects of successfully amortizing the core deposit intangible asset.
The amortization of the core deposit intangible asset may be settled soon as Congress is considering legislation that will affect the amortization of intangible assets. The legislation, HR 3035, introduced by Rep. Dan Rostenkowski, chairman of the House Ways and Means Committee, would allow the amortization of acquired intangible assets including goodwill. Passage of HR 3035 would, in all likelihood, eliminate future controversies concerning the core deposit intangible asset and goodwill. (1) IT&S of Iowa, Inc., 97 TC 496 (1991). See also People's Bancorporation, TC Memo 1992-285. (2) Rev. Rul. 74-456, 1974-2 CB 65. (3) Colorado National Bankshares, Inc. and Subsidiaries, TC Memo 1990-495. (4) Citizens and Southern Corp. and Subsidiaries, 91 TC 463 (1988), aff'd without published opinion, 900 F2d 266 (11th Cir. 1990). (5) Banc One Corp., 84 TC 476 (1985), aff'd by court order without opinion, 815 F2d 75 (6th Cir. 1987).. (6) AmSouth Bancorporation & Subsidiaries, 681 F Supp 698 (N.D. Ala. 1988)(61 AFTR2d 88-877, 88-1 USTC [Paragraph] 9232).
Richard K. Ellsworth, PE, ASA, CFA Manager of Financial Valuation Valuation group Deloitte & Touche Northeast Office Edison, N.J.
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|Author:||Ellsworth, Richard K.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 1992|
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