Citi's $38 Billion Tax Break Fiasco

There's been a lot of discussion and anger today about the news that Citigroup is being allowed to take advantage of a $38 billion tax credit when it technically shouldn't. The issue is not at all transparent, however. Populist outrage hardly does it justice. This is a complicated situation, but I wanted to take a stab at navigating through it.

By far the best explanation of what's going on I've seen comes from Edward Harrison (hat tip: Atlantic Wire). Here's where the break comes from:

At issue is accounting for loss carry-forwards. Basically, it works like this: if a company loses money in one year, the company can then offset its profit during a fixed number of subsequent years with that prior loss to reduce its tax bill. For instance, if Megacorp loses $100 million in year 0, but makes $200 million in Year 1, it can pay Year 1 taxes as if it had only made $100 million. This tax treatment is designed to level the playing field for cyclical companies that operate at a loss for part of the business cycle.

The problem, however, is that this can be used by predators in mergers. The predator company can swoop in and buy a company in a deal that makes no sense except to gain a tax benefit from the huge net operating losses (NOLs) it inherits from its prey. In order to prevent tax-motivated acquisitions of loss-making companies, the IRS limits how much of the NOLs a company can use post-merger. In Canada, unclaimed NOLs expire immediately when change of control occurs.

During the financial crisis, this got tricky, because some banks didn't want to acquire troubled ones (think Wells Fargo - Wachovia) without reaping the carry-forward benefit. So somehow, the Bush Treasury amended the law in order to make that happen. Harrison says that was probably illegal, and February's stimulus bill appears to have language that repealed this law change and forbid the Treasury from doing something like this again in the future -- so no company now should be able to utilize carry-forward benefits when a change of ownership occurs. That would include Citi.

I know what you're thinking: but what change of ownership occurred with Citi? Well, since the U.S. obtained a 34% stake in the bank, it will technically qualify as a change of ownership once the U.S. gets rid of its stake. That should wipe out Citi's opportunity to carry-forward its losses.

Despite that law change, the Obama Treasury, like the Bush Treasury, wants to make an exception for Citi. Funny how little has changed. Should Geithner & Co. be able to do this?

Yes. No. Maybe. If the stimulus bill did, in fact, wipe out the exception that the Bush Treasury created and forbid further such provisions, then the Obama Treasury shouldn't be legally permitted to give Citi this tax break. At the same time, however, it seems little "twisted" (to quote Harrison) that Citi would be deprived of being able to carry forward its losses just because it received a bailout from the government. After all, the spirit of the change-of-ownership provision is to avoid predatory merger activity, as Harrison explained above. That's clearly not what happened here.

As you can see, this situation is ugly and complicated. I'm not sure there's a good answer. But these are the kind of shenanigans that become commonplace with bailouts, because they're an unnatural economic activity that make a mess of markets. All rules are thrown to the wind, so it's hard to decipher what's right. If the U.S. had never had a major ownership stake in Citi, then it would have retained the right to carry forward its losses. But it did -- so should Citi retain this right? I'm not sure, but feel free to weigh in with your thoughts.