The Ninth Circuit Rejects the Government’s Effort to Disregard “Economic Realities” in Washington Mutual
[Note: Miller & Chevalier is counsel to Washington Mutual in this case.]
In the past decade, the government has often defeated taxpayer claims that tax benefits flowed from certain transactions on the grounds that the economic substance of the transactions did not justify the tax benefits and that the taxpayer’s contrary arguments reflect a hypertechnical reading of the rules. In Washington Mutual Inc. v. United States (9th Cir. No. 09-36109), the proverbial shoe was on the other foot. A key element of the taxpayer’s business transaction was the receipt of regulatory rights in exchange for incurring the cost of relieving the government of impending liabilities. The government argued, however, that, with respect to determining basis in those intangible assets, technical requirements in the reorganization rules trumped the economic reality that the taxpayer had purchased those rights. The Ninth Circuit rejected that argument and ruled for the taxpayer.
The controversy stemmed from an acquisition by Washington Mutual’s predecessor, Home Savings, of three failed thrifts during the savings and loan crisis of the early 1980s. In part due to skyrocketing interest rates, many thrifts at that time had deposit liabilities that exceeded the value of their assets. The policy of the Federal Savings and Loan Insurance Corporation (FSLIC) was to encourage healthy thrifts to acquire such failed thrifts in what were called “supervisory mergers,” which would spare FSLIC the liability it would otherwise incur if it had to liquidate the thrifts and pay off its insurance obligation to depositors. In this case, the primary inducement offered to Home to convince it to enter into what would otherwise have been a losing proposition was a pair of regulatory rights (the right to open branches in other states and the right to the accounting treatment for regulatory purposes that was involved in United States v. Winstar Corp., 518 U.S. 839 (1996)).
Home indisputably incurred a cost in getting FSLIC off the hook in this way because Home inherited the failed thrifts’ net liabilities. Arguing that the transaction was in substance a purchase of regulatory rights, Washington Mutual contended that basic tax principles dictated that Home took a cost basis in the acquired assets – that is, the two regulatory rights. Alternatively, Washington Mutual argued that the assets could have a fair market value basis, through the operation of Code section 597, if they were viewed as FSLIC assistance rather than as the object of a purchase. The government objected to both theories on technical grounds. It argued that the assignment of a carryover basis to the thrift assets under the “G” reorganization rules precluded assigning a cost basis to the regulatory rights. And it raised a variety of hypertechnical textual objections to application of section 597. The district court agreed with the government, holding that the regulatory rights had no basis at all.
The Ninth Circuit reversed in an opinion authored by Judge Betty Fletcher and joined by Judge Bybee, holding that Home took a cost basis in the regulatory rights. The opinion began by emphasizing the “overarching principle” that, “absent specific provisions, the tax consequences of any particular transaction must reflect the economic reality.” In this case, “the economic realities of the transaction” were that Home engaged in one “all-encompassing transaction” in which it acquired the failed thrifts and received the regulatory rights as “part of the consideration.” The majority explained that the government’s argument based on the “G” reorganization rules did not respect the economic reality of this “all-encompassing transaction,” and the majority concluded that those rules were “not incompatible” with the conclusion that Home took a cost basis in the regulatory rights. In sum, the majority ruled that the tax treatment should follow the economic reality that Home did not acquire the regulatory rights in the “G” reorganization but rather purchased the rights from FSLIC and paid for them by allowing the thrifts, which had negative value, to merge into Home.
Given its ruling on cost basis, the majority did not address the alternative theory that Home took a fair market value basis through the operation of Code section 597. Judge Fernandez, however, found that theory more persuasive, and he concurred in the reversal of the district court on that ground (remarking that he therefore had “no need to wrestle with” the cost basis question). Like the majority, he concluded that the government’s technical theories were unsound and could not justify disregarding the economics of the transaction. “Home Savings greatly benefitted the government at a time of great need,” and “it was given the [regulatory] Rights as part of the inducement to do so. . . . Whether one accepts the analysis of the majority or mine, the result is that Home Savings did have a basis in them.”
The Ninth Circuit’s decision is a welcome reminder that what’s good for the goose is good for the gander. In the words of the majority opinion, when a taxpayer enters into a transaction that “has economic substance and is economically realistic,” the taxpayer should benefit from the accompanying tax treatment provided under the law.
The briefs and opinions in the case are linked below.
If the government decides to seek rehearing of the Ninth Circuit’s decision, its petition would be due on April 18.