Amicus Curiae Brief — Continental Illinois Corp. v. Commissioner

No. 93-567

IN THE

Supreme Court of the Gnited States

OCTOBER TERM, 1993

CONTINENTAL ILLINOIS CORPORATION,

Pe titione ¥

Vv.

COMMISSIONER OF INTERNAL REVENUE,

Responde nt.

On Petition for a Writ of Certiorari

to the United States Court of Appeals

for the Seventh Circuit

BRIEF OF THE AMERICAN BANKERS ASSOCIATION

AS AMICUS CURIAE IN SUPPORT OF PETITIONER

JOHN J. GILL II]

General (C‘ounse /

Counsel of Record

MICHAEL F. CRorTryY

Deputy General Counsel

HENRY C. RUEMPLER

Director of Tar A Accounting

AMERICAN BANKERS ASSOCIATION

1120 Connecticut Ave., N.W.

Washington, D.C. 20036

(202) 668-5026

Counsel for Amicus Curiae

December &, 1993

PRESS OF BYRON S. ADAMS, WASHINGTON, D.C. (202) 347-8203

QUESTION PRESENTED

Whether the court of appeals incorrectly held, con-

trary to this Court’s decision in Commissioner v. In-

dianapolis Power & Light Co., 493 U.S. 203 (1990),

that a taxpayer must report funds as income upon

receipt even though the taxpayer is contractually ob-

ligated to repay those funds unless contingencies oc-

cur that are outside of the taxpayer’s control.

il

TABLE OF CONTENTS

Page

QUESTION PREGIV EEL) scsccsrecscsvesrsésessorssecsstveinneren: i

TAM CF AUTRE OED cittsiccintetecsnrmmenneun ill

INTEREST OF AMICUS CURIAE .................cccesceeees 1

REASONS FOR GRANTING WRIT .................cceeceeeee 3

I. THE SEVENTH CIRCUIT’S DECISION ON

THE TAX TREATMENT OF CAP LOANS

WILL CREATE ADVERSE CONSEQUENCES

THROUGHOUT THE BANKING INDUSTRY. . 3

Il. THE SEVENTH CIRCUIT’S DECISION ON

CAP LOANS HAS CREATED UNCERTAINTY

ABOUT THE TAX TREATMENT OF FINAN-

CIAL PRODUCTS WHICH COULD STIFLE

FUTURE FINANCIAL INNOVATIONG. .......... )

Ill. THE SEVENTH CIRCUIT MISCONSTRUED

THE PRINCIPLES OF INDIANAPOLIS

POWER & LIGHT AND FAILED TO APPLY

THEM TO THE CAP LOANS OFFERED BY

CATINT ENE S PRs TRINA: ssvioccnrianssncesssnaceioesesens 7

CATNCLASGNES scanvisecacvcersaaneeastuanananan Seat 8

iil

TABLE OF AUTHORITIES

CASES: Page

Commissioner v. Indianapolis Power and Light, 493

U.S. 208 (1990) ....secccccrrcccrcssccovccvesevezevecseeesorees passim

Newark Morning Ledger Co. v. United States 113

BS, Ce. 16TO (IGG]) .nccovevvcccsccscosesscesssesesenscveveeees 3

Quill Corporation v. State of North Dakota 112 S.

Be CIID cenceecesevecesscceresveserysorsenssneseonneess 3

STATUTES:

EE COTES... ccsovenccescossncvasoenecessacsersees

MISCELLANEOUS:

Testimony of Fred T. Goldberg, Commissioner of

Internal Revenue before the Permanent Sub- ,

committee on Investigations, Senate Commit-

tee on Governmental Affairs, April 17,

il aladeibenenabenserentneeennensessers 4

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IN THE

Supreme Court of the Gnited States

OCTOBER TERM, 1993

No. 93-567

CONTINENTAL ILLINOIS CORPORATION,

Petitioner,

Vv.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

BRIEF OF THE AMERICAN BANKERS ASSOCIATION

AS AMICUS CURIAE IN SUPPORT OF PETITIONER

The American Bankers Association hereby respect-

fully submits this brief as amicus curiae in support

of the Petitioner in accordance with the provisions of

Rule 37.2 of the Supreme Court Rules. Both parties

have consented to this filing, and their written con-

sents are filed with this brief.

INTEREST OF AMICUS CURIAE

The American Bankers Association (‘‘ABA”’) is the

principal national trade association of the commercial

banking industry in the United States. ABA members

are located in each of the fifty states and the District

of Columbia and represent banks of all types and

sizes—money center, regional and community banks.

ABA members hold approximately ninety percent of

the domestic assets of United States banks.

The decision of the Seventh Circuit Court of

Appeals in this case! raises a tax issue of substantial

importance to commercial banks across the nation.

The tax treatment of the CAP loan product offered

by Continental Bank for the years under audit would

be significant both to the tax treatment of that prod-

uct offered by other banks and to the treatment of

similar bank-customer financial transactions which in-

volve receipt of funds by the lender which are subject

to repayment to the borrower based on future con-

ditions. Since the CAP loan product was widely of-

fered by commercial banks, the decision in this case

will impact bank cases where the issue was raised on

audit. In addition, the Seventh Circuit’s application

of the principles in the Indianapolis Power and Light?

case raises serious questions about the scope of the

this Court’s ruling in that case. Banks which are at-

tempting to develop innovative financial products for

their customers should not be left in a state of un-

certainty with respect to the fundamental tax law

criteria for determining how a taxpayer should treat

the receipt of funds subject to repayment.

The American Bankers Association is in a unique

position to express the views of the financial insti-

tutions across the country regarding the issues raised

in this case. The ABA has a broad base of member-

ship including banks of all sizes and types. More spe-

cifically, the ABA serves as a clearing house of

information for its member banks by working with

committees of bankers who are experts on a wide

variety of commercial banking practices of all types,

1998 F 2d. 513 (1993).

2493 U.S. 203 (1990).

—

including lending innovations. Moreover, the ABA has

developed and maintained for 25 years a very active

role in the public debate over the tax treatment of

financial institutions and their products. The ABA

maintains regular liaison with the Congressional tax-

writing committees, the IRS Assistant Chief Counsel

(Financial Institutions and Products) and the IRS In-

dustry Specialist—Commercial Banks. The ABA has

also filed amicus curiae briefs in two recent U.S.

Supreme Court cases which affected the taxation of

commercial banks—Newark Morning Ledger Co. v.

U.S and Quill Corp. v State of North Dakota‘. In

light of ABA’s clearing house function for banking

practices and active participation in the issues sur-

rounding taxation of banks and their products, the

ABA has the experience and knowledge base from

which to comment about the significance of this case

to the commercial banking industry. Therefore, the

ABA believes that its views would be of assistance

to the Court in determining whether this matter mer-

its further review.

REASONS FOR GRANTING WRIT

I. The Seventh Circuit ruling on the tax treatment of

CAP loans will create adverse consequences through-

out the banking industry.

The CAP loan product offered by Continental Bank

during the tax years in issue constituted a significant

financial innovation for commercial loan customers.

In an environment of uncertain interest rates lenders

might be disadvantaged by a traditional fixed rate

$113 S. Ct. 1670 (1993).

#112 S. Ct. 1904 (1992).

loan and borrowers might be disadvantaged by a tra-

ditional floating rate loan. In contrast, the CAP loan

product afforded both parties to the transaction an

opportunity to accommodate the changing interest

rate environment by adjusting the interest rate at the

end of the transaction, within parameters set by the

original contract. The CAP loan product, including

variations, has been widely offered throughout the

commercial banking industry.

The Internal Revenue Service effectively confirmed

the significance of the CAP loan product by making

that issue one of only five ‘‘coordinated issues’’ for

the commercial banking industry. The coordinated ex-

amination program was developed in 1966 as a way

to enhance examinations of large corporate taxpay-

ers.’ While the coordinated issues for the commercial

banking industry have changed somewhat since the

1960’s, since 1986 there have been five coordinated

issues for the commercial banking industry, without

change.*®

The effect of designation of a coordinated issue by

the IRS is to require all IRS agents to challenge on

audit the tax treatment of CAP loan products and

require the taxpayer to recognize the entire amount

of funds received as taxable income when received,

* As background on the IRS coordinated examination program,

see statement of Fred T. Goldberg, Jr. Commissioner of Internal

Revenue before the Permanent Subcommittee on Investigations,

Senate Committee on Governmental] Affairs, April 17, 1991.

6 Five issues for commercial banks are: (1) accrual of interest

on non-performing loans (2) recognition of interest on CAP loans

(3) amortization of the purchase price paid for core deposits (4)

the character of gain or loss from the sale of foreclosed property,

and (5) the creditability of certain foreign withholding taxes.

~

ee

just as it did in Continental’s case. The identification

of CAP loans as a coordinated issue caused many

bank taxpayers to have this issue raised on audit and

it is not uncommon for large commercial banks to

have audits open for 10 years or more because of the

complexity of the issues involved. As a result, the

absence of Supreme Court review of this case will

mean that many banks outside the Seventh Circuit

will be left with uncertainty about the tax treatment

of CAP loans.

One of the principal benefits of CAP loans is to

permit lenders and borrowers to strike a mutually

acceptable agreement on a loan transaction even in

the face of a changing interest rate environment.

Bank lenders expect to continue to need CAP loans

or alternative financial products as a way to facilitate

the pricing of loans. CAP loans are a particularly

attractive product for smaller commercial banks with

assets of less than $1 billion, because these banks are

reluctant to offer more expensive and sophisticated

financial products such as derivatives. The ABA thus

believes that CAP loans will continue to be a very

attractive financial product both for small bank lend-

ers and for middle market and small commercial bor-

rowers.

Il. The Seventh Circuit decision on CAP loans has cre-

ated uncertainty about the tax treatment of financial

products which could stifle future financial inno-

vation.

The Court should accept the Continental case for

review in order to clear the air on the treatment of

rebated funds, lest the current uncertainty impair the

future consideration of innovative financial products

which involve the same tax issue. The prospects for

—_

financial innovations that involve the same tax issue

as the Continental case seem almost limitless. One

recent example illustrates the chilling impact of the

uncertain state of the law on product development.

A product under consideration by a large regional

bank in the upper midwest involves construction lend-

ing during a period when the building was being built

. up, to be replaced by permanent financing once the

project is completed. Traditionally, construction lend-

ing is at a rate higher than the permanent financing,

thereby creating a financial incentive for the builder

to complete the project as quickly as possible. In a

rising interest rate environment, however, the tra-

ditional gap between construction financing and per-

manent financing may not be sufficient incentive.

Therefore, this large regional bank is considering in-

corporating into its construction lending contracts a

provision for rebate of a portion of interest to the

borrower, if a permanent lender is found within a

specified period.

This construction lending rebate is very similar to

the CAP loan product offered by Continental Bank.

In both cases there would be an agreement at the

outset that the borrower would pay the lender a stated

rate but at some period in the future the borrower

may receive an interest rebate based upon events

beyond the lender’s control. Thus, both cases involve

the question of whether the receipt of funds which

might be rebated under the agreement have to be

recognized as income at the time of receipt. The bank

which is considering the construction loan product and

other banks that may offer the same product or var-

iations or innovative applications of interest rebate

loans should be entitled to know whether or not the

Supreme Court ruling in the Indianapolis Power and

Light would apply to their situation. We believe that

there are many other financial innovations which in-

volve the tax principles of the Continental case.

This Court’s decision in Indianapolis Power and

Light established clear expectations about the tax

treatment of financial institution products that in-

volved a rebate of interest to the borrower. Now that

the Seventh Circuit opinion in the Continental case

has confused those expectations, it is incumbent on

this Court to resolve the conflict. This issue is a mat-

ter of broad importance to the industry and we urge

the Court to address it now.

III. The Seventh Circuit misconstrued the principles of

Indianapolis Power and Light and failed to apply

them to the CAP loans offered by Continental Bank.

This Court’s decision in the Indianapolis Power &

Light case set clear rules for determining when the

receipt of funds would not constitute income under

Section 61(a) of the Internal Revenue Code. The Court

directed that a determination be made based on the

rights and obligations of the party at the time the

money was paid and said ‘‘the key is whether the

taxpayer has some guarantee that he will be allowed

to keep the money.’”’

Like the taxpayer in that case, Continental Bank

had an “express obligation to repay’’ the interest re-

ceived over the CAP loan rate, based on factors out-

side its own control. The bank did not have complete

dominion over the ‘“‘excess interest’ and the bank’s

experience was that there was a high probability that

7 Commissioner v. Indianapolis Power and Light, 493 U.S. at

210.

——

the funds would have to be repaid to the borrower.

Therefore, the bank should not have to recognize as

income the “excess interest’’ at the time the money

is paid.

The American Bankers Association believes that the

Seventh Circuit incorrectly interpreted the rule in the

Indianapolis Power & Light case and failed to apply

it in the case of the CAP loan product. Moreover,

the Seventh Circuit’s decision substantially confuses

the recognition of income rules for financial trans-

actions like CAP loans. It simply declares that CAP

loans are a gray area between deposits (no recognition

of income) and warranties for defective goods (which

reduce the certainty of a seller’s stream of income)

and concludes the Commissioner did not abuse his

discretion by requiring recognition of income. The

“gray area’ approach is inadequate as a guide for

financial institutions attempting to devise products for

customers so that both parties will know at the outset

the tax consequences of the transaction. A bank would

not be able to determine whether a new product such

as the construction loan rebate described earlier would

be in the “gray area’ and if so, whether the Com-

missioner might exercise his discretion one way or

another.

CONCLUSION

The commercial banking industry and other simi-

larly situated taxpayers are understandably confused

about the recognition of income in the case of finan-

cial products such as CAP loans as a direct result of

the conflict between the Supreme Court’s ruling in

Commissioner v. Indianapolis Power & Light, and the

Seventh Circuit’s decision in Continental Illinois Cor-

poration v. Commissioner. The only remedy for this

conflict is for this Court to grant the petition for a

writ of certiorari in this case.

Respectfully submitted,

JOHN J. GILL III

General Counsel

Counsel of Record

MICHAEL F. CROTTY

Deputy General Counsel

HENRY RUEMPLER

Director of Tax and Accounting

AMERICAN BANKERS ASSOCIATION

1120 Connecticut Avenue, N.W.

Washington, DC 20036

202-663-5026

Counsel for Amicus Curiae

December 8, 1993