Tax Breaks Sweeten Countrywide Purchase
Guess who's helping Bank of America pay for its $4.1 billion purchase of Countrywide Financial? Answer: The taxpayers of the United States.
That's because if all goes as planned, Bank of America, which is solidly profitable, will be able to offset part of its own taxable income with the losses Countrywide ran up before being acquired.
The tax break could total about half a billion dollars over the first five years, according to an estimate by Robert Willens, Lehman Brothers' long-time tax expert who's now in business as Robert Willens LLC. The losses could be worth considerably more to Bank of America starting in the sixth year.
At this point, of course, no one knows how much in losses Countrywide has run up since the junk-mortgage market began souring and defaults accelerated. Countrywide itself probably doesn't know. But it seems almost certain to be in the billions of dollars.
In tax circles, Bank of America is famous for its 1988 purchase of the failed FirstRepublic Bank of Dallas, which was being auctioned off by federal regulators. Bank of America (then known as NCNB Corp., the parent of North Carolina National Bank) discovered a way to save $1 billion in taxes with moves that none of the rival bidders realized they could use. That tax advantage allowed NCNB to outbid its rivals for the bank and still come out way ahead.
The Countrywide tax break isn't in the same league, but it would still be worth a lot of money. Willens estimates that Bank of America will be able to deduct $270 million of Countrywide's pre-acquisition losses annually for the first five years it owns the firm. That's based on Bank of America's projected $6 billion cost of buying Countrywide -- the $4 billion of stock it plans to give Countrywide's common stockholders, plus the $2 billion of preferred stock it bought from Countrywide in August.
Willens says you multiply that $6 billion by 4.49 percent, the long-term tax-exempt rate, to determine how much of Countrywide's losses Bank of America can deduct annually for five years after the purchase. A $270 million annual deduction would save Bank of America something more than $100 million a year in federal and state income taxes.
The long-term tax-exempt rate, which is based on Treasury rates and other things so complicated that they make my teeth hurt, changes each year but not by much. When I asked how it's calculated, Willens, a master of tax arcana, threw up his hands (metaphorically, of course). It's "like the formula for Coca-Cola," he said. "No one outside the circle knows it."
So over the first five years, Bank of America can use a total of $1.35 billion of Countrywide's losses to shelter its income -- the aforementioned $270 million, multiplied by five. This saves the bank about $500 million of taxes.
Just before the deal closes, Countrywide will total up both its realized and unrealized losses. If they exceed $1.35 billion, Willens says, the bank will be able to deduct the rest of the losses, without limit, starting in the sixth year. (Any losses incurred after Countrywide becomes part of BofA would, of course, be fully deductible by the bank.)
Is this going to be a good deal for Bank of America? There's no way to know. When the bank bought the $2 billion of convertible preferred stock from Countrywide in August, lots of people -- including me -- considered it brilliant. The preferred shares carried a fat 7.25 percent dividend and were convertible into Countrywide common stock at $18 apiece, below Countrywide's stock price at the time. The purchase also calmed the financial markets, if only briefly.
But the August purchase doesn't look so brilliant now because things are far worse than almost anyone thought back in the summer. The $18 conversion price is almost triple Countrywide's current stock price.
The pending purchase of the company for less than Countrywide's shares fetched the day before the deal was announced also looks like smart bargaining. But who knows what liabilities lurk at the firm?
The tax benefits Bank of America stands to get from Countrywide's pre-acquisition losses are nice. But if BofA has gotten it as wrong this time as it did last summer, its tax breaks on Countrywide's losses won't be enough to turn a bad deal into a good one.
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FOLLOW-UP: A year ago, I wrote about Sam Zell's takeover of Tribune Co. and predicted that the tax-dodging employee stock ownership plan structure he was using would be widely imitated by other dealmakers. It wasn't, which I should have said in my year-end column two weeks ago. Mea culpa. I'm still happy that the House Ways & Means Committee is trying to close the loophole.
Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@ fortunemail.com.