Alternative Capital Vs. the Tax Exemption: A False Choice

The NCUA board recently issued an ANPR seeking comments on alternative forms of capital for federally-insured credit unions. Perhaps the thorniest issue on which the ANPR invites comment is the extent to which alternative capital might pose a threat to credit unions' federal income tax exemption. As in the past, no doubt some commenters will see the taxation threat as a "third rail" that justifies the avoidance of all exploration of alternative capital. However, the credit union system is probably better positioned today than ever before to develop these long-overdue capital formation tools – without significantly jeopardizing the vaunted tax exemption.

The ANPR uses "alternative capital" to mean both "secondary" and "supplemental" capital. Secondary capital is available today to low-income credit unions to help them meet both net worth ratio and applicable risk-based net worth requirements. On the other hand, "supplemental capital" may be available to some federally-insured, state-chartered credit unions (depending on state law) and may someday be authorized for federal credit unions. However, as currently envisioned, "supplemental capital" would only be useful in meeting credit unions' risk-based net worth requirements.

Since the 1990s, there have been multiple efforts to provide credit unions additional flexibility and strength through contributed capital. Despite significant support from credit union leaders, trade associations and academics, each of those efforts was ultimately shelved. Whatever the other hurdles, fear of losing the tax exemption seemed to be one of the biggest reasons these efforts fizzled out.

Since last fall, the NCUA has again taken up the alternative capital challenge, this time with particular care and thoughtfulness, building on lessons from the past as well as the cumulative research and discourse. Armed with sound analysis and arguments, and, given a new laissez-faire atmosphere in Washington, credit unions today may be better positioned than ever to gain access to new capital formation tools and techniques. This opportunity may not occur again – at least not for a long while. Accordingly, credit unions interested in gaining access to alternative capital tools may want to reconsider their past apprehensions over the tax exemption, opting instead to put forth the best arguments possible for why access to alternative capital need not be at odds with long-standing tax policy.

For starters, it's surprising that many credit union supporters do not realize that federal credit unions and state credit unions are exempt from federal income tax for two completely separate reasons. Federal credit unions are specifically exempt under Section 122 of the Federal Credit Union Act. Also, the IRS has issued several rulings that make it clear that federal credit unions are exempt by virtue of the fact that, in a sense, they are federal instrumentalities.

On the other hand, state-chartered credit unions find their exemption in Section 501(c)(14)(A) of the Internal Revenue Code. That section creates a three-prong test to determine the availability of the exemption: The institution must be chartered as a "credit union" under state law; it must not issue "capital stock" and it must be "organized and operated for mutual purposes and without profit."

The first prong is a "gimme," right? So, for state credit unions, the main issues are the meanings of "capital stock" and "mutual purposes and without profit." While there is a considerable body of legal, regulatory and interpretive discussion on these two issues (that are beyond the scope of this writing), the broad concepts are relatively straightforward.

As to the second prong, both court cases and IRS guidance shed light on which attributes are more likely to cause an instrument to be treated as "capital stock." At the risk of oversimplification, to avoid "capital stock" treatment, an instrument should resemble "debt" more than "equity." Common indictors of "debt" are a fixed rate of return and no appreciation of the instrument's value over time (e.g., it would never be redeemed for more than its face amount). A common "equity" indicator is a return conditioned on available net earnings; the return on debt ("interest") is typically payable as scheduled, even if net earnings are insufficient.

As to the third prong, the IRS's General Counsel opined in 1971 that "for mutual purposes" implies an "identity" between lender and borrower, that the depositors and lenders at a credit union are the same group of people – the members. Also, a 1980 IRS General Counsel opinion found that "membership control" of a credit union is an important characteristic of the members' "mutuality of interest."

Until 1951, savings and loans joined credit unions in relying on "mutuality" as a key basis for being tax exempt. In that year, Congress removed S&Ls' tax exemption while continuing the exemption for credit unions. In so doing, Congress found that, by the late 1940s, there was little if any correlation between S&L members as depositors and S&L members as borrowers. Also, S&Ls had begun accumulating vast stores of retained earnings that were available to members only if the S&L were liquidated.

As long as credit unions continue their commitment to key aspects of "operating for mutual purposes," – e.g., by maintaining the "identity" of depositors and borrowers and the reasonable return of profits to the members on an ongoing basis – they probably have little to fear about the structure of potential alternative capital instruments. Indeed, most of today's credit unions' operations demonstrate a commitment to mutuality. For example, a few weeks ago my credit union distributed an $8 million bonus dividend to its "member-depositor-borrower-owners." Know any bank depositors or borrowers who can say that?

Commenters should also note that, although the ANPR invites comments on the "mutual ownership structure" as affecting all credit unions, technically, "mutuality" is only an element of the three-prong tax exemption test for state credit unions, and arguably has no place in determining the availability of the tax exemption for federal credit unions.

Bottom line – commenters on the ANPR should ensure they are well educated on the legal and regulatory bases for the tax exemption. Alternative capital for credit unions can – and should – become a reality this time around. And it will be, if supported by well-articulated comment letters that stand up to unreasonable fears about losing credit unions' tax exemption. There is no reason credit unions need to make a false choice between alternative capital and preserving their tax exemptions.

François Henriquez is a Partner for Shutts & Bowen LLP. He can be reached at 305-415-9076 or [email protected].