Bankrupt bond insurer Ambac Financial Group Inc used an accounting treatment for insurance contracts that was apparently unique in the industry, drawing the ire of tax authorities and putting its ability to pay policyholders further in jeopardy.
Ambac's spiral into bankruptcy last week was expected after years of financial difficulty, but the tax accounting questions that landed the company in bankruptcy court before it could reach a deal with bondholders were not.
Now those questions threaten the company's future, and its ability to make good on thousands of municipal bond insurance policies and other guarantees sold to banks and investors. They could even have far-reaching effects on how companies account for credit default swap (CDS) contracts generally if they prompted U.S. tax authorities to clarify the rules.
Wisconsin Insurance Commissioner Sean Dilweg, who is working to rehabilitate the insurer and protect its policyholders, told Reuters he would be "very concerned" about Ambac losing tax refunds which equal about a third of the liquid assets it has available to pay policyholders.
"We will be making sure that everything is done to protect the tax refund," Dilweg said, adding he is hiring additional lawyers to work on the issue.
The bond insurance industry is a fraction of what it used to be after the financial crisis impaired the ability of most firms to write new business. Ambac, which has insured over $1 trillion in securities since it went public in 1991, is one of three remaining bond insurers left, along with industry leader MBIA Inc and the Wilbur Ross-backed Assured Guaranty. But it started warning almost a year ago that it could be headed for bankruptcy.
At the center of Ambac's dispute with the Internal Revenue Service is a massive $700 million tax refund, which may be worth more than the company itself.
According to court documents, Ambac sought the refunds from the Internal Revenue Service in 2008 and 2009 for carrying back losses that resulted from CDS contracts. But an October 28 letter from the IRS, questioning the propriety of the accounting method Ambac used to justify the refunds was what sent the company hurtling into bankruptcy court.
The bankruptcy filing prevented the IRS from taking immediate action to seize the $700 million, and also protected an additional $7 billion of net operating losses (NOLs) at the company, representing potential future tax refunds.
CHANGE IN METHODS
At issue is whether Ambac was, financially speaking, trying to have its cake and eat it too, by switching the way it accounted for gains and losses on CDS contracts in good years and bad years.
Prior to 2008, Ambac recognized gains on its CDS contracts as capital gains, which kept those profits at a lower tax rate. But when the financial crisis hit and the market turned against them, Ambac switched its accounting method and began recognizing losses on the CDS as operating losses, creating the refund and NOLs.
The NOLs are potentially valuable because they could be used by the company for years to allow it to avoid paying taxes. Ambac has already written off the $7 billion asset on the balance sheet it reports to investors because it does not currently have taxable profits that it can use the NOLs against. The NOLs could also be lost entirely if the company changed control or was eventually sold.
"The NOLs of $7 billion, are in my view, a pipe dream," Wisconsin's Dilweg said, adding that they were not factored into his stress case scenarios.
The bankrupt bond insurer, however, appears to have been alone among the survivors in its industry in using that accounting method.
Ambac's competitors say their accounting for credit default swaps is not and has not been comparable.
"Our accounting in this area and our structure in the way we've undertaken it is quite different from Ambac," Chuck Chaplin, chief financial officer of MBIA, said in an interview.
Like Ambac, MBIA reported tax losses that led to refunds -- $400 million for 2009 alone. But Chaplin said these were standard losses and that any IRS review was to be expected.
"We expect, given the size of the refund, that the return is ultimately going to be scrutinized," Chaplin said, adding that such scrutiny would be "in the ordinary course" given the size of the refund.
Assured Guaranty Ltd also said that it has not changed its tax treatment for CDS at any time, but that it too has held onto its CDS contracts and reported them as operating items.
Ambac, for its part, said in court papers that it had sought guidance from the IRS as early as 2005 on the issue, but did not receive it and went ahead with the change in 2008. An Ambac spokesman did not respond to requests for comment and Ambac's auditor, KPMG, declined to comment, citing client confidentiality.
But Ambac is not the only company in history to use such methods, as questions about when a capital gain can become an operating loss have been debated for years, according to tax accounting expert Robert Willens.
"There are only two ways to do it -- capital or ordinary -- and I think probably whatever produced the best result for these companies was how they accounted for it in the absence of any guidance from the IRS," said Willens, who is president of consulting firm Robert Willens LLC.
"The IRS has been negligent, I think, in not putting out something on this a long time ago."
An IRS spokesman declined to comment for this story, saying it cannot discuss details related to individual taxpayers.
However, in 1988, the U.S. Supreme Court ruled on a similar dispute about the tax treatment for losses arising from stock sales, saying that transportation company Arkansas Best Corp's loss from a sale of stock was a capital loss, regardless of the motive the corporation had for purchasing the stock.
"I'm pretty sure it will come down to whether that reasoning applies to CDS contracts. On the surface it seems like it probably does, but there might be other arguments for Ambac and the others to make," Willens said.
er meinte, ambac wird diese Thematik runter spielen und die Anwendung oder Kalkulation von CDS-contracts wird es andere Argumente oder Methodik finden.
Eine Kompromise mit IRS wird es scheinbar sein!
