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Banks moved billions to shelter income tax

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Banks Moved Billions to Shelter Income From Taxes
Thu Aug 7, 1:03 AM ET

Some of the nation's biggest banks have sheltered hundreds of millions of dollars from state taxes by creating investment funds that didn't sell shares publicly but paid tax-exempt dividends to the banks, Thursday's Wall Street Journal reported.

A review of Securities and Exchange Commission (news - web sites) records shows that at least 10 major banks shifted more than $17 billion into such funds. Bank of America Corp. (BAC) alone transferred at least $8 billion into its fund, sheltering more than $750 million in income from 1999 through last May. The banks contend the funds were legitimate vehicles for raising investment capital, but many appear to have served little purpose beyond sheltering income. In effect, the funds converted interest income from the banks' loan portfolios into tax-exempt dividends.

All but one of the known funds -- 11 in all -- were set up with advice from KPMG LLP, an accounting firm whose tax shelter practices are under scrutiny by the Internal Revenue Service (news - web sites). They were created in 1999 and 2000, but have been gradually shut down over the last two years, after the SEC and California revenue officials quietly began looking into the practice. It is not known if more such funds remain active. California officials, calling the maneuver " outrageous" and "egregious," are auditing several banks' tax returns in an effort to recoup lost revenues and looking as far back as 1993. The officials declined to identify the banks, citing tax-confidentiality laws.

"We do not believe this is appropriate," California controller Steve Westly said of the funds. "This is something we need to fix." New York State tax authorities also are examining the issue. It's unclear how many other states might be affected.

Exactly how much the strategy has cost cash-strapped California, where many of the banks have their headquarters, is unclear. Revenue officials said a sampling of tax returns from just a handful of banks showed that the maneuver trimmed those institutions' levies by a total of $46 million in 2000.

SEC records show that the following 10 institutions created investment fund subsidiaries under the federal law that governs mutual funds: Washington Mutual Inc. (NYSE:WM - News) , the nation's eighth largest bank; Bank of America, the third largest; Summit Bancorp, now part of Fleet Bank ; Zions First National Bank, now Zions Bancorp , which had two funds; Cathay Bancorp ; East-West Bancorp; City National Bank Corp.; NBT Bancorp ; Imperial Bank, now part of Comerica Inc. (NYSE:CMA - News) ; and Chinatrust.

Each of the 10 banks registered a subsidiary with the SEC as a "regulated investment company" (also known as a "registered investment company") under the Investment Company Act of 1940, the federal law enacted to protect mutual fund investors. The banks then transferred some of their loan portfolios and other assets into the funds and used the interest and other income they generated to pay themselves dividends.

In California, the banks could contend that they didn't have to pay taxes on the dividends because the state exempts money transferred between subsidiaries and corporate parents. Many of the banks do a large portion of their business in California. But other states with favorable tax treatment for transfers between subsidiaries and parents, or for investment company dividends, also are vulnerable to the strategy. In New York, just 40% of such payments are taxed.

"What they're doing is they're creating this corporate structure that they're passing assets off to," said Michael Bucci, spokesman for the New York State Department of Taxation and Finance. "If it is not set up as a mutual fund, 100% of the dividends would be subject to taxes. Essentially, they're getting 60% of the income tax-free."

It's unclear how much, if any, federal tax benefit the banks also received. One bank fund, NBT Investment Co., said in an SEC filing that it was optimistic that its structure "will be sufficient to relieve it from all or substantially all federal and state income taxes."

The investment funds themselves typically aren't subject to state or federal taxes, because individual investors are supposed to pay taxes on income generated by such funds.

Spokesmen for the banks said the funds were legitimate vehicles for raising capital. City National's fund "was intended primarily to provide our company with capital enhancement opportunities [but it] also resulted in some tax- related benefits," said bank spokesman Cary Walker.

A spokesman for East West said its fund qualified for investment-grade interest rates on loans while the bank itself didn't. Washington Mutual, the largest savings and loan in the country, said "various tax, accounting and legal advisers" had approved the fund and that "neither the SEC nor any other governmental agency has contacted us." Several other banks had no immediate comment.

Wall Street Journal Staff Reporter Glenn R. Simpson contributed to this report.

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