National Bank Appeals Process:
Appeal of Appropriate Treatment of Intercompany Transactions (Second Quarter 1997)
Background
A bank filed a second-tier appeal with the ombudsman regarding
the appropriate accounting and legal treatment of certain intercompany
transactions, sometimes referred to as "round trip dividends." The transactions
represent a series of substantially simultaneous events between the bank and
its parent companies in accordance with a preexisting regulatory commitment.
The transactions facilitate amortization of a note payable from a subsidiary
corporation to the parent holding company. The parent holding company owns 100
percent of the subsidiary corporation, which owns 100 percent of the bank. At
issue was whether the funds could be returned to the bank as undivided profits
or as surplus and whether they reduce the bank's dividend-paying capacity under
12 USC 56 and 60.
Bank management questioned whether the bank should treat each
intercompany transfer as a separate payment or whether it could view the
payments together at their net amount. In the latter case, the substance of the
transaction would be a nonevent for accounting purposes, and thus, for legal
dividend purposes as well. The OCC agreed to allow the bank to treat future
payment as a net transaction for accounting and legal purposes under the
following conditions:
1)
The parent companies formally commit to immediately return the funds to the distributing
bank, and 2) the entities establish an escrow agreement to ensure compliance
with the agreement. The agency concluded, however, that previous intercompany
payments made before the bank establishment of the escrow arrangement should be
viewed as separate transactions. The OCC decided that the bank should account
for historical payments to its parent companies as dividends, and the return of
the funds to the bank as capital contribution, not additions to undivided
profits.
Discussion
The statute (12 USC 60(b)) requires a national bank to obtain
prior OCC approval if the total of all dividends declared in any one calendar
year exceeds the total of its net income of that year plus the retained net
income (net income less dividends) for the preceding two years. The legislative
history of the statute indicates that its intent was to protect the capital of
national banks. It provides the OCC with a legal mechanism to prevent national
banks from dissipating their capital through dividend payment.
Bank management claims they never considered these
intercompany payments to be dividends. In order to provide the fullest possible
disclosure of intercompany transactions to their regulators, the bank reported
the payments from the bank as cash dividends and their return to the bank as
"other transactions with parent holding company." In reality, however, these
transactions constituted a series of substantially simultaneous events fully in
accord with a preexisting regulatory commitment. Consequently, the capital
accounts on the bank's book are not affected.
Generally accepted accounting principles do not specifically
address the treatment of these intercompany payments. The Financial Accounting
Standards Board's "Statements of Concepts," however, give preference to
economic substance over legal form. The bank's external accountants, a "big
six" accounting firm, provided a letter stating that the substances and
economics of the transactions should be viewed together as a nonevent for
accounting purposes. The related transactions, therefore, should be accounted
for on a net basis without affecting the bank's undivided profits account.
In this case, the accounting largely drives the legal question
regarding the applicability of 12 USC 60. If the intercompany payments are not
dividends, the dividend statutes do not apply.
Conclusion
The ombudsman concurs with the chief national bank examiners
that future payments and receipts of the same amounts made under the escrow
arrangement represents a net transaction for accounting and legal purposes.
These payments do not meet the basic elements of a dividend payment in that the
funds effectively do not leave the bank.
From a safety and soundness
perspective, the ombudsman believes the escrow arrangement provides a
reasonable safeguard against the potential dissipation of bank capital.
The ombudsman also concurs with the chief national bank
examiner that the previous intercompany payments made before the bank
established the escrow arrangement should normally be treated as dividends. The
proper handling would have been to use the escrow arrangement for these
payments. In this rather unusual case, however, the ombudsman is willing to
allow these historical payments to be treated as a net transaction for
accounting and legal purposes. The ombudsman bases this exception on four
primary factors: 1) the bank's initial perspective that these payments did not
represent dividends in the normal sense of the term; 2) the economic substances
of the transaction; 3) the bank's demonstration that the parent companies
immediately returned the funds to the bank according to plan; and 4) the
existence of a formal commitment to ensure return of the payments. Also,
because of the unusual nature of these transactions, the bank was unaware of
the necessity of the escrow arrangements and acted in good faith to accomplish
the objective of not dissipating the bank's capital. The ombudsman granted this
exception on the condition that the banks amend previously filed call reports
that reflected these payments as dividends, if significant in amount.
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