What are the consequences for a bank of acquiring a Bank Qualified (BQ) transaction?
A – Many years ago when banks did not pay interest on demand deposits, they were allowed to invest in tax-exempt obligations without any arbitrage consequences. As banks started paying interest on deposits, the Internal Revenue Service started looking at the fact that banks were earning interest that was exempt from federal income taxes AND deducting the interest expense related to the funds used to acquire the tax-exempt investment. As a result, the IRS created the TEFRA rules that only allowed banks to deduct 80% of the interest costs related to a tax-exempt investment. In 1986, the IRS considered not allowing banks this privilege at all and as a result of much lobbying by municipal entities, it came up with the “small issuer exemption” or BQ. If a bank were to acquire a not-bank qualified transaction, it would lose the entire deductibility of the interest expense; however, the interest income would still be tax-exempt.
