The Internal Revenue Service (IRS)  claimed Ambac Assurance — which had $312.8 million of cash in the middle of 2010 — may owe more than $700 million in taxes. Its parent company is bankrupt.

The U.S. government argued it has every right to collect taxes it is owed regardless of how the Ambac structures itself.

A move by federal authorities to seize Ambac’s assets to satisfy tax claims could detonate a catastrophic chain of events for the company: state regulators could assume control of Ambac Assurance, causing a technical default that would trigger a $3 billion payment to terminate swap policies.

The solution was to shunt the potential tax liability into a segregated account currently under the control of Wisconsin regulators and beyond the purview of federal authorities.

Wisconsin’s Department of Insurance argued the federal government does not have the sovereignty to seize assets the state controls.

The IRS, though, contends that a reshuffling of assets and liabilities cannot change the fact that the company owes taxes. While the IRS acknowledges it cannot place a lien on assets controlled by a state, the insurer itself is not controlled by a state.

The U.S. District Court for the Western District of Wisconsin, in Rehabilitation of Segregated Account of Ambac Assurance Corp. v. United States of America, will decide.

Once the second-biggest bond insurer, Ambac ran into serious trouble in late 2007 because of decaying credit quality in its structured finance policies, which included contracts guaranteeing to cover losses on mortgage bonds and credit default swaps.

Sean Dilweg, who served as the Wisconsin insurance commissioner from January 2007 until last week, enacted a plan in March last year to prevent claims in a $114.7 billion structured ­finance insurance book from ­overwhelming the company’s capital and ruining policies in its $223.2 billion muni insurance book.

Wisconsin placed about 1,000 of ­Ambac’s riskiest policies, with about $60 billion par value, in a walled-off account. Claims in the separate account were ­temporarily frozen to stop Ambac from hemorrhaging more than $150 million a month.

The account includes policies on bonds with names like Residential ­Funding Corp., GMACM Home Loan Trust, Residential Asset Mortgage ­Products, and the infamous Las Vegas Monorail.

Dilweg proposed a rehabilitation plan in October which would give segregated account policyholders a quarter of their claims in cash and 75% in notes backed by the company’s surplus.

Ambac issued a $2 billion note to the segregated account, which remains its only asset. Payments on claims would come from the cash flows generated by the note. The segregated account already faces more than $1 billion in unpaid claims.

Nothing in this rehabilitation of the segregated account was expected to impair the municipal insurance book — that is, until Oct. 28, when the IRS sent the company a “mild request.”

Ambac Assurance had submitted for and received a $700 million tax refund based on accounting methods the IRS was now questioning.

The dispute centers on how Ambac recorded losses on its credit-default swap policies.

Ambac was losing money on its ­mortgage CDS policies, and paying out to its counterparties as mortgage quality eroded. The company booked these losses as “ordinary losses,” which are deducted from taxable ­income. Thus, its taxable income was ­reduced by ordinary losses on the CDS.

The IRS has never prevailed on how exactly to record CDS gains or losses, but it holds out the possibility that they should be booked not as ordinary losses but as “capital losses.” Capital losses can only be deducted from other capital gains — not from total taxable income.

In short, Ambac might have to pay back the $700 million refund it collected because its CDS losses shouldn’t have been deducted from taxable income.

By the time of the IRS inquiry, Ambac’s parent company, Ambac Financial Group, was on the verge of defaulting on its $1.6 billion of debt. It was unable to raise capital and already was headed for bankruptcy.

But the IRS inquiry raised an uncomfortable prospect. If the IRS determines Ambac Assurance owes and cannot pay $700 million in taxes, the government can declare a “deficiency,” under which it places a levy on the company’s liquid assets to satisfy the tax obligation.

That in turn would most likely prompt the Wisconsin insurance department to rehabilitate the entirety of Ambac Assurance — not just the segregated account — to protect resources devoted to paying claims to muni bond policyholders.

A rehabilitation of Ambac Assurance would trigger a technical default under many of its CDS contracts, and force the company to close out the swaps and pay whatever it owes. As of its parent company’s bankruptcy filing in October, that amount was $3 billion.

Dilweg promptly ordered any IRS claims into the segregated account, where they would be treated like any other claim: part in cash, part in IOU.

Ambac Financial Group promptly filed for bankruptcy. Dilweg obtained a state court injunction prohibiting the IRS from “commencing or prosecuting any actions, claims, lawsuits or other formal legal proceedings ... in any state, federal or foreign court.”

The prohibition extended to Ambac Assurance, the segregated account, any subsidiary, and the rehabilitator. The state court then claimed “exclusive jurisdiction” over any such claims.

Wisconsin and the IRS will fight this out in federal court. The Wisconsin ­regulators rely on the McCarran-Ferguson Act, which stipulates that states have the authority to regulate insurance businesses without ­interference from most federal regulations.

Dilweg, citing state insurance law, treats the IRS claim as subordinate to ­policyholders claims. He says the IRS is attempting to “jump the line” to receive its allocation, and by doing so it violates state law and causes a “massive disruption” to the efforts of rehabilitation.

“Permitting the IRS to levy or attach on assets based on a disputed tax liability would circumvent the state insurance priority statute because it would allow the United States to get paid in full, ahead of policyholders,” Dilweg argued in federal court.

The IRS acknowledges it has no ­authority to disrupt state insurance rehabilitations, and no access to the assets ­under Wisconsin’s custody. However, Ambac Assurance isn’t in Wisconsin’s custody.

Wisconsin is rehabilitating the ­segregated account — not the hundreds of ­billions of dollars in the rest of Ambac Assurance.

“Simply put, they wish to have their cake — keep the Ambac general account out of rehabilitation — and eat it too — consign the Ambac general account’s potential federal tax liability out of rehabilitation,” the IRS said in a court document filed Jan. 7.

The IRS argues this is not an insurance dispute, but a tax one. It points out that Ambac’s “tentative” tax refund was granted before the segregated account was ­created, and a corporate restructuring ­cannot escape its repayment.

The regulator’s arguments about the integrity of the rehab proceeding, the IRS argues, “obscure the indisputable fact that the Ambac general account is neither under the custody of the rehabilitation court nor subject to the Wisconsin insolvency statutes.”

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