Bond insurer Ambac Financial Group is offering the Internal Revenue Service (IRS) $102 million to settle the agency’s $800 million claim against it.

Ambac made the announcement Monday after negotiating for several months with the IRS.

Ambac insured MBS before the recent recession along with insuring municipal bonds. During the recession, claims on the securities’ insurance took off and Ambac ended up filing for bankruptcy protection from creditors.

In response, in March 2010 the Wisconsin insurance commissioner took a step to protect Ambac’s muni insurance business. Wisconsin placed about 1,000 of Ambac’s riskiest policies in a walled-off account handled by the state.

In October 2010, the IRS contacted Ambac and said it was questioning an $800 million tax refund that Ambac had received.

The dispute centers on how Ambac recorded losses on its credit-default swap (CDS) policies.
In the recession, 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 indicated that the CDS losses 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.

The IRS wanted Ambac to pay back the $800 million refund it collected because its CDS losses shouldn’t have been deducted from taxable income.

However, as of mid-2010, Ambac had only $312.8 million in cash.

Ambac is proposing paying $100 million from its segregated account, and $1.9 million from its main company, and “the relinquishment by the Ambac Financial consolidated tax group of all loss carry-forwards resulting from losses on CDS contracts arising on or before Dec. 31, 2010, to the extent such loss carry-forwards exceed $3.4 billion.”

The IRS has not yet agreed to the settlement.

The settlement is conditional on approval by the court overlooking Ambac’s Chapter 11 case and the court overseeing the rehabilitation of the segregated account.

In other Ambac news, Ambac Financial filed a third amended plan of reorganization with a U.S. bankruptcy court on Friday. The plan is found at in the court documents section.

The deadline for voting and objecting to the plan is 5 p.m. and 4 p.m., respectively, on Wednesday.

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