The chances that Ambac Assurance Corp. will be able to keep $700 million of disputed tax refunds increased last week when a federal court in Wisconsin again threw out the Internal Revenue Service’s (IRS) case against the bond insurer.
The IRS claims that Wisconsin-based Ambac — which had $313 million of cash in the middle of 2010 and whose parent is bankrupt — has obtained a “completely unprecedented” order from state courts that prevents the agency from retrieving federal taxes.
The IRS told the federal court on Feb. 11 that state courts “lacked any jurisdiction, authority, or right” to rule on internal revenue laws and called the orders “null and void as a matter of federal law.”
The federal court disagreed.
Federal District Court Judge Barbara Crabb dismissed the IRS case Friday on grounds that it “lacked jurisdiction to consider the legality of a state court’s order made in the context of an insurance rehabilitation proceeding.”
Crabb said the principles of federalism stipulate that federal courts should abstain from interfering with specialized regulatory schemes. The judge called the IRS claims “disruptive” to the state’s rehabilitation proceedings and said the state has a right to provide strong protection to policyholders.
The case pits the IRS against Ambac, the Wisconsin insurance commissioner, and the Dane County court that made the “unprecedented” ruling. The decision and court filings are posted at Ambacpolicyholders.com.
Crabb’s 11-page decision is consistent with her ruling from one month ago when she opined that the federal court lacked jurisdiction to decide the motion and moved the case back to state court.
The IRS was seeking to dissolve a state ruling that prohibits it from initiating a lawsuit against Ambac and prevents it from placing a lien on the insurer’s assets.
If the IRS decides the tentative tax refund given to Ambac was improper, it can make a claim in the rehabilitation proceedings.
Its claims would be cordoned into the segregated account — a walled-off account established by the commissioner last March — that holds roughly $60 billion of Ambac’s riskiest assets.
The rehab plan green-lighted last month calls for policyholders in the segregated account to receive 25% of their claims in cash and the rest in surplus notes bearing a 5.1% coupon and maturing in 2020.
Before the financial crisis, Ambac carried triple-A-ratings and was the second-largest bond insurer in the industry.
When housing prices dipped and the financial crisis hit, mortgage-backed securities it insured and credit default swaps it sold wrecked its balance sheet.
The tax dispute centers on how Ambac recorded losses on the CDS.
Ambac booked these payouts as “ordinary losses,” which are deducted from taxable income. Thus, its taxable income was reduced by those ordinary losses on the CDS.
The IRS has never prevailed on how 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.
If the IRS were not blocked from state courts from pursuing the bond insurer, then it could determine that Ambac needs to pay back the $700 million refund it collected because its CDS losses shouldn’t have been deducted from taxable income.
The risk for Ambac is that the massive tax claim could force the insurance commissioner to rehabilitate the entire company, rather than just the segregated account.
That would trigger a default, forcing Ambac to pay the mark-to-market value of derivatives contracts, which were valued at $3 billion in October.
The next step in the case, according to Judge Crabb, is for the Seventh Circuit Court of Appeals to decide whether the IRS can appeal her Jan. 18 ruling to move the case to state court.
Her ruling was “not reviewable on appeal,” but the appeals court allowed the IRS to file a memo explaining why its motion should not be dismissed. A decision on the matter is pending.
“It may be that the court of appeals will conclude that the [IRS’] objections to the state court’s ruling should be heard in this court rather than the state court or the bankruptcy court,” Crabb concluded. “However, unless the court of appeals makes such a determination, this court will abstain from resolving the merits of the [IRS] claims.”
A spokesman from Ambac didn’t immediately return calls to comment.
Ted Nickel, the commissioner of insurance, declined to comment on the case. A spokesman would only add: “The opinion speaks for itself.”