The Treasury Department’s financial rescue plan has quickly provoked controversy in the month since it was passed, not least because of an IRS rule change that could well violate the Tax Code.

The ruling involves how banks can write off the tax losses of other banks they acquire, a change that seems to re-open a loophole that Congress had supposedly closed 22 years ago. The IRS ruling, announced in a brief five-paragraph notice in late September in the midst of the debates over the financial rescue bill, took some observers by surprise, but it wasn’t widely publicized at first. However, as relatively healthy banks took advantage of the rule change to snap up distressed banks with the hope of deducting billions of dollars from their taxes, the rule change has quickly gained notoriety.

Wells Fargo, for example, soon announced plans to acquire Wachovia, beating out Citigroup’s bid and could enjoy a federal tax cut estimated at $25 billion by the law firm Jones Day. Other acquirers who could benefit include Banco Santander, which could deduct Sovereign Bancorp’s $2 billion in tax losses, and PNC Financial Services, which could gain $5.1 billion in tax savings from its acquisition of National City.

Jones Day estimates that banks could save $140 billion from the rule change. However, that will mean a substantial hit to the U.S. Treasury, on top of the $700 billion bailout package. States, which are facing extra challenges this year in balancing their budgets, will also see tax losses. The state of California, for example, could lose $2 billion in tax revenue at a time when Governor Arnold Schwarzenegger is appealing to Washington for help and considering raising sales taxes.

The rule change came without warning and revises Section 382 of the Tax Code, which Congress passed in 1986 in order to discourage companies from gobbling up others specifically to benefit from their tax losses, according to The Washington Post. Members of Congress, including Sen. Charles Schumer, D-N.Y., and Sen. Charles Grassley, R-Iowa, are outraged and demanding answers from the Treasury. However, they are in a sticky spot because they don’t want to risk undoing any of the mergers and wreaking further havoc on the economy.

Still, like so much of the rescue plan, the rule change is troubling as it seems to benefit some banks and companies at the expense of others. With the Treasury still at the time of this writing refusing to help struggling auto makers that appear to be headed for bankruptcy by the end of the year, while pouring tens of billions more dollars into a troubled insurance company, it begs the question of why some companies and financial institutions seem to enjoy favored status in the department’s rescue plans.

Congress is right to demand more of the transparency that Secretary Paulson had promised when he testified about the rescue plan a little over a month ago. Since then, the plan has morphed from one in which the Treasury buys up hard-to-price assets, such as securitized mortgages and credit default swaps, to another in which hundreds of billions of dollars of capital are injected into banks and other financial institutions in exchange for preferred stock. But the Treasury has not explained the criteria for the choices it makes among the banks and companies it rescues and those it does not.

When it announced it had signed accounting services contracts with PricewaterhouseCoopers and Ernst & Young, the Treasury posted the contracts on the Internet, but blacked out and redacted significant portions. With a new administration set to take office in January, maybe then the Treasury will finally shed more light on what’s going on with taxpayer’s money.

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