Harl, Neil E.

English

Research Papers in Economics

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History and Unique Features of the Farm 
Credit System
Neil E. Harl
The proposed buyout of Farm Credit Services of America
(FCSA) by Rabobank in late July 2004, and the subse-
quent rejection of the offer by the FCSA board in late
October 2004, focused attention on the uniqueness of the
Farm Credit System as a national cooperative lender to
agriculture, on congressional expectations for the system
(inasmuch as the system was created by successive congres-
sional acts), and on the very unusual tax status of the Farm
Credit System, especially the Federal Land Bank segment.
The proposed Rabobank buyout posed the policy question
of whether a buyout of a component of the Farm Credit
System was inconsistent with the statutory and regulatory
framework of the system.
The matter of expectations of the stockholders of the
buyout target was also highly relevant but the proposed
buyout did not progress to the point of assessing stock-
holder positions on the matter.
History of the Farm Credit System
Early History
By 1912, politicians found it universally popular to prom-
ise that strong measures to deal with the farm credit prob-
lem would be taken by government. In that year, all three
political parties (Republican, Democratic, and Progressive)
adopted platform planks calling for strong rural credit leg-
islation. As early as 1908, President Theodore Roosevelt’s
Country Life Commission had recommended a coopera-
tive credit system that would provide agricultural credit to
farmers and ranchers on fair terms.
Compromises or reconciliation of such polarized con-
cepts—the one system private, the other public—proved
difficult. Congress tied both plans together and adopted
them into a single enactment as the Farm Loan Act of
1916.
Thus, the Land Banks and their affiliated associations
came into being in 1916, because farmers had an urgent
need for more and better long-term mortgage financing.
Money was scarce in most rural areas, and when lenders
could be found, costs usually were high. Every few years,
mortgages had to be renewed or refinanced. There was the
ever-present danger that renewals or a new lender would
not be available.
After the wartime prosperity of 1918–1920, American
agriculture fell into a deep depression, and the Federal
land program and its private counterpart, the joint stock
land banks, were unable to provide the needed credit.
In the early 1920s, the War Finance Corporation
endeavored to establish a program for short-term agricul-
tural credit. Congress, responding to the nation’s depressed
rural economy, enacted the Agricultural Credit Act of
1923, which established the Federal Intermediate Credit
Banks to finance and discount the paper of agricultural
credit organizations, commercial banks, savings institu-
tions, and cooperatives, in order to channel funds to indi-
vidual farmers for their operating needs.
The Great Depression
The nationwide depression that deepened in 1929 and
continued into the 1930s accelerated the problems of rural
America. Upon assuming office, President Roosevelt acted
quickly to establish a means to revive financially the farm
economy. By Executive Order, the President created the
Farm Credit Administration, thereby concentrating the
supervision and authority over the foundering rural assis-
tance programs.
Thereafter, Congress enacted the Farm Credit Act of
1933, establishing a system of production credit corpora-
tions and associations, with financing from the Federal
Intermediate Credit Banks, to provide operating loans to
farmers on a short-term credit basis. That legislation also12 CHOICES 1st Quarter 2005 • 20(1)
brought into the Farm Credit
Administration the banks for cooper-
atives. In the same year, the Emer-
gency Farm Mortgage Act provided
for refunding and revising the opera-
tions of the Federal Land Bank asso-
ciations to meet the problems of farm
foreclosures and debt defaults.
In the late 1960s, it became
increasingly apparent that the system,
which was based on several underly-
ing statutes, should be recodified,
updated, and made ready for the
years ahead.
In 1985, in the midst of a deep-
ening farm debt crisis characterized
by low commodity prices, high farm
debt-to-asset ratios, and steeply fall-
ing land values, the Farm Credit Sys-
tem banks held some $6 billion in
loans in which the face amount
exceeded the value of the collateral.
Increasing amounts of nonaccrual
and other high-risk loans ($10 billion
in September 1985), record losses,
and increasing acquisition of prop-
erty through foreclosure or liquida-
tion severely strained the resources of
the system, with individual banks
and associations in danger of col-
lapse. In response to the growing cri-
sis, Congress passed the Farm Credit
Act Amendments of 1985 which (a)
reorganized the central administra-
tion of the system to make the Farm
Credit Administration a more inde-
pendent, arm’s-length regulator of
the System; (b) increased the FCA’s
enforcement powers; and (c) created
the Farm Credit System Capital Cor-
poration to assist the system as a
ready source of financial assistance.
Although the act did not appropriate
additional funds for the FCA, it did
provide the Department of the Trea-
sury with discretionary authority to
provide financial assistance after cer-
tification of need from the FCA.
The Agricultural Credit Act of
1987 provided for reorganization of
the Farm Credit System in terms of
powers and capitalization. Federal
Land Banks and Federal Intermediate
Credit Banks within each district
were merged.
Under the Agricultural Credit
Act of 1987, on consolidated or sys-
tem-wide obligations, each bank was
responsible for obligations issued on
its own behalf and jointly and sever-
ally liable on other obligations as
called upon by the Farm Credit
Administration. After five years, the
FCSIC fund was to be exhausted
before a bank was asked to be liable
for other banks’ obligations.
The Agricultural Credit Act of
1987 created an FDIC-type fund for
the Farm Credit System. The new
fund was designated the Farm Credit
System Insurance Corporation
(FCSIC). The 1987 legislation also
created the Farm Credit System
Financial Assistance Corporation
(FCSFAC) to provide capital to FCS
institutions experiencing financial
difficulty.
The Exit Fee
The payment of the exit fee in the
proposed Rabobank buyout in 2004
was of importance because (a) much
of the capital involved, which was
held as unallocated earnings, would
flow out of FCSA and, in large mea-
sure, outside the four-state area to
benefit other FCS borrowers in other
states; (b) payment of the fee would
diminish the amount to which stock-
holders would be entitled; and (c) the
expected income tax consequences
meant that the US government and
the respective states would be major
beneficiaries of the payment of the
exit fee.
Payment of the exit fee, estimated
to total nearly $900,000,000, was to
be paid by FCSAmerica out of unal-
located surplus—not by Rabobank.
The exit fee is based on the aver-
age daily balances of assets and liabil-
ities for the 12-month period
preceding the termination date with
adjustments. To calculate the fee,
assets are multiplied by 6%, and that
amount is subtracted from total capi-
tal. Thus, the exit fee is all capital
above 6% of assets.
The exit fee is paid to the Farm
Credit System Insurance Fund. The
exit fee could have been avoided if a
buyout or merger were to occur with
another Farm Credit System unit
with the full amount of the fee
retained within the system.
Income Tax Implications
The income tax implications are
important because of the impact on
the purchase price (the greater the
negative income tax consequences,
the lower the purchase price) and the
potential effect on the amount avail-
able for distribution to stockholders.
History of Exemptions from Income Tax
Income earned by the Federal Land
Banks (FLB) and the Federal Land
Bank Associations (FLBA) is exempt
from federal, state, municipal, and
local taxation. The exempt status was
provided for in the original act creat-
ing the Federal Land Banks in 1916
(the Federal Farm Loan Act) and has
been continued in subsequent legisla-
tion.
Bonds, debentures, and other
obligations issued by Federal Land
Banks are exempt from all taxes other
than federal income tax. This makes
Federal Land Bank bonds more
attractive to the investing public. The
exemption benefits security holders
and also allows securities to be priced
more favorably.1st Quarter 2005 • 20(1) CHOICES 13
Effect of the Agricultural Credit Act of 
1987 on FLB
The FLB and FLBA exemptions were
called into question by the IRS fol-
lowing the enactment of authority in
the Agricultural Credit Act of 1987,
allowing the merger of Federal Land
Banks into an Agricultural Credit
Association (ACA). The Internal
Revenue Service ruled on three occa-
sions that Agricultural Credit Associ-
ations (created upon the merger of
Federal Land Banks and Production
Credit Associations under the Agri-
cultural Credit Act of 1987) were not
exempt from income tax from long-
term lending activities previously car-
ried on by a predecessor Federal Land
Bank or Federal Land Bank Associa-
tion.
FCSA is listed as an Agricultural
Credit Association. However, a fed-
eral district court in Fargo, North
Dakota held that the Federal Land
Bank exemption from income tax
could continue after 1987. In that
case, an ACA was formed by the
merger of an exempt FLBA (offering
long-term land loans) and a nonex-
empt Production Credit Association
(PCA) offering short- and intermedi-
ate-term loans. The income from the
ACA’s long-term land loans was held
to be exempt. The court said that to
conclude that Congress intended to
deny the continuance of the exemp-
tion would be “illogical and absurd.”
The court said that no specific lan-
guage was needed for the long-term
land loan income exemption because
it already existed and was incorpo-
rated by reference. Thus, FCSA has
continued to enjoy an exemption of
income from long-term land lending.
Taxation of Other Units of FCSA
The production credit lending of
FCSA has continued to be subject to
cooperative taxation rules.
The special tax status of coopera-
tives involves patronage refunds
whereby a percentage of the patron-
age earnings (80%) is retained by the
cooperative, with 20% of the earn-
ings paid out to the member as
patronage. The income tax on the
entire amount is paid by the patron.
For earnings not classified as patron-
age, the cooperative (other than those
earning exempt income) pays income
tax on the earnings at the corporate
rate.
Treatment of the Exit Fee
The proposed buyout of FCSA by
Rabobank also raised a question
about the income tax consequences
of payment by FCSA of the exit fee
that was expected to total nearly
$900,000,000. Inasmuch as earnings
from the Federal Land Bank (and
Federal Land Bank Associations) are
exempt from income taxes, payment
of the exit fee out of tax-exempt
funds raises a question of whether the
payment would subject tax-exempt
earnings used to pay the fee to federal
(and state) income tax. That is the
case under well-established tax prin-
ciples.
Because of a 1992 US Supreme
Court case, which held that fees and
costs associated with a merger or
acquisition were not deductible but
had to be amortized over a lengthy
time period, there would have been
no offsetting deduction.
Taxation of Other Exempt Earnings
It was also unclear how the remain-
ing tax-exempt earnings in FCSA
would be taxed and to whom (FCSA
or Rabobank) upon completion of
the transaction or at a later time.
The United States Supreme
Court has long held the view that
when a new corporation succeeds to
the rights and powers of an old cor-
poration, the new corporation is not
entitled to the old corporation’s spe-
cial statutory exemptions, including
exemptions from taxation, in the
absence of an express provision in a
statute.
Therefore, it appeared that
Rabobank would not have succeeded
to the tax-exempt status enjoyed by
FCSA for long-term land loans.
Thus, the remaining tax-exempt
earnings would have been subjected
to tax, probably upon takeover.
No Guidance Requested from IRS
Apparently, a private letter ruling had
not been requested from the Internal
Revenue Service on the exit fee issue,
the issue of tax reporting by stock-
holders of the purchase price (which
was payment for the interest of the
stockholders in FCSAmerica), and
the issue of taxation of the remaining
tax-exempt earnings inside FCSA.
Policy Implications
The question still remains (and will
persist until the Congress revisits the
issue) of whether it was the intent of
Congress from 1916 to the present to
allow a buyout of part or all of the
Farm Credit System by a private-sec-
tor lender. This is an important pol-
icy issue that deserves a full-dress
debate in Congress with an opportu-
nity for all points of view to be heard.
If that is not done, the stage will be
set for another buyout proposal at
some future time, which will likely
proceed under the assumption that
inaction by Congress indicates acqui-
escence in the idea of a private-sector
buyout. The public interest in this
issue goes well beyond the public
resources that have been invested in
the system over nearly 90 years.
At a minimum, if Congress
decides to allow private sector buy-
outs, a clear legislative roadmap
should be enacted showing the14 CHOICES 1st Quarter 2005 • 20(1)
income tax consequences, when
those consequences are triggered, and
who bears liability for the tax.
Neil E. Harl is Charles F. Curtiss
Distinguished Professor in Agricul-
ture and Emeritus Professor of Eco-
nomics, Iowa State University.

History and Unique Features of the Farm Credit System

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