What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax The Much Anticipated Bad Debt Guidance for Banks When banks take bad debt write-offs under section 166, proving the worthlessness of the debt can be a time-consuming task because the IRS does not allow charge-offs for financial accounting or regulatory purposes to automatically prove worthlessness for tax purposes. As this article explains, the IRS recently issued guidance that provides relief to banks in these situations. Overview December 22, 2014 by Liz L Hommedieu and Matt Mosby, Washington National Tax, and Anthony Rodriguez, Federal Tax Liz L Hommedieu is a principal and Matt Mosby is a senior manager in the Financial Institutions and Products group of Washington National Tax ( WNT ) and Anthony Rodriguez is a senior manager in the federal tax practice (Sacramento). The evidentiary rules concerning bad debt write-offs under section 166 for banks have had many areas of contention over the years, mainly related to whether the debt is partially or wholly worthless and the timing of when the debt becomes worthless. The IRS has regularly taken the position that a charge-off for financial accounting or regulatory purposes does not necessarily substantiate that the debt is worthless for tax purposes. In such cases, banks must make this factual determination on a loan-by-loan basis. This places significant burdens on banks, their subsidiaries, and IRS agents. In response to these concerns, the IRS recently provided Large Business & International ( LB&I ) division examiners with a directive regarding bad debt deductions claimed under section 166 by a bank or a bank subsidiary (the Directive ). 1 This Directive generally provides that LB&I examiners should not challenge these taxpayers bad debt deduction to the extent that the bad debt deductions correspond to credit-related charge-offs taken for book purposes. The IRS also previously issued Notice , which requested public comments regarding various complications that arise with respect to a taxpayer s troubled debt. Some of those issues are addressed in the LB&I Directive while others, such as the application of the conformity election to non-bank federally regulated companies, still remain open. However, the request for public comments suggests that the IRS is continuing to research these issues and further guidance is expected. 1 LB&I (Oct. 24, 2014). The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.

2 The Much Anticipated Bad Debt Guidance for Banks page 2 This article first summarizes some of the history of the bad debt deduction under section 166 and then delves into the implications of the LB&I Directive recently issued by the IRS. Background For federal income tax purposes, taxpayers are generally eligible to recognize a wholly or partially worthless bad debt deduction if the following conditions are satisfied: The debt becomes wholly or partially worthless within the tax year; 2 and, For partial bad debt deductions, the debt is charged-off during the year the bad debt deduction is recognized. 3 For purposes of determining worthlessness (i.e., the first requirement), the regulations provide three methods: (1) the facts and circumstances method, which applies to all taxpayers; (2) the conclusive presumption method, which applies to banks and other corporations subject to federal or state supervision; and (3) the conformity election, which only applies to banks. 4 The Facts and Circumstances Method Section (a) Under the facts and circumstances method, the taxpayer bears the burden of proof that the debt becomes worthless during the year (i.e., the debt has value at the beginning of the year and no value, or reduced value, at the end of the year). This determination is made based on the evidence from all surrounding circumstances and the IRS acknowledges that no precise test exists for purposes of determining worthlessness. 5 This is supposed to be done on a loan-by-loan basis. With the burden of proof falling on the taxpayer for the deduction, there are several factors to consider, including the value of the collateral 2 Section 166(a)(1) and (2). 3 Section 166(a)(2). Section 166(a)(1) does not require a charge-off when a taxpayer Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended (the Code ) or the applicable regulations promulgated pursuant to the Code (the regulations ). recognizes a wholly worthless bad debt deduction. 4 There is a fourth method under section 585, the reserve method, which is available only for small banks (defined as banks with assets equal to or less than $500 million). The Directive does not apply to this method. 5 Estate of Mann v. United States, 731 F.2d 267 (1984); Rev. Rul , C.B. 585.

3 The Much Anticipated Bad Debt Guidance for Banks page 3 securing the debt, the financial condition of the debtor, whether the taxpayer has pursued legal action in the collection of the debt, and if the debtor has filed for bankruptcy. 6 Due to the sheer volume of loans a bank maintains, it can be an administrative burden to identify all relevant facts and circumstances surrounding each of the bank s loans to support a write-off. With this in mind, there are two other provisions under section that have historically provided a more feasible approach to claiming a bad debt deduction. The Conclusive Presumption Method--Section (d)(1) The conclusive presumption rule under section (d)(1) enables banks (and other regulated corporations) to take a bad debt deduction if a debt is charged off due to an order from the institution s supervisory authority or it is charged off in accordance with established policies of such authorities, and, upon the taxpayer s first audit subsequent to the charge-off, the authorities confirm in writing that the loan would have been ordered to be charged off if the audit had been made on the date of the charge-off. 7 However, regulatory agencies have been reluctant to provide taxpayers with the required evidentiary support to substantiate a bad debt deduction under the conclusive presumption standard. 8 In fact, some federal regulators have explicitly confirmed a policy of not issuing any letters that would substantiate the requirements under the conclusive presumption method. 9 As such, this method is unavailable for many banks in today s regulatory environment. Conformity Election--Section (d)(3) As a result of the administrative burden under the facts and circumstances method and the regulatory constraints of applying the conclusive presumption method, the conformity election is the preferred method for banks wishing to simplify their bad debt deduction calculation and achieve some measure of certainty of treatment. Under section (d)(3), a bank can claim a bad debt deduction to the extent a loan is classified as a 6 See generally section (a) (d). 7 Section (d)(1). 8 American Bankers Association, Application for Industry Issue Resolution Program Bad debts and other issues, March 29, Federal and state regulators generally issue an examination report to a bank, which lists the loans and debt securities the regulator ordered to be charged-off. However, the document is privileged and confidential and the IRS is not authorized to view the document. 9 Id.

4 The Much Anticipated Bad Debt Guidance for Banks page 4 loss asset pursuant to the bank s regulatory loss asset classification standards, provided the regulator issues a letter to the bank making an express determination that the bank s loss asset classification standards conform to the regulator s loss asset classification standards (the express determination letter ). Generally, this allows a bank to recognize a tax deduction for debts that are charged off for regulatory purposes (in part or in whole), assuming certain requirements are satisfied. The conformity election is generally only available to banks, as defined in section 581 (i.e., regulated banking entities). 10 Therefore, the conformity election is unavailable to bank affiliates that do not meet the bank definition under section 581 (e.g., entities that do not accept deposits). Further, certain banks may have been unable to obtain an express determination letter from their regulators or are unaware of the regulatory requirements to apply the conformity election. These institutions are generally required to apply the facts and circumstances method. Selling Costs In the case of a secured loan, financial institutions will generally take a charge-off in an amount equal to the excess of the carrying value or basis of the loan over the fair market value of the underlying collateral. A reserve for estimated selling costs is generally included in the fair market value of the property (thereby reducing the fair market value and increasing the charge-off). The IRS has frequently challenged the basis for including a reserve for selling costs in the calculation of the fair market value of the property. This position by IRS examiners has levied taxpayers with additional administrative burden in trying to create a separate calculation for tax purposes related to the write-off of a collateralized loan. In addition, the IRS position seems to contradict the purpose of the conformity election under section (d)(3), which aims to unify the calculations for U.S. generally accepted accounting principles ( GAAP ) and tax Section (d)(4)(i). The conformity election also apples to a corporation that would be a bank within the meaning of section 581 except for the fact it is foreign but only with respect to the banking business effectively connected with a trade or business within the United States. The conformity election also applies to Farm Credit System institutions that are subject to supervision by the Farm Credit Administration. 11 Recently the IRS informally announced it will no longer challenge this issue upon examination.

5 The Much Anticipated Bad Debt Guidance for Banks page 5 LB&I Directive Applicable Provisions The Directive addresses many of the issues discussed above. The Directive generally directs LB&I examiners not to challenge bad debt deductions for certain debt and debt securities taken by banks and certain bank subsidiaries if the deduction is the same amount as the charge-off taken on an applicable financial statement. The Directive also reaffirms that selling costs that are factored into charge-offs are eligible to be included in the bad debt deduction. The Directive applies to banks and certain subsidiaries of banks. 12 It acknowledges that a bank s controlled subsidiaries are generally subject to the same supervision and oversight by regulators as a bank, and the regulators generally apply identical standards to subsidiaries of a bank as they do to a bank. As such, if the following requirements are satisfied, a bank s subsidiary will be subject to the guidance in the Directive: The businesses of the subsidiary are the same businesses that a bank may conduct; The subsidiaries and the bank are members of the same affiliated group (within the meaning of section 1504(a)(1)), 13 and the bank serves as the direct or indirect parent of the subsidiary 14 ; and The subsidiary is under supervision by the bank s regulator. The Directive only applies to bad debt deductions taken by banks and qualifying bank subsidiaries on eligible debt and eligible debt securities. An eligible debt is an obligation within the scope of Accounting Standards Codification ( ASC ) , Troubled Debt Restructurings, as well as ASC 450, Contingencies, but does not include debt that is accounted for under ASC (previously SOP 03-3). An 12 For these purposes, a bank continues to have the meaning as provided under section (d)(4)(i) (modifying the definition with respect to foreign corporations by substituting the words Eligible Debt or Eligible Debt Securities for loans) and is subject to regulation by a bank regulator. 13 This determination is made without regard to the exception for S corporations contained in section 1504(b)(8). For purposes of this determination, a partnership owned by a bank and or bank subsidiaries will be treated as a corporation. 14 Specifically, the subsidiary bears the same relationship to the bank that members of an affiliated group bear to their common parent under section 1504(a)(1).

6 The Much Anticipated Bad Debt Guidance for Banks page 6 eligible debt security is an obligation that meets the definition of a security for GAAP purposes. 15 Eligible debt and eligible debt securities must also be subject to a bad debt deduction under section 166 and must not be subject to section The Directive curiously provides that eligible debt cannot be a section 165(g)(2) security, regardless of whether it would still be eligible for a section 166 bad debt deduction (e.g., if held by a bank), but does apply to eligible debt securities that are section 165(g)(2)(C) securities held by a bank. 17 The Directive provides specific directions to examiners with respect to bad debts on eligible debt and eligible debt securities under three different sets of rules for bad debt the facts and circumstances rule, the conclusive presumption rule, and the conformity election. For banks and bank subsidiaries (hereinafter referred to as bank taxpayers ) that follow the facts and circumstances method under section (a), LB&I examiners are directed not to challenge a bank taxpayer s bad debt deduction for eligible debt and eligible debt securities if the deduction is the same amount as the credit-related impairment portion of its charge-off as reported in its applicable financial statements. 18 The term charge-off has a different meaning for eligible debt and eligible debt securities. A charge-off of eligible debt is defined as any accounting entry or set of accounting entries that reduce the basis in the obligation when the obligation has been classified in whole or part as a loss asset. 19 A charge-off of an eligible debt security is any accounting entry that reduces the carrying value and results in a realized loss or a charge to the statement of operations. 15 Eligible debt securities must fall within the scope of ASC 320, Investments - Debt and Equity Securities. 16 We assume this means not subject to the mark-to-market requirements of section 475(a). 17 Securities, as defined in section 165(g)(2), are generally not subject to the bad debt rules in section 166. Section 166(e). The exception is for securities held by banks. The scope of the Directive is generally consistent with this rule. The Directive only includes section 165(g)(2) securities if they are eligible debt securities held by a bank. All other section 165(g)(2) securities are excluded from the scope of the Directive. We note that this includes otherwise eligible debt held by a bank that is a section 165(g)(2) security. 18 Applicable financial statements are defined in the Directive as either (1) a financial statement that is required to be filed by a bank taxpayer with the SEC or (2) a financial statement that is required to be provided to the bank taxpayer s regulator. 19 An obligation will be considered a loss asset if it meets the requirements of loss asset classification under the bank taxpayers regulatory standards.

7 The Much Anticipated Bad Debt Guidance for Banks page 7 As stated, LB&I examiners are directed not to challenge the tax deduction in an amount equivalent to the credit-related impairment portion of the bank taxpayer s charge-off. But note that there are two important limitations to this book-tax consistency rule. First, taxpayers can only deduct the credit related charge-off; the Directive does not apply to any deduction taken under the facts and circumstances rule related to other factors (e.g., increases in market interest rates). Second, the tax deduction cannot cause the post-deduction tax basis to be less than the post chargeoff book basis (or carrying value) increased by any balance not attributable to credit impairment. This presumably means that the tax deduction will be reduced as necessary to maintain the proper tax basis. The Directive provides a similar set of guidelines for bank taxpayers that follow the conclusive presumption rules under section 166-2(d)(1), with an important variation and change in requirements. The Directive directs examiners generally to follow the same general book-tax conformity principles for bank taxpayers using conclusive presumption that apply under facts and circumstances. Unlike the general facts and circumstances, however, the Directive permits a bank taxpayer on conclusive presumption to include in its bad debt deduction the portion of a charge-off in excess of a credit related impairment if the charge off was taken pursuant to a specific order or written confirmation of a regulator. The Directive then removes the requirement that the bank or bank subsidiary present such specific order or written confirmation of the charge-off from their regulator. 20 The deduction allowed under the Directive is limited to the extent it reduces tax basis below the postcharge-off book basis (or carrying amount) increased by any non-credit related impairment and reduced by any amount in excess of the creditrelated impairment taken pursuant to a specific order or written confirmation. The Directive also addresses the challenges conformity method taxpayers have in obtaining the express determination letter. 21 LB&I examiners are directed not to challenge bad debt deductions of banks if a bank made a 20 The Directive allows banks and bank subsidiaries to certify to the IRS that a charge-off in excess of the credit-related amount is subject to a specific order or written confirmation without having to produce a letter or evidence of the order. This certification process is intended to address the challenges around obtaining the letter. 21 The conformity election only applies to banks, as defined in section (d)(4), and not to other corporations.

8 The Much Anticipated Bad Debt Guidance for Banks page 8 proper conformity election, regardless of whether the bank received an express determination letter from its regulator in order to substantiate its tax deduction of its book charge off. For application to bank taxpayers on conformity, the Directive makes no distinction in the credit related impairment portion of the bank taxpayer s charge-off, and any charge-off not related to credit impairment. Likewise, the Directive does not specify a post charge-off basis floor for bank taxpayers on conformity, in contrast to the basis specifications for bank taxpayers under the facts and circumstances and conclusive presumption rules. The Directive also informs agents to not challenge the inclusion of estimating selling costs in the bank and bank subsidiary s bad debt deductions to the extent the estimated selling costs are included in the charge-off recognized in their applicable financial statements. This provision applies to banks and bank subsidiaries that use the facts and circumstances method or the conclusive presumption method, and to banks that have made a conformity election. As discussed in recent commentary, this has been a particularly contentious issue between taxpayers and their agents over the past several years. 22 Implementation and Transition The Directive applies on an entity-by-entity basis. A bank or bank subsidiary may elect to first apply the Directive no earlier than its 2010 tax year and no later than a tax year that begins in Pending any future guidance modifying or superseding the Directive, once a bank or bank subsidiary chooses to apply the directive, it must apply it consistently in future years to all bad debt deductions claimed with respect to eligible debt and eligible debt securities. Taxpayers are eligible to apply the guidance to prior years by filing amended returns or, if under audit, working with the auditor to decide whether the application of the guidance is appropriate. For the current year (2014), taxpayers are eligible to apply the guidance on an original return. The Directive is silent as to whether the application of this guidance is a change in accounting method. However, transition rules infer that changes under the Directive are not method changes. The transition rules require that a bank taxpayer recognize an adjustment in the first year it applies the guidance. The adjustment is equal to the 22 American Bankers Association, Application for Industry Issue Resolution Program Bad debts and other issues, March 29, 2013.

9 The Much Anticipated Bad Debt Guidance for Banks page 9 difference between (1) the bad debt deduction that the bank or bank subsidiary would recognize under the Directive s guidance and (2) the difference between the pre-charge off tax basis of the debt over the postcharge off book basis of the debt. 23 The First Year Adjustment presumably then applies to adjust the basis of the eligible debt or eligible debt security, after it has already been adjusted for the bad debt deduction otherwise permitted under the ongoing rules in the Directive. If the postadjustment tax basis is less than post-charge off book basis (adjusted, as required, for non-credit related impairments), the bad debt deduction is reduced (even potentially to a negative number) to ensure the postdeduction tax basis is not less than the post-charge off book basis (as adjusted). This adjustment is intended to take into consideration any differences between the old method and the method under the Directive for the year of change. Certification and Document Retention Requirements Taxpayers that apply the Directive guidance must provide a certification to their agent within 30 days of a request for the certification statement. The certification statement must be provided for each year under audit and generally requires the signor to agree that the bad debt deduction for eligible debt and debt securities equals the GAAP charge-off attributable to credit-related impairment and the charge-off satisfies the basis limitation rules discussed above. A separate certification statement may be requested for each bank and bank subsidiary applying the terms of the Directive. Failure to comply with any of these terms makes the bank or bank subsidiary ineligible to apply the Directive and causes them to be subject to the regular audit procedures. The Directive requires that a bank taxpayer retain underlying accounting documentation used in the calculation. The documentation is intended to permit the examiner to reconcile the charge-off on the applicable financial statement with the amount of the bad debt deduction on the return. If the bank or bank subsidiary fails to submit the requested documentation on a timely basis, the Industry Director or his/her delegate may determine that the Directive does not apply to the bank or bank subsidiary. 23 The amount of the difference in the second step is increased by any portion of the charge-off not related to credit impairment and not allowed as a deduction under the Directive. It is not entirely clear whether this should have been a decrease to the difference.

10 The Much Anticipated Bad Debt Guidance for Banks page 10 KPMG Observations The Directive is welcome guidance for many banks. The Directive generally provides the relief requested on the compliance burdens around section 166. Banks and bank subsidiaries are no longer thrown into the lengthy examination process under the general rules simply due to the inability to obtain a proper confirmation letter or express determination letter. Banks and bank subsidiaries that have chosen not to apply either special rule should also be able to simplify the exam process with respect to the calculation of their bad debt deductions. The only adjustment to the book charge-off is generally for amounts that are not related to credit impairment (other than selling costs), which should eliminate considerable time spent on the amount of the bad debt deduction. The Directive does not cover all entities or all years. It applies only to banks and their direct and indirect subsidiaries. It does not apply to brother-sister entities, bank holding companies, and real estate investment trusts (REITs). Those entities must either continue to use the general facts and circumstances rule or the conclusive presumption rule. The Directive does not apply to banks using the reserve method under section 585. The Directive also provides that banks and bank subsidiaries may first apply the Directive on an entity-by-entity basis and to years beginning no earlier than the 2010 tax year and no later than the 2014 tax year. For open years before 2010, the Directive does not expressly apply, although presumably the examiner and the taxpayer may decide to apply the principles of the Directive. 24 The application of the guidance may also contain certain traps for the unwary. There are occasionally different rules for eligible debt and eligible debt securities. For example, GAAP generally requires taxpayers to recognize a charge to earnings equal to the difference between a security s carrying value and its fair value if the taxpayer intends to sell the security. This charge to earnings will include both an amount that represents credit loss as well as amounts that may relate to other factors (e.g., increases in market interest rates). As such, bank taxpayers using the facts and circumstances method should be cognizant that they may need to remove the balance attributable to the other factors when applying this guidance, as the Directive only applies to charge-offs attributable to credit impairment. 24 Treasury and the IRS s priority guidance plan currently has a project evaluating the regulations under section

11 The Much Anticipated Bad Debt Guidance for Banks page 11 The Directive does not explicitly address how it affects certain ancillary guidance that relies on section 166. For example, Revenue Ruling requires banks to continue to accrue interest on a non-performing loan in spite of the fact that the loan is placed on non-accrual for regulatory purposes. 25 However, the revenue ruling allows banks on the conformity method to recognize a bad debt deduction equal to the foregone interest. This is under the theory that not accruing the interest for regulatory purposes is tantamount to recognizing the accrued interest as income and immediately charging off the uncollected interest receivable as a loss asset. However, the ruling does not extend the deemed charge-off to taxpayers using the facts and circumstances method or the conclusive presumption method. The ability of bank taxpayers to now follow regulatory charge-offs under the Directive (regardless of whether a conformity election was made) may also extend the application of the deemed charge-off under Revenue Ruling It is also not entirely clear to what extent this applies to specific reserves where the basis or carrying value of the asset is not reduced, but a reserve is established specifically against the debt instrument. Finally, we note that the Directive should be considered in evaluating which method of claiming bad debt deductions to use going forward. The Directive is not an official pronouncement of law. Therefore, in considering the proper method, each taxpayer must determine whether the method set forth in the Directive is supportable as a matter of law given the taxpayers specific facts. What's News in Tax is a publication from the Washington National Tax practice of KPMG LLP ( KPMG ) that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP C.B