Recent IRS guidance sheds light on tax accounting method issues

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1 Accounting Methods Spotlight / Issue 11 / November 2014 Did you know? p1 / Other guidance p2 Recent IRS guidance sheds light on tax accounting method issues This month s issue includes a discussion on the IRS recent indication that it is unlikely to challenge taxpayers that fail to compute a favorable Section 481(a) adjustment relating to the final tangible property regulations. In addition, we have included discussions on recent IRS memorandums which present conclusions on: whether certain reductions in basis must be taken into consideration in the ACE calculation; methods for allocating mixed service costs for utilities; whether a change in the treatment of gains from a participation agreement constitutes a change in accounting method; an energy company improperly changed its method of accounting for oil production contracts because of failure to obtain the Commissioner s consent; and recurring item exception was disallowed for liability deduction of a professional moving company. This month s issue also discusses a recent LB&I directive providing instructions to LB&I examiners in reference to eligible bad debt deductions claimed by banks and bank subsidiaries under Section 166. Did you know..? IRS states that is it unlikely to challenge taxpayers that fail to compute taxpayerfavorable 481(a) adjustments related to tangible property regulations (TPR) The American Institute of Certified Public Accountants (AICPA) held its fall Tax Division meeting in Washington DC on November 5. At that meeting, government officials present indicated that the government primarily is concerned with taxpayers being compliant with the final TPR on a prospective basis, and that they generally will not challenge taxpayers accounting method change applications that fail to compute taxpayerfavorable negative Section 481(a) adjustments. The government officials explained that the final TPR require a section 481(a) adjustment primarily to address

2 taxpayers that took aggressive positions prior to the final TPR and thus would have a taxpayer-unfavorable positive 481(a) adjustment. The recently issued final TPR generally require taxpayers to file a change in method of accounting (Form 3115) in order to comply with the new rules. Unless otherwise provided, the accounting method change applications require taxpayers to calculate a cumulative catch-up adjustment (i.e., Section 481(a) adjustment) to avoid any omissions or duplications resulting from the change. The calculation of this adjustment theoretically requires taxpayers to go back as many tax years as necessary to determine the difference between the present and proposed methods of accounting on the basis of the taxpayer s tangible property. Some practitioners at the Accounting Methods and Periods panel at the Fall AICPA Tax Division Meeting indicated that taxpayers would like to avoid the compliance burden associated with going through years of records to calculate the exact Section 481(a) adjustment, especially if they historically overcapitalized costs and any resulting potential adjustment would be taxpayer favorable. Therefore, some taxpayers are considering the option of filing their accounting method change requests with corresponding Section 481(a) adjustments of zero. Andrew Keyso, IRS Associate Chief Counsel, Income Tax and Accounting, indicated that the IRS Chief Counsel s office likely will respect a Form 3115 filed with an incorrect or zero section 481(a) adjustment, unless it's clear that the adjustment should have been much different. He said he thought the error would have to be egregious to attract officials' attention. However, he also noted that the review of a section 481(a) adjustment is the jurisdiction of IRS exam. With respect to an IRS examination of section 481(a) adjustments, IRS officials present at the meeting noted that unless a taxpayer has taken aggressive positions in the past or has in no way applied a proper capitalization method, the IRS is unlikely to focus its efforts on examining a zero or nominal negative Section 481(a) adjustment. According to the officials, a section 481(a) adjustment was required in the final regulations as a way to allow field agents to examine taxpayers' aggressive positions. That is, officials were concerned about the number of method changes filed in the past that were based on proposed regulations that specifically stated they were not to be relied upon. They felt some taxpayers were taking aggressive positions, so the government didn't want to provide an across-the-board cutoff in the final regulations. Observation: IRS exam may audit the Form 3115 in a later year and require a taxpayer to calculate the proper Section 481(a) adjustment, especially if the taxpayer included a zero adjustment where the adjustment should have been a positive adjustment or additional deductions for the year of change could negatively impact the taxpayer such as related to expiring NOLs, Section 199, credits, or amount of earnings and profits. Thus, it is recommended that taxpayers perform a review of their methods to ascertain compliance with the final TPR and to understand the potential impact of the section 481(a) adjustment in the year of change. Other guidance Basis reduction must be taken into account for ACE calculation In ILM , the IRS addressed various interpretations of the methodology for computing alternative minimum taxable income (AMTI) and adjusted current earnings (ACE), explaining that AMTI and ACE involve calculations that are separate from, but parallel to, the calculation of regular taxable income. The IRS then concluded that a required reduction in the basis of loans held by a taxpayer s subsidiary bank prior to an ownership change must be taken into account in determining the amount of a bad debt deduction for purposes of calculating the taxpayer s adjusted current earnings (ACE). 2 PwC

3 The memorandum describes a taxpayer that owned a bank subsidiary with which it filed a consolidated US federal income tax return. The taxpayer underwent a Section 382 ownership change at a time in which the aggregate adjusted basis of its assets exceeded their fair market value, resulting in a net unrealized built-in loss (NUBIL). A significant portion of the NUBIL was attributable to loans held by the bank on the date of the ownership change. As prescribed under Notice , any deduction properly allowed after the ownership change with respect to losses on these loans would not be treated as a built-in loss or a deduction attributable to periods before the change date. Further, no statute required Taxpayer to reduce the basis of those loans for regular tax or alternative minimum tax purposes (excluding the effect of any adjusted current earnings adjustment) as a result of the ownership change. Subsequent to the ownership change, the taxpayer took bad debt deductions for charge-offs and write downs of the pre-change loans in computing both taxable income and AMTI. AMTI is computed similar to regular taxable income, but takes into account certain adjustments, preference items, and other modifications prescribed under Sections 56 to 59. For C corporations, Section 56(g) requires that AMTI be increased by 75% of the company s ACE adjustment (before alternative tax net operating losses). Negative ACE adjustments which reduce AMTI also are permitted, but are subject to certain limitations. ACE is calculated similar to AMTI, with certain adjustments for items such as depreciation, E&P income or losses, basis, and others as prescribed under Section 56(g)(4). Included under this section is a required reduction to the basis of a company s assets where a Section 382 ownership change has occurred and the corporation has a NUBIL. When both conditions are met, immediately after the ownership change, the adjusted basis of each asset for ACE purposes is equal to its proportionate share of the fair market value of the assets immediately before the ownership change. In ILM , the taxpayer agreed that a reduction in the basis of the prechange loans was required for purposes of determining ACE. However, the taxpayer contended that, unlike other provisions under Section 56(g)(4), which specifically require that the adjusted basis of an asset be taken into account when computing ACE, there is no specific requirement that the adjusted basis of the loans be taken into account in determining the bad debt deduction for ACE purposes. As such, the taxpayer asserted that the bad debt deduction should be the same for determining regular taxable income, AMTI, and ACE. The IRS asserted that the language in the statute was ambiguous and could be interpreted to mean that either (1) AMTI is calculated separately taking into account the adjustment and preference items, or (2) taxable income for regular tax purposes is increased or decreased by the specified adjustment and preference items. However, after examining a brief history of the AMT, the IRS concluded that only the first interpretation would result in appropriate treatment of the adjustment and preference items. Specifically, the IRS cited the 1986 Act's introduction of differences between when items of income or deduction are taken into account in computing AMTI versus taxable income and provided examples under these rules where simply increasing or decreasing the regular tax amount for adjustment and preference items would produce absurd results. In light of the statutory language and legislative history of the 1986 Act, the IRS also refuted the taxpayer s narrow and restrictive interpretation as to when the basis adjustments should be taken into account. As an example, the IRS pointed to the application of Section 1001(a) to determine the gain or loss on the sale or disposition of depreciable property. In this situation, although there is no specific statute requiring the gain or loss provisions to be applied separately using the adjusted basis for the AMT or ACE calculations, Congress has made clear in the legislative history that this treatment is appropriate. Furthermore, the Taxpayer s narrow view could result in permanent differences between the AMT and regular tax, despite the fact that the differences relate to temporary items. 3 PwC

4 Based on this analysis, the IRS concluded that the basis reduction to the pre-change loans must be taken into account in determining the amount of a bad debt deduction for purposes of calculating adjusted current earnings. In reaching this conclusion, the IRS stated its position that the calculation of AMTI and ACE should involve a separate but parallel computation to that used to calculate regular taxable income, and basis adjustments required for AMT or ACE purposes must be considered in performing the parallel computation. IRS LB&I issues memorandum regarding methods for allocating mixed service costs for utilities The IRS Large Business & International (LB&I) division recently released a memorandum (LB&I ) providing guidance to examiners of electric and/or natural gas utilities (utilities) on determining whether the taxpayer's method for allocating mixed service costs to self-constructed tangible personal property is appropriate and should not be challenged. Generally, a taxpayer subject to Section 263A is required to capitalize direct and certain indirect costs that directly benefit or are incurred by reason of the performance of capitalizable production activities, including the production of selfconstructed assets. Costs required to be capitalized include service costs (typically incurred in general and administrative departments such as legal, accounting, human resources, and IT) that are partially allocable to capitalizable production activities and partially allocable to deductible activities ( mixed service costs ). For utility companies, the capitalization of indirect costs to self-constructed property, and in particular, of mixed service costs, historically has been an issue of disagreement with the IRS. Prior to 2005, many utility companies used the simplified service cost method (SSCM) to allocate mixed service costs between production and non-production activities. However, the IRS issued regulations that limited the ability of companies to use the SSCM for allocating mixed service costs to self-constructed property that is not mass-produced or does not have a high degree of turnover for the 2005 tax year and thereafter. For property that is not eligible for the SSCM, taxpayers must allocate mixed service costs based on a reasonable allocation method such as the "facts and circumstances" method. Thus, utility taxpayers had to identify a new method to allocate mixed service costs under Section 263A. On September 15, 2009, the IRS published IDD #5, which provided instructions to IRS revenue agents of electric utilities to devote examination resources to particular issues which were considered more significant (e.g., generation mixed service departments) versus less significant (e.g., consistent headcount ratio used to allocate mixed service costs). Taxpayers expected the IRS to issue a directive extending IDD #5 to natural gas utilities and making some clarifications to the existing method. However, on October 14, 2014, the IRS released LB&I , which changes the approach taken in IDD #5 by including clear language that examiners should not challenge the reasonableness of the methods identified in the new directive. Under the new LB&I directive, which applies to electric utilities, natural gas utilities, and combined electric and gas utilities, IRS examiners are instructed to not challenge the reasonableness of the following mixed service cost (MSC) allocation method: Step 1. Consistent headcount ratio. The taxpayer allocates MSC among (i) transmission and distribution (T&D) and other departments, and between (ii) capital (i.e., production or resale) and non-capital activities within a T&D department based on an annually determined headcount ratio. In performing this allocation, the taxpayer must categorize total MSC among company-wide MSC (which is separately allocated between various departments based on a company-wide headcount ratio); MSC attributable to deductible service departments; and, MSC attributable to other non-company-wide departments such as fleet, stores, engineering, electric transmission and distribution (Electric T&D), natural gas transmission and distribution (Gas T&D), and generation, which are allocated based on a headcount 4 PwC

5 ratio that includes only those department employees who actually benefited from the MSC being allocated. Step 2. Production cost ratio. The taxpayer then allocates capitalizable MSC among capital activities according to the production cost ratio that is provided in the directive. Notably, the denominator of the production cost ratio excludes 50% of purchased electricity and natural gas, and continues the IDD#5 exclusion [for costs of temporary facilities, plus an exclusion] for electricity or gas sold outside the taxpayer s service area. The new directive indicates it does not apply if the taxpayer includes any of the following elements in its MSC allocation methods: Taxpayer treats additional costs of working in an energized environment treated as deductible costs of maintaining electric service Taxpayer uses overly broad or inappropriate cost drivers, such as cost drivers that result in the allocation of MSC to departments that receive no benefit from the MSC, and The taxpayer uses a production ratio based on hypothetical events, such as the estimated cost that would have been paid for generating power instead of purchasing power, or an estimated headcount based on the number of employees that would have been required to generate the electricity instead of purchasing it. It is important to note that LB&I is not a settlement or technical analysis, but rather reflects an examination approach in the interest of allocating IRS resources. However, the release of the new guidance indicates an IRS commitment to resolving this industry issue for both electric and gas companies with the same approach. IRS provides that change in the treatment of gains from a participation agreement is a change in accounting method In ILM , the IRS Chief Counsel s office concluded that a change in the treatment of participation agreements to recognize the gains in the year of realization constitutes a change in method of accounting under Section 446. Further, the recognition of a Section 481(a) adjustment is needed to eliminate any distortions caused by the accounting method change and such adjustment should include gains realized (but not recognized under the old accounting method) in a closed tax year. The taxpayer, an investment advisor, entered into management agreements with related hedge fund entities. Under the agreements, the taxpayer provided investment services to the hedge funds and was compensated through management fees equal to a percentage of the fund s net assets. The taxpayer also was entitled to incentive fees each year equal to a percentage of the net appreciation in the fund s shares, but could choose to defer the incentive fees for a specified period. During the deferral period, the fees were deemed to be reinvested in the applicable fund and could increase or decrease in value depending on the performance of the fund s assets. For each of the years in question, the taxpayer chose to defer its incentive fees. To hedge its price risk with respect to this deferral, the taxpayer also entered into a participation agreement with one of its consolidated investment funds under which the taxpayer received a participation interest in a credit default swap the fund had executed with an investment bank. Although the taxpayer realized gains on the participation agreement in two of the years in question, no recognized gain was reported on its U.S. federal tax return. Instead, the taxpayer determined that, because the participation agreement was part of a hedging transaction, the gains from the credit default swap should be deferred until the gains or losses from the deferred incentive fees were recognized. The IRS exam team is reviewing the current deferral treatment and is considering proposing 5 PwC

6 adjustments to require the taxpayer to recognize the participation gains upon realization, which could impact closed tax years. The legal memorandum addressed whether the field s proposed adjustment would constitute a change in accounting method. Section 446 and the corresponding regulations generally define the term "method of accounting" to include any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. Case law generally has concluded that in determining whether timing is involved, the relevant consideration is whether the accounting practice permanently affects the taxpayer's lifetime income or merely changes the tax year in which taxable income is reported. A taxpayer is considered to have adopted a method of accounting for a specified item when either: (1) the item is treated properly (under a permissible method) in the first return that reflects the item, or (2) the item is treated in the same way in determining the gross income or deductions in two or more consecutively filed tax returns (without regard to any change in status of the method as permissible or impermissible). The Chief Counsel s office determined that the change in treatment from deferring the recognition of gains from the participation agreement until the gains or losses from the incentive fees are recognized to recognizing the gain in the year of realization constitutes a change in method of accounting. This treatment involves the proper time for the inclusion of the gain in gross income and each alternative would result in recognition of the same amounts of taxable income over the lifetime of the taxpayer. The only difference is the taxable year in which the income was reported. The legal memorandum also addressed, whether a change in treatment of the gains from the participation agreement would require an adjustment under Section 481(a) to eliminate any distortions caused by the accounting method change and would include the gains realized by the taxpayer in a closed tax year. Although the statute of limitations for one year was already closed at the time of the IRS audit, the IRS sought to include the gains from the closed tax year in the Section 481(a) adjustment in the following year to prevent the taxpayer from permanently omitting this income. The Chief Counsel s office noted that the year of change would be the second consecutive year in which the participation agreement gains were excluded from the tax return, and that this year was the earliest open tax year under examination. As such, the gains realized on the participation agreement in this year would be included in income under the new method of accounting and no further adjustment would be required under Section 481(a) for those gains. However, the gains realized in the closed tax year were never recognized under the old method of accounting (as they were deferred), and will not be subject to the new method as they were realized prior to the year of change. Because these gains would not be recognized under either method, an unfavorable Section 481(a) adjustment would be required to resolve this potential omission. Energy taxpayer improperly changed its method of accounting In ILM , the IRS concluded that the taxpayer, an energy company, made an unauthorized change in method of accounting for certain foreign contracts because the taxpayer failed to obtain the Commissioner's consent before implementing a change from the lease method to report the income and expenses associated with oil production contracts to the contingent purchase price (CPP) method. The IRS determined that the contracts in question were a material item, and that no exception existed to allow the company to change the method of accounting without first seeking IRS consent. The taxpayer conducted business in a foreign country through its wholly-owned subsidiary, a member of the taxpayer's consolidated group. During the years at issue, the subsidiary operated under contracts with the foreign country for the exploration of oil and gas properties. The energy company historically accounted for the income and expenses related to the oil production under these contracts using the lease 6 PwC

7 method, but later changed to the contingent purchase price (CPP) method without filing an application to request the IRS's consent to change the method of accounting. While the taxpayer reported the same amount of cumulative taxable income under both the lease method and the CPP method, the CPP method resulted in additional foreign source gross income, and additional amounts of interest expense. The change in treatment had the effect of reducing the taxpayer s U.S.-source taxable income and increasing foreign-source taxable income by the same amount. As a result, the taxpayer experienced an increase in its foreign tax credit limitation, as well as its available foreign tax credit, resulting in claims for refund of U.S. tax. The taxpayer argued that the change to the CPP method was not a change in method of accounting but merely a change in characterization or a correction of errors involving the inconsistent treatment of the contracts. That is, the taxpayer stated that it had an established business practice of treating acquisition of oil and gas interests as either a lease or a purchase (i.e. sale), depending on the underlying characteristics of the transaction. The transactions at issue were mistakenly characterized as leases when they properly belonged in the sale category. The taxpayer also contended that the change aligned the treatment with its previously established method of accounting and thus, was not a change in method of accounting. To support its theory of deviation from an established method, the taxpayer relied heavily upon Standard Oil Co. v. Commissioner, 77 T.C. 349 (1981). The IRS rejected the taxpayer s contention however, stating that the taxpayer in Standard Oil had clear evidence of the accounting method from which the asserted deviation occurred. By contrast, the IRS argued that the taxpayer showed little or no evidence that it customarily treated contracts as purchases, and thus failed to establish the essential factual core of Standard Oil and other divergent treatment cases. Furthermore, the IRS found that the older cases relied on by the taxpayer were anomalies and anachronisms under the current state of the law. Recent court cases the IRS said, have distinguished, questioned, or outright rejected these older divergent treatment cases. The IRS further argued that the taxpayer s treatment of its contracts implicated an accounting method under the section 446 regulations because it involved the proper timing of income and deductions. That is, the cumulative amount of taxable income recognized by the taxpayer over the lifetime of the contracts would be same whether the taxpayer used the lease method or the CPP method, only the timing of taxable income recognition (the amounts of taxable income recognized in various years) would differ between these two methods. According to the IRS, the change in treatment of such material item constituted a change in accounting method unless the change fell within one of the recognized exceptions listed in the regulations, which in this case, it did not. As a result, the IRS concluded that the taxpayer s treatment of the contracts under the lease method constituted a method of accounting, and that the taxpayer was required to seek and obtain the Commissioner s consent before changing such method of accounting to the CPP method. Since the taxpayer did not request consent from the Commissioner, the taxpayer was precluded from implementing the change for the applicable tax years. Taxpayer disallowed recurring item exception for liability deduction In ILM , the IRS concluded that a professional moving company could not use the recurring item exception for the liability to pay for damaged goods. The taxpayer, a professional moving company, entered into contracts with customers, which established the level of the taxpayer's liability for damaged or lost goods, with two options for placing a value on the customer's shipment. The first option limits the taxpayer's liability to a certain amount, while the second option limits the taxpayer's liability per article lost or stolen. A customer may seek reimbursement or replacement of lost or damaged items only by submitting a written claim to the taxpayer. 7 PwC

8 Under its accrual method of accounting, the taxpayer deducts its liability for claims received and paid within the taxable year and also for claims pending at year-end that are paid within the first five months of the subsequent taxable year. The taxpayer uses the recurring item exception under Treas. Reg. Sec to deduct the liability for claims paid subsequent to the taxable year-end. Under the section 461 regulations, a liability generally is treated as incurred for federal income tax purposes when all events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. Treas. Reg. Sec (g) specifies that certain liabilities meet the economic performance test only when, and to the extent that, payment is made to the person to whom the liability is owed. These liabilities include, in part, insurance, warranty and service contracts, and other liabilities that cannot properly be characterized as liabilities covered by the economic performance rules provided elsewhere in the regulations. In addition, the regulations provide an exception to the economic performance requirement for certain types of liabilities that are recurring in nature. Under the recurring item exception, a liability is treated as incurred for a particular tax year if: All events have occurred that establish the fact of the liability, and the amount can be determined with reasonable accuracy; Economic performance occurs on or before the earlier of (a) the date that the taxpayer files a timely return (including extensions) for the tax year or (b) within 8 ½ months after the close of the tax year; The liability is recurring in nature; and Either (a) the liability is not material or (b) the accrual of the liability for the particular tax year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the tax year in which economic performance occurs ("matching requirement"). The recurring item exception applies to insurance, warranty and service contracts, but does not apply to other liabilities. In this case, the taxpayer argued that the liability for damaged goods is considered an insurance, or warranty or service contract for purposes of the economic performance rules and thus, the recurring item exception was applicable to the liability. The IRS disagreed with the taxpayer and disallowed the use of the recurring item exception. In its analysis, the IRS explored the definition of insurance because the term is not defined under current guidance. The taxpayer s contracts stated that the provision was not insurance but a tariff, which served to limit the taxpayer s liability for any damage. Thus, the IRS determined that the payment liability for damaged goods under the taxpayer s contracts with its customers does not constitute insurance for federal income tax purposes. With respect to a service or warranty contract, the regulations state that a warranty or service contract is a contract that a taxpayer enters into in connection with property bought or leased by the taxpayer, pursuant to which the other party to the contract promises to replace or repair the property under specified circumstances. Because the taxpayer s contracts covered property owned by customers, and the taxpayer was obligated to pay damages if the customer s property was lost, damaged, or destroyed, the IRS found that the taxpayer s contracts were neither warranty nor service contracts. As a result, the IRS determined that by default, the taxpayer s liability constituted an other liability, and the taxpayer could not use the recurring item exception for its liability to pay for damaged goods. 8 PwC

9 LB&I issues directive to examiners on bad debt deductions claimed by banks and bank subsidiaries. The IRS Large Business and International Division (LB&I) recently issued a directive (LB&I ) providing instructions to LB&I examiners in reference to eligible bad debt deductions claimed by banks and bank subsidiaries under Section 166. Two special rules are provided under the Section 166 regulations for banks to determine their bad debt deduction. First, the regulations provide a "conclusive presumption rule" under which worthlessness is generally presumed to occur in the same year that a bank, or other regulated corporation, charges off a debt in whole or in part pursuant to Federal or state bank regulatory rules and established policies, or pursuant to a specific order by a bank regulator. Alternatively, the regulations provide a "conformity election" under which worthlessness is conclusively presumed if a bank regulator makes an express determination that the bank maintains and applies loan loss classification standards that are consistent with regulatory standards. Many banks have subsidiaries that are not themselves banks, but are facilitative of the banks' banking and lending businesses. In general, a bank's controlled subsidiaries are subject to the same supervision and oversight by bank regulators as the bank, and a bank regulator generally applies identical standards to a bank's controlled subsidiaries as they do to the bank, where the controlled subsidiaries conduct any business that can be conducted by the bank. However, bank subsidiaries generally aren t eligible for the special bad debt deduction rules applicable to banks in the Section 166 regulations, and instead must determine worthlessness under the general facts & circumstances rules. In the directive, LB&I acknowledges that independently determining worthlessness amounts under Section 166 imposes a significant burden on banks, bank subsidiaries, and LB&I examiners. In addition, the LB&I stated that changes in bank regulatory standards and processes have caused concerns about complying with the conclusive presumption regulations under Section 166. The directive provides an administrative resolution generally based on accepting charge-off amounts reported by banks and bank subsidiaries for GAAP and regulatory purposes as sufficient evidence of worthlessness, until further guidance under Section 166 is issued. Specifically, the LB&I directive provides as follows: For a bank using the conformity election under Treas. Reg. Sec (d)(3), agents are instructed not to challenge the bank's bad debt deduction for eligible debt and debt securities where a proper conformity election has been made, regardless of whether the express determination letter requirement has been satisfied. For a bank or bank subsidiary using the conclusive presumption rule under Treas. Reg. Sec (d)(1), agents are instructed not to challenge a bad debt deduction for eligible debt and debt securities where equal to the amounts reported for credit-related impairment of same, as reported in the entity's financial statements. Deductions in excess of the credit-related impairment are allowed where taken pursuant to a regulator's specific order, which can be certified by the taxpayer. Post-deduction tax basis generally cannot be less than the financial statement carrying value. For all banks and bank subs, agents are instructed not to challenge the inclusion of estimated selling costs included in the bad debt deduction, to the extent such estimated costs are included in the bank's financial statement expense. A bank or bank subsidiary may apply the directive no earlier than its 2010 taxable year, and no later than a taxable year that begins in 2014, by filing amended tax returns or by making the change it is current taxable year. Once a bank or bank 9 PwC

10 subsidiary chooses to apply the directive, it must apply it consistently going forward from year to year. The directive does not apply to small banks that use the reserve method of accounting for loan losses under Section 585; however, the directive states that LB&I may consider issuing a separate directive for determining the amount and timing of charge-offs under Section 585. The directive is available to small banks that do not use the reserve method of accounting for loan losses. Let s talk For a deeper discussion of how these issues might affect your business, please contact: Annette Smith, Washington, DC +1 (202) [email protected] Adam Handler, Los Angeles +1 (213) [email protected] Dennis Tingey, Phoenix +1 (602) [email protected] Christine Turgeon, New York +1 (646) [email protected] Jennifer Kennedy, Washington, DC +1 (202) [email protected] George Manousos, Washington, DC +1 (202) [email protected] Monic Kechik, New York, NY +1 (646) [email protected] 2014 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a Delaware limited liability partnership), which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. SOLICITATION This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 10 PwC