Application for Industry Issue Resolution Program - Bad debts and other issues

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1 Francisca N. Mordi Vice President & Senior Tax Counsel (202) Office of Prefiling and Technical Services Large Business and International Division Mint Building 3rd Floor M Constitution Avenue, NW Washington, DC RE: Application for Industry Issue Resolution Program - Bad debts and other issues The American Bankers Association (ABA) 1 hereby submits the following issues for IRS guidance under the Industry Issue Resolution program (IIR): 1. Guidance relating to the tax treatment by banks that have made the conformity election pursuant to Treasury Regulation Section (d)(3) concerning differences between (i) generally accepted accounting principles and regulatory accounting requirements for estimating the fair market value of collateral and (ii) the Service s current examination view of fair market value, including specifically the treatment of estimated selling costs. 2. Guidance relating to documentation to satisfy the conclusive presumption of worthlessness provision under Treas. Reg. section (d)(1) for banks that have not made the conformity election. 3. Conformity election eligibility for the controlled subsidiaries of a bank that has made the conformity election. 4. OREO expenses: Current deduction for carrying costs including maintenance and necessary repair costs. Automatic accounting method change for banks that are currently capitalizing such costs. These issues are all appropriate for the IIR program. IRS guidance addressing them will impact an extremely large taxpayer base and provide much needed certainty and clarity on issues which are currently generating uncertainty and resulting in disputes for taxpayers and their examination teams. 1 The ABA represents banks of all sizes and charters and is the voice for the nation s $13 trillion banking industry and its two million employees

2 Page 2 of 7 1. Estimated Selling Costs: Issue: A Bank that has made the conformity election should not be subject to different accounting and tax rules with respect to charge off for debts that are conclusively presumed to be wholly or partially worthless pursuant to Regulation Section (d)(3). Specifically, under generally accepted accounting principles and regulatory accounting requirements, the charge-off related to a secured loan is for the amount by which the loan balance exceeds the fair market value of the underlying collateral, net of estimated selling costs. On audit, adjustments have been proposed to reduce the amount of the book charge off by the selling expenses reflected in the calculation of the fair market value of the collateral. The definition of fair market value should not be different for purposes of Treasury Regulations section (2)(d)(3). Thus, a bank that has made the conformity election should be taking a tax deduction at the time and in the same amount of a book charge off pursuant to the regulations. However, many banks are having issues raised on audit related to the amount of the charge off for tax purposes. The conformity election was specifically put in place to streamline the compliance and audit process by using GAAP amounts for tax purposes. It has worked well for over 20 years, allowing the IRS and taxpayers to avoid extensive and detailed discussions over the appropriate amount and timing of tax deductions for bad debts. Requiring a separate calculation solely for tax purposes (within the context of conformity) is inconsistent with the intent of the provision and results in burdensome and time consuming record keeping for banks that have made the conformity election. This does not serve the goals of either the taxpayer or the IRS. As a general matter, Regulation Section (d)(3) does not require a taxpayer to make any adjustments or modifications from book amounts. This policy should be respected by the IRS. Thus, if a bank has made a proper conformity election and has complied with the requisite procedures, including receiving an express determination letter, there is a conclusive presumption of whole or partial worthlessness associated with the bank s classification of the asset as a loss asset. A review or discussion of the components of a charge off that has been taken for book purposes should not be relevant or appropriate under IRS Regulation Section (d)(3). Guidance should clarify that a bank that has made a valid conformity election should be permitted to conform the amount and timing of its book charge-offs and its tax deductions for bad debts without making any adjustments to such amounts for selling costs reflected in the book charge-off. 2. Conclusive Presumption of Worthlessness: Issue: IRS s refusal to accept anything other than a confirmation letter as proof that the banking regulators either ordered a bank s charge-offs or subsequently confirmed the charge-offs renders Treas. Reg. section (d)(1) effectively unusable. Treas. Reg. section (d)(1) permits a bank that is not on the conformity method to conclusively presume a debt to be worthless or partially worthless for tax purposes if the bank is able to show that it charged off such debt in whole or in part, either in obedience to the specific orders of its banking regulators, or in accordance with established policies of such regulatory authorities, and, upon their first

3 Page 3 of 7 audit of the bank or other corporation subsequent to the charge-off, such authorities confirm in writing that the charge-off would have been subject to such specific orders if the audit had been made on the date of the charge-off In effect, these regulations generally allow a bank to take tax deductions for loans and other debt securities that the regulators have determined or confirmed to be worthless or partially worthless and have thus, ordered the bank to charge-off for book purposes. As a general matter, federal and state banking regulators issue an examination report to a bank at the conclusion of a regulatory exam. This examination report includes a list of loans and other debt securities that the regulator has ordered the bank to charge-off and/or confirmed as proper to charge-off for loans and other debt securities that the bank had charged off prior to the examination date. However, this examination report is a confidential document and the IRS is not an authorized viewer of the document. Therefore, it is impossible for a bank to prove to the IRS that the banking regulator either ordered or confirmed charge-offs that the bank has taken since the only proof that the bank has is the exam report unless the bank is able to provide a letter from the regulator separate and apart from the exam report. Some of the federal banking regulators have confirmed (in writing) that they do not have a policy of issuing any letters other than an express determination letter (EDL) to a bank pursuant to a regulatory exam. For instance, in a letter from the FDIC to an ABA member bank, the FDIC indicated that the only document it would issue to the bank aside from the examination report is the EDL. This EDL was rejected by the IRS as the required evidence that the regulator confirmed the loans charged off to be worthlessness because the bank had not made the conformity election for tax purposes. This has resulted in a situation where the IRS appears to be disallowing tax deductions that banks have taken simply due to a lack of agreement between the IRS and the banking regulators over how the banking regulator must document its views. The IRS s refusal to accept anything other than a confirmation letter as the required proof under the regulations largely results in a situation where banks are unable to avail themselves of the (d)(1) provisions to take tax deductions for worthless or partially worthless loans and other debt securities. IRS and banking agencies need to agree on some protocol that would be reflected in guidance that would help facilitate the implementation and usability of Regulation Section (d)(1) and/or provide an alternative mechanism for a bank to otherwise satisfy the apparent intent of the regulation, for example the provision of a certification statement attesting that its bad debts deductions for worthless or partially worthless loans and other debt securities are in accordance with established policies of its primary regulatory authority. 3. Conformity election for non-bank operating subsidiaries of banks: Issue: The section 166 presumption of worthlessness applies only to banks as defined within section 581 and other regulated corporations. Many banking organizations have subsidiaries that do not meet the section 581 definition of a bank, but are facilitative of the organization s banking and lending businesses. (For example, the mortgage operations of many banks are in controlled subsidiaries.) These controlled subsidiaries cannot make the conformity election but are subject to same supervision and oversight by Federal or State authorities as the bank. In effect, the regulators generally apply identical standards to bank operating subsidiaries as they do to the regulated bank where the subsidiaries conduct any business

4 Page 4 of 7 that can be conducted by the bank. Reporting is prepared and reviewed on a consolidated basis, and in general, bank subsidiaries are required to apply processes consistent with parent bank s regulatory requirements. By only applying the conformity election to the bank and not also to its controlled subsidiaries, a bank is penalized if part of its business is operated in subsidiaries. If these subsidiaries were liquidated into the bank, the conformity election would apply. However, there may be business restraints that can make it difficult to execute such liquidations. The regulatory authority s review and supervision of the bank and its subsidiaries would be the same with or without such liquidation. However, this is not true with regards to the application of the tax rules. When considering the intent of the conformity election, it is the proper result for the tax rules to be applied in a similar manner to the regulatory authority s supervision. IRS should reconsider its position adopted 20 years ago not to allow non-bank subsidiaries of a bank make the conformity election. The IRS has expressed an interest in ways to streamline the audit process in light of the demands on agents and budget limitations. The benefit of the conformity rule (for both the IRS and taxpayers) would be further enhanced if the rule expands the conformity election to the controlled subsidiaries of a banking organization. Resolution of this issue would help streamline the audit process by eliminating the unnecessary time being spent by both the IRS and the taxpayer on charge-offs at the bank s controlled subsidiaries. The IRS should expand the conformity election in Regulation Section (d)(3) to include non-bank subsidiaries of a bank (i.e., non-bank subsidiaries that are regulated in the same manner and by the same federal or state regulators as the bank). The application of the conformity election for non-bank subsidiaries would increase IRS audit efficiency without materially impacting the timing or amount of deductions. 4. OREO Expenses a. Issue: The issue is whether a bank is required under Section 263A to capitalize maintenance and repair expenses relating to OREO property. While it is true that Section 263A requires the capitalization of direct and indirect costs associated with: i) property produced ( produce includes activities that encompass to construct, build, install, or improve); and ii) property acquired for resale, we do not believe that 263A capitalization rules apply to certain expenses incurred by a bank in relation to foreclosed property (OREOs). Because the foreclosed property relates to the underlying loan, its acquisition and subsequent sale are an extension of the lending activity. In effect, the foreclosed property is an ordinary asset, and like the underlying loan and lending activity which is clearly excluded from 263A, it should be excluded also from 263A as well. Moreover, according to FSA , if a loan is originated by a bank which later forecloses on the underlying property, the foreclosed property takes on the character of the underlying loan (ordinary asset), which is excluded from the application of 263A. We do not believe that the treatment of foreclosed property by banks was taken into consideration when section 263A and the accompanying regulations were drafted. Banks do not produce the asset (foreclosed

5 Page 5 of 7 property) nor acquire them for resale in the ordinary course of their business as manufacturers, retailers and developers do. Banks incur various types of expenses with respect to OREO properties: costs incurred (i) prior to foreclosure, (ii) during foreclosure and (iii) after foreclosure (a) maintenance and carrying costs, e.g, RE taxes, lawn mowing, snow or trash removal, necessary repairs, electricity; and (b) costs incurred for improvements to the property, e.g. additions or major renovations. There should not be any question about whether the costs incurred prior to foreclosure (when the bank has not acquired the property) and during foreclosure should be deductible. Thus, guidance is requested with respect to item (iii) above. For financial reporting purposes, costs incurred to maintain the OREO property (maintenance and carrying costs) are expensed, whereas costs incurred to improve (or make additions) to the property are capitalized. The treatment should be the same for tax for several reasons. OREO properties are ordinary income properties a direct extension of the underlying debt and therefore, expenses incurred to maintain and repair such properties should be excluded from the application of 263A. On March 1, 2013, Chief Counsel memorandum (AM ) was issued advising field agents on the tax treatment of certain expenses incurred by banks to maintain OREO property prior to disposition of such property. The memo concedes that OREO acquired by the loan-originating bank through foreclosure proceedings or by deed-in-lieu of foreclosure is not property acquired for resale within the meaning of 263A(b)(2). In effect, a bank that acquires property through foreclosure or by deed-in-lieu of foreclosure because the underlying loan is bad is not a manufacturer or other retailer who acquires property with the intent of increasing its value in order to generate a profit upon resale. The bank s purpose in acquiring the property is to recoup the principal on the bad loan, rather than to generate a profit upon resale. Therefore, since the bank is not a reseller within the meaning of the statute and regulations, the bank is not required to capitalize expenses incurred to maintain the property (under section 263A) prior to disposition. The memo covers a very narrow scope OREOs for which the underlying loan was originated by the bank. The rule should not be so limited in its scope and application. In addition to originating loans that are secured by real property, banks typically acquire loans that are secured by real property, which could result in OREO for which the underlying loan was acquired, rather than originated by the bank. Guidance should clarify that expenses incurred by a bank for maintenance and necessary repairs (i.e., repairs that are necessary to put the property in sellable condition) relating to OREO property are currently deductible and thus, excluded from the application of section 263A or 263(a) regardless of whether the OREO relates to originated loan or acquired loan. Furthermore, it should not make a difference whether the underling loan relating to the OREO was acquired by the bank for resale or acquired for investment. b. Issue: A bank that wants to change its method of accounting to deduct OREO maintenance expenses should not be required to do so under the non-automatic method change process, which would involve obtaining IRS consent, payment of a user fee and other administrative burdens that accompany a non-automatic change.

6 Page 6 of 7 The March 1, 2013 Chief Counsel memo did not provide the necessary guidance on how a bank can change its method of accounting for OREO maintenance expenses pursuant to the IRS s position in the memo without having to go through the burdensome and expensive non-automatic method change process. Guidance is required to clarify that a bank may change its method of accounting for OREO carrying expenses under the IRS s automatic method change procedure. In effect, a bank that is currently capitalizing such costs because of the IRS s previous position on the topic, should be permitted to change its accounting method to start expensing these costs without having to go through any unduly burdensome procedures or paying a user fee. Thank you in advance for your consideration of our request. Please contact me at or fmordi@aba.com for any questions or to schedule a follow-up meeting. Sincerely, Francisca N. Mordi cc: Heather Maloy Commissioner, LB&I 1111 Constitution Ave. N.W. Attn: SE:LB&I Washington, DC Rosemary Sereti Industry Director, Financial Services SE:LB:FS 290 Broadway, 12th Floor New York, NY Deborah Inganamorte Executive Assistant (Technical) LB&I Financial Services 290 Broadway, 12th Floor New York, NY 10007