Non-Performing Loans

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1 Non-Performing Loans

2 Non-Performing Loans Accounting Treatment Legal Factors Tax Treatment Audit Process

3 NPL Accounting Types of Loans Subject to Nonaccrual Accounting Commercial Loans Consumer Real Estate Loans Unsecured Consumer Loans typically continue to accrue until ~180 days past due at which point: Principal is charged off Accrued interest receivable is reversed against interest income Current interest stops accruing

4 NPL Accounting Collection and Recovery If any portion of the loan is rated Doubtful, collections of any kind (principal or interest) are accounted for as payments of principal. If no portion is rated Doubtful or Loss, collections of interest may be treated as interest income when received.

5 NPL Legal Default Loan is in formal default typically when lender notifies borrower that one or more terms of the loan contract have been violated Foreclosure process may start on secured loans Unsecured loans become immediately due and payable Bankruptcy Legal process of restructuring, cancelling, or reducing debts As a rule, interest stops accruing on loans to a bankrupt person or entity Pre-petition accrued interest receivable falls into a disfavored position

6 NPL Tax Treatment Accrual of Interest Charge-off of Receivable Collections

7 NPL Tax Accrual Accrual of Interest Interest income for an accrual basis taxpayer is recognized when all events have occurred that fix the right to the income, and the amount can be determined with reasonable accuracy. See section 451. Generally, the right to receive interest income becomes fixed as it is earned over the period of the loan. See Rev. Rul ; Rev. Rul ; Reg (b)

8 NPL Tax Accrual Doubtful Collectibility Lender does not need to accrue interest if there is no reasonable expectation of payment (the doubtful collectibility exception) A taxpayer, even though keeping his books on an accrual basis, should not be required to pay a tax on accrual income unless it is good and collectible, and, when it is of doubtful collectibility or it is reasonably certain it will not be collected, it would be an injustice to the taxpayer to insist upon taxation. Corn Exchange Bank v. United States, 37 F.2d 34 (2 nd Cir, 1930).

9 NPL Tax Accrual Revenue Ruling Facts Taxpayer uses the accrual method of accounting and makes a loan to A in Year 1. Initially, interest and principal are collectible, but late in Year 2, A suffers sudden and severe financial reverses, becomes insolvent, and defaults on the loan. The security is sufficient to satisfy only the principal amount of the loan.

10 NPL Tax Accrual Rev. Rul (cont.) Holding Taxpayer must currently accrue interest income up to the time of A's insolvency. To the extent that the accrued interest subsequently becomes uncollectible because of A's insolvency, taxpayer may deduct the accrued interest as a bad debt. Interest related to the time after A's insolvency does not properly accrue, since the interest is uncollectible at the time. Therefore, such interest need not be included in gross income.

11 NPL Tax Accrual Revenue Ruling Facts Taxpayer is a bank. Bank expects the borrower to make some, but not all, of the payments due under the loan. Bank stops accruing interest on the loan, pursuant to federal banking rules, though Bank has not written loan off for regulatory purposes.

12 NPL Tax Accrual Rev. Rul (cont.) Can Bank stop accruing interest for tax purposes? Bank must continue to accrue interest notwithstanding that federal banking rules forbid accrual of interest on such loans for regulatory purposes. [Bank] reasonably expects the borrower to continue making some but not all payments.... Therefore, the borrower's default... only demonstrates that timely repayment is not occurring. The late payment of interest by itself is not sufficient to demonstrate that [Bank] has no reasonable expectation of payment of the accrued interest.... Under these circumstances, the no reasonable expectancy of payment exception to the general accrual rule does not apply.

13 NPL Tax Charge-off Bank Bad Debt Conformity Election Rev. Rul Facts Same facts as before except Bank has made the bad debt conformity election under Reg (d)(3)

14 NPL Tax Charge-off Rev. Rul Must continue to accrue interest May claim bad debt deduction for previously accrued interest For regulatory purposes,... [Bank]'s right to... accrued interest has such little value that recognition of the accrued interest receivable as a bankable asset is not warranted. Under these circumstances, [Bank]'s failure to recognize... accrued interest for regulatory financial statement purposes is tantamount to recognizing the accrued interest as income and immediately charging off the uncollected accrued interest receivable as a loss asset.

15 NPL Tax Charge-off Loans Not Subject to Conformity Election Securitized Loans Restructured Loans resulting in gain or loss under Reg Loans Accounted for on a Principal Recovery Basis In-Substance Foreclosures Purchased Impaired Loans Subject to SOP 03-3 Loans held by non-banks

16 NPL Tax Collections Reg (e) provides that payments on a loan are interest to the extent interest has accrued on the loan as of the date the payment is due. Basically restates existing law. Story v. Livingston, 38 U.S. (13 Pet.) 359 (1839) The correct rule as to interest is that the creditor shall calculate interest whenever a payment is made. To this extent the payment is first to be applied, and if it exceed the interest due, the balance is to be applied to diminish the principal.

17 NPL Tax Collections Unless the borrower is insolvent. The significance of petitioner's insolvency cannot be minimized.... And we find it difficult to believe that a creditor who [h]as foreclosed on the collateral of an insolvent debtor, and who will never get back the full amount of his principal, is required to report a fictitious amount of income designated as interest. Newhouse, 59 T.C. 783 (1973) Also, John Hancock Mutual Life Ins. Co., 10 B.T.A. 736 (1928)

18 NPL Tax Collections Rev. Rul Facts Same as before, but Bank receives a payment that is less than the accumulated accrued unpaid interest legally due under the loan contract. For regulatory purposes, Bank applies the payment to principal rather than reporting it as interest.

19 NPL Tax Collections Rev. Rul Holding Even though for regulatory purposes, Bank applies the payment to principal, under Reg (e), Bank must characterize any payment (other than late charges) as a payment of interest for federal income tax purposes to the extent there is uncollected accrued interest outstanding.

20 NPL Tax Issues Transition to bad debt conformity treatment of nonaccrued interest Treatment of conformity-ineligible assets of a conformity electing bank Principal Recovery Loans Purchased Impaired Loans

21 NPL Tax Audit Process The Factual Question: Is It Collectible? Official Guidance Requires Loan-by- Loan Review Non-Performing Loans Directive #1 (2010) Rev. Rul (2007) MSSP Training Guide (1995?) Coordinated Issue Paper (1991)

22 NPL Tax Audit Process Alternatives Rev. Proc Other

23 Questions