Tax News and Developments January 2024
In brief
On 28 December 2023, the Treasury and the IRS issued a notice of proposed rulemaking regarding whether a debt instrument is worthless for US federal income tax purposes under Code section 166 (the “Proposed Regulations“)1. The Proposed Regulations would update the standards under Treas. Reg. § 1.166-2 used to determine when debt instruments held by regulated financial companies or members of a regulated financial group are conclusively presumed worthless.
Contents
Key takeaways
- Effective dates. The final regulations would apply to charge-offs of presumed worthless debt made by a regulated company or a member of a regulated financial group that occur in taxable years ending on or after the date the Treasury and the IRS publish their decision adopting the Proposed Regulations as final regulations. Taxpayers can also choose to apply the final regulations to financial statements in taxable years ending on or after the date the final regulations are published in the Federal Register and before Treasury and the IRS publish their decision adopting the Proposed Regulations as final regulations.
- What is a charge-off? An accounting entry, or set of accounting entries, made to reduce the carrying value of a debt when the debt is determined to be wholly or partially worthless.
- Who is a regulated financial company? State and federally regulated banks and insurance companies, including national banks, banks that are members of the Federal Reserve System and incorporated by law, Federal Home Loan Banks, and insurance companies regulated by the Federal Housing Finance Agency and the Farm Credit Administration.
- Who is a member of a regulated financial group? A regulated financial group is a group of corporations connected through stock ownership where the common parent is a regulated financial company. A member of a regulated financial group is a corporation in the regulated financial group.
- Deadline to submit comments: 26 February 2024.
Background
Section 166(a) allows taxpayers to deduct debt that becomes wholly or partially “worthless” within the taxable year.
As noted in the preamble to the Proposed Regulations, the existing regulations do not define “worthless.”2 The general rule in the regulations requires the IRS to “consider all pertinent evidence” in determining whether a debt has become worthless in whole or in part.3 The regulations further provide that bankruptcy “is generally an indication of worthlessness.”4
The existing regulations apply special rules to banks and other corporations subject to “substantially equivalent” supervision by federal or state authorities.5 A bank or similarly regulated corporation can conclusively presume debt as wholly or partially worthless and charge off debt if 1) required by state or federal authorities, either in obedience to a specific order or pursuant to federal or state bank regulatory rules and established policies and the authorities confirm the charge-off in writing in a subsequent audit,6 or 2) the bank or similarly regulated corporation elects to use a method of accounting that meets specific requirements7 (together, the “Conclusive Presumption Regulations”).
However, the IRS acknowledged in Notice 2013-35 that changes in regulatory standards in the banking industry might necessitate amendments to the Conclusive Presumption Regulations.8 As noted by comments provided in response to Notice 2013-35, the existing Conclusive Presumption Regulations were burdensome and outdated.9 For example, commenters observed that “bank regulators now rarely order banks to charge off particular loans.”10 However, commenters also pointed out that the Conclusive Presumption Regulations were beneficial because they helped “avoid costly factual disputes” between the IRS and taxpayers.11 Commenters argued that the financial accounting and regulatory standards were sufficiently similar to the tax standards for worthlessness under section 166 and should therefore be used to revise the rules.12
Additionally, the IRS issued directives in 2012 and 2014 acknowledging the significant burden on banks and regulated insurance companies of determining worthlessness under section 166.13 The directives allowed charge-off amounts reported for financial statements or regulatory purposes as sufficient evidence of worthlessness under section 166.14 As noted in the preamble to the Proposed Regulations, through the directives, the IRS has “previously recognized that the present values of timing differences in taxable income that arise from applying the regulatory standards instead of the tax standards to determine worthlessness are likely to be minor and therefore do not outweigh the costs of having two different standards for book and tax purposes.”15
Proposed amendments to Treas. Reg. § 1.166-2(d)
Treasury and the IRS issued the Proposed Regulations to update the Conclusive Presumption Regulations for regulated financial companies and members of regulated financial groups, which incorporate US Generally Accepted Accounting Principles (US GAAP) and Current Statements of Statutory Accounting Principles (SSAPs).16 Treasury and the IRS agreed with commentators and now believe that regulated financial companies and members of regulated financial groups are subject to regulatory and accounting standards for charge-offs that are sufficiently similar to the US federal income tax standards for determining worthlessness under section 166.17 US GAAP, SSAPs, and section 166 all use a facts and circumstances analysis to determine the collectability of debt.18
Current US GAAP method
The current US GAAP standard (effective for public SEC filers after 15 December 2019)19 generally requires entities to recognize expected credit losses (ECL) in the allowance for credit losses when the financial asset is initially recognized.20 The ECL must be assessed each reporting period.21 The ECL is estimated based on past events, current conditions, and reasonable and supportable forecasts.22 Under US GAAP, a charge-off of the financial asset reduces the allowance in the period the asset is deemed uncollectible and the carrying value of the financial asset.23
Current SSAPs method
Publicly traded insurance companies prepare their financial statements for the SEC in accordance with US GAAP. Privately held insurance companies can also prepare their financial statements for the SEC in accordance with US GAAP. Additionally, state law requires all insurance companies to prepare their financial statements in accordance with SSAPs.24 SAPs require entities to write down the carrying value of an asset if the loss is other than temporary impairment (OTTI).25 The OTTI standard requires taxpayers to consider “all available evidence at their disposal.”26
Proposed Regulations
The Proposed Regulations would amend current Treas. Reg. § 1.166-2(d) to update the Conclusive Presumption Regulations. The amended rules would allow regulated financial companies and members of regulated financial groups to conclusively presume that charge-offs made in accordance with US GAAP, or SSAPs in the case of insurance companies that do not produce US GAAP financial statements, satisfy the requirements for bad debt deductions under section 166 (“Allowance Charge-off Method“).27
Definition of “charge-off”
For entities that apply US GAAP, such as banks and publicly traded insurance companies, a charge-off is an accounting entry, or set of accounting entries, that reduces the carrying value of debt when the debt is determined to be wholly or partially worthless.28 For regulated financial companies using the SSAPs, a charge-off is an accounting entry, or set of accounting entries, that reduces the debt’s carrying value and “results in a realized loss or a charge to the statement of operations (as opposed to recognition of unrealized loss)” on the regulated insurance company’s annual statement.29
Definition of “regulated financial company”
Prop. Treas. Reg. § 1.166-2(d)(4)(ii) defines regulated financial companies to include state and federally-regulated banks and insurance companies, including national banks, banks that are members of the Federal Reserve System and incorporated by law, Federal Home Loan Banks, and insurance companies regulated by the Federal Housing Finance Agency and the Farm Credit Administration. The Proposed Regulations do not include credit unions or US branches of foreign banks in the definition of a “regulated financial company.”30 Treasury and the IRS have requested comments on whether the Proposed Regulations should be modified to include such entities as well.31
Under Prop. Treas. Reg. § 1.166-2(d)(4)(vii), corporations that, although they are “licensed, authorized, or regulated by one or more States to sell insurance, reinsurance, or annuity contracts to persons other than related persons,” do not engage in “regular issuances of insurance, reinsurance, or annuity contracts with persons that are not related persons” are not considered regulated insurance companies.32 Treasury and the IRS have requested comments on whether the Proposed Regulations should be modified to include a reinsurance entity that regularly issues reinsurance contracts only to related persons.33
Definition of “regulated financial group” and “member of a regulated financial group”
A regulated financial group is a group of corporations “connected through stock ownership with a common parent corporation” that is a regulated financial company.34 A member of a regulated financial group is “any corporation in the chain of corporations of a regulated financial group.”35
Definition of “financial statement”
Prop. Treas. Reg. § 1.166-2(d)(4)(ix) defines financial statements to include financial statements, including amendments or supplements, prepared according to US GAAP or SSAPs. Additionally, a financial statement is defined as a taxpayer’s financial statement that has the highest priority. In descending priority, financial statements are:
- Financial statements prepared in accordance with US GAAP that is a Form 10-K or annual statement to shareholders.
- Financial statements are required to be provided to a bank regulator.
- In the case of insurance companies, a financial statement based on US GAAP that meets certain criteria, such as financial statements “given to creditors for purposes of making lending decisions, given to equity holders for purposes of evaluating their investments in the regulated financial company or member of a regulated financial group, or provided for other substantial non-tax purposes”.
- In the case of insurance companies, a financial statement is prepared in accordance with SSAPs and filed with the insurance regulatory authorities.
Conclusion
With the issuance of the Proposed Regulations, Treasury and the IRS have provided welcome relief to taxpayers and modernized the Conclusive Presumption Regulations.
1 REG-1545-BO11, 88 Fed. Reg. 89636 (Dec. 28, 2023). Unless otherwise indicated, all section references are to the US Internal Revenue Code of 1986 (the “Code”), as amended, and the US Treasury Regulations.
2 REG-1545-BO11, 88 Fed. Reg. at 89636.
3 Treas. Reg. § 1.166-2(a).
4 Treas. Reg. § 1.166-2(c).
5 Treas. Reg. § 1.166-2(d).
6 Treas. Reg. § 1.166-2(d)(1).
7 Treas. Reg. § 1.166-2(d)(3).
8 Notice 2013-35.
9 The Clearing House Association L.L.C. and American Bankers Association, Comment Letter Submitted Pursuant to Notice 2013-35 on Conclusive Presumption Regulations, 8 October 2013; American Council of Life Insurers, Notice 2013-35 and Conclusive Presumption Regulations, 8 October 2013.
10 Id.
11 American Council of Life Insurers, Notice 2013-35 and Conclusive Presumption Regulations, 8 October 2013.
12 The Clearing House Association L.L.C. and American Bankers Association, Comment Letter Submitted Pursuant to Notice 2013-35 on Conclusive Presumption Regulations, 8 October 2013; American Council of Life Insurers, Notice 2013-35 and Conclusive Presumption Regulations, 8 October 2013.
13 On 30 July 2012, the IRS issued the LB&I Directive Related to Partial Worthlessness Deduction for Eligible Securities Reported by Insurance Companies (LB&I-4-0712-009), which stated LB&I examiners would not challenge an insurance company’s partial worthlessness deductions under section 166(a)(2) if charge-offs were made pursuant to SSAPs. Similarly, on 24 October 2014, the IRS issued the LB&I Directive Related to § 166 Deductions for Eligible Debt and Eligible Debt Securities applicable to banks (LB&I-04-1014-008). The bank directive directed examiners to accept a bank’s deduction for partial or wholly worthless debts under section 166 if the deduction followed those reported for GAAP and regulatory purposes.
14 Id. Note that the US GAAP standards for financial institutions recognizing credit losses have changed since the 2014 directive was issued, and the prior US GAAP standards did not incorporate considerations for future events.
15 REG-1545-BO11, 88 Fed. Reg. at 89639.
16 REG-1545-BO11, 88 Fed. Reg. 89636. The SSAPs are detailed in the National Association of Insurance Commissioners’s (NAIC’s) Accounting Practices and Procedures Manual.
17 REG-1545-BO11, 88 Fed. Reg. at 89639.
18 Id.
19 ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.
20 ASC 326-20-30-1. See the ASC 326-20-55-64 example of a bank purchase of a credit deteriorated loan below:
DR Loan – par amount $1,000,000
CR Loan – noncredit discount $75,000
CR Allowance for credit losses $175,000
CR Cash $750,000
21 ASC 326-20-35-1.
22 ASC 326-20-30-7.
23 ASC 326-20-35-8. See the ASC 326-20-55-52 example of a loan write off below:
DR Allowance for credit losses $125,000
CR Loan receivable $125,000
24 Statutory Accounting Principles, https://content.naic.org/cipr-topics/statutory-accounting-principles.
25 SSAP No. 43R – Loan-Backed and Structured Securities.
26 INT 06-07: Definition of Phrase “Other than Temporary.”
27 Prop. Treas. Reg. § 1.166-2(d)(1).
28 Prop. Treas. Reg. §§ 1.166-2(d)(1)(i), (4)(i).
29 Prop. Treas. Reg. §§ 1.166-2(d)(1)(ii), (4)(i).
30 REG-1545-BO11, 88 Fed. Reg. at 89640.
31 Id.
32 Prop. Treas. Reg. § 1.166-2(d)(4)(vii).
33 REG-1545-BO11, 88 Fed. Reg. at 89640.
34 Prop. Treas. Reg. § 1.166-2(d)(4)(iii).
35 Prop. Treas. Reg. § 1.166-2(d)(4)(vi). Certain limitations apply under Prop. Treas. Reg. § 1.166-2(d)(4)(vi) if a corporation is “held by a regulated financial company pursuant to 12 U.S.C. 1843(k)(1)(B), 12 U.S.C. 1843(k)(4)(H), or 12 U.S.C. 1843(o), or if it is a Regulated Investment Company under section 851 of the Code, or a Real Estate Investment Trust under section 856 of the Code.”
