Tax

On December 28, 2023, the U.S. Treasury Department (“Treasury“) and the Internal Revenue Service (“IRS“) issued proposed regulations (REG-121010-17) updating the standards for when a debt instrument held by a regulated financial company or a member of a regulated financial company group will be conclusively presumed to be worthless for U.S. federal income tax purposes (the “Proposed Regulations“).[1] The Proposed Regulations would amend Reg. §1.166-2(d) (the “Existing Regulations“) to align the U.S. federal income tax standards used to determine the worthlessness of debt instruments held by a regulated financial company or a member of a regulated financial company group with the significant changes made over time to the regulatory and accounting standards dealing with loan charge-offs. The Proposed Regulations can be relied upon pending the issuance of final regulations.

Background

            Section 166(a)(1) allows taxpayers to take a deduction for any debt that becomes “worthless” within the taxable year. Moreover, Section 166(a)(2) allows taxpayers a deduction for partially worthless debt, in an amount not in excess of the portion of such debt charged off as worthless during the taxable year. Neither the Code nor the Existing Regulations define the term “worthless.” For purposes of allowing a deduction for wholly or partially worthless debt, the IRS will consider all pertinent evidence establishing the worthlessness of such debt, including the value of the collateral, if any, securing the debt and the financial condition of the debtor. Reg. §1.166-2(a).

            The Existing Regulations provide two alternative, but outdated, conclusive presumptions of worthlessness for bad debt. First, pursuant to Reg. §1.166-2(d)(1), if a “bank”[2] or other corporation subject to supervision by federal authorities, or by State authorities maintaining substantially equivalent standards, charges off a debt in whole or in part, either (1) in obedience to the specific orders of such authorities or (2) in accordance with the established policies of such authorities and, in the latter instance, such authorities at the first audit subsequent to the charge-off confirm in writing that the charge-off would have been subject to specific orders, then the debt is conclusively presumed to have become worthless, in whole or in part, to the extent charged off during the taxable year.

            Second, pursuant to Reg. §1.166-2(d)(3), a bank (but not any other corporation) subject to supervision by federal authorities, or by State authorities maintaining substantially equivalent standards, may elect to use a method of accounting that establishes a conclusive presumption of worthlessness for debts, provided the bank’s supervisory authority has made an express determination that the bank maintains and applies loan loss classification standards that are consistent with the regulatory standards of that supervisory authority.

            The underlying policy rationale of the Existing Regulations was to align the standards for determining the worthlessness of a debt for U.S. federal income tax purposes with the non-tax regulatory and accounting standards with respect to loan charge-offs. Treasury and the IRS believed that the non-tax standards for determining worthlessness were sufficiently similar to the worthlessness standards for tax purposes. Thus, allowing banks and similarly regulated entities to take tax deductions for bad debts as determined under non-tax standards was administratively convenient for both taxpayers and the IRS.[3] Unfortunately, the criteria for satisfying the existing conclusive presumptions for worthlessness for tax purposes no longer conform to existing regulatory and accounting standards.

            The Proposed Regulations are the next step in a decade’s long process by Treasury and the IRS to update and align the standards permitting the tax write-off of bad debts of banks and similarly regulated entities (including insurance companies) to bad debt write-off standards for regulatory purposes, where sufficiently reliable.[4]

Explanation of the Proposed Regulations

            The Proposed Regulations generally update the conclusive presumption for determining whether debt held by a regulated financial company or a member of a regulated financial group is worthless for U.S. federal income tax purposes, to align it with charge-offs under generally accepted accounting principles (“GAAP”) from the allowance for credit losses of debt instruments or, in the case of an insurance company that does not have GAAP financial statements for substantive non-tax purposes, charge-offs pursuant to the Statement of Statutory Accounting Principles (“SSAP”) detailed in the National Association of Insurance Commissioner’s (“NAIC’s”) Accounting Practices and Procedure Manual standards. This is referred to in the Proposed Regulations as the “Allowance Charge-Off Method.”

            As discussed below, the scope of financial institutions and affiliated entities covered by the Proposed Regulations varies from the Existing Regulations, both in terms of the types of institutions covered (or not) and in covering members of a regulated financial group.

            Under the Proposed Regulations, the term “charge-off” generally means an accounting entry or set of accounting entries for a taxable year that reduces the basis of the debt when the debt is recorded in whole or in part as a loss asset on the applicable financial statement of the regulated financial company or the member of a regulated financial group for that year. For a regulated financial company that is a regulated insurance company using a financial statement that is prepared in accordance with SSAP standards set out by the NAIC and filed with State insurance regulatory authorities, the term means an accounting entry or set of accounting entries that reduces the debt’s carrying value and results in a realized loss or a change to the statement of operations (as opposed to the recognition of an unrealized loss) that is recorded on the regulated insurance company’s annual statement.

            For this purpose, a “financial statement” includes, in order of priority: (1) a GAAP financial statement that is a Form 10-K or annual statement to shareholders filed with the U.S. Securities and Exchange Commission; (2) a financial statement required to be provided to a bank regulator, along with any amendments or supplements to that financial statement; and additionally, in the case of an insurance company: (3) a financial statement based on GAAP that is prepared contemporaneously with a financial statement prepared in accordance with the standards set out by the NAIC and given to creditors for purposes of making lending decisions or equity holders for purposes of evaluating an investment decision, or provided for other substantial non-tax purposes that meet certain criteria set forth in the Proposed Regulations; or (4) a financial statement that is prepared in accordance with standards set out by the NAIC and filed with State insurance regulatory authorities.

            Treasury and the IRS are requesting comments on all aspects of the Proposed Regulations, including how best to transition from the existing rules to the Proposed Regulations.

a. Institutions Covered (or Not)

            In general, a “regulated financial company” means (A) a bank holding company that is a domestic corporation; (B) a covered savings and loan holding company; (C) a national bank; (D) a bank that is a member of the Federal Reserve System and is incorporated by special law of any State, or organized under the general laws of any State, or of the United States, or other incorporated banking institution engaged in a similar business; (E) an insured depository institution; (F) a U.S. intermediate holding company formed by a foreign banking organization in compliance with regulatory requirements; (G) an Edge Act corporation organized under section 25A of the Federal Reserve Act; (H) a corporation having an agreement or undertaking with the Board of Governors of the Federal Reserve System under section 25 of the Federal Reserve Act; (I) a Federal Home Loan Bank; (J) a Farm Credit System Institution chartered and subject to the provisions of the Farm Credit Act of 1971; (K) a regulated insurance company, as discussed below; (L) the Federal National Mortgage Association; (M) the Federal Home Loan Mortgage Corporation; and (N) any additional entities that may be provided in IRS guidance.

            The preamble to the Proposed Regulations notes that the definition of a “regulated financial company” does not include credit unions, U.S. branches of foreign banks, and non-bank systemically important financial institutions (“SIFIs“). However, with respect to credit unions and U.S. branches of foreign banks, Treasury and the IRS are requesting comments regarding whether and, if so, how the Proposed Regulations should be modified to apply to credit unions and U.S. branches of foreign banks. Treasury and the IRS are also open to receiving comments with respect to non-bank SIFIs but would need to understand the extent to which regulators of non-bank SIFIs apply standards of “worthlessness” that are sufficiently similar to U.S. federal income tax principles.

            The Proposed Regulations define a “regulated insurance company” generally to mean a domestic corporation that is subject to tax under subchapter L of chapter 1 of the Code, is licensed, authorized, or regulated by one or more States to sell insurance, reinsurance, or annuity contracts (other than to certain related persons), and is engaged in regular issuances of insurance, reinsurance, or annuity contracts with persons that are not related persons. The preamble to the Proposed Regulations notes that entities regulated by insurance regulators and various federal regulators, such as the Federal Housing Finance Agency and the Farm Credit Administration, are included in the definition of a “regulated financial company.”

            A “regulated financial group” generally means one or more chains of corporations connected through stock ownership with a common parent corporation that is a regulated financial company described in “A” through “F” above and which satisfies the 80% vote and value tests for Section 1504 affiliation. A corporation is not considered to be part of a regulated financial group, however, if it is a regulated investment company (RIC), a real estate investment trust (REIT), or certain other specified entities.

b. Transition to the Allowance Charge-Off Method

            The Proposed Regulations provide that the Allowance Charge-Off Method constitutes a method of accounting. As such, under the Proposed Regulations, a taxpayer wishing to change to the Allowance Charge-Off Method would have to follow the change of method of accounting rules under Section 446. Accordingly, the taxpayer may need to seek the consent of the IRS under Section 446(e) before changing its method of accounting to the Allowance Charge-off Method with respect to its bad debt deductions. The IRS expects that taxpayers intending to change their method of accounting to the Allowance Charge-off Method would request the consent of the IRS by filing Form 3115, Application for Change in Method of Accounting.

Proposed Applicability Dates and Reliance on the Proposed Regulations

            Pending final regulations, the Proposed Regulations can be relied upon for taxable years ending on or after December 28, 2023. The final regulations are proposed to apply to charge-offs made by a regulated financial company or a member of a regulated financial group on its applicable financial statement that occur in taxable years ending on or after the date of publication of the final regulations in the Federal Register. Accordingly, at such time, a regulated financial company that does not use or change to the Allowance Charge-Off Method would not be entitled to a conclusive presumption of worthlessness and generally would be required to use the specific charge-off method. If it so chooses, a regulated financial company or a member of a regulated financial group would be able to apply the final regulations retroactively to taxable years ending on or after December 28, 2023.

[1] All “Section” references are to the U.S. Internal Revenue Code (the “Code”) and all “Reg. §” references are to the Treasury Regulations promulgated thereunder.

[2] The term “bank” means any bank or trust company incorporated and doing business under the laws of the United States (including laws relating to the District of Columbia) or of any U.S. state (a “State”), a substantial part of the business of which consists of receiving deposits and making loans and discounts, or of exercising fiduciary powers similar to those permitted to national banks under authority of the U.S. Comptroller of the Currency, and which is subject by law to supervision and examination by State or federal authority having supervision over banking institutions; such term also means a domestic building and loan association and, under the Existing Regulations, a Farm Credit System institution that is subject to supervision by the Farm Credit Administration. See Section 581, Reg. §1.166-2(d)(4). Under the Existing Regulations, the term “bank” also includes a foreign corporation that would be a bank as defined but for the fact it is a foreign corporation, except only with respect to loans the interest on which is effectively connected with the conduct of a banking business within the United States.

[3] See Treasury Department, Report to the Congress on the Tax Treatment of Bad Debts by Financial Institutions (September 1991),at19-22.

[4] See LB&I Directive Related to Partial Worthlessness Deduction for Eligible Securities Reported by Insurance Companies, LB&I 04-0712-009 (July 30, 2012) (allowing conformity for certain write-offs for insurance companies); LB&I Directive Related to § 166 Deductions for Eligible Debt and Eligible Debt Securities, LB&I 04-1014-008 (October 24, 2014) (allowing conformity of certain write-offs by banks). In Notice 2013-35, 2013-24 I.R.B. 1240, the IRS requested comments on whether changes that have occurred in bank regulatory standards and processes since the adoption of the Existing Regulations required amendment of such regulations, and whether the application of the Existing Regulations remained consistent with Treasury’s underlying policy rationale for its implementation at the time of issuance.