LB&I-04-1014-008 October 24, 2014 MEMORANDUM FOR All LB&I Employees FROM: Heather C. Maloy /s/ Heather C. Maloy Commissioner, Large Business & International Division SUBJECT: LB&I Directive Related to § 166 Deductions for Eligible Debt and Eligible Debt Securities I. INTRODUCTION This Directive provides Large Business & International (LB&I) examiners with guidance regarding bad debt deductions claimed under § 166 by a Bank or Bank Subsidiary. In addition, this Directive clarifies that LB&I examiners will not challenge the inclusion of certain estimated selling costs in a Bank or Bank Subsidiary’s bad debt deduction. Independently determining worthlessness amounts under § 166 imposes a significant burden on Banks, Bank Subsidiaries, and LB&I examiners. Moreover, changes in bank regulatory standards and processes have created concerns about how to comply with the conclusive presumption regulations under § 166. Notice 2013-35, 2013-24 IRB 1240, solicits comments on possible changes to the conclusive presumption regulations. Pending any future guidance modifying or superseding this Directive, this 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. This Directive is intended to provide an efficient manner of resolving many bad debt deduction issues for Banks and Bank Subsidiaries and to more efficiently manage LB&I’s audit resources until further guidance under § 166 is issued. This Directive does not apply to small banks that use the reserve method of accounting for loan losses under § 585, but is available to small banks that do not use the reserve method of accounting for loan losses. LB&I may consider issuing a separate directive for determining the amount and timing of charge-offs under § 585. This Directive is not an official pronouncement of law, and cannot be used, cited, or relied on as such. In addition, nothing in this Directive should be construed as affecting the operation of any other provision of the Code, regulations or guidance thereunder. II. DEFINITIONS “Applicable Financial Statement” means: (1) a financial statement that is required to be filed by a Bank and/or Bank Subsidiary (see definitions below) with the Securities and Exchange Commission (the 10-K or the Annual Statement to Shareholders); or (2) a financial statement that is required to be provided by a Bank and/or Bank Subsidiary to a Bank Regulator. “Bank” means a bank within the meaning of Treas. Reg. § 1.166-2(d)(4)(i) (modifying the definition with respect to foreign corporations by substituting the words “Eligible Debt or Eligible Debt Securities” for “loans”) and is subject to regulation by a Bank Regulator. “Bank Regulator” means the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board, the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS) prior to its merger with the OCC, the Farm Credit Administration, any successor to any of the foregoing entities, or State authorities maintaining substantially equivalent standards as these Federal regulatory authorities. A “Bank’s Regulator” means the Bank Regulator responsible for the supervision of the Bank and its Bank Subsidiaries. "Bank Subsidiary" means an entity that (a) is not a Bank, but conducts businesses that a Bank may conduct, (b) is a member of the same affiliated group (within the meaning of § 1504(a)(1)), determined without regard to the exception for S corporations contained in § 1504(b)(8)) as a Bank ("Owning Bank") (or would be a member of the same affiliated group as Owning Bank after the application of the following sentence), (c) bears the same relationship to Owning Bank that the members of an affiliated group bear to their common parent under § 1504(a)(1), and (d) is under the supervision of Owning Bank's Regulator. For purposes of this definition (including for purposes of determining whether a partnership would be an "includible corporation" within the meaning of § 1504(b)), any partnership whose interests are wholly and directly owned by Owning Bank, a Bank wholly owned by Owning Bank, and/or one or more Bank Subsidiaries shall be treated as if it were a corporation; provided, however, that a partnership shall not be treated as wholly and directly owned by Owning Bank and/or one or more Bank Subsidiaries if any interests in such partnership are owned by one or more entities in which the partnership, directly or indirectly, owns an interest. “Charge-off of Eligible Debt” means an accounting entry or set of accounting entries for a taxable year that reduces the basis of the Eligible Debt when the Eligible Debt is recorded in whole or part as a Loss Asset on the Bank or Bank Subsidiary’s Applicable Financial Statement for that year. "Charge-off of Eligible Debt Security” means an accounting entry or set of accounting entries for a taxable year that reduces the Eligible Debt Security’s carrying value and results in a realized loss or a charge to the statement of operations (as opposed to recognition of an unrealized loss) that is recorded on a Bank or Bank Subsidiary’s Applicable Financial Statement for that year. “Eligible Debt” means any debt (whether originated or acquired) reported in the Applicable Financial Statement (balance sheet) of a Bank or Bank Subsidiary that is subject to a bad debt deduction under § 166, is not a security as described in § 165(g)(2)(C), is not subject to § 475, and is either within the scope of Accounting Standards Codification (ASC) 450 or ASC 310-40 under U.S. GAAP, or the predecessors or successors of such accounting standards, or would be subject to such accounting standards (or such predecessors or successors) if such debt were accounted for under U.S. GAAP (for example, accounted for under IFRS). “Eligible Debt Securities” means any debt securities reported in the Applicable Financial Statement (balance sheet) of a Bank or Bank Subsidiary that are subject to a bad debt deduction under § 166, are not debt securities described in § 165(g)(2) (unless these are debt securities described in § 165(g)(2)(C) and held by a Bank), are not subject to § 475, and are either within the scope of ASC 320 under U.S. GAAP, or the predecessors or successors of such accounting standard, or would be subject to such accounting standard (or such predecessors or successors) if such debt were accounted for under U.S. GAAP (for example, accounted for under IFRS).[1] “Express Determination Letter” means a written determination that satisfies the express determination requirement described by Treas. Reg. § 1.166-2(d)(3)(iii)(D). “Loss Asset” means an Eligible Debt or Eligible Debt Security that meets the requirements of the loss asset classification under the regulatory standards and established policies of the Bank Regulator. III. § 166 DEDUCTIONS FOR ELIGIBLE DEBT AND ELIGIBLE DEBT SECURITIES A. Background Section 166(a)(1) provides that “[t]here shall be allowed as a deduction any debt which becomes worthless within the taxable year.” Section 166(a)(2) provides that "[w]hen satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction." Treas. Reg. § 1.166-2(a) provides that “[i]n determining whether a debt is worthless in whole or in part the district director will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor.” Banks can determine their bad debt deduction in one of four ways. First, they may apply the general facts and circumstances test under Treas. Reg. § 1.166-2(a) to determine whether a debt is worthless in the same manner as other types of taxpayers. In the alternative, Banks may use one of two special rules provided in Treas. Reg. § 1.166-2(d)(1) and (3). Finally, small banks are entitled to apply the reserve method of accounting for loan losses. See § 585. Section 1.166-2(d)(1) provides 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. Section 1.166-2(d)(3) provides a “conformity election” under which worthlessness is conclusively presumed if a Bank’s 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.[2] B. Issue tracking: Any cases having this issue should use the following Uniform Issue List number: UIL 166.07-00 - Bad Debt Deductions for Eligible Debt and Eligible Debt Securities - Banks and Bank Subsidiaries. C. Examination guidance: LB&I examiners should not challenge a Bank or Bank Subsidiary’s bad debt deduction for Eligible Debt or Eligible Debt Securities as follows: 1. Bank or Bank Subsidiary using the general facts and circumstances test of Treas. Reg. § 1.166-2(a). Do not challenge a Bank or Bank Subsidiary’s bad debt deduction for Eligible Debt and Eligible Debt Securities if the deduction is the same amount as the amount of the credit-related impairment portion of its Charge-off of Eligible Debt and the amount of the credit-related impairment portion of its Charge-off of Eligible Debt Securities as reported on its Applicable Financial Statement. In no event, however, may the post-deduction tax basis of Eligible Debt be less than the post-Charge-off book basis of the Eligible Debt as increased by any portion of the Charge-off not related to credit impairment, nor may the post-deduction tax basis of Eligible Debt Securities be less than the post-Charge-off carrying amount of the Eligible Debt Securities as increased by any portion of the Charge-off not related to credit impairment. In addition, do not challenge the inclusion in the Bank or Bank Subsidiary’s bad debt deduction for Eligible Debt of estimated selling costs to the extent such estimated selling costs are included in the Charge-off reported in the Bank or Bank Subsidiary’s Applicable Financial Statement. 2. Bank or Bank Subsidiary using the conclusive presumption rule of Treas. Reg. § 1.166-2(d)(1). Do not challenge a Bank or Bank Subsidiary’s bad debt deduction for Eligible Debt and Eligible Debt Securities if the deduction is the sum of: (1) the amount of the credit-related impairment portion of its Charge-off of Eligible Debt and the amount of the credit-related impairment portion of its Charge-off of Eligible Debt Securities as reported on its Applicable Financial Statement; and (2) the portion of the Charge-off of Eligible Debt and Eligible Debt Securities in excess of the credit-related impairment that was taken pursuant to a specific order or written confirmation (as described in Treas. Reg. § 1.166-2(d)(1)) by a Bank Regulator as reported on its Applicable Financial Statement. Do not challenge regardless of whether or not a Bank or Bank Subsidiary presents a specific order by Bank Regulators or confirmation in writing as described in Treas. Reg. § 1.166-2(d)(1). However, a signed Certification Statement from the Bank or the Bank Subsidiary is required. In no event, however, may the post-deduction tax basis of Eligible Debt be less than the post-Charge-off book basis of the Eligible Debt as increased by any portion of the Charge-off not related to credit impairment and reduced by any amount of the Charge-off in excess of the credit-related impairment that was taken pursuant to a specific order or written confirmation (as described in Treas. Reg. § 1.166-2(d)(1)) by a Bank Regulator, nor may the post-deduction tax basis of Eligible Debt Securities be less than the post-Charge-off carrying value of the Eligible Debt Securities as increased by any portion of the Charge-off not related to credit impairment and reduced by any amount of the Charge-off in excess of the credit-related impairment that was taken pursuant to a specific order or written confirmation (as described in Treas. Reg. § 1.166-2(d)(1)) by a Bank Regulator. In addition, do not challenge the inclusion in the Bank or Bank Subsidiary’s bad debt deduction for Eligible Debt of estimated selling costs to the extent such estimated selling costs are included in the Charge-off reported in the Bank or Bank Subsidiary’s Applicable Financial Statement. 3. Bank using the conformity election under Treas. Reg. § 1.166-2(d)(3). Do not challenge a Bank’s bad debt deduction for Eligible Debt and Eligible Debt Securities if a Bank made a proper conformity election under Treas. Reg. § 1.166-2(d)(3) regardless of whether or not the express determination requirement as described in Treas. Reg. § 1.166-2(d)(3)(iii)(D) is satisfied. In addition, do not challenge the inclusion in the Bank bad debt deduction for Eligible Debt of estimated selling costs to the extent such estimated selling costs are included in the Charge-off reported in the Bank Applicable Financial Statement. D. Implementation In general This Directive applies on an entity-by-entity basis. A Bank or Bank Subsidiary may apply this Directive no earlier than its 2010 taxable year and no later than a taxable year that begins in 2014. Pending any future guidance modifying or superseding this Directive, once a Bank or Bank Subsidiary chooses to apply this Directive, it must apply it consistently going forward from year to year. If a Bank or Bank Subsidiary chooses to follow the provisions of this Directive, it may implement any applicable changes by filing amended returns or making the changes in its current taxable year. If a Bank or Bank Subsidiary is under examination, LB&I examiners, in consultation with the Taxpayer, may decide whether it is appropriate to change the amount of bad debt deduction for the Eligible Debt and Eligible Debt Securities for the open taxable year(s) under examination to be consistent with this Directive or to allow the Taxpayer to file amended returns. First year adjustment If a Bank or Bank Subsidiary described in C.1 or C.2 above chooses to follow the provisions of this Directive, its first taxable year in which changes are made is the “Adjustment Year.” For the Adjustment Year, LB&I Examiners should not challenge a Bank or Bank Subsidiary’s bad debt deduction if the amount of the deduction is determined as provided in C.1, and, where applicable, in C.2 above, reduced or increased by a positive or negative adjustment, determined on December 31 of the Adjustment Year (or the last day of the Adjustment Year, if different from December 31) as set out below. The overall Adjustment Year bad debt deduction may be negative, and, depending on the size of the adjustment, may be an income item. A. Bank or Bank Subsidiary described in C.1 for Eligible Debt and Eligible Debt Securities. The first step in determining the amount of the First Year Adjustment for Eligible Debt and Eligible Debt Securities of a Bank or Bank Subsidiary described in C.1 above is to determine the amount of the bad debt deduction in the Adjustment Year as provided in C.1. The second step in determining the amount of the First Year Adjustment for Eligible Debt and Eligible Debt Securities is to determine the amount that is the difference between (i) the pre-Charge-off tax basis of the Eligible Debt or Eligible Debt Securities over (ii) the post-Charge-off book basis of the same Eligible Debt (reflecting estimated selling costs as part of the Charge-off) or post-Charge-off carrying value of the Eligible Debt Securities; the amount of this difference is increased by any portion of the Charge-off not related to credit impairment and not allowed as deductible under this Directive. The third step in determining the amount of the First Year Adjustment for Eligible Debt and Eligible Debt Securities is to determine the amount representing the difference (whether positive or negative) between the amount determined in the first step in this section D.2.A over the amount determined in the second step in this section D.2.A. This is the amount of the First Year Adjustment. In no event may the post-deduction tax basis of Eligible Debt or Eligible Debt Securities be less than the post-Charge-off book basis of the Eligible Debt or the post-Charge-off carrying value of the Eligible Debt Securities increased by any portion of the Charge-off not related to credit impairment and not allowed as deductible under this Directive. B. Bank or Bank Subsidiary described in C.2 for Eligible Debt and Eligible Debt Securities. The first step in determining the amount of the First Year Adjustment for Eligible Debt and Eligible Debt Securities of a Bank or Bank Subsidiary described in C.2 above is to determine the amount of the bad debt deduction in the Adjustment Year as provided in C.2. The second step in determining the amount of the First Year Adjustment for Eligible Debt and Eligible Debt Securities is to determine the amount that is the difference between (i) the pre-Charge-off tax basis of the Eligible Debt or Eligible Debt Securities over (ii) the post-Charge-off book basis of the same Eligible Debt (reflecting estimated selling costs as part of the Charge-off) or the post-Charge-off carrying value of the Eligible Debt Securities where the Charge-off was taken for credit-related impairment and any amount in excess of credit-related impairment pursuant to a specific order by a Bank Regulator, or pursuant to a written confirmation that a Charge-off was made in accordance with the regulatory standards and established policies of the Bank Regulator; the amount of this difference is increased by any portion of the Charge-off not related to credit impairment and not allowed as deductible under this Directive. The third step in determining the amount of the First Year Adjustment for Eligible Debt and Eligible Debt Securities is to determine the amount representing the difference (whether positive or negative) between the amount determined in the first step in this section D.2.B over the amount determined in the second step in this section D.2.B. This is the amount of the First Year Adjustment. In no event may the post-deduction tax basis of Eligible Debt or Eligible Debt Securities be less than the post-Charge-off book basis of the Eligible Debt or the post-Charge-off carrying value of the Eligible Debt Securities increased by any portion of the Charge-off not related to credit impairment, and reduced by any amount of the Charge-off in excess of credit-related impairment that was taken pursuant to a specific order or written confirmation (as described in Treas. Reg. § 1.166-2(d)(1)) by a Bank Regulator. Charge-off conformity in subsequent years For each taxable year beginning after the Adjustment Year, the amount of the bad debt deduction under § 166 for Eligible Debt and Eligible Debt Securities should be determined as provided in C.1 for Banks and Bank Subsidiaries described in section C.1, and as provided in section C.2 for Banks and Bank Subsidiaries described in section C.2. IV. Certification statement If the Taxpayer has claimed a bad debt deduction under § 166 in compliance with the provisions of this Directive, then upon examination, the Taxpayer must sign and complete the attached LB&I Directive on § 166 Bad Debt Deduction for Eligible Debt and Eligible Securities ("Certification Statement"). The Taxpayer must complete all sections of the Certification Statement, have the statement signed by an authorized individual, and provide the statement to the LB&I examiner within 30 days of a request for the Certification Statement. A separate Certification Statement may be requested for each taxable year under audit. For a consolidated Federal income tax return, a separate Certification Statement may be requested for each Bank and Bank Subsidiary applying the terms of this Directive. A LB&I examiner will consider any Taxpayer not in compliance with these requirements ineligible for this Directive and subject to regular audit procedures. The Certification Statement must be signed by an individual who is authorized to execute the Taxpayer’s Federal income tax return for the taxable year under audit, and must certify, under penalty of perjury that, for the taxable year under audit, for: 1) Taxpayers described in C.1 and C.2, A) the bad debt deduction claimed on the Taxpayer’s Federal income tax return for Eligible Debt and Eligible Debt Securities is the same amount as the amount of the credit-related impairment portion its Charge-off of Eligible Debt and the same amount of the credit-related impairment portion of its Charge-off of Eligible Debt Securities as reported on the Taxpayer’s Applicable Financial Statement for the same accounting period, subject to 2) below for Taxpayers described in C.2, and B) the post-deduction tax basis of Eligible Debt or Eligible Debt Securities is not less than the post Charge-off book basis of the same Eligible Debt or the carrying value of the same Eligible Debt Securities, as applicable under C.1 or C.2 above. 2) Taxpayers described in C.2, if the bad debt deduction claimed in the Taxpayer’s Federal income tax return is in excess of the credit-related impairment portion of the Charge-offs reported on the Taxpayer’s Applicable Financial Statement, then such excess amount was charged-off pursuant to a specific order or written confirmation (as described in Treas. Reg. § 1.166-2(d)(1)) by a Bank Regulator as reported on its Applicable Financial Statement. In addition, the Taxpayer should retain the underlying accounting documentation that would permit the LB&I examiner to reconcile the Taxpayer’s Applicable Financial Statement with the amount of its bad debt deduction for Eligible Debt and Eligible Debt Securities reported on the Taxpayer’s Federal income tax return. If a Taxpayer fails to properly and timely submit the requested documentation, then the Industry Director or his/her delegate may determine that this Directive does not apply to the Taxpayer. Footnotes: [1] Debt securities classified as trading securities are excluded from the definition of Eligible Debt Securities. [2] See 12 USC 24a (subsidiaries of national banks); 12 USC 1831a (subsidiaries of FDIC insured State banks); 12 USC 1467a(c)(1), (2), (9) (subsidiaries of federal savings associations and savings and loan holding companies). See also 12 CFR 5.34 (operating subsidiaries of national banks); 12 CFR 362.1 - 362.4 (subsidiaries of FDIC insured State banks); 12 CFR 238.53, 238.54 (subsidiaries of thrift holding companies, previously at 12 CFR 584.2); 12 CFR 239.11 (subsidiaries of thrift holding companies in mutual form, previously at 12 CFR 575.14). LB&I directive related to Section 166 deductions for eligible debt and eligible debt securities certification statement Taxpayer Name: ______________________________________ Taxpayer EIN: ________________________________________ Tax Year: ____________________________________________ Relevant Period of Applicable Financial Statement: ________________________________ Status of Taxpayer (Bank or Bank Subsidiary): _______________________________________ Taxpayer’s Bank Regulator: ______________________________________________________ (For a Bank Subsidiary, list the Owning Bank’s Regulator) Specify whether the Taxpayer is described in the Directive under: C.1, C.2, or C.3:___________ _____________________________________________________________________________ Please provide the following information for: Taxpayers described in the Directive under C.1, C.2, and C.3: A. Amount of the Charge-off reported on the Applicable Financial Statement for: 1) Eligible Debt: _______________________________________________ 2) Eligible Debt Securities: _______________________________________ B. Amount of the § 166 bad debt deduction reported on Federal income return for: 1) Eligible Debt: ________________________________________________ 2) Eligible Debt Securities:________________________________________ C. Post-Charge-off: 1) Book basis for Eligible Debt: ______________________________________ 2) Carrying value for Eligible Debt Securities:____________________________ D. Post-deduction tax basis for: 1) Eligible Debt:__________________________________________________ 2) Eligible Debt Securities:_________________________________________ Taxpayers described in the Directive under C.1 and C.2: E. The portion of the Charge-off not related to credit impairment, if any: 1) Eligible Debt:__________________________________________________ 2) Eligible Debt Securities:_________________________________________ F. The First Year Adjustment determined on December 31 of the Adjustment Year (or the last day of the Adjustment Year, if different): 1) For Eligible Debt: _______________________________________________ 2) For Eligible Debt Securities: _______________________________________ Taxpayers described in the Directive under C.2: G. The portion of the Charge-off charged-off pursuant to a specific order or written confirmation by a Bank Regulator: 1) Eligible Debt: ________________________________________________ 2) Eligible Debt Securities: ________________________________________ Certification By signing this certification statement, the taxpayer agrees to readily provide (upon request of the IRS) all relevant data and records to establish to the satisfaction of the IRS that the statements made in this certification statement are true, correct and complete. I certify, under penalties of perjury, that for the taxable year under audit, for: 1) Taxpayers described in C.1 and C.2, A) the bad debt deduction claimed on the Taxpayer’s Federal income tax return for Eligible Debt and Eligible Debt Securities is the same amount as the amount of the credit-related impairment portion its Charge-off of Eligible Debt and the same amount of the credit-related impairment portion of its Charge-off of Eligible Debt Securities as reported on the Taxpayer’s Applicable Financial Statement for the same accounting period, subject to 2) below for Taxpayers described in C.2, and B) the post-deduction tax basis of Eligible Debt or Eligible Debt Securities is not less than the post Charge-off book basis of the same Eligible Debt or the carrying value of the same Eligible Debt Securities, as applicable under C.1 or C.2 above. 2) Taxpayers described in C.2, if the bad debt deduction claimed in the Taxpayer’s Federal income tax return is in excess of the credit-related impairment portion of the Charge-offs reported on the Taxpayer’s Applicable Financial Statement, then such excess amount was charged-off pursuant to a specific order or written confirmation (as described in Treas. Reg. § 1.166-2(d)(1)) by a Bank Regulator as reported on its Applicable Financial Statement. Signature: ____________________________________________________ Title: ____________________________________________________ Date: ____________________________________________________ For corporations, the certification must be signed by an individual authorized under I.R.C. section 6062.
