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Proposed regulations would update the conclusive presumption rules for bad debts of eligible financial entities
January 2024
In brief
What happened?
Treasury and the IRS recently issued proposed regulations under Section 166 that would provide guidance regarding whether a debt instrument is conclusively presumed to be worthless for Federal income tax purposes for eligible entities, primarily banks and insurance companies. Under the proposed rules, regulated financial companies and members of regulated financial groups would have the option to use a new method of accounting for Federal income tax purposes that generally follows book charge-offs for recognizing tax losses from partially worthless or wholly worthless debts.
Why is it relevant?
The proposed regulations would update the “book conformity method” currently applicable to banks for determining when a debt instrument is conclusively presumed to be worthless. If finalized, banks, as well as other regulated financial companies or members of a regulated financial group, would be allowed to account for worthless debts using the Allowance Charge-off Method, which generally would allow these taxpayers to conclusively presume that charge-offs of debt instruments reported on their financial statements satisfy the Section 166 requirements for a bad debt deduction. The proposed regulations, if adopted, generally would apply to charge-offs made by a regulated financial company or a member of a regulated financial group on its applicable financial statement (AFS) that occur in tax years ending on or after the date that final regulations are published in the Federal Register, although these taxpayers may choose to apply the final regulations to charge-offs made on its AFS that occur in tax years ending on or after December 28, 2023, and before the date of publication of final regulations.
Actions to consider
As proposed, these rules appear to require nearly all taxpayers operating in the banking and insurance industries wishing to secure a conclusive presumption of worthlessness of debt instruments to file a request to change to the Allowance Charge-off Method with the IRS National Office. Affected entities should consider submitting comments by February 26, 2024.
Observation: Currently, eligible entities would be required to use the nonautomatic procedures to file a method change, but the government has indicated that it intends to issue guidance allowing taxpayers to use the automatic procedures and to be able to early adopt for the 2023 tax year.
In detail
Background
In general, Section 166 allows a deduction for any debt that becomes worthless within the tax year and a portion of a partially worthless debt that does not exceed the amount charged-off within the tax year. Whether a debt is worthless in whole or in part generally is a facts-and-circumstances determination that depends on all pertinent evidence, including the value of any collateral securing the debt and the financial condition of the debtor.
The current Section 166 regulations, promulgated in 1993, provide two alternative conclusive presumptions of worthlessness for bad debts of a bank or other corporation that is subject to supervision either by federal authorities or by state authorities maintaining substantially equivalent standards (Conclusive Presumption Regulations). Because regulatory changes and other hurdles made it difficult for taxpayers to meet either presumption, the IRS Large Business and International Division (LB&I) issued two industry directives to address the significant compliance burden imposed by the Conclusive Presumption Regulations on banks and insurance companies. A 2012 directive generally allowed insurance companies to use the regulatory accounting standard for tax purposes in limited circumstances, regardless of whether that standard was precisely the same as the tax standard for worthlessness under Section 166. Under a 2014 directive, a bank or bank subsidiary generally was permitted to claim loss deductions for partial and wholly worthless debts for charge-offs (related to credit impairment) reported for US generally accepted accounting principles (US GAAP) and regulatory purposes.
In response to significant changes in the regulatory standards applicable to banks for loan charge-offs, Treasury and the IRS requested comments in Notice 2013-35 on whether (1) changes that have occurred in bank regulatory standards and processes since adoption of the Conclusive Presumption Regulations required amendment of those regulations, (2) application of the Conclusive Presumption Regulations was consistent with the principles of Section 166, and (3) other types of entities or industries should be permitted to apply a conclusive presumption of worthlessness to determine their loss deductions for partial and wholly worthless debts.
Observation: Although the industry directives reduced controversy on this issue, this regulation package has been included on the IRS Priority Guidance Plan for over a decade. Increased levels of bad debts arising from the pandemic and implementation of the current expected credit loss (CECL) model under Accounting Standards Update 2016-13 only heightened the need for new rules that address the book and tax issues surrounding partially or wholly worthless debts.
New conclusive presumption rules
Citing sufficiently similar standards for regulatory, accounting, and Federal income tax purposes, Treasury and the IRS have proposed rules on the conclusive presumption of worthlessness under Section 166 for eligible financial companies. Similar to recent legislative and regulatory provisions that use applicable financial statement (AFS) amounts to determine tax treatment, the proposed regulations generally would allow these taxpayers to rely on their AFS in determining their deductions for losses from partially or wholly worthless debts.
The proposed regulations provide that debt held by an eligible financial company would be conclusively presumed to be worthless, in whole or in part, to the extent that the amount of any charge-off determined under a new method, the Allowance Charge-off Method, is claimed as a Section 166 deduction for the tax year in which the charge-off takes place. Under the proposed regulations, a charge-off is defined as an accounting entry or set of accounting entries for a tax year that reduces the basis of the debt when the debt is recorded in whole or in part as a loss asset on the AFS. For a regulated insurance company whose AFS is its annual statement, the proposed regulations would define the term charge-off as 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) in the annual statement. The proposed regulations also would provide relief for taxpayers claiming bad debt deductions in years subsequent to the year of charge-off.
Observation: Stakeholders should consider submitting comment letters and consider addressing the charge-off definition in the proposed regulations. The definition set forth in the proposed regulations appears to retain the loss asset classification requirement in the current regulations, but the “loss asset” definition has been dropped. Because a “loss asset” is a banking regulatory concept, it is unclear how retention of the term might impact the application of the conclusive presumption of worthlessness to non-bank entities. For example, some IRS examination teams have used loss asset classification documentation as a means to rebut the Conclusive Presumption Regulations, making it difficult for taxpayers seeking certainty and reduced controversy burdens.
Observation: Foreign insurance companies that elect to be treated as domestic insurance companies under Section 953(d) would not be included in the definition of a regulated insurance company (see below) under the proposed regulations. Such companies are not required by their local regulator to prepare financial statements in accordance with the National Association of Insurance Commissioners (NAIC) standards. However, Subchapter L generally requires that the NAIC statutory accounting principles must be followed in determining taxable income.
Affected entities
The proposed regulations generally would apply to “regulated financial companies,” defined to include entities that are regulated by insurance regulators and various Federal regulators, including the Federal Housing Finance Agency and the Farm Credit Administration, and members of “regulated financial groups,” if certain requirements are met.
Method change
Under the proposed regulations, a change to the Allowance Charge-off Method is a change in method of accounting that requires IRS consent. Upon promulgation of final rules, the preamble to the proposed regulations states that eligible financial companies would be required to use the Allowance Charge-off Method in order to secure a conclusive presumption of worthlessness; otherwise, these taxpayers would not be entitled to a conclusive presumption of worthlessness and would be required to use the specific charge-off method – i.e., facts and circumstances to determine worthlessness – for deducting bad debts.
Observation: Taxpayers that change to the Allowance Charge-off Method prescribed in the proposed regulations generally would be required to use the nonautomatic procedures and file a Form 3115 by the end of the tax year for which the change is to be effective, unless the IRS prescribes automatic procedures. Some taxpayers that currently use the book conformity method in the current regulations may not have any Section 481(a) adjustment to report, however.
Comments requested
In addition to the specific request for comments on how best to transition from the existing regulations to the proposed regulations, Treasury and the IRS also ask for comments on all aspects of the proposed regulations, including the following issues:
- Whether and, if so, how the proposed regulations should be modified to apply to credit unions or US branches of foreign banks;
- Whether prudential or other regulators of non-bank systemically important financial institutions (SIFIs) apply regulatory standards for worthlessness that are sufficiently close to tax standards to determine whether the rules provided in the proposed regulations should apply to those SIFIs;
- Whether and how the proposed regulations should be modified to include a reinsurance entity that regularly issues reinsurance contracts only to related persons, provided the risks reinsured are regularly those of persons other than related persons;
- Whether financial statements that are prepared in accordance with standards set out by the NAIC and filed with state insurance regulatory authorities should be assigned different levels of priority and, more generally, on the definition of a financial statement in the insurance industry context; and
- Whether to extend tax conformity to US GAAP post-impairment accounting for recoveries.
Written or electronic comments and requests for a public hearing must be received by February 26, 2024.
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