The impact of bad loans on a bank's financial statements is tough enough without the internal Revenue Service compounding the problem.
First, the bad loan is a concern in terms of credit standards and customer relationship. Second, management must provide a reserve and show a financial statement expense.
Now, even the bank's tax deduction is in question. The IRS had an opportunity to clarify a difficult area of tax law - but it did not hit the mark.
The final rules, effective for taxable years ending on or after Dec. 31, 1991, allow banks and thrift institutions to conform tax and regulatory accounting for bad debts. This choice would allow loans charged off for regulatory purposes to be charged off in the same year for tax purposes.
Under the election, a debt is conclusively presumed to be worthless when it is charged off for regulatory purposes. This is known as the "conformity presumption."
Banks have actively sought book/tax conformity for bad debts for several years. This action was heightened in 1991 as banks faced a troubled economic environment characterized by increasing loan-quality pressures and significantly higher chargeoffs and nonaccrual loans.
As this downturn continues, the current disparity in the way bank and tax regulators treated chargeoffs and nonaccuruing loans has become more problematic to the banking industry.
This is due to the negative impact it has on capital and the uncertainty created for bank management because an indeterminable amount of interest expense on tax deficiencies may arise in subsequent years.
Although the February 1992 rules recognize the need for regulatory/tax conformity, the rules are not successful in alleviating or resolving the issue.
It should be emphasized that a bank's claim of a tax deduction for bad debts follows a reduction in book earnings for the debt on the bank's financial statements.
There is a natural tension, based on strong management and shareholder discipline, that works against accelerating tax deductions for loan losses.
A Fair Solution
In light of that tension and the magnitude of loan losses, a mechanism for a conclusive presumption keyed to bank regulatory standards for chargeoffs is an appropriate means of fair tax administration.
However, the mechanism employed by the February 1992 regulations, the election, will not further the policy objectives behind the promulgation of these regulations, as most banks will forgo the election for the longstanding conclusive presumption standard of Section 166.
If a financial institution elects to apply the conformity standard, it is precluded from using the conclusive presumption standard contained in the Treasury regulations.
Once an institution makes the election and meets the "express determination requirement" described below, debts that are charged off, in whole or in part, for regulatory purposes, may be conclusively presumed totally or partially worthless.
Bat-debt deductions for debts that are subject to regulatory loss-classification standards are allowed for a taxable year only to the extent that the debt is conclusively presumed worthless pursuant to the regulations.
Once an institution makes the election, it is permitted to deduct those bad debts in the year in which they are conclusively presumed worthless, in whole or in part.
If the debt is subject to the regulatory loss-classification standards, the electing institution cannot claim a bad debt deduction under the Internal Revenue Code.
To make the election, an institution must obtain, from its regulatory authority, an express statement that the institution maintains and applies loan-review and loss-classification standards that are consistent with regulatory standards.
Once the election is made, the institution must continue to obtain express determination statements for each examination by the regulator.
This issue of automatic revocation may be moot given the current attitude of the four financial institution regulators - the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Federal Reserve Board, and the Office of Thrift Supervision. These agencies are unwilling to issue the "express determination" letter described in the regulations.
Given this attitude, it is imperative that the IRS work with these agencies to temper their legal concerns.
Despite the long-sought regulatory/tax conformity that these regulations attempt to provide, negative consequences may result under this conformity rule.
For example, it appears that neither the conclusive-presumption-of-worthlessness rule nor the general rule would apply where a bank elects to have the conformity standard apply for 1991 but has charged off loans in 1991 prior to the loans being classified as loss assets.
As such, institutions that have already filed their 1991 returns with protective elections based on the proposed regulations should consider amending their returns to avoid making the election if the loss of flexibility in deducting chargeoffs under the final regulations would prove problematic.
Under the final rules, a bank examiner could will withhold the required "express determination" due to differences in loan classification for a small percentage of individual loans.
As finalized, the IRS is seeking a determination with respect to the loan-review process, which can be demonstrated by consistency with agency classification in a high percentage of individual loans but does not require absolute consistency.
Moreover, it does not appear to be in the interest of the IRS to have an examiner withholding an "express determination" and denying the availability of the conclusive presumption where the bank examiner's position is that the bank has not charged off loans as quickly as the supervisory agency would like.
It would be extremely ironic if this effort to simplify IRS audits of bank bad-debt deductions were undermined by having bank examiners withhold "express determination" letters because banks had not charged off some loans fast enough.
Comment Letters Bypassed
Several issues that were raised in comment letters to the IRS were not addressed in the final rules and their exclusion undermines the benefits that the rules do provide.
For example, the IRS rejected recommendations to expand the conformity election to allow nonbank affiliates of a bank to conform their tax and regulatory accounting methods for bad debts.
The effect of not including "or other corporations" in Treasury regulations is to exclude nonbank subsidiaries of banks, bank holding companies, and subsidiaries of bank holding companies - many of which are engaged in broad-based lending activities which have a similar need for a conclusive presumption for bad-debts deductions.
Another issues that was not addressed in the final rules concerns assets treated as debts for tax purposes. The final rules and not extend the presumption that a debt charged off for regulatory purposes is worthless for tax purposes to apply to assets treated as debts for tax purposes, even if the assets are not so treated for regulatory purposes.
Under current case law, banks can claim additional bad-debt deductions for tax purposes that are not of themselves loans. These include interest accrual reversals and loans accounted for on a cost-recovery basis.
The conclusive presumption is limited to assets classified as loss assets immediately prior to the chargeoffs. Often, however, there are instances in which a loan is moved from a doubtful classification without formally being characterized as a loss asset.
The procedure on any individual loan should not preclude the use of the conclusive presumption where the bank regulatory agency has provided an express determination that the bank's loss-classification standards on a systemwide basis are consistent with the regulatory standards of the agency.
Imposing Additional Burdens
Banks that have the benefit of the conclusive presumption under Treasury regulations, based on written confirmation of chargeoffs, are not required to classify the asset as a loss immediately before the chargeoff in order to get the tax deduction.
There is not reason to impose that additional requirement on those banks that seek to use the conclusive presumption, provided by the election.
The final regulations did not address the issue of interest on nonaccrual loans. At a time when the Bush administration is pressuring banks to make loans to lift the economy out of the recession, the current IRS position on nonaccruals is a major obstacle to this policy objective.
The IRS examination posture on nonaccrual loans effectively forces banks to prepay tax on unpaid interest income, most of which they will never receive.
It appears logical to use a conclusive presumption of uncollectibility for accrued but unpaid interest based on bank regulatory classification. As with bad debts, there is a natural tension between a bank's objectives for financial statement purposes and its tax filing position with respect to accrual of interest on loans.
Most banks will forgo the conformity election and will continue to conduct business under the existing regulations.
Ms. Ames is tax regulation counsel for the American Bankers Association Washington.