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By Peter H. Winslow, Esq.
Scribner, Hall & Thompson, Washington, DC
The recent turmoil in the financial markets has raised interest in the tax rules covering nonperforming assets. For insurance companies, a significant issue has emerged as to whether their book write-downs of distressed interests in Real Estate Mortgage Investment Conduits (REMICs) qualify for partial bad debt deductions under §166.1
For tax purposes, there are two general types of write-downs for principal of debt instruments. The first is a worthless security deduction under §165(g). That section allows a capital loss for the basis of the debt instrument if it is a "security" issued by a corporation. A security is defined as a stock, subscription right or bond, debenture, note or certificate or other evidence of indebtedness with interest coupons or in registered form. Regs. §5f.103-1(c)(1) defines registered form. According to the regulation, an obligation is in registered form if the debt may be transferred only through a book entry system maintained by the issuer or if the obligation is registered with the issuer as to both principal and any stated interest and any transfer of the obligation may be effected only by surrender of the old instrument and either the reissuance by the issuer of the old instrument to the new holder or the issuance by the issuer of a new instrument to the new holder.
Classification of the investment as a security is a disadvantage for achieving a tax write-down because the security must be wholly worthless to qualify for a loss. Regs. §1.165-4(a) provides that a deduction cannot be taken for a mere decline in value of a security. A security is worthless if a reasonable person in the exercise of sound business judgment would regard collection as hopeless. The investment is not worthless if there is a liquidation value or the possibility of future recovery.
The second general type of write-down for an impaired asset is a bad debt deduction under §166 applicable to worthless debts that are not a securities subject to §165(g). The taxpayer may claim a bad debt deduction for partial worthlessness or can wait until the asset is wholly worthless and claim a deduction at that time. To claim a deduction for a partial bad debt, however, the taxpayer must charge off the value on its books and records. This differs from a deduction based on total worthlessness, which must be taken during the year the asset became wholly worthless regardless of the year it was charged off for book purposes.
A regular interest in a REMIC entitles the certificate holder to a portion of the cash flows from underlying residential mortgages packaged as securities by financial institutions. Regular interest REMICs have experienced dramatic declines in value as the result of the mortgage crisis and insurance companies have recorded impairments for accounting purposes. Many taxpayers assume erroneously that the contingent nature of the cash flows from REMIC regular interests suggests that they would be classified as securities and ineligible for bad debt treatment. However, for federal income tax purposes, REMIC regular interests are treated as debt instruments under §860B.2 Importantly, moreover, they typically are issued by a trust rather than a corporation. This means that REMIC regular interests should not be treated as "securities" for purposes of the bad debt rules.3 Thus, book impairments of REMIC regular interests potentially may be eligible for a partial bad debt deduction under §166 if the impairment satisfies the partial worthlessness standard for tax purposes. Taxpayers may be able to demonstrate that a book write-off, or at least a portion of the write-off, represents a worthless portion of the instrument under the tax standard (i.e., that collection of that portion is hopeless). To the extent the amount of partial worthlessness of a REMIC regular interest is difficult to prove, insurance companies may contend that the conclusive presumption of worthlessness under Regs. §1.166-2(d) applies.
Regs. §1.166-2(d)(1) provides for a conclusive presumption of worthlessness for a write-down of debt instruments in the amount required by federal or state regulators. The regulation states:
(d) Banks and other regulated corporations. – (1) Worthlessness presumed in year of charge-off. If a bank or other corporation which is subject to supervision by Federal authorities, or by State authorities maintaining substantially equivalent standards, charges off a debt in whole or in part, either – (i) In obedience to the specific orders of such authorities, or (ii) In accordance with established policies of such authorities, and, upon their first audit of the bank or other corporation subsequent to the charge-off, such authorities confirm in writing that the charge-off would have been subject to such specific orders if the audit had been made on the date of the charge-off.
Under the predecessor of Regs. §1.166-2(d)(1), there was a split of authority over whether a charge-off order of a regulatory authority created a conclusive presumption of worthlessness or merely a rebuttable presumption. Compare Citizens Nat'l Bank of Orange v. Comr., 74 F.2d 604 (4th Cir. 1935), and Second Nat'l Bank of Philadelphia v. Comr., 33 B.T.A. 750 (1935), acq., XV-1 C.B. 21. To resolve the conflict, the Treasury Department amended the regulations in 1936 to conform with the Fourth Circuit's interpretation that the presumption is conclusive. T.D. 4633, XV-1 C.B. 118. In Rev. Rul. 80-180, 1980-2 C.B. 66, the IRS concluded that the purpose of Regs. §1.166-2(d)(1) is to ensure that a taxpayer receives fair and consistent treatment when dealing with the IRS and another branch of the government. The ruling cited U.S. v. Bechman, 104 F.2d 260 (3d Cir. 1939), which, along with Citizens Nat'l Bank of Orange, are two cases that articulate the rationale for the regulation. In the latter case, the court stated:Here we have a case in which one branch of the government can compel the taxpayer to take an action with regard to its securities which, when taken, will not be recognized by another branch of the government. This is not fair to the taxpayer. There should be at least some semblance of coordination between the several branches of the government in dealing with a taxpayer. Id.at 605.
For the conclusive presumption to apply, the insurance company's state regulators must maintain substantially similar standards as federal regulators. The critical criterion in making this determination seems to be whether the state regulators have the authority to compel the charge-off on the financial statements of the company in a manner similar to federal regulators of banks. Rev. Rul. 79-214, 1979-2 C.B. 90. Because state insurance departments have broad authority to impose financial accounting methods so that the public and policyholders in their states will be protected, a strong argument can be made that Regs. §1.166-2(d)(1) applies to insurance companies. In addition, state insurance regulators' bad debt charge-off standards for REMICs also seem sufficiently similar to federal bank charge-off standards to qualify for the conclusive presumption.
In September 2009, the National Association of Insurance Commissioners adopted Statement of Statutory Accounting Principles 43R (SSAP 43R), providing guidance for the impairment of loan-backed and structured securities. SSAP 43R requires a charge against current statutory earnings for other-than-temporary impairments that are credit-related to the extent the discounted expected cash flows are less than book value. It requires a further impairment to fair value and a charge against current earnings if the company has the intent to sell the instrument or does not have the ability to hold it until recovery. In the latter situation, SSAP 43R requires insurance companies to disclose the amount of the impairment to fair value that is interest-related. The federal bank standard for bad debt is set forth in the Uniform Agreement on the Classification of Assets and Appraisal of Securities Held by Banks and Thrifts. In general, like SSAP 43R, the Uniform Agreement requires a write-down of impaired debt to an amount based on projected cash flows that the bank or thrift expects to collect. These standards appear to be sufficiently similar to qualify insurance companies for the conclusive presumption of worthlessness for regular interests in REMICs.
At the time of drafting this Commentary, the IRS has not adopted a position as to whether the conclusive presumption applies to insurance companies. There is no published IRS guidance or caselaw that addresses the issue. In one unreported case, however, the Court of Federal Claims held that the presumption applied to a write-off of a reinsurance receivable, based on findings that the Ohio Department of Insurance order was in writing and that Ohio's standards for bad debts were similar to the Federal banking standard.4 Because this has become a recurring issue in insurance company audits, we can expect further developments and possibly IRS guidance soon.
For more information, in BNA's Tax Management Portfolios, see McCoy, 538 T.M., Bad Debts, and in Tax Practice Series, see ¶2360, Bad Debts.
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