RULING CONSIDERS INTERNATIONAL LOAN CHARGE-OFFS.

Rev. Rul. 92-14

ISSUE

Is the portion of an international loan held by a bank that is subject to an allocated transfer risk reserve under federal banking regulations treated as a debt charge-off in obedience to a specific order of the bank's supervisory authority for purposes of the conclusive presumptions under section 1.166-2(d)(1) and section 1.166-2(d)(3) of the Income Tax Regulations?

FACTS

Section 905(a) of the International Lending Supervision Act of 1983, Pub. L. No. 98-181, 97 Stat. 1153 (1983), directs the federal banking agencies (Comptroller of the Currency, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation) to promulgate regulations requiring banks to establish special transfer risk reserves against certain international loans when the agencies determine that the quality of those assets has been impaired by a protracted inability of borrowers in the foreign country concerned to make payments on their external indebtedness. The regulations promulgated by the federal banking agencies require a bank to establish an allocated transfer risk reserve (ATRR) for an international loan found by the agencies to be affected by transfer risk problems as described above. 12 C.F.R. 20.8, 211.43, 351.1.

Under the banking regulations, "transfer risk" means the possibility that a loan cannot be serviced in the currency of payment because of a lack of, or restraints on the availability of, needed foreign exchange in the country of the obligor. At least annually, the federal banking agencies determine jointly 1) which international loans subject to transfer risk warrant establishment of an ATRR, 2) the amount of the ATRR for the specified loans, and 3) whether an ATRR established for a specified loan may be reduced.

Factors considered by the agencies in determining whether an ATRR is required for particular international loans include whether 1) the obligors have failed to make full interest payments on external indebtedness, 2) the obligors have failed to comply with the terms of any restructured indebtedness, or 3) a foreign country has failed to comply with any International Monetary Fund or other suitable adjustment program, or whether no definite prospects exist for the orderly restoration of debt service.

In determining what portion of the loan is subject to the ATRR, the agencies consider 1) the length of time the quality of the loan has been impaired, 2) recent actions taken to restore debt service capability, 3) prospects for restored loan quality, and 4) such other factors as the agencies may consider relevant to the quality of the loan.

The regulations promulgated by the federal banking agencies further provide that, for financial accounting purposes, a bank shall account for an ATRR separately from the allowance for possible loan losses. The ATRR must be established for each loan subject to the ATRR in the percentage amount specified by the agencies. However, the regulations provide that a bank need not establish an ATRR if it charges off, in the period in which the ATRR is required, the requisite amount against the allowance for possible loan losses.

LAW AND ANALYSIS

Section 166(a) of the Internal Revenue Code generally allows as a deduction any debt that becomes worthless within the taxable year.

Section 1.166-2(d)(1) of the regulations provides that if a corporation subject to supervision by federal authorities, or state authorities maintaining substantially equivalent standards, charges off a debt in whole or in part in obedience to the specific orders of the authorities, then the debt shall, to the extent charged off within the taxable year, be conclusively presumed to have become worthless in that year.

In lieu of section 1.166-2(d)(1), section 1.166-2(d)(3) of the regulations provides that, if a bank meets the express determination requirement of paragraph (d)(3)(iii)(D) of that section and makes a conformity election, debts charged off, in whole or in part, for regulatory purposes during a taxable year are conclusively presumed to have become worthless, in whole or in part, during that year. The conclusive presumption is only available if the bank's charge-off of bad debts 1) results from a specific order of the bank's supervisory authority, or 2) corresponds to the bank's classification of the debt, in whole or in part, as a loss asset pursuant to the Uniform Agreement on the Classification of Assets and Securities held by Banks, or similar guidance.

Section 585 of the Code and the regulations thereunder provide rules permitting a deduction for a reasonable addition to a reserve for bad debts in the case of losses on the loans of certain banks in lieu of any deduction under section 166(a).

In Rev. Rul. 84-94, 1984-1 C.B. 34, the Service recognized that, in accordance with the regulations promulgated by the federal banking agencies, a bank with certain international loans affected by transfer risk will be directed by the agencies to establish on its books a separate ATRR in a specified percentage, unless the bank charges off the requisite portion of each loan against the allowance for possible loan losses. The ruling states that the Service will view either accounting treatment as the charge-off of a debt in whole or in part pursuant to the specific orders of the federal authorities within the meaning of section 1.166-2(d)(1) of the regulations.

Because Rev. Rul. 84-94 was published prior to the promulgation of section 1.166-2(d)(3) of the regulations, it does not address ATRRs established by banks that make a conformity election under that section. Section 1.166-2(d)(3) and section 1.166-2(d)(1) both provide for a conclusive presumption of worthlessness where a bank is ordered to charge off all or part of a loan by its supervisory authority. The portion of a loan subject to an ATRR should be treated the same for purposes of both sections.

HOLDING

The portion of an international loan held by a bank that is subject to an ATRR (because the bank would be directed by its supervisory authority to charge this portion to an ATRR if the bank did not charge it against the bank's allowance for possible loan losses) is treated as a debt charge-off in obedience to a specific order of the bank's supervisory authority for purposes of the conclusive presumptions under section 1.166-2(d)(1) and section 1.166-2(d)(3) of the regulations. In the case of a bank that accounts for its bad debts on the reserve method pursuant to section 585 of the Code, this portion of the loan is excluded from the bank's loans outstanding for purposes of determining a reasonable addition to the bank's reserve.

EFFECT ON OTHER REVENUE RULINGS

Revenue Ruling 84-94 is amplified and superseded.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Carol A. Schwartz and Bernita L. Thigpen of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Ms. Schwartz or Ms. Thigpen on (202) 566-3297 (not a toll-free call).