Regs Clarify Rules on Presumption of Worthlessness of Banks' Bad Debts

 [4830-01]

 ACTION: Temporary regulations.

 SUMMARY: This document contains temporary regulations that clarify the scope of the express determination that is required under section 1.166-2(d)(3) in order for a bank to elect to use a method of accounting that conforms tax accounting for bad debts to regulatory accounting by providing a conclusive presumption of worthlessness for debts charged off for regulatory purposes. The temporary regulations affect banks that have made or intend to make an election under section 1.166-2(d)(3). The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations cross-referenced in the notice of proposed rulemaking in the proposed rules section of this issue of the Federal Register. EFFECTIVE DATE: These temporary regulations are effective October 1, 1992, and apply to taxable years ending on or after December 31, 1991.

 FOR FURTHER INFORMATION CONTACT: Bernita L. Thigpen, 202-622-4016 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

Under section 1.166-2(d)(3), a bank may elect to use a method of accounting that allows the bank to conform its tax accounting for bad debts with its regulatory accounting (the "conformity election"), and thereby deduct for tax purposes those debts that are classified as loss assets and charged off for regulatory purposes. Generally, pursuant to section 1.166-2(d)(3)(iii)(D), the election is effective only if the bank's supervisory authority (as defined in that section) expressly determines that the bank maintains and applies loan review and loss classification standards that are consistent with those standards of the supervisory authority. Pursuant to Rev. Proc. 92-18, 1992-10 I.R.B. 24, the express determination is in the form of a uniform letter that is provided to banks by the supervisory authorities.

 To afford the supervisory authorities time to develop and disseminate procedures for issuing express determination letters, section 1.166-2(d)(3)(iii)(E) of the regulations provides a transition rule which allows a bank to make the conformity election prior to its first examination in which it could obtain an express determination letter. If, in the first such examination, the bank does not obtain an express determination letter, pursuant to section 1.166-2(d)(3)(iv), the bank's conformity election is revoked automatically effective beginning with the taxable year of the election.

Explanation of Provisions

 The requirement that a bank's supervisory authority expressly determine that the bank maintains and applies loan review and loss classification standards consistent with regulatory standards was intended to ensure that the bank properly identifies, classifies, and charges off debts that become loss assets for regulatory purposes. After the final regulations were published, concerns were raised that a supervisory authority's express determination could be interpreted as exceeding the intended scope of the express determination by, for example, indicating regulatory approval of the adequacy of a bank's general allowances for loan and lease losses notwithstanding the explicit language to the contrary in the express determination letter. To alleviate these concerns, section 1.166-2(d)(3) is being amended to require that a bank's supervisory authority expressly determine that the bank maintains and applies "loan loss classification" standards, rather than "loan review and loss classification standards" that are consistent with regulatory standards. See section 1.166-2T(d)(3)(iii)(D). The revised language does not alter the intended scope of the express determination requirement.

 In addition, because the supervisory authorities may have conducted a number of examinations relating to a bank's loan review process after December 31, 1991, and may not have issued express determination letters, under the regulations any examined bank that made the conformity election for the 1991 taxable year may have its election automatically revoked. Accordingly, the transition rules in section 1.166-2(d)(3) are being amended to allow a bank to make the conformity election without in express determination letter until its first examination (involving the loan review process) that is after the date of these amendments. See section 1.166-2T(d)(3)(iii)(E) and (d)(3)(iv)(C)(2) Need For Temporary Regulations

 The provisions contained in this Treasury decision are needed immediately to afford banks the benefits of the conformity rules in section 1.166-2(d)(3). The provisions merely clarify what was initially intended by the regulations and, although not substantive in nature, change the content of the express determination that is required for a valid conformity election. In addition, the provisions extend the transitional period to prevent the automatic revocation under section 1.166-2(d)(3)(iv) of any election made by a bank in reliance on the regulations for its 1991 taxable year. Therefore, it is found impracticable and contrary to the public interest to issue this Treasury decision with prior notice under section 553(b) of title 5 of the United States Code.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Bernita L. Thigpen, Office of the Assistant Chief Counsel (Financial Institutions & Products), Internal Revenue Service. However, other personnel from the Service and Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR 1.161-1 THROUGH 1.194-4

 Income taxes, Reporting and recordkeeping requirements.

Treasury Decision 8441

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.166-2 is amended by revising paragraphs (d)(3)(iii)(D), (d)(3)(iii)(E) and (d)(3)(iv)(C)(2) to read as follow:

SECTION 1.166-2 Evidence of worthlessness.

* * * * *

(d) * * *

(3) * * *

(iii) * * *

(D) [Reserved]. See section 1.166-2T(d)(3)(iii)(D).

(E) [Reserved]. See section 1.166-2T(d)(3)(iii)(E).

(iv) * * *

(C) * * *

(2) [Reserved]. See section 1.166-2T(d)(3)(iv)(C)(2).

* * * * *

Par. 3. Section 1.166-2T is added to read as follows:

SECTION 1.166-2T EVIDENCE OF WORTHLESSNESS (TEMPORARY).

(a) through (d)(3)(iii)(C) [Reserved].

(d)(3)(iii)(D) EXPRESS DETERMINATION REQUIREMENT. In connection with its most recent examination involving the bank's loan review process, the bank's supervisory authority must have made an express determination (in accordance with any applicable administrative procedure prescribed hereunder) that the bank maintains and applies loan loss classification standards that are consistent with the regulatory standards of that supervisory authority. For purposes of this paragraph (d)(3)(iii)(D), the supervisory authority of a bank is the "appropriate Federal banking agency" for the bank, as that term is defined in 12 U.S.C. 1813(q) or, in the case of an institution in the Farm Credit System, the Farm Credit Administration.

(E) TRANSITION PERIOD ELECTION. For taxable years ending before completion of the first examination of the bank by its supervisory authority (as defined in paragraph (d)(3)(iii)(D) of this section) that is after October 1, 1992, and that involves the bank's loan review process, the statement or Form 3115 filed by the bank must include a declaration that the bank maintains and applies loan loss classification standards that are consistent with the regulatory standards of that supervisory authority. A bank that makes this declaration is deemed to satisfy the express determination requirement of paragraph (d)(3)(iii)(D) of this section for those years, even though an express determination has not yet been made.

(iv)(A) through (C)(1) [Reserved].

(iv)(C)(2) YEAR OF REVOCATION. If a bank makes the conformity election under the transition rules of paragraph (d)(3)(iii)(E) of this section and does not obtain the express determination in connection with the first examination involving the bank's loan review process that is after October 1, 1992, the election is revoked as of the beginning of the taxable year of the election or, if later, the earliest taxable year for which tax may be assessed. In other cases in which a bank does not obtain an express determination in connection with an examination of its loan review process, the election is revoked as of the beginning of the taxable year that includes the date as of which the supervisory authority conducts the examination even if the examination is completed in the following taxable year.