Editor: Michael Dell, CPA
Special Industries
The IRS issued a Large Business & International (LB&I) Industry Director Directive (IDD) (LB&I-4-0712-009) addressing partial worthlessness deductions under Sec. 166(a)(2) taken by insurance companies for eligible loans. The directive instructs LB&I examiners to not challenge an insurance company’s partial worthlessness deduction under Sec. 166(a)(2) if the amount deducted matches the amount of credit-related impairment charged off by the insurance company under National Association of Insurance Commissioners (NAIC) Statement of Statutory Accounting Principles (SSAP) 43R for eligible loans as reported on the company’s annual statement.
While the IDD is applicable only if the insurance company meets certain requirements, it directs field examiners not to challenge the company’s partial bad debt deductions for any open year. Although not stated explicitly, this audit protection extends even to years prior to the year of adoption of the terms of the IDD.
Background
Sec. 166(a)(2) indicates that when satisfied that a debt is recoverable only in part, the IRS may allow a partial deduction on the debt, in an amount not in excess of the part charged off within the tax year.
State law typically requires insurance companies to file annual statements with insurance regulatory authorities using accounting principles set out in the NAIC’s Accounting Practices and Procedures Manual. SSAP 43R establishes accounting rules that taxpayers must follow if their loan-backed or other structured securities are impaired and subject to charge-off for all reporting periods ending on or after Sept. 30, 2009.
The issue of an insurance company’s ability to use the presumptive conclusion of worthlessness under Regs. Sec. 1.166-2(d) or how it should otherwise deal with partial worthlessness deductions was submitted to the IRS’s Industry Issue Resolution Program (IIR) and was accepted in 2011. It would appear that this IDD is a response to the accepted IIR request.
Requirements Under the IDD
If an insurance company complies with the IDD, LB&I examiners should not challenge an insurance company’s partial worthlessness deduction for eligible debt.
First-year adjustment: For the first tax year in which the insurance company applies the IDD (the adjustment year), the company’s Sec. 166(a)(2) deduction will generally be equal to the company’s SSAP 43R credit-related impairment charge-offs for the same items, except that the company increases or reduces its deduction by a positive or negative adjustment. This adjustment is determined on Dec. 31 of the adjustment year and is the difference between (1) the tax basis of the eligible loans over (2) the statutory carrying value of the same items increased by any noncredit-related portion of any charge-off that may not be deducted under the IDD.
Thus, a positive adjustment will occur to the extent the company’s tax deductions for partial worthlessness for years prior to the adjustment year are less than its SSAP 43R credit-related impairment charge-offs, and a negative adjustment will occur to the extent the tax deductions were greater than the book charge-offs. The tax basis of the eligible items may never be less than the post-charge-off statutory carrying value under SSAP 43R. The adjustment year partial worthlessness deduction may be negative and, therefore, becomes an income item. The adjustment year cannot be earlier than the 2009 tax year, nor can it be later than the 2012 tax year.
Subsequent years: Similarly, for tax years beginning after the adjustment year, the insurance company’s Sec. 166(a)(2) deduction is equal to the company’s SSAP 43R credit-related impairment charge-offs for the same items as reported on the company’s annual statement. The tax basis of the eligible items may not be less than the post-charge-off statutory carrying value under SSAP 43R as adjusted for noncredit impairment. The IDD does not provide a “true-up” mechanism for differences between tax basis and book carrying value for any year after the adjustment year, such as those that could arise as a result of noncredit-related impairments. Nor does the IDD provide any guidance on whether tax accruals on impaired debt (e.g., of interest or original interest discount) will conform to book accruals, or on how to handle situations in which recoveries on an impaired item exceed the impaired value of the debt.
Conformity: If the insurance company elects to apply the IDD, it must apply it to the SSAP 43R credit-related impairment charge-offs of all eligible debt that is partially worthless.
Certification: Upon examination by the IRS, an insurance company that has used its SSAP 43R credit-related impairment charge-offs of eligible debt items reported on its annual statement as the amount of a Sec. 166(a)(2) deduction must have an authorized individual within the company sign and complete an “LB&I Directive on Sec. 166 Partial Worthlessness Deduction Certification Statement.”
Recordkeeping: Any insurance company that falls within the IDD should retain the underlying accounting documentation that would permit the LB&I examiner to reconcile the company’s annual statement with its partial worthlessness deductions reported on the federal income tax return. Failure to timely provide such documentation may result in a determination that the IDD is inapplicable.
Implementation
For an insurance company that is already under examination on this issue, LB&I examiners, in consultation with the insurance company, will decide whether the most appropriate means of implementation is to change the amount of the partial worthlessness deduction for the tax years under examination or to allow an amended income tax return.
An insurance company that is not yet under IRS examination may choose to implement the IDD either by filing amended federal income tax returns or by applying the directive to the current tax year. The company must attach a statement to the tax return for the adjustment year, whether it is an amended return or a timely filed original return, indicating the use of the IDD.
Implications
While the IDD has a number of uncertainties, it is a welcome resolution for insurance companies on a widespread tax issue. The IDD does not explicitly rely on the presumptive conclusions available under Regs. Sec. 1.166-2(d) or address the issue of whether these presumptions apply to insurance companies. Rather, it provides a safe harbor for insurance companies regarding partial worthlessness by providing a deduction equal to the credit-related portion of the impairment in an amount that is consistent with SSAP 43R. Thus, this IDD offers an efficient manner of resolving many partial-worthlessness issues that are either currently under examination or likely would be in the future.
The IDD does not allow an insurance company a partial worthlessness deduction for any portion of its SSAP 43R adjustment related to noncredit-related impairments. SSAP 43R takes into account numerous factors in determining the amount of an impairment adjustment for statutory financial reporting purposes. While most, if not all, of the SSAP 43R adjustment is likely to be related to credit impairment factors, the underlying valuations should contain a breakout between credit and noncredit-related impairment factors. Depending on the size of the noncredit-related impairments and the level of documentation supporting the split available to the taxpayer, this breakout may be a time-consuming exercise both internally and in dealing with the IRS.
Sec. 166 deductions are not available for debt evidenced by a security under Sec. 165(g)(2)(C), and, thus, the IDD does not apply. The determination of whether a debt instrument is a security or a loan requires analysis of the facts and circumstances. This can be time-consuming for taxpayers that have a large portfolio of investments.
The IDD is not considered an official pronouncement of law and affects neither the Code nor its regulations. It does, however, effectively give taxpayers audit protection.
As the IDD does not rely on Regs. Sec. 1.166-2(d), the rules governing its implementation are different from those applicable to banks relying on this regulation. Banks that have made a conformity election under Regs. Sec. 1.166-2(d)(3) have specific requirements that differ from the IDD. In addition, banks attempting to use Regs. Sec. 1.166-2(d)(1) still have a requirement for a letter from the banking regulator containing certain language, which can be difficult to obtain.
A version of this item appeared in Ernst & Young’s International Tax Alert.
EditorNotes
Michael Dell is a partner with Ernst & Young LLP in Washington, D.C.
For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
