The IRS has requested comments (Notice 2013-35) regarding whether changes in bank regulatory standards and processes require an update of Treas. Reg. Sec. 1.166-2(d)(1) and (3), and whether the regulations continue to be consistent with the principles of Section 166.
Section 166(a)(1) permits a deduction for any debt that becomes worthless in a taxable year, and Section 166(a)(2) provides that Treasury may allow a deduction for debt when it is partially worthless to the extent that the debt is charged-off within the taxable year. Whether a debt has become worthless within a taxable year is determined by examining all the facts and circumstances, including objective considerations, such as the value of the collateral and the financial condition of the debtor.
Treas. Reg. Sec. 1.166-2(d)(1) and (3) provide two alternative rules that, if met, provide banks or other regulated corporations a conclusive presumption that a debt is worthless. The first alternative rule under Treas. Reg. Sec. 1.166-2(d)(1) allows for a conclusive presumption under a "specific order method," whereby a charge-off would be in response to a specific order by an appropriate federal or state authority.
The second alternative rule under Treas. Reg. Sec. 1.166-2(d)(3) provides that banks can elect the "book conformity method," which provides that loans are conclusively presumed worthless to the extent they are charged-off during a taxable year if a bank regulator issues an express determination letter stating that the bank maintains and applies standards consistent with the bank regulator.
While comments on any aspect of the specific order method and the book conformity method are welcome by the IRS, the IRS specifically requests comments in Notice 2013-35 related to the following:
- What are other corporations regulated by a federal or state entity that should be covered by revised conclusive presumption rules?
- Should the specific order method and the book conformity method be modified to reflect the changes in bank regulatory standards since the regulations were adopted?
- Are current bank regulatory standards under GAAP sufficiently similar to Section 166's worthlessness standards to formulate revised rules?
- Should the specific order method and the book conformity method be replaced with a single rule, or should more than one rule be retained?
- What process should be required to verify that the regulated entity applied appropriate regulatory standards in taking a charge-off?
- Are there limits that should be placed on the timing of a deduction under Section 166 that may vary from the time when the regulatory standards mandate a charge-off?
- Are there impediments to the uniform application of a loss standard across different GAAP debt classifications?
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