Thurs 345-515-loan workouts

Loan Workouts

David A. Thornton, PartnerCrowe Horwath LLP, New York, NY

James D. Slivanya, Senior ManagerCrowe Horwath LLP, New York, NY

James W. Ahern, Tax Director-Capital MarketsSynchrony Financial, Stamford, CT

Agenda

Overview of Loan Modification Rules

Loan Workouts After a §382 Ownership Change

Bad Debt Tracking Challenges Under Business Combination Accounting

Foreclosure Issues

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Reg. §1.1001-3 provides rules defining when the modification of a debt instrument constitutes a taxable exchange Both lenders and borrowers are potentially impacted by

these rules (borrowers can have taxable CODI) Significant modifications result in a deemed taxable

exchange of the “old” debt for the “new” (modified) debt For a debt that is not publicly traded, the taxable gain/

loss is determined using the issue price of the new debt This issue price is the stated principal amount of the new

debt if the new debt has adequate stated interest

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Reg. §1.166-3(a)(3) provides for a deemed partial charge-off when taxable gain is recognized under Reg. §1.1001-1(a) as a result of a significant modification andthe taxpayer has claimed a deduction for partial worthlessness of the debt in any prior taxable year

The amount of the deemed charge-off is the amount, if any, by which the tax basis in the modified debt exceeds the greater of the FMV of the modified debt or the amount of the debt on the taxpayer’s books reduced by a specific allowance for loan losses

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Modification Defined A modification includes any alteration of a legal right or

obligation of the issuer or holder A modification by operation of the terms of the debt instrument

is not a modification under Code §1001, with the following exceptions:• A change in the obligor or nature (e.g., recourse or non-recourse)

of an instrument;• An alteration that results in an instrument that is not debt for federal

income tax purposes; AND• Certain alterations resulting from an exercise of an option, unless

the option is unilateral and does not result in a deferral or reduction in any scheduled payment of interest or principal

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Significant Modification Defined General Rule – A modification is significant if, based on all

the facts and circumstances, the legal rights or obligations being changed, and the degree to which they are being changed, are economically significant

Besides the general rule, there are also specific rules for particular types of modifications

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Significant Modification Defined Change in yield – A change in yield will constitute a

significant modification if the change is more than the greater of:• 25 basis points (i.e., 0.25%), OR• 5% of the original yield of the debt instrument• “Yield” – Annual rate of return on an investment based on all

principal and interest payments to be received• See Reg. §1.001-3(e)(2)(iii) for additional discussion regarding the

yield of the modified instrument• A reduction in the principal amount due on a debt instrument is a

significant modification where the resulting change in yield is more than the thresholds as described above

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Significant Modification Defined Extension of maturity – A change in the timing of

payments may be a significant modification based upon the facts and circumstances, including:• Length of the deferral• Original term of the instrument• Amount of payments that are deferred• Time period between modification and actual deferral of payments• Safe harbor – Not a significant modification if all payments deferred

are unconditionally payable at the end of the deferral period and the deferral period is no greater than the lesser of five years or 50 percent of the original term of the debt instrument

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Significant Modification Defined Change in obligor – A change in obligor on a recourse

note is generally a significant modification, except:1) If the change in obligor results from a transaction to which Sec.

381(a) applies (i.e., tax-free reorganizations), and the transaction does not result in a change in “payment expectations”

2) If the change in obligor results from a transaction in which the new obligor acquires substantially all of the assets of the original obligor, and the transaction does not result in a change in payment expectations

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Significant Modification Defined Change in obligor – Other rules:

1) An election to treat a qualified stock purchase of an issuer’s stock as an asset acquisition does not result in the substitution of a new obligor

2) The substitution of a new obligor on non-recourse debt is not a significant modification

3) The addition or deletion of a co-obligor generally is not a significant modification unless the addition or deletion results in a change in payment expectations

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Significant Modification Defined Change in collateral – A change in collateral for a

recourse debt instrument is generally a significant modification if the modification results in a change in payment expectations

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Significant Modification Defined Change in payment priority – A change in priority of

payment of the debt relative to other obligations of the issuer will result in a significant modification if it results in a change in payment expectations• For non-recourse debt, a substitution of collateral is treated as a

significant modification unless the collateral is fungible or otherwise of a type where the specific units pledged are unimportant

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Significant Modification Defined Payment expectations – A change in payment

expectations will occur if, as a result of the transaction:• The issuer is substantially more able to meet the payment

obligations under the debt instrument, OR• The issuer’s ability to meet the payment obligations under the debt

instrument is substantially impaired

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Significant Modification Defined Other Changes:

• A change in the nature of a debt instrument to something that is not debt for federal income tax purposes is a significant modification

• A change in the recourse nature of a debt obligation (i.e., from non-recourse to recourse or vice versa) is a significant modification

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Example:Facts Assume Bank A holds a loan with a principal amount of

$100,000 The loan bears stated interest at 8% There is no OID with the loan, and the loan was initially

due 3 years from the date of issue The loan is past due by several months, and Bank A has

ceased to accrue interest for book and tax purposes The cumulative past-due interest on the note is equal to

$15,000

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Example - continued:Facts (cont.)

Bank A has taken a partial charge-off for both book and tax purposes in the amount of $20,000 against the loan principal Accordingly, Bank A has a tax basis in the loan equal to

$80,000 The loan is renegotiated with the following terms:

• Interest rate reduced to 7%• Accrued, but unpaid, interest added to principal• Principal is due 5 years from date of renegotiation As a result, the modified note has a new stated principal

amount of $115,000

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Example - continued:Result The change in interest rate from 8% to 7% is a significant

modification Additionally, the extension in maturity from 3 years to 5 years

exceeds 50 percent of the original maturity Accordingly, the renegotiation is a taxable event Bank A will recognize a taxable gain equal to the difference

between its tax basis in the loan and the new stated principal amount, or $35,000 However, Bank A may be allowed a deemed partial charge-off

deduction of up to $35,000 under Reg. §1.166-3(a)(3) if certain conditions are met

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If a Net Unrealized Built-in Loss (“NUBIL”) exists upon an ownership change, targeted tax planning may be necessary to mitigate the impact of the annual limitation on post-ownership change bad debt deductions

NUBIL exists if the tax basis of total assets exceeds the fair market value of total assets immediately before the ownership change AND the NUBIL exceeds a deminimis threshold

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NUBIL is not an issue unless the total NUBIL immediately before the ownership change exceeds the lesser of• $10 million; or• 15% of the fair market value of the total assets immediately

before the ownership change, exclusive of cash and marketable securities whose tax basis does not differ substantially from fair market value

If the NUBIL exceeds this threshold, then recognized built-in losses (“RBIL”) with respect to the pre-ownership change assets within prescribed time periods after the ownership change date are subject to the annual §382 limitation

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RBILs in excess of the annual limitation are carried forward for 20 years, thus according them a treatment similar to pre-change NOLs

The general rule for treatment of post-ownership change losses on NUBIL assets is that losses recognized from the sale or other liquidation of the asset within 5 years of the ownership change date are RBIL to the extent of the excess of tax basis over fair market value of the asset immediately prior to the ownership change

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However, special rules apply to bad debt deductions resulting from charge-offs of loans IRS Notice 2003-65 provides two alternative approaches

for determining the RBIL from assets after an ownership change:• The §1374 Approach; and • The §338 Approach The §1374 approach contains a simplifying assumption

with respect to bad debt charge-offs that may be very appealing from a tax planning perspective and may also be administratively convenient to apply

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The §1374 approach:• Assumes that the entire amount of any bad debt deduction

claimed within the first year after an ownership change is RBIL, regardless of the excess of tax basis over the fair market value of the loan immediately before the ownership change

• Bad debt deductions claimed after the first anniversary of the ownership change date are not treated as RBIL

• Planning strategies that effectively delay bad debt deductions until after the first anniversary of the ownership change will enable the deduction to escape the §382 annual limitation

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The §1374 approach – EXAMPLE• Assume Bank has experienced an ownership change (with

NUBIL) and incurs the following charge-off on a particular loan:• $1,000,000 partial charge-off within the first year after the

ownership change on a loan whose tax basis exceeded fair market value by $800,000 immediately before the ownership change

• If the $1 million partial charge-off is claimed as a current deduction, it will be treated as RBIL and subject to the §382 annual limitation

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Tax Planning Point:• While IRC §166 does not permit the deferral of bad debt

deductions for wholly-worthless loans beyond the year in which they become wholly-worthless, bad debt deductions for partially-worthless loans may be deferred and claimed when the loan becomes wholly worthless or is otherwise settled

• By deferring bad debt deductions for partial-charge-offs until later years, banks may be able to mitigate the impact of the §382 annual limitation on RBIL from loan charge-offs

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Tax Planning Point (Continued):• However, in order to effectively implement this planning

strategy, the bank must have the flexibility to defer the tax deduction for partial charge-offs

• Such a deferral is a departure from book-tax conformity and, consequently, the deferral strategy is not possible if the bank has the §166 bad debt conformity election in place

• For this reason, many banks facing a potential NUBIL limitation from a pending ownership change either avoid adopting the bad debt conformity election or revoke it prior to the year in which the ownership change occurs

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The §338 approach:• Applies no special rule to bad debt deductions, so the

general rule applies• Bad debt deductions claimed within the first 5 years after

an ownership change are RBIL, but only to the extent of the excess of tax basis over the fair market value of the loan immediately before the ownership change

• Delaying partial bad debt deductions may also work under the §338 approach, but they would need to be deferred until after the fifth anniversary of the ownership change date

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The §338 approach – EXAMPLE• Assume Bank has experienced an ownership change (with

NUBIL) and incurs the following charge-off on a particular loan:• $1,000,000 partial charge-off during the fourth year after

the ownership change on a loan whose tax basis exceed fair market value by $800,000 immediately before the ownership change

• If the $1 million of partial charge-off is claimed as a deduction in the fourth year after the ownership change; $800,000 of this deduction will be treated as RBIL and subject to the §382 annual limitation; the excess $200,000 is not considered to be a built-in loss

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Note that the special 1-year rule under the §1374 approach only applies to bad debt deductions

Losses from the sale or other taxable disposition of loans are RBIL, up to the amount of the original day-1 NUBIL, if they occur within 5 years of the ownership change date under both the §1374 and §338 approaches (i.e. the general rule applies)• Limited to the aggregate recognized NUBIL

Charge-offs claimed immediately before, or commensurate with, a loan sale should be scrutinized

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Alternative Minimum Tax Issue:• If the NUBIL as of the ownership change date exceeds the

de minimis threshold amount, IRC §56(g)(4)(G) requires that the tax basis of each asset is adjusted to its fair market value immediately before the ownership change for Adjusted Current Earnings (“ACE”) purposes

• Thus, the ACE calculation will have to be determined using a tax basis in each asset that is different than the basis for regular tax purposes

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Alternative Minimum Tax Issue (Continued):• Given the NUBIL circumstances that cause this basis re-

determination, the 75% ACE adjustment is likely to be a (potentially substantial) increase to AMT taxable income

• This tracking is necessary for the entire holding period of these assets, not just during the applicable RBIL windows

• AMT paid as a result of this adjustment is credited to future periods, but can be an expense issue for a bank with a full valuation allowance against its deferred tax assets (i.e., any AMT paid is ultimately recorded through expense in this circumstance)

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Bad Debt Tracking Challenges Under Business Combination

Accounting

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When business combination accounting is applied to a transaction that results in carryover of tax basis under IRC §381, the ability to track future bad debt deductions can be challenging

For book purposes, the acquired loans are recorded at fair value (“FV”) and any reduction to FV due to credit concerns is recorded as part of business combination accounting

When the application of business combination accounting results in an excess of tax basis over book basis in acquired loans, this excess represents future tax deductions that must be properly tracked under IRC §166 and/or §1001

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EXAMPLE:• Bank A acquires Bank B via tax-free reorganization• Bank B’s loan portfolio has a book and tax basis of $800

million immediately before the acquisition• For book purposes, Bank A writes this loan portfolio down to

a FV of $750 million through business combination accounting

• This creates a $50 million excess of tax basis over book basis in the acquired loan pool

• How / when will this excess tax basis be recognized in taxable income?

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Bad debts deductions claimed after the acquisition are still governed by the principles of IRC §166

However, the tax basis in the acquired loans now differs from the book basis, so additional analysis is necessary over and above what is done for book purposes

Matching the bad debt deductions to charge-offs recorded through the Allowance for Loan Losses will not be sufficient as the excess tax basis will never be recorded as a charge-off for book purposes

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Failure to properly analyze the excess tax basis could result in a permanent loss of the deduction (i.e. bank fails to claim a deduction for a wholly-worthless loan in a year that is now closed under the statute of limitations)

In most cases, the excess tax basis in loans will appear as a deferred tax asset in the tax footnote to the financial statements – i.e., a good place to look for the presence of this issue

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Business combination accounting scenarios highlight a key shortcoming in the effectiveness of the bad debt conformity election (IRS recently issued Notice 2013-35 to re-examine the overall effectiveness of the election) When the bad debt conformity election was developed, the

target’s allowance for loan losses carried over in business combination accounting and therefore bad debts in the acquired loan pool were often sufficiently captured in the post-acquisition Allowance for Loan Losses activity However, the conformity election has failed to keep pace

with developments in GAAP accounting for credit quality issues under business combination accounting scenarios

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GAAP now requires FV adjustments to the target’s loans at acquisition (including FV adjustments resulting from credit quality concerns) to be recorded through business combination accounting The accounting for the collectability of these FV credit

marks will generally not run through the Allowance for Loan Losses as “loss assets” Thus, any bad debt deduction of the excess of tax basis

in loans over book basis created by these marks likely falls outside the purview of the bad debt conformity election

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In recent years, loan acquisitions from failed banks under FDIC receivership have posed significant challenges to tracking post-acquisition bad debts and general loan accounting

While these transactions are typically structured as taxable asset purchases, they commonly result in book-tax basis differences in acquired loans due to the application of IRC §597

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Many of these transactions involve federal financial assistance in the form of “loss sharing agreements” under which losses on certain covered loans are indemnified by the FDIC up to a certain amount Under these circumstances, IRC §597 requires these

loans to be recorded with a tax basis of not less than the maximum indemnified amount Given that the maximum indemnified amount often

exceeds the FV recorded for book purposes, a substantial excess of tax basis over book basis in the acquired loans often results

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This creates difficulties beyond merely tracking the excess tax basis over book basis for purposes of claiming bad debt deductions For book purposes, any interest accrued is likely being

calculated on the recorded balance of the loan, not on the contractual loan terms as required for tax purposes In addition, there will be differences in the amount and

methodology employed to calculate the accretion of the loan purchase discount because this amount is calculated on a different loan basis for book and tax

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Tracking mechanisms seen in the marketplace Specialized software

• Benefits:• Precision• Automatic calculations• Detailed support for the schedule M adjustments

• Drawbacks:• Price• Output is only as good / reliable as data input

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Tracking mechanisms seen in the marketplace Manual calculations (i.e. spreadsheets)

• Benefits:• No additional software to purchase• Complete control over the calculations / assumptions

• Drawbacks:• Time consuming• Calculations are complex, so often relies upon

assumptions• May not be practical if there are too many loans to track

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Tracking mechanisms seen in the marketplace Deferred Tax Asset / Liability Approach

• Benefits:• No additional software to purchase• Typically focuses on calculating the year end tax basis of loans

(under the MTM method or otherwise) and comparing that tax basis to book basis to arrive at the ending book-tax basis difference

• The M adjustment is measured as simply the change in the beginning and ending book-tax basis difference

• Specific interest, market discount, charge-off, and gain/loss adjustments are presumed to fall into place

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Tracking mechanisms seen in the marketplace Deferred Tax Asset / Liability Approach

• Drawbacks:• Precision may be lower than with other methods• Often lacks detailed support for specific schedule M

calculations because the M is driven from proof of the balance sheet position. However, this is often done for other types of M adjustments – i.e. deferred loan fees, loan servicing, etc.

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ForeclosureIssues

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Foreclosure Issues

• Regulations under §1.166-6 govern the procedural steps to be recognized for tax purposes when a bank forecloses on property pledged as loan collateral

• According to §1.166-6(a), a bad debt deduction is allowable for the excess (if any) of the loan balance over the proceeds from the sale of foreclosed property, assuming the unsatisfied balance of the loan is determined to be worthless

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Foreclosure Issues

• According to §1.166-6(b), a taxable gain or loss must be recognized for the difference between the amount bid for the property at foreclosure and the fair market value of the property, if purchased by the lender at foreclosure

• As a result of this taxable event, the collateral is taken into possession with a tax basis equal to the fair market value of such property

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Foreclosure Issues

Foreclosed property is required to be taken into possession with a tax basis equal to its FMV [see Reg. §1.166-6(b)]

Once OREO is taken into possession, subsequent write-downs to FMV are not deductible for tax purposes until the property is sold

Under examination, there is often disagreement about what the FMV of the OREO was at the foreclosure date based upon the timing of appraisals

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Foreclosure Issues

For post-foreclosure appraisals:• IRS may argue that declines in value occurred after the

foreclosure date, rendering the decline a non-deductible post-foreclosure write-down

• IRS may argue that an appraised value in excess of the foreclosure date recorded value means the charge-off was overstated (i.e. the increased value was there at the foreclosure date)

Ideally, appraisals dated on, or very close to, the foreclosure date should be used to support the amount of the charge-off claimed upon foreclosure

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Foreclosure Issues

If the value of the property is in dispute, the taxable income or loss determined on the foreclosure date may be an issue under examination IRS may challenge taxpayers who reduce the FMV of

OREO at foreclosure by anticipated selling costs - see Bank of Kirksville, case – taxpayer favorable but IRS has indicted they will not follow the decision If the taxpayer is under the bad debt conformity election

and the bad debt deduction claimed matches the portion of the loan classified as a loss asset for regulatory purposes, the deduction should be protected

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Foreclosure Issues

In recent years, there had been a coordinated effort by the IRS to require capitalization of carrying costs on non-income producing OREO property

The IRS argument was based upon an assertion that the OREO property is “inventory” acquired for resale and, consequently, §263A requires all carrying costs to be capitalized to the basis of the individual properties (which would permit them to be deducted upon disposal of the applicable properties)

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Foreclosure Issues

Numerous taxpayers conceded this issue under examination because the IRS would not settle the issue in Appeals However, in March 2013, the IRS released a

memorandum (AM 2013-001) indicating a reversal of their position on this issue The IRS officially abandoned this position with the

issuance of Revenue Procedure 2014-16 in January of 2014 This pronouncement reverses the capitalization initiative

and allows taxpayers who had capitalized these costs to correct the issue with an automatic change in tax accounting method (IRS form 3115)

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Questions?

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The information provided herein is educational in nature and is based on authorities that are subject to change.

You should contact your tax adviser regarding application of the information provided to your specific facts and circumstances.

Crowe Horwath LLP is an independent member of Crowe Horwath International, a Swiss verein. Each member firm of Crowe Horwath International is a separate and independent legal entity. Crowe Horwath LLP and its affiliates are not responsible or liable for any acts or omissions of Crowe Horwath International or any other member of Crowe Horwath International and specifically disclaim any and all responsibility or liability for acts or omissions of Crowe Horwath International or any other Crowe Horwath International member. Accountancy services in Kansas and North Carolina are rendered by Crowe Chizek LLP, which is not a member of Crowe Horwath International. © 2014 Crowe Horwath LLP

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Thurs 345-515-loan workouts