ACLI Update: Proposed Regulations Under Section 166 on the Conclusive Presumption of Worthlessness
By Sarah Lashley and Regina Rose
TAXING TIMES, November 2024
On Dec. 28, 2023, Treasury and the IRS issued proposed regulations[1] determining when a debt that is charged off for financial statement purposes is “conclusively presumed” to be worthless (wholly or in part) under section 166. The proposed regulations are important to the insurance industry and other industries that hold substantial debt investments because they determine when the portion of a debt that is conclusively presumed to be worthless can be deducted for federal income tax purposes.
The proposed regulations would update existing regulations and modify guidance provided to the insurance industry in an Industry Director’s Directive (IDD) in 2012 (Insurance IDD). Like the Insurance IDD, the proposed regulations would not apply to worthless securities under section 165(g)(2)(C). Additionally, the proposed regulations would exclude foreign-domiciled insurance companies and insurance companies that engage only in intragroup reinsurance. In another departure from the insurance IDD, which follows SSAP accounting, the proposed regulations require insurance companies that prepare GAAP financial statements for nontax purposes to use GAAP accounting standards to determine when a debt is worthless.
In response to comments from ACLI and others, the IRS issued separate guidance in Rev. Proc. 2024-30, permitting taxpayers to adopt the methodology in the proposed regulations automatically on a cut-off basis, stipulating that a taxpayer cannot take a deduction for any amount of debt previously deducted as worthless under its former method of accounting.
ACLI, in coordination with the American Property Casualty Insurance Association (APCIA), the National Association of Mutual Insurance Companies (NAMIC), and the Reinsurance Association of America (RAA) (the Joint Insurance Trades) submitted comments on the proposed regulations in February and are in continuing dialogue with Treasury and the IRS on the proposed regulations.
Background
As a result of the 2008 financial crisis, many insurance companies sustained substantial losses on mortgage-backed securities (MBS). Many of these losses were recorded on companies’ financial statements in accordance with Statement of Statutory Accounting Principles No. 43 – Revised Loan-Backed and Structured Securities (SSAP 43R). SSAP 43R outlines the statutory accounting requirements for insurance companies to charge off declines in the value of loan-backed, structured, or mortgage-referenced securities due to other-than-temporary impairment (OTTI).
For federal income tax purposes, section 166(a)(2) provides Treasury and the IRS with authority to permit taxpayers to deduct the portion of a debt that becomes partially worthless in the year it is “charged off” for financial statement purposes. A debt is typically considered to have been “charged off” when the taxpayer has eliminated the amount of a debt, or the part of a debt that is worthless, from its books.[2] This elimination may occur, for example, through recognition of a realized loss or a charge to a company’s statement of operations.
For banks and other regulated corporations (including insurance companies), a debt is conclusively presumed to be worthless in the year it is fully or partially charged off either to comply with a specific regulatory order or under the regulator’s established policies if the regulator later confirms the charge off would have been subject to such a specific order during an audit.[3]
In addition, banks (but not insurance companies) can elect to conclusively presume a debt is worthless if the bank’s regulator has determined that the bank maintains and applies loan loss classification standards that are consistent with the regulator’s standards.[4]
2012 IRS Large Business & International Division Directive
In the case of insurance companies, before the issuance of the Insurance IDD and under the existing guidance in 2008, it was not clear if amounts charged off under SSAP 43R could be conclusively presumed to be worthless. Considering the substantial losses many insurers incurred, tax certainty was needed.
To obtain certainty, a coalition joined by several insurance trade associations, including ACLI, requested guidance under the IRS Industry Issue Resolution program in 2011. After consultation with the coalition, the IRS issued the Insurance IDD, permitting insurance companies to deduct portions of loan-backed and structured securities charged off in accordance with SSAP 43R.[5]
Notice 2013-35, Request for Comments on Existing Regulations
A year after it released the Insurance IDD, the IRS published a notice requesting comments on the regulations under section 166.[6] ACLI joined several other insurance industry trade associations to provide comments encouraging the IRS to update the regulations and to adopt the principles in the Insurance IDD as a model for future regulations.[7]
Proposed Regulations
The proposed regulations issued in December 2023 would update section 1.166-2(d), to provide for the “Allowance Charge-off” method under which debts as defined under section 166 and held by a “Regulated Financial Company” or member of a “Regulated Financial Group” are conclusively presumed to be worthless to the extent that they are charged off on the taxpayer’s Applicable Financial Statement (AFS).
The proposed regulations also state that the adoption of the Allowance Charge-off Method would be a change in method of accounting.
As mentioned previously, the proposed regulations do not apply to section 165(g)(2)(C) securities. While section 582 provides some exceptions, section 166(e) explains that section 166 does not apply to securities defined under section 165(g)(2)(C). These securities include most bonds and other evidence of indebtedness, issued by corporations and governments. In comments, the Joint Insurance Trades recommended that insurance companies be permitted to use the standards in the Allowance Charge-off Method to determine when a security is wholly worthless under section 165(g)(2)(C).
Regulated Financial Companies
The proposed regulations state that the definition of a Regulated Financial Company includes several types of financial institutions that are primarily lending and depository institutions as well as “Regulated Insurance Companies.” The proposed regulations define a Regulated Insurance Company as a corporation that:
- Qualifies as a life or property and casualty insurance company for federal tax purposes;
- Is domiciled or organized under the laws of one of the 50 states or Washington, DC (States);
- Is licensed, authorized, or regulated by one or more states to sell insurance, reinsurance, or annuity contracts to unrelated persons; and
- Regularly issues (or is liable for) insurance, reinsurance, or annuity contracts with unrelated persons.
Many major U.S. and multinational insurance groups include entities that are not domiciled or organized under U.S. law such as “section 953(d) companies” and Controlled Foreign Corporations (CFCs). The proposed regulations thus exclude foreign insurance companies, including section 953(d) companies that make a federal tax election to be taxed as a U.S. company[8] and Controlled Foreign Corporations (CFCs). CFCs calculate taxable income based on the same U.S. tax principles as if they were domestic corporations for which U.S. shareholders are liable for the shareholders’ proportionate share of what the CFC’s income would have been if it were a U.S. company.
Many U.S. domestic captives of U.S. insurance groups only engage in intragroup reinsurance. Reinsurance is routinely used to manage risks and surplus of members of the same group. Whether entering into reinsurance contracts with related or unrelated insurance companies, the business and accounting issues are the same and the reinsurer is a regulated company.
The Joint Insurance Trades’ comment letter requests that the definition of a Regulated Insurance Company be expanded to include section 953(d) companies, CFCs, and companies that only engage in intragroup reinsurance, noting that these companies are subject to the same or similar requirements as U.S. companies that insure unrelated persons.
Regulated Financial Groups
The proposed regulations define a Regulated Financial Group as one or more chains of corporations connected through stock ownership and for which the common parent corporation is a Regulated Financial Company. Additionally, the common parent cannot be a real estate investment trust or regulated investment company. The Joint Insurance Trades have requested that Treasury and the IRS clarify whether a company that would not otherwise qualify as a Regulated Insurance Company would be permitted to adopt the Allowance Charge-off Method as a member of a Regulated Financial Group.
Applicable Financial Statement
Under the proposed regulations, a hierarchy applies to determine which financial statement is used as a taxpayer’s AFS. The preamble to the proposed regulations explains that the hierarchy is intended to be similar to the hierarchies in the recently enacted Corporate Alternative Minimum Tax and section 451(b).[9] Under the proposed regulations, an insurance company’s AFS is generally a U.S. GAAP financial statement if the company prepares a GAAP financial statement for a substantial nontax purpose.[10] If an insurance company does not prepare a GAAP financial statement for a substantial nontax purpose, then a company’s statutory financial statement that is filed with the state insurance regulator has the next greatest priority.[11]
The Joint Insurance Trades’ comments recommended that the final regulations prioritize statutory financial statements over GAAP financial statements, in part because of the different purposes the CAMT, section 451(b)(3), and section 166 serve. Sections 56A and 451(b)(3), which prioritize GAAP accounting are intended to ensure income is accounted for when it has been reported to shareholders, creditors, and others. Alternatively, the determination of worthlessness and, in particular, the conclusive presumption of worthlessness accorded to book accounting, depends on the consistent application of objective standards that are relied upon by a regulator and approximate the tax standards for worthlessness. In addition, the Internal Revenue Code requires insurance companies to use the NAIC annual statement as the starting point for computing taxable income, all states regulate insurance companies based on statutory capital determined under NAIC accounting standards, not GAAP capital, and virtually all domestic insurers file an NAIC annual statement with their regulators while not all insurance companies prepare GAAP financial statements
Adoption of the Allowance Charge-off Method
The proposed regulations require taxpayers to follow procedures applicable for changes in accounting methods to adopt the Allowance Charge-off Method, but did not provide additional detail. In July, the IRS issued Rev. Proc. 2024-20. The Revenue Procedure indicates that taxpayers should adopt the Allowance Charge-off Method automatically, without having to request permission from the IRS and that the method is adopted on a cut-off basis, meaning that the Allowance Charge-off Method does not apply to any charge offs occurring before the taxpayer adopts the Allowance Charge-off Method. Additionally, taxpayers are not permitted to deduct charge offs deducted under a prior method for a second time under the Allowance Charge-off Method. Because the IRS issued the revenue procedure permitting automatic adoption of the Allowance Charge-off Method in July, taxpayers may elect to adopt the proposed regulations for the 2023 tax year.
The Joint Insurance Trades are continuing to engage with Treasury and the IRS on the application of the proposed regulations to the insurance industry.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or the respective authors’ employers.
Sarah Lashley is assistant vice president, Tax Policy, for the American Council of Life Insurers and may be reached at sarahlashley@acli.com.
Regina Rose is senior vice president, Tax Policy, for the American Council of Life Insurers and may be reached at reginarose@acli.com.
Endnotes
[1] REG-121010-17, 88 FR 89636.
[2] Fairless v. Commr., 67 F.2d 475 (8th Cir. 1933).
[5] LB&I Directive Related to Partial Worthlessness Deduction for Eligible Securities Reported by Insurance Companies, LB&I Control No: LB&I-4-0712-009 (July 30, 2012).
[6] Notice 2013-35, 2013-24 I.R.B. 1240.
[7] Subsequently in 2014, the Service issued an IDD (the “Banking IDD”), addressing bad debt deductions under section 166 by banks and bank subsidiaries. See LB&I Directive Related to § 166 Deductions for Eligible Debt and Eligible Debt Securities, LB&I-04-10114-008 (October 24, 2014).
[8] Internal Revenue Code section 953(d)
[9] See 56A(b). The CAMT requires that taxpayers pay a minimum tax equal to 15% of the income reported on their financial statement. Section 451(b) generally requires that taxpayers include an item in taxable income no later than the tax year in which the item is reported on the taxpayer’s financial statement.