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By Bill Pauls and Michael Miles, Sutherland
Asbill & Brennan LLP
On July 30,
2012, the IRS Large Business & International (LB&I) Division issued
guidelines intended to reduce the controversy associated with partial
worthlessness deductions claimed by insurance companies. In brief, the
guidelines, which were released as an industry director directive (the
Directive), instruct IRS examiners not to challenge partial worthlessness
deductions claimed by an insurance company under § 166(a)(2)* if (i) they are
limited to the credit-related portion of the impairment charge-off (not the
full fair market value) and (ii) they comport with the National Association of
Insurance Commissioners (NAIC) Statement of Statutory Accounting Principle
(SSAP) 43R accounting rules. Importantly, although the Directive does not
discuss whether the conclusive presumption of worthlessness standard of Treas.
Reg. § 1.166-2(d) applies to insurance companies, the Directive, in effect,
applies that standard to the credit-related impairment portion of the
respect to a debt that does not constitute a security (as defined in §
165(g)(2)(C)), the rules concerning the determination of worthlessness are set
forth in § 166. In general, § 166(a)(2) provides that the IRS may allow a
deduction with respect to a debt in an amount that is not in excess of the part
of the debt that is charged off within the taxable year "when satisfied that a
debt is recoverable only in part." Stated differently, § 166(a)(2) generally
provides that partial worthlessness deductions may be allowed to be claimed
with respect to a non-security debt.
general matter, insurance companies are required by state law to file annual
statements using the accounting principles set out in the NAIC Accounting
Practices and Procedures Manual (NAIC Accounting Manual). SSAP 43R, which is
found in the NAIC Accounting Manual, provides the statutory accounting rules
that must be followed when loan-backed and other structured securities are
impaired and subject to charge-off. SSAP 43R became effective on September 30,
2009, and applies for all reporting periods ending on or after September 30,
insurance companies reported large partial worthlessness deductions under §
166(a)(2) on account of investment losses suffered during the credit crisis of
2008 and 2009 and the corresponding impairment charge-offs required for
statutory accounting purposes by SSAP 43R. More recently, these partial
worthlessness deductions ripened into proposed adjustments from IRS examiners,
as attempts to verify compliance with bad debt deduction requirements strained
resources on both sides of the issue. Up to now, the IRS and insurance
companies have not had much success in resolving the amounts of the
worthlessness deductions, largely because they have been pursuing different
avenues for substantiation of the deductions. For the most part, the IRS has
examined the details of substantiation under general standards for
worthlessness, whereas insurance companies principally have relied on the
conclusive presumption set forth in Treas. Reg. § 1.166-2(d) for regulated
industries in support of the conclusion that the worthlessness standard has
been met. For this reason and others, the insurance industry and the IRS agreed
to try to resolve the problem through the IRS's Industry Issue Resolution
Directive generally provides that LB&I examiners should not challenge a
partial worthlessness deduction claimed by an insurance company under §
166(a)(2) for the amount of the SSAP 43R credit- related impairment charge-offs
of eligible securities as reported on its annual statement. If an insurance
company claims a partial worthlessness deduction for eligible securities, but
does not meet the requirements of the Directive, regular audit procedures will
apply. For the Directive to apply, an insurance company must use the SSAP 43R
credit-related impairment charge-off amount for all eligible securities that
are partially worthless.
purposes of the Directive, the following definitions apply:
"Annual statement" means the annual statement approved by the NAIC that
an insurance company is required to file with insurance regulatory authorities
of a state.
"Eligible securities" means investments in loan-backed and structured
securities within the scope of SSAP 43R, subject to § 166, and not subject to §
165(g)(2)(C), including real estate mortgage investment conduit (REMIC) regular
"Insurance company" means a life insurance company (as defined in §
816(a)) or a non-life insurance company (as defined in § 831(c)) that is
subject to regulation as an insurance company, that is subject to taxation
under Subchapter L of the Code, and that files an annual statement for which a
state regulator has examination authority.
Sutherland Observation: In light of these definitions, it
does not appear that partial worthlessness deductions claimed by section 953(d)
companies are covered by the Directive.
first taxable year in which an insurance company applies the provisions of the Directive
(the Adjustment Year), which can be no earlier than the company's 2009 and no
later than the company's 2012 taxable years, the company's partial
worthlessness deduction for eligible securities will be the same amount as the
company's SSAP 43R credit-related impairment charge-offs for the same
securities as reported on its annual statement, except that the company must
make an adjustment to account for the difference between (i) the tax basis of
the eligible securities and (ii) the statutory carrying value of the same
securities (as increased by any non-credit-related portion of any charge-off
not allowed as deductible under the Directive). For taxable years beginning
after the Adjustment Year, the insurance company's partial worthlessness
deduction for eligible securities will be the same amount as the company's SSAP
43R credit-related impairment charge-offs for the same securities as reported
on its annual statement. Assuming that an insurance company complies with these
mechanisms for the determination of its partial worthlessness deductions, the
Directive states that LB&I examiners should not challenge the company's
partial worthlessness deductions for eligible securities as reported on its
federal income tax returns for all open years ending before the Adjustment
insurance company is under examination and wants to apply the provisions of the
Directive, the company generally will have two options: (i) change the amount
of the company's partial worthlessness deduction for eligible securities for
the taxable year(s) under examination to be consistent with the Directive or
(ii) file amended federal income tax returns. If an insurance company is not
under examination, it may choose to implement the provisions of the Directive either
by filing amended federal income tax returns or by applying the Directive to
the company's current taxable year. In either case, the insurance company must
attach a statement to its federal income tax return for the Adjustment Year
(either an amended return or the current taxable year return) stating that it
is implementing the provisions of the Directive beginning in that Adjustment
Year (an Implementation Statement).
the case of a consolidated return, the Directive indicates that a separate
Implementation Statement should be attached for each insurance company that is
a member of the consolidated group filing that return.
examination, if an insurance company has used its SSAP 43R credit-related
impairment charge-offs as the amount of a partial worthlessness deduction, the
company must complete a certification statement (a copy of which is accessible
by clicking here)
and provide that statement to the LB&I examiner within 30 days of a request
for the statement. Per the Directive, an LB&I examiner will consider any
insurance company not in compliance with this requirement ineligible for the
Directive and subject to regular audit procedures.
companies should retain the underlying accounting documentation that would
permit the LB&I examiner to reconcile the companies' annual statements with
any partial worthlessness deductions claimed.
otherwise specified, all "section" and "§" references are to the Internal
Revenue Code of 1986, as amended (the Code), and all "Treas. Reg. §" references
are to the Treasury regulations promulgated thereunder, all as in effect as of
the date of this document.
Sutherland Asbill & Brennan LLP. All Rights Reserved.
This communication is
for general informational purposes only and is not intended to constitute legal
advice or a recommended course of action in any given situation. This communication
is not intended to be, and should not be, relied upon by the recipient in
making decisions of a legal nature with respect to the issues discussed herein.
The recipient is encouraged to consult independent counsel before making any
decisions or taking any action concerning the matters in this communication.
This communication does not create an attorney-client relationship between
Sutherland and the recipient.
have any questions about this Legal Alert, please feel free to contact any of
the attorneys listed below or the Sutherland attorney with whom you regularly
Michael R. Miles
William R. Pauls
© 2012 Sutherland Asbill & Brennan LLP. All
Rights Reserved. This communication is for general informational purposes only
and is not intended to constitute legal advice or a recommended course of
action in any given situation. This communication is not intended to be, and
should not be, relied upon by the recipient in making decisions of a legal
nature with respect to the issues discussed herein. The recipient is encouraged
to consult independent counsel before making any decisions or taking any action
concerning the matters in this communication. This communication does not
create an attorney-client relationship between Sutherland and the recipient.
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