2 9 15am - loan workouts


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2 9 15am - loan workouts

  1. 1. EDITS Bill Reilly – Advisory Board Member (not listed as AB member) Lori St. Marie - Advisory Board Member (not listed as AB member) Clark Wulf – remove the “,” after Tax Director REMOVE Dean Uminski
  2. 2. Loan Workouts Michael Blinder – Deloitte Tax LLP Craig Gibian – Deloitte Tax LLP John Kinsella – US Bancorp 2
  3. 3. Agenda • • • • Loan Modifications Bad Debt Deduction Foreclosure Property Expenses Mortgage Securitizations 3
  4. 4. Loan Modifications
  5. 5. Loan Modifications - Overview • It is often advantageous for both the borrower and the lender to modify the terms of a loan prior to default. • These modifications, often referred to as “amend and extend,” can have important tax consequences for both the borrower and the lender. • The threshold question is whether the modification is treated as a “significant modification” under the relevant rules, thereby causing a deemed exchange of the original loan for a loan with the modified terms. 5
  6. 6. Loan Modifications – Overview (cont.) • From the lender’s perspective, a deemed exchange may cause the current recognition of gain or loss. While the result is generally a timing difference, certain entities must also consider character issues, including the possibility of recognizing a capital loss and the future inclusion of ordinary income. • From the borrower’s perspective, a deemed exchange may cause the recognition of cancellation of debt income (“CODI”). Similar to the result for lenders, this generally results in a timing difference for tax purposes by accelerating income, but can lead to a permanent difference for borrowers in certain circumstances. 6
  7. 7. Loan Modifications – Overview (cont.) • The calculation of gain or loss for lenders and the determination of CODI for borrowers is based upon the “issue price” of the loan issued in the deemed exchange; this in turn depends upon whether the loan is considered to be “publicly traded” for tax purposes. • Treasury regulations finalized last year expanded the definition of publicly traded property, but with one important exception that narrows the definition in limited circumstances. 7
  8. 8. Loan Modifications – Overview (cont.) • This discussion covers three key concepts: • When does a modification of the terms of a loan trigger a deemed exchange for tax purposes? • What are the tax consequences to lenders and borrowers upon a deemed exchange? • How does the expanded definition of publicly traded property impact lenders and borrowers? 8
  9. 9. Loan Modifications – “Significant Modifications” • The rules for determining whether a modification of a loan is a “significant modification” that causes a deemed exchange are found in Treas. Reg. § 1.1001-3. • With limited exceptions, modifications that occur by operation of the terms of a loan, including modifications that occur pursuant to a unilateral option, are not tested. • Generally, other than the five categories of modifications discussed below, the question is whether the modification is “economically significant.” For purposes of this test, the cumulative effect of modifications are considered. 9
  10. 10. Loan Modifications – “Significant Modifications” (cont.) • Yield change. A change in the annual yield by more than the greater of (a) 25 basis points or (b) 5% of the yield of the unmodified loan is a significant modification. This test is based on cumulative changes over the prior 5 years. • Change in timing of payments. A deferral of payments within the safe harbor of the lesser of 5 years and 50% of the loan’s original term is not a significant modification. • Change in obligor or security. With limited exceptions, a change in obligor on a recourse loan is a significant modification. The treatment of a change in security depends upon a number of factors. 10
  11. 11. Loan Modifications – “Significant Modifications” (cont.) • Change in nature of the loan. A modification that results in the loan not being treated as debt for tax purposes or changes the recourse nature of the loan is a significant modification. • Change in accounting or financial covenants. A modification that alters customary accounting or financial covenants is not a significant modification; however, if a payment is made by the borrower to change a covenant, the change in yield test must also be considered. 11
  12. 12. Loan Modifications – Determination of Issue Price • The determination of the issue price of a loan issued for property (including the new modified loan in a deemed debt-for-debt exchange) generally depends on whether either the new modified loan or the old unmodified loan is “publicly traded.” • If the new loan is publicly traded, then the issue price is the fair market value of the new loan. • If the new loan is not publicly traded, but the old loan is publicly traded, then the issue price of the new loan is the fair market value of the old loan. • If neither the new loan nor the old loan is publicly traded, then the issue price of the new loan is determined under IRC § 1274 (generally the face amount if the loan has adequate stated 12 interest).
  13. 13. Loan Modifications – Lender Consequences • The amount realized by lenders (including secondary purchasers) upon a deemed exchange will equal the issue price of the new modified loan (plus any cash consideration received). • If such amount is greater than the lender’s tax basis, the lender will realize gain, and, conversely, if the amount realized is less than the lender’s tax basis, the lender will realize loss. Gain or loss may not be recognized if the “recapitalization” rules apply in the case of corporate borrowers where the loan is a “security” for these purposes. • Even where gain or loss is currently recognized, the result is generally a timing difference that will accelerate current gain or loss, with offsetting income or deduction realized over the remaining life of the loan through the inclusion of original issue discount (OID) or the deduction of premium. 13
  14. 14. Loan Modifications – Lender Consequences (cont.) • For certain lenders or purchasers of loans, these rules do have the potential to cause character whipsaws where taxpayers may recognize a current capital loss, and then take into account OID as ordinary income over time. • For purchasers of loans, the rules can also turn “market discount” into OID, which generally is an unfavorable result because it will generally accelerate income. • We also note that in certain circumstances involving distressed loans, taxpayers may not be required to accrue interest or follow the market discount rules. 14
  15. 15. Loan Modifications – Borrower Consequences • Borrowers will have CODI to the extent that the issue price of the new modified loan is less than the “adjusted issue price” of the original unmodified loan (generally the stated principal amount of the loan if it was originally issued for par and pays cash interest currently). • Distressed borrowers may recognize a large amount of CODI if fair market value is used to determine issue price (i.e., in situations where the new loan or the old loan is treated as publicly traded). Consider the application of any exceptions for bankruptcy and insolvency. • Because the new loan deemed to be issued would generally have OID equal to the amount of the CODI, the result is often a timing difference for borrowers as opposed to a permanent difference. However, the application of the applicable high yield discount obligation (AHYDO) rules can cause a permanent difference if the borrower is not entitled to deduct all of the OID as it accrues or is paid. 15
  16. 16. Loan Modifications - Publicly Traded Property • A debt instrument is considered to be publicly traded if it is “traded on an established securities market.” • Recent Treasury regulations replace the four categories of publicly traded property under the prior regulations with three categories of property, each determined by looking to the 31-day period ending 15 days after the issue date of the new instrument. • These rules make it likely that a large, syndicated loan will be treated as publicly traded for this purpose. 16
  17. 17. Loan Modifications - Publicly Traded Property (cont.) Category 1: Sales Price • The price for an executed purchase or sale of the property is reasonably available within a reasonable period of time after the sale. Category 2: Firm Quotes • A price quote is available from at least one identified broker, dealer or pricing service, and the price is substantially the same as the price for which the person could purchase or sell the property. Category 3: Indicative Quotes • A price quote is available from at least one broker, dealer or pricing service, and the price quote is not a firm quote. If the quote is from a pricing service, the broker/dealer providing the quote 17 need not be identified.
  18. 18. Loan Modifications - Publicly Traded Property (cont.) • Small Debt Exception. A loan will not be treated as publicly traded if the stated principal amount of the loan does not exceed $100 million. In this case, if the loan is restructured or modified, the debt will be deemed to be issued at its face amount (assuming it has adequate stated interest), regardless of its actual fair market value. This rule generally alleviates the CODI concern for borrowers. • Section 1274. As part of the new regulations package, the regulations under IRC §1274 were revised to provide that taxpayers may not use the “recent sales transaction” exception to IRC §1274 to use fair market value for issue price in the case of a debt-for-debt exchange. • Anti-abuse Rule. If the purpose of any temporary restriction on trading of property is to avoid causing such property to be publicly traded, then the property will be treated as publicly traded. If a principal purpose of any sale or price quotation is to cause the property to be publicly traded or to materially misrepresent the value of the property, 18 such sale or price quotation will be disregarded.
  19. 19. Publicly Traded Property (cont.) • Determination of Fair Market Value. The fair market value of publicly traded property will be presumed to be equal to its sales price or quoted price. If there are multiple prices, a taxpayer may use any reasonable method to determine fair market value. For indicative quotes, if the taxpayer determines that the indicative quote materially misrepresents the fair market value of the property, the taxpayer may use any method that provides a reasonable basis to determine the fair market value of the property. • Issuer/Holder Reporting Consistency. Issuers are required to exercise reasonable diligence to determine if property is publicly traded and, in such case, its fair market value and to disclose that information to holders. The determination made by the issuer is binding on the holder, unless the holder explicitly discloses a different determination on its tax return. 19
  20. 20. Bad Debt Deduction
  21. 21. Bad Debt Deduction – Requirements • Generally, a bank is entitled to an ordinary deduction under IRC § 166(a) if it owns a debt instrument that becomes either wholly worthless, or partially worthless and is charged off. • For non-banks, there are other requirements to obtain ordinary treatment, including a requirement that the debt not be a security under IRC § 165(g)(2)(C). 21
  22. 22. Bad Debt Deduction – Worthlessness • A wholly worthless bad debt deduction must be taken in the year the debt becomes worthless. • Taxpayer has the burden of proof; • Taxpayer must show that the debt had some value at the beginning of the tax year and no value at the end; and • Taxpayer must show an identifying event during the year indicating worthlessness or otherwise satisfy the burden of proof based on the taxpayer’s documentation. 22
  23. 23. Bad Debt Deduction – Partial Worthlessness • Under the general rule, the taxpayer must prove partial worthlessness independently of the amount of the charge-off. The same general standards apply in determining partial worthlessness as total worthlessness. • There are special rules to establish partial worthlessness (discussed later). • Specific orders by regulators under Treas. Reg. § 1.166-2(d)(1) (conclusive presumption). • Conformity election available to banks under Treas. Reg. § 2(d)(3). • Industry Director Directive for insurance companies. 23
  24. 24. Bad Debt Deduction – Partial Worthlessness (cont.) • Establishing partial worthlessness under the general rule does not mean a mere difference between a debt’s face amount and its fair market value. • As a practical matter, the taxpayer may be able to follow book where the security is charged off based on “credit losses.” • A “credit loss” is measured based on expected flows discounted at the original yield of the security. • The determination of “credit loss” under general accounting rules might suffice to establish worthlessness under IRC § 166. 24
  25. 25. Bad Debt Deduction – Charge-off requirement • The purpose of the book charge-off requirement is to prevent taxpayers from carrying assets on their books at a higher value than such assets are carried for tax. • Neither the Internal Revenue Code nor the regulations prescribe a particular method for making a charge-off of a bad debt. • Generally speaking, an effective charge-off has been made if the book entries relied upon have effectively eliminated the amount of the debt (or the part which is worthless) from the book assets of the taxpayer. 25
  26. 26. Bad Debt Deduction – Charge-off requirement (cont.) • Must a charge-off occur for the year of the deduction? • Can a taxpayer claim a partial bad debt deduction by amending a prior return? • Can a taxpayer claim a partial bad debt deduction in a year subsequent to the book charge-off? • Consider deemed charge-offs under Treas. Reg. § 1.166-3(a)(3), relating to significantly modified debt. 26
  27. 27. Bad Debt Deduction – Conclusive Presumption • Banks or other corporations subject to supervision by Federal or State authorities may take a bad debt deduction in whole or in part if it occurs: • In obedience to the specific order of such authorities, or • In accordance with established policies of such authorities, and, upon their first audit of the bank or other corporation subsequent to the charge-off, such authorities confirm in writing that the charge-off would have been subject to such specific orders if the audit had been made on the date of the charge-off. • Applies to banks and other corporations subject to supervision by Federal authorities, or by State authorities maintaining substantially equivalent standards. 27
  28. 28. Bad Debt Deduction – Book conformity method • This is a method of accounting under which a bank claims a bad debt deduction in the year in which the debt is charged-off for regulatory purposes. Treas. Reg. § 1.166-2(d)(3). • If a bank regulator issues an express determination letter stating that a bank electing this method applies loan loss classification standards consistent with regulatory loan loss classification standards, loan losses are conclusively presumed to be worthless in whole or in part. 28
  29. 29. Bad Debt Deduction – Notice 2013-35 • In Notice 2013-35, the IRS requested comments by October 8, 2013 on whether recent changes to the bank regulatory standards for loan charge-offs require changes to the conclusive presumption and the book conformity method. • The IRS is concerned that changes to bank regulatory standards have created standards that are no longer consistent with the principles of IRC § 166. • Treasury has indicated that administrative convenience alone is not a sufficient reason for the conclusive presumption and the book conformity method. 29
  30. 30. Bad Debt Deduction – Notice 2013-35 (cont.) • Notice 2013-35 raises a number of specific questions, including: • In addition to banks, which other corporations should be covered by revised rules? • What process should be required to verify losses? • Should there be just a single rule providing for conclusive presumptions? 30
  31. 31. Bad Debt Deduction – Industry Director Directive • Industry Director Directive (LB&I-4-0712-009) allows insurance companies to claim a partial bad debt deduction for the amount of SSAP 43R credit-related impairment charges as reported on the company’s annual statement. • Must be elected no earlier than the taxpayer’s 2009 return and no later than its 2012 return. • Allows taxpayers to claim a partial bad debt deduction without demonstrating that the debt is partially worthless for tax purposes. 31
  32. 32. Foreclosure Property Expenses
  33. 33. Foreclosure Property – Treatment of Expenses • Costs associated with certain real or personal property acquired by a taxpayer for resale are required to be capitalized. IRC § 263A(b)(2)(A). • There has been an ongoing controversy regarding whether expenses incurred by banks with respect to “other real estate owned” (OREO) acquired in foreclosures must be capitalized. • Until earlier this year, the IRS took the position that banks were required to capitalize expenses that are attributable to OREO. 33
  34. 34. Foreclosure Property – Treatment of Expenses (cont.) • In AM 2013-001, the IRS changed its position in a situation involving OREO acquired through foreclosure proceedings by the bank that originated the underlying loan. • The IRS focused on whether the bank had acquired the OREO for resale, consistent with the wording of IRC § 263A(b)(2)(A). • The IRS then looked to regulations providing that a bank’s expenses relating to loan origination activities are not required to be capitalized. • Based on this analysis, the IRS concluded that the bank was not required to capitalize its expenses because the OREO was not “property acquired for resale” within the meaning of IRC § 263A(b)(2)(A). 34
  35. 35. Foreclosure Property – Treatment of Expenses (cont.) • Following AM 2013-001, a number of issues remain: ‒ Will the IRS position apply to OREO resulting from loans acquired by a bank (as opposed to originated by the bank)? ‒ Will IRC § 263A apply to expenses to improve the OREO? ‒ Will taxpayers that voluntarily changed their method or whose methods were changed on exam to subject OREO to IRC § 263A be allowed to make automatic changes? 35
  36. 36. Mortgage Securitizations
  37. 37. Mortgage Securitizations • The Home Affordable Refinance Program (HARP) is a government program intended to provide refinancing options for homeowners with certain mortgages owned or guaranteed by the agencies. • As expanded in 2012, HARP allows homeowners to refinance mortgages even if the loan-to-value (LTV) ratio is in excess of 125 percent. • The available options for securitizing these High-LTV mortgages may be limited. 37
  38. 38. Mortgage Securitizations (cont.) • The use of Real Estate Mortgage Investment Conduits (REMICs) is the sole avenue for securitizing mortgages in a manner that involves time-tranching without causing an entity-level tax under the taxable mortgage pool (TMP) rules. • The statutory REMIC rules provide that an obligation is REMIC eligible only if it is principally secured by an interest in real property. • The regulations provide that an obligation is principally secured by an interest in real property if the value of the real property securing the obligation is at least 80 percent of the adjusted issue price of the obligation at the time the obligation is originated or transferred to the 38 REMIC.
  39. 39. Mortgage Securitizations (cont.) • Because mortgages refinanced through HARP may have an LTV in excess of 125 percent (i.e., the value of the real property securing the mortgage may be less than 80 percent), it is not entirely clear if these High-LTV mortgages are REMIC eligible. • In a situation involving mortgage modifications with respect to the Home Affordable Modification Program (HAMP), the government provided relief to REMICs and other securitization vehicles. • To date, the market has avoided time-tranching with respect to the securitization of such High-LTV mortgages because of the risk of the application of the TMP rules. Instead, the market is making use of variable strips, which have previously been the subject of favorable private rulings. 39
  40. 40. About this presentation This presentation contains general information only and the respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation. 40
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