2

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(b) Subparagraph (C) of section 593(b)(2) of such Code is

2 amended by striking "which are not described in section

3 591(b)".

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(c) The amendments made by this section shall apply

5 with respect to taxable years ending after the date of the 6 enactment of this Act.

SUMMARY AND DESCRIPTION

PRESENT LAW

Under present law (sec. 593), mutual savings banks, savings and loan associations, and certain other financial institutions ("thrift institutions") can deduct from taxable income a reasonable addition to their reserves for losses on qualifying real property loans (such as home mortgages). The amount so added to a reserve for such losses cannot exceed the largest of three amounts determined under three separate methods the percentage of taxable income method (sec. 593(b)(2)), the percentage method applicable to banks (sec. 593(b)(3)), and the experience method (sec. 593(b)(4)).

The amount determined under the percentage of taxable income method generally cannot exceed 40 percent of the taxpayer's taxable income for the year. However, because the deduction under section 593(b) is designed in part to encourage financial institutions to provide real property loans, the percentage of taxable income determined under paragraph (2) is reduced to the extent that an insufficient percentage of the taxpayer's holdings consist of real property loans and certain other assets (such as cash) described in section 7701(a)(19)(C) (“qualified property").

In the case of mutual savings banks that do not have capital stock represented by shares, at least 72 percent of total assets must be qualified property in order for the addition to the bad debt reserve, as determined under section 593(b)(2)(B), to equal 40 percent of taxable income for the year. If less than 72 percent of their assets are qualified property, then the 40-percent cap on the addition to the bad debt reserve is reduced by 12 percentage points for each one percentage point by which an insufficient proportion of total assets so qualify.

A more stringent rule regarding the holding of real property loans applies to all other thrift institutions (including mutual savings banks that have capital stock represented by shares). For these institutions, the full 40-percent cap applies only if at least 82 percent of total assets are qualified property. For each one percentage point by which an insufficient proportion of assets so qualify, the 40-percent cap is reduced by 34 of 1 percentage point.

EXPLANATION OF THE BILL

Under the bill, mutual savings banks that have capital stock represented by shares would be treated like other mutual savings banks, rather than like all other thrift institutions, for purposes of the permissible addition to bad debt reserves under the percentage of taxable income method. Thus, only 72 percent of the total assets of a stock mutual savings bank, rather than 82 percent as under present law, would have to be qualified property in order for the 40-percent cap, rather than a reduced cap, to apply.

EFFECTIVE DATE

The bill would apply to taxable years ending after the date of enactment.

REVENUE EFFECT

The provisions of the bill are estimated to decrease fiscal year budget receipts by less than $50 million annually.

STATEMENT OF CHASE MANHATTAN BANK, N.A.

Mr. Chairman and Members of the Subcommittee; we are pleased to submit this statement as part of your hearings of October 3, 1984 on H.R. 1343, a bill designed to address certain alleged inequities in the bad debt reserve tax deductions afforded stock savings banks in comparison to the deductions that are available to mutual savings banks. Chase applauds your Committee's consideration of H.R. 1343 as a healthy indication that the area of bad debt reserve allowances for financial institutions is now being assessed and reviewed.

The bad debt reserve rules currently contained in the Internal Revenue Code (the "Code") are permeated with anomalies and flaws such as those sought to be corrected by H.R. 1343. Chase is greatly concerned with the bad debt reserve rules, and in particular those governing allowances for commercial banks because the current Code provisions do not provide an adequate measure for an addition to their loan loss reserves. Members of both tax writing Committees have taken increasing notice

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of this problem and have introduced legislation 1 designed to correct the flaws of the current statutory scheme. As is made clear by the discussion in the body of our statement, these issues, like the ones raised by H.R. 1343, merit prompt Congressional attention and should be viewed as part of the larger question of proper loss reserve rules for all financial institutions.

Statutory background

The Tax Reform Act of 1969 established the current framework for computing bad debt reserves of commercial banks. That Act provided two alternative measures for an addition to the loan loss reserve. Under the first, the "percentage of eligible loans" methods, an addition to the reserve for bad debts was allowable to the extent sufficient to increase the reserve to a specified percentage of eligible loans. For taxable year 1982, the specified percentage was 1.0 percent, and for years 1983 to 1987 the specified percentage is 0.6 percent As of 1988, the percentage of eligible loans method will be phased out completely, and will no longer be available to commercial banks to compute their deductions for additions to bad debt reserves. For years beginning after 1987, commercial banks will be limited strictly to the second alternative, the "experience method," which represents a statutory codification of the "Black Motor case" formula.2

Under the experience method, the reserve addition is based on a six-year moving average so that the amount added to reserves in a given taxable year is a function of actual bad debts in the immediately preceding five taxable years. Non-bank corporate taxpayers are permitted by statute to make use of other methods to calculate their bad debt reserve if the Black Motor formula yields an unreasonable results. By contrast, commercial banks are currently compelled to use the Black Motor formula in the event they elect not to use the percentage method, and after 1987, it will be the only available method.

Defects in the current statutory scheme as it relates to commercial banks

The statutory scheme under which commercial banks operate is clearly deficient in providing for reasonable bad debt reserves. The percentage method, which until recently produced some measure of fairness, has been phased down to a level (0.6 percent) that simply does not comport with experience in the industry. Moreover, even this percentage phases out in 1987, leaving banks only the Black Motor method. Unfortunately, however, the Black Motor formula cannot yield a consistently sound result for banks given the assumptions of the formula and the nature of their business.

The Black Motor formula has been the subject of considerable general criticism since its recognition by the Board of Tax Appeals.3 Without attempting to formulate a complete list of the formula's frailties, the discussion below will focus on some of its more glaring deficiencies when applied to banks.

First, banks have historically experienced considerable growth in the size of their outstanding loan portfolios and in the amount of their bad debt experience, trends which have accelerated in recent years. In particular, the bad debt experience of banks has shown tremendous volatility, as evidenced by chart A attached to this statement. When the Black Motor formula is applied to banks, these trends collide with the rigid presumptions in the formula that the size of loan portfolios and the level of bad debt experience are static over time. Thus, as illustrated on charts B-I and B-II attached to this statement, the formula will dramatically underprovide for prospective bad debts in the case of banks, because its underlying assumptions of static loan portfolios and bad debt levels are generally incorrect.

These assumptions are not, however, the only fundamental conceptual flaws in the formula with especially harsh application to banks. The Black Motor method is also premised on the assumption that loans during the six-year experience period will have a one-year life. For banks, which typically have loan portfolios with lives in excess of one year, the formula yields faulty results.

Charts B-III and B-IV graphically illustrate the virtual meaninglessness of the formula in the situation where loans extend beyond one year. Chart B-III illustrates

1 See H.R. 4551, introduced by Representative Jake Pickle (D. Tex.) and Bill Frenzel (R. Minn.); and S. 1509, introduced by Senators William Roth (R. Del.), Steve Symms (R. Idaho), and Lloyd Bentsen (D. Tex.), both of which were introduced in the first Session of the Ninety-eighth Congress.

2 This method, set forth in section 585(b)(3) of the Code, is derived from the decision in Black Motor Co., 41 B.T.A. 300 (1940), acq. 1940-1 C.B. 1, aff'd on another issue, 125 F2d 977 (6th Cir. 1942).

3 See, e.g., Whitman, Gilbert, and Picotte, "The Black Motor Bad Debt Formula: Why It Doesn't Work And How To Adjust It," J. Tax. 366 (December 1971).

the fairly rare situation where the loan portfolio does indeed have an average oneyear life and where other factors are static. In this situation, of course, the formula produces a reasonable addition and an adequate reserve because this is the precise situation that the formula was designed to reflect. By contrast, however, Chart B-IV illustrates that even where the loan portfolio and bad debt experience are static, the experience method dramatically understates adequate reserves for a portfolio with an average life in excess of one year.

The Black Motor concept is critically deficient in at least one other respect that is particularly detrimental to banks. The banking industry, perhaps more than any other, is vulnerable to the effects of a severe economic downturn or recession. The Black Motor formula is utterly retrospective in its application, and permits no consideration whatsoever of the anticipated future economic climate. This inflexibility in the formula, which requires banks to anticipate the future contingency of losses on loans without reference to evidence of future trends, only makes the Black Motor formula's results more unrealistic, and even heightens the exposure of banks to the consequences of economic events.

Even the supposed objectivity of the Black Motor formula, used by many to defend its application, is illusory given the fairly common controversy between taxpayers and the I.R.S. over the factors entering into it. For example, the issues of the timing and amount of actual loan losses must be resolved in actually applying the formula, and each introduces an element of subjectivity into the calculation.

All of the defects described above are, of course, in some measure relevant for non-bank taxpayers who must also grapple with the Black Motor formula; indeed, the sum total of these flaws suggest that the application of the formula can be seriously questioned in the case of many corporate taxpayers-not just commercial banks. There is a critical difference, however: taxpayers other than commercial banks have at least some flexibility because the Code does not actually impose the formula on them. The Code allows for deductions of "reasonable" additions to reserves and the implementing regulations clearly envision case-by-case, year-to-year, and industry-by-industry flexibility based on facts and circumstances in calculating reasonable additions. By contrast, for commercial banks the formula is mandated without modification, except in the limited circumstance of approval by the Service of a shorter time period to measure experience. But this limited exception does nothing to correct the structural defects in the formula, described above. This result is anomalous because the nature of the loan portfolios and bad debt experience of commercial banks makes strict application of the Black Motor formula even less appropriate than in the case of other corporate taxpayers.

The necessary statutory revisions

The solution to the structural flaws and historical bias of the current loan loss reserve rules is twofold. First, the percentage of eligible loans method should be made a permanent feature of the Code, with the percentage set at 1.0 percent. This level is generally acknowledged within the industry, and by the Comptroller of the Currency and the Federal Deposit Insurance Corporation,5 as the appropriate level for bad debt reserves. Because a 1.0 percent level roughly conforms with the average reserve maintained on the books of account of many, if not most, banks, it provides no tax expenditure, preference or subsidy. A fixed percentage set at 1.0 percent can thus be viewed as a safe haven at the proper level of magnitude with the virtues of simplicity and some relative ease of administration. Moreover, given the industrywide experience on bad debts, it produces a more accurate result than the Black Motor formula itself.

Second, the Black Motor formula should be recrafted to take into account factors which it does not presently reflect: e.g., growth in loans, bad debt experience, and receivables of longer terms than one year. Chase and others are currently giving active consideration to technical modifications to the Black Motor formula. We are mindful, however, that the formula can never be made to reasonably reflect the situation of all banks under all circumstances. No mechanical formula can accomplish that task. We, therefore, believe that a most critical modification to the loan loss rules for commercial banks would be to put them on parity with other corporate taxpayers by permitting deviations from any mechanical formula upon a showing of "facts and circumstances" which justify a departure from the formula's strict application. A bank, like other corporate taxpayers, should be allowed the opportunity to

4 Section 166(c) of the Code; Reg. § 1.166-4(b).

5 Letters from C.T. Conover (Comptroller of the Currency) and from William M. Isaac (Chairman of the Federal Deposit Insurance Corporataion) to Congressman Bill Frenzel (R. Minn.) (July 27 and 23, 1982).

establish, in the face of the Internal Revenue Service's presumption of correctness, that a reserve addition is reasonable even though not based upon or derived from the Black Motor formula.

SUMMARY AND CONCLUSION

We commend this issue to the attention of the Committee as one in need of prompt attention. Even if the serious defects of Black Motor are avoided by electing to take the percentage method available through 1987 under present law, the current level for the percentage method of 0.6 percent is clearly inadequate to the task, given the experience of the banking industry as a whole. Thus, many commercial banks are presently faced with a Hobson's choice between the inadequate percentage method and the arbitrary and often unreasonable results obtained under Black Motor formula. Moreover, the worst possible outcome would be for the banking industry to face 1988 and all later years locked into the inflexible application of the Black Motor formula.

We strongly urge that the percentage method be maintained and set at a reasonable level of 1.0 percent for banks, and that the structural defects of the Black Motor formula be eliminated to the extent possible. Lastly, banks must be given the opportunity to determine their reserves by reference to facts and circumstances in those instances in which the Black Motor formula yields an unreasonable result.