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Revenue Effect

The provision is estimated to increase fiscal year budget receipts by $70 million in 1987, $125 million in 1988, $110 million in 1989, $104 million in 1990, and $103 million in 1991.

4. Cancellation of indebtedness for solvent taxpayers (sec. 822 of the Act and sec. 108 of the Code)104

Prior Law

Under both present and prior law, gross income includes "income from discharge of indebtedness" (sec. 61(a)(12)). A discharge of indebtedness is considered to occur whenever a taxpayer's debt is forgiven, cancelled, or otherwise discharged by a payment of less than the principal amount of the debt. The amount of indebtedness discharged is equal to the difference between the face amount of the debt, adjusted for any unamortized premium or discount, and any consideration given by the taxpayer to effect the discharge. Both present and prior law contain exceptions to the general rule in cases where the discharge occurs in a case arising under title 11 of the United States Code (relating to bankruptcy) or when the taxpayer is considered to be insolvent.

Prior law also provided an exception where the indebtedness discharged was qualified business indebtedness (sec. 108(a)(1)). Qualified business indebtedness was indebtedness that was incurred or assumed by a corporation or indebtedness that was incurred or assumed by an individual in connection with property used in the individual's trade or business. A taxpayer was required to elect to have the indebtedness treated as qualified business indebtedness (sec. 108(d)(4)).

In the case of a discharge of qualified business indebtedness, the amount of the discharge that would have been included in gross income had the discharge not been of qualified business indebtedness was instead applied to reduce the basis of depreciable property of the taxpayer (sec. 108(c)(1)). An election was available to treat inventory as depreciable property for this purpose. The amount of discharge income that could have been excluded as a discharge of qualified business indebtedness was limited to the basis of the taxpayer's depreciable property. If the amount of discharge income exceeded the basis of depreciable property, the excess was required to be included in gross income for the year in which the discharge occurred.

Reasons for Change

The Congress believed that the prior law treatment of the discharge of qualified business indebtedness was too generous. Income from such a discharge generally was deferred by reducing the basis of depreciable assets, regardless of the capacity of the taxpayer to currently pay the tax. In addition, the provision produced disparate results among taxpayers depending upon the makeup of their de

104 For legislative background of the provision, see: H.R. 3838 as reported by the Senate Committee on Finance on May 29, 1986, sec. 323; S. F p. 99-313, pp. 161-162; and H. Rep. 99-841, Vol. II (September 18, 1986), pp. 324-325 (Conference Report).

preciable assets. For taxpayers without sufficient amounts of inventory or depreciable assets, the full benefit of the deferral was not available.

Explanation of Provision

The Act repeals the provision of prior law (sec. 108(a)(1)(C)) which provided for the exclusion from gross income of income from the discharge of qualified business indebtedness. The effect of the Act is to require that any discharge of indebtedness, other than a discharge in title 11 cases and a discharge that occurs when the taxpayer is insolvent, results in the current recognition of income in the amount of the discharge.

The Congress did not intend to change the present law treatment of a discharge of indebtedness that occurs in a title 11 case or when the taxpayer is insolvent.105 The Congress also did not intend to change the provision of prior and present law (sec. 108(e)(5)) that treats any reduction of purchase-money debt of a solvent debtor as a purchase price adjustment, rather than a discharge of indebted

ness.

Effective Date

The provision is applicable to discharges of indebtedness occurring after December 31, 1986.

Revenue Effect

The provision is estimated to increase fiscal year budget receipts by $60 million in 1987, $85 million in 1988, $67 million in 1989, $57 million in 1990, and $46 million in 1991.

105 Sec. 405 of the Act provides special rules for certain solvent farmers for the purpose of determining whether there is income from the discharge of indebtedness. (See Title IV., Part

TITLE IX-FINANCIAL INSTITUTIONS

A. Reserves for Bad Debts (Sec. 905 of the Act and secs. 585, 586, and 595 of the Code) 1

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Under prior law, all commercial banks2 were allowed to use either the specific charge-off method or the reserve method in computing their deduction for bad debts for Federal income tax purposes. A commercial bank using the specific charge-off method takes a deduction for bad debt expense at the time a specific debt becomes partially or totally worthless in the amount of such worthlessness. A commercial bank using the reserve method takes a deduction for bad debt expense at the close of the taxable year. The amount of the deduction is limited to the amount necessary to increase the year-end balance of the bad debt reserve account to an amount computed under either the "bank experience method" or the "percentage of eligible loans method." A commercial bank may switch between the bank experience method and the percentage of eligible loans method of determining the addition to its reserve for losses on loans from one year to another.

Bank experience method

The maximum allowed ending reserve balance for a bank using the bank experience method is the amount of loans outstanding at the close of the taxable year times a fraction, the numerator of which is the sum of actual bad debts for the current and five preceding taxable years, and the denominator of which is the sum of the amount of loans outstanding at the close of the each of those

years.

Percentage of eligible loans method

The maximum allowed ending reserve balance for a bank using the percentage of eligible loans method is equal to a specified percentage of the outstanding eligible loans at the close of the taxable

1 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 801; H. Rep. 99-426, pp. 574-583; H.R. 3838 as reported by the Senate Committee on Finance on May 29, 1986, sec. 801; S. Rep. 99-313, pp. 285-288; and H. Rep. 99-841, Vol. II (September 18, 1986), pp. 326-332 (Conference Report).

? A commercial bank is defined as a domestic or foreign corporation, a substantial portion of whose business consists of receiving deposits and making loans and discounts, or of exercising fiduciary powers similar to those permitted national banks, and who are subject by law to supervision and examination by State or Federal authority having supervision over banking institutions (sec. 581). For the purpose of determining the deduction for bad debts, the term cial bank" does not include domestic building and loan associations, mutual savings banks, or cooperative nonprofit mutual banks ("thrift institutions").

commer

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year, plus an amount determined under the bank experience method for loans other than eligible loans. The specified percentage for taxable years beginning after 1982 is 0.6 percent.3 Eligible loans for this purpose generally are loans incurred in the course of a bank's normal customer loan activities on which there is more than an insubstantial risk of loss.4

The availability of the percentage of eligible loans method expires after 1987. For taxable years beginning after 1987, banks are limited to the bank experience method in computing additions to bad debt reserves.

Under both the bank experience method and the percentage of eligible loans method, the ending reserve balance need not be less than the balance at the end of the "base year," providing that the amount of outstanding loans at the close of the current year is at least as great as the balance at the close of the base year.

If the bad debt reserve deduction for the taxable year determined under the above rules exceeds the amount which would have been allowed as a deduction on the basis of actual experience, the deduction is reduced by 20 percent of such excess (sec. 291). Also, 59 and 5/6ths percent of the deductible excess (after the 20-percent reduction) is treated as a tax preference for purposes of computing the corporate minimum tax (sec. 57).

Reason for Change

The Congress believed that the reserve method of accounting for bad debts generally should be repealed for several reasons. First, the use of the reserve method for determining losses on bad debts results in deductions being taken currently for tax purposes for losses that statistically are expected to occur in the future. In this regard, the reserve for bad debts is inconsistent with the treatment of other deductions under the all events test. Second, the use of the reserve method allows deductions to be taken prior to the time that the losses actually occur and, therefore, allows deductions larger than the actual present value of the losses. Finally, the Congress is concerned that many banks, particularly those who are members of large banking organizations, have used the reserve method for determining losses from bad debts to lower substantially their Federal income tax liabilities.

At the same time, the Congress was concerned that the repeal of the reserve method for smaller banks may have a potentially adverse impact. The Congress sought to balance these concerns by providing for the continued availability of reserves for bad debts for smaller banks, as under prior law, while requiring larger banks to compute their losses from bad debts using the specific charge-off method.

3 For taxable years beginning after 1975 and before 1982, the specified percentage was 1.2 percent. For taxable years beginning in 1982, the specified percentage was 1.0 percent.

* Specifically excluded from the definition of an eligible loan are a loan to a bank; a loan to a domestic branch of a foreign corporation which would be a bank were it not a foreign corporation; a loan secured by a deposit in the lending bank or in another bank if the taxpayer bank has control over the withdrawal of such deposit; a loan to or guaranteed by the United States, a possession or instrumentality thereof, or to a State or political subdivision thereof; a loan evidenced by a security; a loan of Federal funds; and commercial paper. Sec. 585(b)(4).

Explanation of Provision

Repeal of reserve method for large banks

The Act repeals the use of reserves in computing the deduction for losses on bad debts in the case of "large banks." A bank is considered a "large bank" if, for the current taxable year or any taxable year beginning after December 31, 1986, the sum of the average adjusted bases of all assets of such bank (or any controlled group of which the bank is a member) exceeds $500 million. The adjusted basis of an asset generally will be considered to be the tax basis of the asset, adjusted by those amounts allowed as adjustments to basis by section 1016. In determining the sum of the average adjusted bases of all assets of a controlled group, interests held by one member of such group in another member of such group are to be disregarded.

The average adjusted bases of the assets of a bank or controlled group is the average of the adjusted bases of the assets for each period of time falling within the taxable year the bank is required to report for regulatory purposes. This is expected to result in the adjusted bases of the assets of a bank generally to be determined quarterly, at the same time as the quarterly call reports for the bank are prepared, regardless of whether or not the end of any such quarter coincides with the end of the taxable year of the bank.

A controlled group for this purpose is a controlled group of corporations described in section 1563(a)(1). For the purpose of determining the sum of the adjusted bases of the assets of a controlled group, all corporations includible in the group under the ownership tests of section 1563(a) are included, without regard to their status as an "excluded member" of a controlled group as a result of the application of section 1563(b)(2), whether or not the corporation meets the definition of a commercial bank, and whether or not the corporation is a foreign or domestic entity.

Recapture of existing bad debt reserves

Direct recapture inclusion method.-A commercial bank that is determined to be a large bank generally is required to include in income the balance in any reserve for bad debts over a period of four taxable years, beginning with the disqualification year. The disqualification year is the first taxable year beginning after December 31, 1986, for which the bank is considered to be a large bank. Ten percent of the reserve balance is included in income in the disqualification year, 20 percent in the first taxable year following the disqualification year, 30 percent in the second following year, and 40 percent in the third taxable year following the disqualification year. The bank may elect to include in income a greater amount in the first year for which recapture is required. If such an election is made, 2/9ths of the remainder of the reserve balance (after reduction for the amount included in income in the first taxable year) must be included in income in the second taxable year, 1/3rd of the remainder in the third taxable year, and 4/ 9ths of the remainder in the fourth taxable year.

A bank, that is directly recapturing its existing bad debts reserve by including an amount in taxable income, may suspend the inclu

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