sion in income of its bad debt reserve for any year in which it is a "financially troubled bank." Nonetheless, a financially troubled bank may elect to include in income currently all or a portion of the amount of its reserves that otherwise would be recaptured that

year.

A bank is a financially troubled bank if the average of its nonperforming loans for the taxable year exceeds 75 percent of the average of its equity capital for the year. Nonperforming loans include (1) loans that are "past due 90 days or more and still accruing," (2) "nonaccrual" loans, and (3) "renegotiated 'troubled' debt" under the existing standards of the Federal Financial Institution Examination Council. Equity capital is assets less liabilities, as those amounts are reported for regulatory purposes. Equity capital does not include the balance in any reserve for bad debts. The average of nonperforming loans and equity capital for the year is to be determined as the average of those amounts at each time during the taxable year that the bank is required to report for regulatory purposes. In the case of a bank that is a member of a controlled group described in section 1563(a)(1), the determination of whether the bank is a financially troubled bank is made with respect to all members of that controlled group.

The inclusion in income of a portion of the bad debt reserve is suspended, not forgiven, during each year in which the bank is considered to be a financially troubled bank. For example, consider a large bank that is financially troubled in the disqualification year, is not financially troubled in the two following years, and then returns to financially troubled status in the fourth year. No portion of the bank's bad debt reserve need be included in income during the disqualification year, since the bank meets the definition of a financially troubled bank. In the second year, the bank must begin the inclusion of its bad debt reserve in income. As the inclusion in income begins in this year, the bank may include in income either 10% of its reserve balance or a greater amount if it so elects. The bank may not elect at this time to use the cut-off method (described below), since it has already tolled the inclusion of the bad debt reserve in income as a financially troubled bank. In the third year, the bank must include in income 2/9ths of the bad debt reserve not included in income in the prior year. The bank returns to troubled status in the fourth year and no portion of the bad debt reserve must be included in income in that year. The bank will be required to include in income the amount it would have included in that year in the next year in which it is not a financially troubled bank.

The provision allowing a financially troubled bank to suspend the inclusion of its bad debt reserve in income does not affect the requirement that a large bank account for its bad debts using the specific charge-off method.

Cut-off method.-In lieu of the recapture of its bad debts reserves by including them in income, the bank may elect to use the cut-off method with regard to its outstanding loans at the time it becomes a large bank. The election to use the cut-off method is made on a taxpayer-by-taxpayer basis. Thus, commercial banks that join in a consolidated Federal income tax return with other commercial banks must follow any election made by the consolidated group to use the cut-off method, and may not independently elect the use of

the cut-off method unless the consolidated group makes such an election. On the other hand, in the case commercial banks which are affiliated but that do not file a consolidated return, each commercial bank can elect the cut-off method regardless of whether other members of the affiliated group also elect the cut-off method. A commercial bank electing to use the cut-off method is required to segregate its outstanding loans into two accounts. One account consists of loans created on or after the first day of the disqualification year. The specific charge-off method is required to be used in computing the deduction for bad debts attributable to the loans in this account. The second account consists of loans that were outstanding on the last day of the taxable year before the disqualification year. The deduction for bad debts attributable to the loans in this account continues to be determined using the reserve method. All charge-offs and recoveries on loans in the second account are adjustments to the reserve account and not separate items of income and expense. However, if the charge-off of any loan would reduce the balance in any reserve account below zero, the chargeoff shall be an adjustment to the reserve account only in the amount necessary to reduce the balance in such account to zero. Any charge-offs in excess of such reserve balance, and any recoveries with regard to such loans, will be items of income and expense in the year of charge-off or recovery, as if the taxpayer had always used the specific charge-off method. Under the cut-off method, no additional deductions in the disqualification year or thereafter are allowable for additions to the reserve for bad debts.

Unless the balance of a reserve account has been reduced to zero by the adjustment required for a charged-off item, the allowable ending balance for the reserve account is computed for year end by taking into account only those debts which were outstanding on the last day of the taxable year before the disqualification year. No additional deductions may be taken for an addition to restore the reserve account to its allowable ending balance.

Effective Date

The provision is effective for taxable years beginning after December 31, 1986.

Under both present and prior law, mutual savings banks, domestic building and loan associations, and cooperative banks without capital stock which are organized and operated for mutual purposes and without profit (collectively called "thrift institutions") are 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. For thrift institutions using the reserve method, the reasonable addition to the reserve for bad debts under prior law was equal to the addition to the reserve for losses computed under the "bank experience" method, the "percentage of eligible loans" method, or, if a sufficient percentage of the thrift insti

tution's assets constitute "qualified assets," the "percentage of taxable income" method. A thrift institution may switch between methods of determining the addition to its loan loss reserve from one year to another.

Permissible methods

Experience and percentage of eligible loans methods. The bank experience and percentage of eligible loans methods for thrift institutions generally were the same as for commercial banks (discussed above).

Percentage of taxable income method.-Under the percentage of taxable income method, an annual deduction is allowed for a statutory percentage of taxable income." The statutory percentage under prior law for tax years beginning after 1978 was 40 percent. The full 40-percent of taxable income deduction was available only where 82 percent (72 percent in the case of mutual savings banks without capital stock) of the thrift institution's assets were qualified. Where the 82-percent test was not met, the statutory rate was reduced by three-fourths of one percentage point for each one percentage point of such shortfall. For mutual savings banks without capital stock, the statutory rate was reduced by one and onehalf percentage points for each percentage point that qualified assets were less than the 72-percent requirement. At a minimum, 60 percent of a thrift institution's assets must have been qualified (50 percent for mutual savings banks without stock) in order for the thrift institution to have been eligible for deductions under the percentage of income method.

Corporate preferences and minimum tax

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

Small business investment companies

Under prior law, small business investment companies operating under the Small Business Investment Act of 1958 and business development companies were allowed to use the reserve method of computing their deduction for bad debts. The allowable ending balance in the reserve account was determined using the bank experience method (prior law sec. 586).

5 For purposes of determining the deduction under the percentage of taxable income method, taxable income is computed without regard to any deduction allowable for any addition to the reserve for bad debts and exclusive of 18/46 of any net long-term capital gain, gains on assets the interest on which was tax-exempt, any dividends eligible for the corporate dividends received deduction and any additions to gross income from the thrift institution's own distributions from previously accumulated reserves.

Reasons for Change

6

Since the last time that the Congress has reviewed the taxation of thrift institution and other financial institutions, there have been several changes in regulatory policies that have expanded the activities in which thrift institutions may engage, and at the same time encouraged other institutions to expand their activities in areas which were traditionally serviced by the thrift institutions. These changes have resulted in other financial institutions being in direct competition with thrift institutions, while prior law provided significantly different tax treatment of these financial institutions. Such policies are not promoted by providing a substantially lower effective tax rate for one competitor than for others.

Accordingly, the Congress believed that the benefit of prior law, which allowed a bad debt deduction to thrift institutions equal to 40 percent of taxable income, should be substantially reduced. The Congress continued to believe that there should be some incentive for thrift institutions to provide residential mortgage loans, and that the provision of a bad debt deduction equal to a reduced percentage of taxable income should be available only to those thrift institutions maintaining a sufficient percentage of qualified assets, including residential mortgage loans.

In reducing, rather than eliminating, the percentage of taxable income method for thrift institutions, the Congress intended to continue to encourage such institutions to continue to hold a significant percentage of the type of assets traditionally held by thrift institutions (i.e., residential mortgage loans) which qualify the institution as a thrift institution while not providing those institutions with a significant competitive advantage over other financial institutions.

The Congress believed that the reasons for preserving a limited deduction for bad debts using the reserve method that was provided for thrift institutions and for commercial banks other than large banks should not be extended to small business investment companies or to small business development companies. These companies do not generally accept, and are not responsible for, the safety of

Until 1952, thrift institutions were exempt from Federal income tax. In 1952, the Congress repealed the exemption of these institutions and subjected them to the regular corporate income tax. At that time, however, these institutions were allowed a special deduction for additions to bad debt reserves which proved to be so large that thrift institutions remained virtually tax exempt. In 1962, the Congress established an alternative 60-percent of taxable income deduction for bad debts. Savings and loan associations were eligible for the full deduction only if 82 percent of their assets were invested in qualifying assets. Mutual savings banks were not subjected to the 82-percent test. In 1969, the Congress established the basics of the prior law (described above) by providing that a thrift institution could determine its deduction for bad debts under either of the methods allowed commercial banks (the bank experience and the percentage of eligible loans methods) as well as the alternative of the percentage of taxable income method. The 60-percent rate in place at the time of the 1969 legislation was phased down at a rate of 3 percent per year until it reached 40 percent in 1979. The requirement that a percentage of the thrift institution's assets be qualifying assets was extended to mutual savings banks in 1969. In passing the 1969 legislation, the Congress was concerned that the previous bad debt reserve provisions for thrift institutions were unduly generous, allowing a much lower effective rate of tax than the average effective rate for all corporations.

7 The effect of the present-law 40-percent deduction, in combination with the 20-percent disallowance for corporate preferences, is to provide a maximum effective tax rate of 31.28 percent to thrift institutions, while other corporations are subject to a maximum effective tax rate of 46 percent. The effect of continuing the 40-percent deduction and the 20-percent disallowance for corporate preferences in combination with the 34-percent maximum corporate rate in the Act would have been to provide a maximum tax rate of 23.12 percent to thrift institutions.

deposits from the general public. The Congress determined, therefore, that small business investment and development companies should be treated the same as those other companies that provide loans from funds other than those deposited by the public (such as finance companies or investment capital companies) that may not use the reserve method of computing losses from bad debts under the Act.

Explanation of Provision

Thrift institutions (mutual savings banks, domestic building and loan associations, and cooperative banks) continue to be able to compute their bad debt deductions using the bank experience method and the percentage of taxable income method. The percentage of eligible loans method is no longer available. In using the percentage of taxable income method, the portion of taxable income which may be deducted as an addition to a reserve for bad debts is reduced from 40 percent to 8 percent. The rules reducing the amount of the percentage of taxable income deduction available to a thrift institution which holds 60 percent of its assets in qualifying assets, but fails to hold a sufficient percentage of qualifying assets to use the maximum percentage of taxable income deduction, are eliminated. Any institution meeting the definition of a thrift institution and holding at least 60 percent of its assets as qualifying assets, is eligible for the full 8 percent of taxable income deduction. The 60-percent test applies to mutual savings banks as well as other types of thrift institutions.

An entity previously treated as a thrift institution that does not meet the new definition of thrift institution (under the 60 percent test) generally is treated as a commercial bank if it otherwise satisfies the definition of section 581. An entity previously treated as a thrift institution now treated as a commercial bank is subject to the tax rules applicable to commercial banks. If the adjusted bases of the assets of the entity (or any controlled group of which the entity is a member) exceed $500 million, such an entity would be considered a large bank and ineligible to use the reserve method of computing deductions for losses on bad debts. The existing bad debt reserve of such an entity is required to be recaptured using either the direct recapture inclusion method or the cut-off method. If the adjusted bases of the assets of the entity (or any controlled group of which the entity is a member) do not exceed $500 million, the entity is considered a commercial bank other than a large bank and continues to be eligible to use the reserve method of computing deductions for losses on bad debts under the bank experience method.

Thrift institutions that claim the 8 percent of taxable income deduction allowed by the Act are not to be treated as having a tax preference for purposes of the 20-percent reduction of section 291. The excess of the percentage of taxable income deduction over the deduction that would have been allowable on the basis of actual experience will be treated as a preference item for the purpose of computing the corporate minimum tax (sec. 57).

The provision of prior law (sec. 586) that allowed small business investment companies operating under the Small Business Invest