viewed as payments necessary to raise SAIF funding to a level appropriate for current needs,’ a
current deduction arguably would be allowable. If, on the other hand, the special assessments
are viewed as current payments that will facilitate the future BIF/SAIF merger (such merger
providing the assessed institutions with significant future benefits such as reduced deposit
insurance rates), capitalization arguably would be required.”

B. Description of H.R. 2494

The bill would provide that the special assessment paid to the SAIF as required by H.R.
2491 would be deductible when paid.

° See, e.g., the testimony of the Hon. John D. Hawke, Jr., Undersecretary of the Treasury
for Domestic Finance on the SAIF, before the Subcommittee on Financial Institutions and
Consumer Credit of the House Committee on Banking and Financial Services, August 2, 1995,
calling for a special assessment at least partially to correct current SAIF weaknesses. The
testimony did not discuss the proper Federal income tax accounting treatment for the assessment.

* See, e.g., Private Letter Rulings 9348003 (August 30, 1993) and 9402006 (September
24, 1994), where the IRS required capitalization of certain "exit and entry" fees paid by
institutions on the transfer of insured deposits from the SAIF to the BIF. However, these tulings
are not dispositive of the proper treatment of the special assessments required under H.R. 2491
because private letter rulings are only applicable to the taxpayers to whom issued and the facts
underlying the rulings differ from the facts underlying the special assessments.

-12-



Il. ACCOUNTING FOR BAD DEBTS BY THRIFT INSTITUTIONS

A. Present Law

Tax treatment of bad debt deductions of savings institutions
Reserve methods of accounting for bad debts of thrift institutions

A taxpayer engaged in a trade or business may deduct the amount of any debt that
becomes wholly or partially worthless during the year (the "specific charge-off" method).
Certain thrift institutions (building and loan associations, mutual savings banks, or cooperative
banks) are allowed deductions for bad debts under rules more favorable than those granted to
other taxpayers (and more favorable than the rules applicable to other financial institutions).
Qualified thrift institutions are eligible to compute deductions for bad debts using either the
specific charge-off method or the reserve method of section 593 of the Internal Revenue Code.
To qualify for this reserve method, a thrift institution must meet an asset test, requiring that 60
percent of its assets consist of "qualifying assets" (generally cash, government obligations, and
loans secured by residential real property). This percentage must be computed at the close of the
taxable year, or at the option of the taxpayer, as the annual average of monthly, quarterly, or
semiannual computations of similar percentages.

If a thrift institution uses the reserve method of accounting for bad debts, it must
establish and maintain a reserve for bad debts and charge actual losses against the reserve, and is
allowed a deduction for annual additions to restore the reserve to its proper balance. Under
section 593, a thrift institution annually may elect to calculate its addition to its bad debt reserve
under either (1) the "percentage of taxable income" method applicable only to thrift institutions,
or (2) the "experience" method that is also available to small banks.

Under the "percentage of taxable income" method, a thrift institution generally is allowed
a deduction for an addition to its bad debt reserve equal to 8 percent of its taxable income
(determined without regard to this deduction and with additional adjustments). Under the
experience method, a thrift institution generally is allowed a deduction for an addition to its bad
debt reserve equal to the greater of : (1) an amount based on its actual average experience for
losses in the current and five preceding taxable years, or (2) an amount necessary to restore the
reserve to its balance as of the close of the base year. For taxable years beginning before 1988,
the "base year" was the last taxable year before the most recent adoption of the experience
method (i.e., generally, the last year the taxpayer was on the percentage of taxable income
method). Pursuant to a.pravision contained in the Tax Reform Act.of 1986, for taxable years
beginning after 1987, the base year is the last taxable year beginning before 1988. The base year
amount is reduced to the extent that the taxpayer's loan portfolio decreases. Prior to 1988,
computing bad debts under a "base year" concept allowed a thrift institution to claim a deduction
for bad debts for an amount at least equal to the institution's actual losses that were incurred
during the taxable year.

3-



testing years. A "testing year" means (1) each taxable year ending on or after December 3 1,
1990, and before January 1, 1996, and (2) each taxable year ending after December 31, 1995,
for which the taxpayer met the residential loan requirement. For this purpose, a residential loan
would be a loan described in section 7701(a)(19)(C)(v) (generally, ioans secured by residential
real and church property and mobile homes). The special rule would continue to apply until the
taxpayer recaptured its entire section 481(a) adjustment. The determination of whether a
member of a controlled group of corporations meets the residential loan requirement would be
made on a controlled group basis. A special rule would provide that a taxpayer that calculates its
estimated tax installments on an annualized basis would determine whether it meets the
residential loan requirement with respect to each such installment. Treasury regulations are
expected to provide rules for the application of the residential loan requirement rules in the case
of mergers, acquisitions, and other reorganizations of thrift and other institutions.

Effective date.--The bill would be effective for taxable years beginning after December
31, 1995.

E. Issues Raised by H.R. 2491 and H.R. 2494

Title II of H.R. 2491 (the proposed banking legislation) and H.R. 2494 (the proposed tax
legislation) raise and address certain accounting, banking, and tax policy issues. First, H.R.
2491 would require a Federally-chartered savings and loan institution to become either a
Federally-chartered bank or a State-chartered savings and loan. If an institution became a bank,
absent any accompanying tax legislation, the converting institution would be denied the future
benefit of the bad debt reserve method of section 593 and, pursuant to proposed Treasury
regulations, would recapture all or a portion (depending on whether the institution would be
treated as a small or a large bank) of its bad debt reserve. Thus, H.R. 2491, without any
legislative tax relief, would impose a financial burden upon those institutions selecting Federal
bank charters rather than State thrift charters. Further, as described in Part C. above, requiring
the recapture of all or a portion of an institution's bad debt reserve may require the institution to
record a deferred tax liability for such amounts, thereby reducing the regulatory capital of the
institution. Taken together, the financial and capital requirements burdens imposed by bad debt
reserve recapture may provide an incentive for thrift institutions to become State-chartered
savings and loans rather than Federally-chartered banks, thus potentially frustrating Federal
banking policy.

H.R. 2494 resolves this issue by forgiving, subject to certain restrictions, recapture with
respect to that the portion of the bad debt reserve for which it is understood that deferred tax
liabilities have not been recorded for financial accounting purposes. Such forgiveness raises
certain tax policy concerns... In general, whenever.a taxpayer changes from one.method of
accounting to another, such change is implemented by way of a section 481(a) adjustment that
reflects the cumulative difference between the old and new accounting methods. This
adjustment generally is restored to income over a specified period of time so that a taxpayer does
not receive a "double deduction" with respect to an item of expense--once under the old method
and again under the new method. Restoring the section 481(a) adjustment to income with
respect to a repeal of a reserve method of accounting for bad debts ensures that the taxpayer does

-8-



B. Prior Law

Savings and loan associations, cooperative banks and mutual savings banks were tax
exempt until the Revenue Act of 1951. While thrift institutions were made taxable as part of that
Act, they also were given generous bad debt deductions that effectively kept thrift institutions
exempt from income tax. In the Revenue Act of 1962, Congress attempted to end this virtual tax
exemption by modifying the bad debt reserve deductions.

The system set up in 1962 allowed thrift institutions to choose among two alternative
formulas: (1) an annual addition to reserves of 60 percent of taxable income (limited to a loss
reserve of 6 percent of qualifying real property loans), or (2) a loss reserve of 3 percent of
qualifying real property loans plus a percentage of other loans based on experience. Savings and
loan associations and cooperative banks were allowed to use these methods only if 82 percent of
their assets were invested in residential real estate, liquid assets and certain other assets, but no
similar restrictions were applied to mutual savings banks.

The Tax Reform Act of 1969 eliminated the 3-percent method, phased down the percent
of taxable income from 60 to 40 percent over 10 years, applied limits on the use of the
percentage of taxable income method to mutual savings banks similar to those applicable to
savings and loan associations (but with a 72-percent qualifying asset requirement in place of 82
percent), provided that the taxable income percentage was to be phased down gradually if an
institution's proportion of qualifying assets fell short of 82 or 72 percent (instead of causing that
institution to lose all benefit from the percentage of taxable income method), and made a series
of other modifications to the bad debt provisions.

The Economic Recovery Tax Act of 1981 expanded the organizations eligible for these
special rules to include stock savings banks. The rules applicable to stock savings banks are the
same as those applicable to savings and loan associations.

The Tax Equity and Fiscal Responsibility Act of 1982 enacted Code section 291 which
required that deductions for bad debts by a thrift institution must be reduced by 15 percent of the
amount that the institution's bad debt deduction exceeded the amount that would have been
allowed under the experience method. The section 291 cut-back percentage was increased to 20
percent by the Deficit Reduction Act of 1984.

The Tax Reform Act of 1986 ("1986 Act") created the present system for accounting for
bad debts by limiting the percentage of taxable income method to 8 percent of taxable income
for those thrift institutions that met the 60-percent qualifying asset test of present law and
repealing the section 291 cutback provision.* The 1986 Act also repealed the percentage-of-

® The 1986 Act changes did not change the effective tax rate applicable to thrift
institutions. Before the 1986 Act, the effective tax rate was 31.28 percent, computed as:

(1) 46-percent corporate tax rate times,

(2) 68 percent (100 percent minus 32-percent deduction allowed under 40-percent

-5-



Bad debt methods of commercial banks

A small commercial bank (i.e., one with an adjusted basis of assets of $500 million or
less) only may use the experience method or the specific charge-off method for purposes of
computing its deduction for bad debts. A large commercial bank must use the specific
charge-off method. If a small bank becomes a large bank, it must recapture its existing bad debt
reserve (i.e., include the amount of the reserve in income) through one of two elective methods.
Under the 4-year recapture method, the bank generally includes 10 percent of the reserve in
income in the first taxable year, 20 percent in the second year, 30 percent in the third year, and
40 percent in the fourth year. Under the cut-off method, the bank generally neither restores its
bad debt reserve to income nor may it deduct actual losses relating to loans held by the bank as
of the date of the required change in the method of accounting. Rather, the amount of such
losses are charged against and reduce the existing bad debt reserve; any losses in excess of the
reserve are deductible. Any reserve amount in excess of actual losses is includible in income.

Recapture of bad debt reserves by thrift institutions

Ifa thrift institution becomes a commercial bank, or if the institution fails to satisfy the
60-percent qualified asset test, it is required to change its method of accounting for bad debts
and, under proposed Treasury regulations,° is required to recapture its bad debt reserve.? The
percentage of taxable income portion of the reserve generally is included in income ratably over
a 6-taxable year period. The experience method portion of the reserve is not restored to income
if the former thrift institution qualifies as a small bank. If the former thrift institution is treated
as a large bank, the experience method portion of the reserve is restored to income either ratably
over a 6-taxable year period, or under the 4-year recapture method described above.

In addition, a thrift institution may be subject to a form of reserve recapture even if the
institution continues to qualify for the percentage of taxable income method. Specifically, if a
thrift institution distributes to its shareholders an amount in excess of its post-1951 earnings and
profits, such excess will be deemed to be distributed from the institution's bad debt reserve and
must be restored to income (sec. 593(e)).

° Prop. Treas- reg. sec. 1:593-13.

* The requirement of the proposed regulations that a thrift institution recapture its bad
debt reserves upon a change in the method of its accounting for bad debts is based on Nash v.
US., 398 U:S. 1 (1970), where the U.S. Supreme Court held that a taxpayer essentially was
required to recapture its bad debt reserve when the related accounts receivable were transferred
by the taxpayer .

4.



indefinite (i.e., generally, a reversal would only occur by operation of sec. 593(e), a condition
within the control of a thrift institution). However, the establishment of 1987 as a base year by
the 1986 Act increased the likelihood of bad debt reserve reversals with respect to post-1987
additions to the reserve and it is understood that thrift institutions generally have recorded
deferred tax liabilities for these additions.

D. Description of H.R. 2494

HR. 2494 (the "Thrift Charter Conversion Tax Act of 1995," introduced by Chairman
Archer, Mr. Leach, and Ms. Roukema on October 11, 1995), would repeal the section 593
reserve method of accounting for bad debts by thrift institutions, effective for taxable years
beginning after 1995. Under the bill, thrift institutions that qualify as small banks would be
allowed to utilize the experience method applicable to such institutions, while thrift institutions
that are treated as large banks would be required to use the specific charge-off method. Thus,
the percentage of taxable income method of accounting for bad debts would no longer be
available for any institution.

A thrift institution required to change its method of computing reserves for bad debts
would treat such change as a change in a method of accounting, initiated by the taxpayer, and
having been made with the consent of the Secretary of the Treasury. Any section 481(a)
adjustment required to be taken into account with respect to such change generally would be
taken into account ratably over a 6-taxable year period, beginning with the first taxable year
beginning after 1995. For purposes of determining the section 481(a) adjustment of a taxpayer,
the balance of the reserve for bad debts with respect to the taxpayer's base year (generally, the
balance of the reserve as of the close of the last taxable year beginning before January 1, 1988,
adjusted for decreases in the taxpayer's loan portfolio) would not be taken into account.
However, the balance of these pre-1988 reserves would continue to be subject to the provisions
of present-law section 593(e) (requiring recapture in the case of certain excess distributions to
shareholders).

Thus, under the bill, subject to the special rule described below, a thrift institution that
would be treated as a large bank generally would be required to recapture its post-1987 additions
to its bad debt reserve, whether such additions are made pursuant to the percentage of taxable
income method or the experience method. In addition, subject to the special rule described
below, a thrift institution that would qualify as a small bank generally only would be required to
recapture its post-1987 additions to its bad debt reserve that were attributable to the use of the
percentage of taxable income method during such period. If such small bank would later
become a large bank, any amount required to be recaptured under present law would be reduced
by the amount of the pre-1988 reserve.

Under a special rule, if the taxpayer meets the "residential loan requirement" for any
taxable year, the amount of the section 481(a) adjustment otherwise required to be restored to
income would be suspended. A taxpayer would meet the residential loan requirement if for any
taxable year, the principal amount of residential loans made by the taxpayer during the year is
not less than the average of the principal amount of such loans made during the six most recent

-7-



TAX TREATMENT OF
THRIFT INSTITUTIONS UNDER H.R. 2494,
THE "THRIFT CHARTER CONVERSION TAX ACT OF 1995"

Scheduled for a Hearing
Before the

HOUSE COMMITTEE ON WAYS AND MEANS

On October 26, 1995

Prepared by the Staff
of the

JOINT COMMITTEE ON TAXATION
October 25, 1995

JCX-46-95



principal reason that accountants changed the treatment of accounting for income taxes with
respect to bad debt deductions of thrift institutions for financial accounting purposes.

H.R. 2494 suspends the recapture of post-1987 additions to the bad debt reserve of a
thrift institution so long as the institution continues to originate a certain level of loans secured
by residential property. The residential loan requirement test is determined with respect to any
loans secured by an interest in residential real or church property (including mobile homes not
used on a transient basis). Such loans could include conforming and nonconforming’ home
purchase mortgages, home improvement loans, second trusts, mortgage refinancings and home
equity loans. This provision raises and addresses certain tax and banking policy issues. The first
issue is whether banking policy should be implemented through the Intemal Revenue Code. The
second issue is whether the residential loan requirement of the bill is appropriately tailored to
meet the perceived banking policy goal of ensuring a source of mortgage financing.

Specifically, (1) should this benefit be provided permanently or during a limited transition
period; and (2) does the provision encompass the appropriate types of loans for the appropriate
types of property?

actual bad debts of $2,500, and (3) under the six-year average formula of the experience method
would be allowed a deduction of $900. Pursuant to the change made by the 1986 Act, T would
be allowed a deduction of $1,000 (i.e., the amount necessary to restore the reserve to its base
year (year-end 1987) level.) Specifically, T would charge the year-end 1988 reserve balance of
$11,500 for the $2,500 actual loss and then add (and deduct) $1,000 to the reserve to restore the
balance to the $10,000 base year amount. Thus, T's post-1987 PTI deduction of $1,500 is
restored to income-under-post-1986-Act law (i.e, T-had actiially losses of $2;500 in 1989, but
only was allowed to deduct $1,000).

’ A loan generally is "conforming" if it readily acceptable on a secondary market. A
loan may be "nonconforming" if it exceeds a certain principal amount, provides for certain
variable interest rates, is secured by both a personal residence and other (e.g., farm) property, or
is made to an individual who fails to meet certain creditworthiness standards.

-10-



not receive a double deduction with respect to the same expense--once when the reserve is
established and again when the bad debt is actually realized. The opposite of implementing an
accounting method change under section 481 of the Internal Revenue Code is the "fresh start"
approach, wherein the taxpayer is allowed deductions under both its old and new methods of
accounting with no adjustment to reconcile the two methods.

H.R. 2494 effectively allows "fresh start" with respect to the pre-1988 reserves of a thrift
institution (subject to the sec. 593(e) limitation) and requires a section 481(a) adjustment with
respect to the post-1987 additions to the reserves of the institution (subject to the residential loan
requirement). Some would argue that allowing “fresh start" is appropriate with respect to bad
debts computed under the percentage of taxable income method of section 593 because such
method effectively acted as a permanent incentive for thrift institutions in the residential
mortgage business. Conversely, others would argue that fresh start is not appropriate because
the benefits of the percentage of taxable income method were never intended to be permanent
benefits--pointing to the recapture potential under section 593(e) (relating to certain excess
distributions to shareholders). Finally, a third argument could be made that it is appropriate to
allow "fresh start" with respect to the pre-1988 portion of the reserve and require recapture for
the post-1987 additions to the reserve because the change made by the 1986 Act establishing
1987 as a permanent base year changed the nature of the bad debt deductions of thrift institutions
from one of permanency to one of timing.® Indeed, the 1986 Act change appears to be the

® As discussed in Parts A. and B. above, the 1986 Act changed the base year balance to
the reserve balance at the close of 1987 taxable year. Prior to the 1986 Act, the base year
balance of a thrift institution was the reserve balance whenever the institution changed from one
bad debt method to another (e.g., from the percentage of taxable income method to the
experience method). How the establishment of 1987 as a permanent base year changed the
nature of bad debt deductions between pre-1988 years to post-1987 years can be illustrated by
the following example:

Assume that a thrift institution ("T") always used the percentage of taxable income
("PTI") method to deduct bad debts through 1986 when its reserve balance was $10,000, Further
assume that in 1987, T: (1) has insufficient taxable income to use the PTI method, (2) has actual
bad debt losses of $1,000, and (3) under the six-year average formula of the experience method,
would be allowed a deduction of $900. Under pre-1986 Act law, T would be allowed a bad debt
deduction of $1,000 (rather than $900) in 1987 because $1,000 is the amount necessary to
restore the reserve to its base year (PTI) level. Specifically, in 1987, T would charge the year-
end 1986 reserve of $10,000 for the $1,000 actual loss and then add (and deduct) $1,000 to the
reserve so that the balance'of-the reserve at-year‘end 1987 is‘once-again $10,000. Thus, T's
former PTI deductions, which gave rise to the $10,000 reserve balance, generally would not be
restored to income under pre-1986 Act law (subject to sec. 593(e)).

Further assume that in 1988, T has sufficient taxable income to be allowed a PTI
deduction of $1,500, increasing the balance of the reserve to $11,500 at year-end 1988. Further
assume that in 1989, T: (1) again has insufficient taxable income to use the PTI method, (2) has

-9-



eligible loans method for taxable years beginning after 1987. The 1986 Act significantly
changed the treatment of accounting for bad debts for other taxpayers by requiring the use of the
specific charge-off method for all taxpayers, except thrift institutions and "small banks" (i.e.
those with assets of $500 million or less). Small banks were allowed to continue to use the
experience method of section 585. The experience method was amended to establish 1987 as a
permanent base year for all taxpayers eligible to use the experience method, including thrift
institutions.

C. Proposed Banking Legislation (H.R. 2491)

Treatment of thrift institutions under H.R. 2491

HR. 2363 (the "Thrift Charter Conversion Act of 1995," introduced by Mrs. Roukema,
and Messrs. Leach, McCollum, Roth, Baker of Louisiana, Bachus, Vento, Flake, Royce, Lucas,
Weller, Metcalf, and Watts of Oklahoma on September 10, 1995, the major provisions of which
are contained in H.R. 2491, the 1995 budget reconciliation bill) would require savings and loan
institutions to forego their Federal thrift charters and become either State-chartered savings and
loan institutions or Federally-chartered banks. Under proposed Treasury regulations, if a thrift
institution becomes a bank, the institution would be subject to recapture of all or a portion of its
bad debt reserve . As described in detail below, it is understood that such recapture would
require the institution to immediately record, for financial accounting purposes, a current or
deferred tax liability for the amount of recapture taxes for which liabilities previously had not
been recorded (generally, with respect to the pre-1988 reserves) regardless of when such
recapture taxes are actually paid to the Treasury. It is further understood that the recording of
this liability generally would decrease the regulatory capital of the new bank.

Financial accounting treatment of tax reserves of bad debts of thrift institutions

In general, for financial accounting purposes, a corporation must record a deferred tax
liability with respect to items that are deductible for tax purposes in a period earlier than they are
expensed for book purposes. The deferred tax liability signifies that, although a corporation may
be reducing its current tax expense because of the accelerated tax deduction, the corporation will
become liable for tax in a future period when the timing item "reverses" (i.e., when the item is
expensed for book purposes but for which the tax deduction had already been allowed). Under
the applicable accounting standard (Accounting Principles Board Opinion 23), deferred tax
liabilities generally were not required for pre-1988 tax deductions attributable to the bad debt
reserve method of thrift institutions because the potential reversal of the bad debt reserve was

of taxable income method, adjusted for the 20-percent cutback of sec. 291).

After the 1986 Act, the effective tax rate also was 31.28 percent, computed as:

(1) 34-percent corporate tax rate times,

(2) 92 percent (100 percent minus 8-percent deduction allowed under percentage of
taxable income method).

-6-



I OVERVIEW

Thrift institutions (i.e., building and loan associations, mutual savings banks, or
cooperative banks) historically have been allowed Federal income tax deductions for bad debts
under reserve methods that were more favorable than those granted to other taxpayers (and more
favorable than the rules applicable to other financial institutions, including banks). The thrift
bad debt method of present law, contained in section 593 of the Internal Revenue Code, allows a
qualified thrift institution to deduct as an addition to its reserve for bad debts an amount equal to
the larger of: (1) 8 percent of its taxable income, or (2) the amount determined under the
experience method generally applicable to small banks. Under proposed Treasury regulations,
the conversion of a thrift institution to a bank requires the institution to recapture all or a portion
of its bad debt reserve.

HR. 2363 (the "Thrift Charter Conversion Act of 1995," the principal provisions of
which are contained in Title II of H.R. 2491, the 1995 budget reconciliation bill), contains a
provision that would require a Federally-chartered savings and loan institution to become a
Federally-chartered bank or State-chartered savings and loan institution. It is understood that the
recapture for Federal income tax purposes of a portion of the bad debt reserve of a thrift
institution upon the conversion to a Federally-chartered bank would require the institution to
record a tax liability for financial accounting purposes that would reduce the regulatory capital
of the institution.

FLR. 2494, the "Thrift Charter Conversion Tax Act of 1995," would (1) repeal the special
bad debt reserve method of section 593 for all thrift institutions, (2) not require the recapture of a
certain portion of the institutions' bad debt reserves, and (3) suspend recapture of the remaining
portion of the reserve for each taxable year an institution met a residential loan requirement. The
residential loan requirement would be met for a taxable year if the institution made a principal
amount of loans secured by certain residential real or church property equal to the average
amount of such loans made by that institution during a preceding 6-year period.

In addition, H.R. 2491 would require thrift institutions to pay a special assessment to the
Saving Association Insurance Fund ("SAIF"), the insurance fund for deposits in thrift
institutions. Effective January 1, 1998, the SAIF would be merged with the Bank Insurance
Fund ("BIF") (the insurance fund for deposits in banks). Thrift institutions and banks currently
are required to pay annual premiums to the SAIF and BIF, respectively, based on the amount of
their insured deposits, but the premium rate for the SAIF deposits is substantially higher than the
premium rate for BIF deposits. After the merger of the SAIF and BIF in 1998, thrift institutions
and banks would be subject to the same lower deposit insurance rates generally applicable to
banks.

It may be unclear under present law whether the payment of the special assessment under

H.R. 2491 would be deductible for the Federal income tax purposes. H.R. 2494 would provide
that the special assessment would be deductible when paid.

-2-



INTRODUCTION

The House Committee on Ways and Means has scheduled a public hearing on October
26, 1995, on H.R. 2494 (the "Thrift Charter Conversion Tax Act of 1995"), which was
introduced by Chairman Archer, Mr. Leach, and Mrs. Roukema on October 11, 1995. H.R. 2494
addresses certain Federal income tax issues relating to the treatment of thrift institutions raised
by proposed banking legislation (H.R. 2363, the "Thrift Charter Conversion Act of 1995," the
principal provisions of which are contained in Title Il of H.R. 2491, the 1995 budget
reconciliation bill as reported by the House Committee on the Budget.') This document,”
prepared by the staff of the Joint Committee on Taxation, describes present law and background
with respect to the treatment of thrift institutions and the provisions contained in H.R. 2494.

Part I of the document provides an overview. Part II provides a description of the
treatment of bad debt reserves of thrift institutions under present law, prior law, and the bill, and
a discussion of the issues raised by H.R. 2491 and H.R. 2494. Part III provides a description of
the tax treatment under present law and under H.R. 2494 of certain special assessments proposed
to be levied upon thrift institutions by H.R. 2491.

* See Title Il of H.R. 2491 (“Seven-Year Balanced Budget Reconciliation Act of 1995"),
as reported (H. Rept. 104-280, October 17, 1995.)

* This document may be cited as follows: Joint Committee on Taxation, Tax Treatment
of Thrift Institutions Under H.R. 2494, the "Thrift Charter Conversion Tax Act of 1995”

(JCX-46-95), October 25, 1995.

-1-



INTRODUCTION
I. OVERVIEW nn
fl

WI.

CONTENTS

ACCOUNTING FOR BAD DEBTS BY THRIFT INSTITUTIONS .

A.

B.

PresentLaw ..........

PriorLaw ............

Proposed Banking Legislation (H.R. 2491) ........ an

Description of H.R. 2494

Issues Raised by H.R. 2491 and H.R. 2494 2.0200...

TAX TREATMENT OF SPECIAL ASSESSMENT ..................

A.

B.

Present Law and Background .........................

Description of H.R. 2494

nN

we



I.. TAX TREATMENT OF SPECIAL ASSESSMENTS
A. Present Law and Background

Title II of H.R. 2491 would require thrift institutions to pay a special assessment to the
Saving Association Insurance Fund ("SAIF"). The SAIF generally is the insurance fund for
deposits in thrift institutions. The amount of the assessment would be the amount necessary to
ensure that the SAIF has reserves of $1.25 for each $100 of insured deposits and the due date of
the payment would be the first business day of January 1996. Effective January 1, 1998, the
SAIF would be merged with the Bank Insurance Fund ("BIF") (the insurance fund for deposits in
banks). Thrift institutions and banks also are required to pay annual premiums to the SAIF and
BIF, respectively, based on the amount of their insured deposits. Currently, the premium rate for
the SAIF deposits is substantially higher than the premium rate for BIF deposits. After the
merger of the SAIF and BIF in 1998, under H.R. 2491, thrift institutions and banks would be
subject to the same lower deposit insurance rates generally applicable to banks.

In general, a taxpayer is allowed to deduct ordinary and necessary expenses paid or
incurred in carrying on a trade or business during the taxable year (sec. 162). However, amounts
that give rise to a permanent improvement or betterment must be capitalized rather than deducted
currently (sec. 263). Whether an expenditure is deductible under section 162 or must be
capitalized under section 263 is often a matter of dispute between the IRS and taxpayers, and has
been the subject of significant litigation. Most recently, in INDOPCO v. Commissioner, 503
U.S. 79 (1992), the U.S. Supreme Court noted that the capitalization of expenditures is the norm
and that a current "income tax deduction is a matter of legislative grace and that the burden of
clearly showing the right to the claimed deduction is on the taxpayer."* In INDOPCO, the Court
distinguished its prior decision in Lincoln Savings v. Commissioner, 403 U.S. 345 (1971),
(relating to additional premiums paid by a thrift institution to the Federal Savings and Loan
Insurance Corporation) to hold that it is not necessary for an expenditure to give rise to the
creation of a separate and distinct asset before such expenditure is capitalized. Rather, the Court
held that “although the presence of an incidental future benefit may not warrant capitalization, a
taxpayer's realization of benefits beyond the year in which the expenditure is incurred is
important in determining whether the appropriate tax treatment is immediate deduction or
capitalization." In INDOPCO, the Supreme Court found that the record supported the lower
courts’ findings that the investment banking fees in question produced significant benefits
extending beyond the tax year in which they were incurred so as to warrant capitalization.

The scope of the INDOPCO decision and its application to the payments of the special
assessments provided in H.R..2491 is uncertain.. On the one hand, ifthe special assessments are

® INDOPCO, citing Interstate Transit Lines v_Comm., 319 U.S. 590, 593 (1943);

Deputy v. DuPont, 308 U.S. 488, 493 (1940); and New Colonial Ice Co. v. Helvering, 292 U.S.
435, 440 (1934).

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