Rev. Rul. 63-122

Advice has been requested concerning the computation of reasonable annual additions to reserves for bad debts under Mimeograph 6209, C.B. 1947-2, 26, and Revenue Ruling 54-148, C.B. 1954-1, 60, by banks which maintain so-called `hold back' accounts with respect to installment paper acquired by them, under the circumstances described below.

Dealers handling various items of merchandise frequently dispose of their customers' installment paper to banks and other financial institutions. The bank in the instant case processes these transactions by establishing, in its individual checking ledgers, special accounts for the dealers, known as `hold back' accounts.

When a dealer discounts his installment paper with the bank, the bank deducts from the face amount of the paper (1) the discount charged to the dealer for taking over the paper and (2) the `hold back.' The entire amount of the discount is immediately credited to unearned interest or some other similar account. The `hold back' is credited to a special checking account which is in the dealer's name, but is restricted by the bank with respect to withdrawal. As additional paper is discounted by a dealer, additional amounts of `hold back' are credited to this account by the bank. Any amount due on paper which is determined by the bank to be uncollectible is charged to the dealer's `hold back' account. At any time that the `hold back' account is more than a specified percentage of the outstanding paper discounted by the dealer, the excess may be paid to the dealer by the bank.

Section 166(c) of the Internal Revenue Code of 1954 allows a deduction for a reasonable addition to a reserve for bad debts.

Mimeograph 6209, as supplemented by Revenue Ruling 54-148, sets forth methods of computing annual additions to bad debt reserves by banks. Mimeograph 6209 indicates that only loans in which an element of risk is present should be considered by a bank in computing additions to bad debt reserves under these methods. Further, an addition to a bad debt reserve may not be based on an item which has never been included in income. See Wilber Glenn Voliva v. Commissioner , 36 Fed.(2d) 212 (1929), Ct. D. 162, C.B. IX-1, 301 (1930).

In the instant case, the `hold back' accounts are clearly in the nature of guarantee deposits left with the bank by the dealers to protect the bank from any loss on the paper. Therefore, it is concluded that, to the extent of such guarantee deposits, the bank has no risk in the paper.

In view of the foregoing, it is held that for the purpose of computing reasonable annual additions to its reserve for bad debts under Mimeograph 6209 and Revenue Ruling 54-148, supra , a bank is required to decrease the face amount of installment paper outstanding by (1) the amount of the `hold back' account and (2) the amount of any discount which has not yet been realized and reported in gross income for Federal income tax purposes.