Rev. Rul. 68-630

SECTION 1. PURPOSE.

The purpose of this Revenue Ruling is to clarify certain questions regarding the eligibility of items for inclusion in the loan base by banks using the uniform reserve ratio method of computing annual additions to reserves for bad debts.

SEC. 2. BACKGROUND.

Section 166(a) of the Internal Revenue Code of 1954 allows a deduction for a debt that became worthless during the taxable year and, under certain circumstances, for a debt that is recoverable only in part and is charged off within the taxable year. Section 166(c) of the Code provides that, in lieu of any deduction under section 166(a) of the Code, there shall be allowed (in the discretion of the Secretary of the Treasury or his delegate) a deduction for a reasonable addition to a reserve for bad debts.

Revenue Ruling 65-92, C.B. 1965-1, 112, provides a revised special method for use by banks for taxable years ending after December 31, 1964, designed to minimize the large variances in permissible reserves that had existed. This method, set forth in Sections 3 through 6 of Revenue Ruling 65-92, utilizes a uniform ratio of 2.4 percent of outstanding loans at the close of the taxable year. Although Revenue Ruling 65-92 indicates that `Government insured or guaranteed loans to the extent so insured or guaranteed' are not to be considered as within the loan base, that Revenue Ruling does not undertake to resolve certain questions with regard to the composition of the loan base upon which allowable annual additions to a reserve for bad debts are to be computed. Revenue Ruling 65-92 has been supplemented by Revenue Ruling 66-26, C.B. 1966-1, 41, which provides guidelines for use by banks in computing bad debt reserves. Those Revenue Rulings have been modified by Revenue Ruling 68-524, page 83, this Bulletin, with respect to the scope of the term `bank.'

SEC. 3. INTERBANK DEPOSITS AND LOANS.

Bank funds on deposit in another bank (as defined in section 581 of the Code) or in a foreign bank are not eligible for inclusion in the loan base upon which allowable deductions for additions to a reserve for bad debts are computed. This would include any funds represented by a certificate of deposit or any other form of instrument evidencing the deposit of a sum of money with the issuing bank that will be available for withdrawal on or after a given date or period of time. A loan to a bank (as defined in section 581 of the Code), and a loan to a branch or agency of a foreign bank engaged in the banking business in the United States that may be entitled to compute the addition to its reserve for bad debts under Revenue Ruling 65-92 (see Revenue Ruling 68-524), are not eligible for inclusion in the loan base irrespective of whether they take the form of repurchase agreements or similar transactions. See Revenue Ruling 68-3, C.B. 1968-1, 75.

SEC. 4. CASH COLLATERAL.

Revenue Ruling 63-122, C.B. 1963-2, 98, holds, in part, that for the purpose of computing reasonable annual additions to its reserve for bad debts a bank is required to decrease the face amount of installment loans outstanding by the amount of any so-called `hold back' accounts related to such installment loans. As described in that ruling `hold back' accounts are in the nature of guarantee deposits left with the bank by dealers discounting installment paper. Revenue Ruling 63-122 also is applicable to the extent that a lending bank has collected and retained cash derived from collateral pledged to the bank and to the extent that loan payments made by a borrower are maintained in a separate account and are not immediately credited to the outstanding loan balance.

The underlying concept behind Revenue Ruling 63-122 is applicable to other situations in which a lending bank has rights in specific cash items or cash balances under its control such as when a lending bank receives collateral in the nature of cash on deposit in the lending bank that is represented by a passbook, certificate of deposit, or other similar instrument.

An outstanding loan otherwise eligible for inclusion in the loan base is not affected by the fact that a borrower is required, by virtue of an arrangement with the lending bank, to maintain a minimum, average, or compensating balance in a demand deposit account within the lending bank while the loan is outstanding. An overdraft in one or more deposit accounts of a customer is an outstanding loan eligible for inclusion in the loan base whether or not other deposit accounts of the same customer have balances in excess of the overdraft.

Loans secured by collateral such as passbooks, certificates of deposit, or other similar instruments representing cash on deposit in a bank (as defined in section 581 of the Code) or in a branch or agency of a foreign bank engaged in the banking business in the United States that may be entitled to compute the addition to its reserve for bad debts under Revenue Ruling 65-92 (see Revenue Ruling 68-524), other than the lending bank, must be excluded from the loan base to the extent that the lending bank may control withdrawal of such cash deposits. These principles do not apply to collateral representing sums held by non-banking institutions.

SEC. 5. UNEARNED DISCOUNT OR INTEREST RECEIVABLE.

Any unearned discount or interest receivable reflected in the face amount of outstanding loans but not realized and reported as income must be excluded from the loan base of banks using the reserve method. See Revenue Ruling 63-122.

SEC. 6. GOVERNMENT INSURED OR GUARANTEED LOANS.

Revenue Ruling 65-92 provides that Government insured or guaranteed loans must be excluded from the loan base to the extent so insured or guaranteed. See also Revenue Ruling 58-259, C.B. 1958-1, 116; Revenue Ruling 57-509, C.B. 1957-2, 145; Revenue Ruling 57-210, C.B. 1957-1, 94; and Miners National Bank of Wilkes-Barre v. Commissioner , 33 T.C. 42 (1959).

The term `Government insured or guaranteed loans' includes both direct loans to a `Government' as well as loans to a third party that are insured or guaranteed, directly or indirectly, by a `Government.' In the case of loans to third parties, however, the amount to be excluded from the loan base is limited to that portion of such loans that are insured or guaranteed by a `Government.'

The term `Government' as used in the cited Revenue Rulings is to be interpreted as having reference to the Federal Government and its instrumentalities, the District of Columbia, Territories or possessions of the United States, and State governments and political subdivisions thereof. Compare section 103 of the Code. Loans to foreign governments, therefore, are includible in the loan base unless insured or guaranteed by a `Government' as that term is used in this section.

SEC. 7. INVESTMENTS IN DEBT SECURITIES.

Section 582(a) of the Code provides that losses arising from the worthlessness of securities, as that term is defined in section 165(g)(2)(C) of the Code, may be deducted as ordinary debt losses under section 166 of the Code rather than as capital losses from worthless securities under section 165 of the Code. However, the special methods of determining allowable deductions for additions to reserves for bad debts of banks can only be justified in the context of the normal customer loan activities of banks. These methods may not appropriately be applied to the trading or investment aspects of a bank's financial activities. Accordingly, the special reserve methods of accounting for bad debts in the case of banks do not apply to securities.

Banks using the methods provided by Revenue Ruling 65-92 for determining allowable deductions for additions to a reserve for bad debts must therefore exclude investments in securities, as that term is used in section 165(g)(2)(C) of the Code, from the loan base upon which such deductions are determined.

SEC. 8. MONEY MARKET INVESTMENTS.

Money market obligations form part of an objective market, and are acquired and disposed of by banks as part of the continual process of maintaining and adjusting their liquidity position. In this context, money market obligations, like debt securities, are functionally related to the trading or investment position of banks rather than the lending position of banks.

Accordingly, it is held that banks using the uniform reserve ratio method specified in Revenue Ruling 65-92 must exclude from the loan base upon which annual additions to a reserve are calculated the following money market obligations:

(1) `Sales' or `loans' of Federal funds irrespective of the purchaser or borrower.

(2) `Commercial paper' however acquired by the taxpayer bank. One example of commercial paper is short-term promissory notes (less than 1 year and generally of 4 to 6 months duration) that may be purchased on the open market.

A bankers acceptance purchased or discounted by a bank is includible in its loan base. Customer's liability to the originating bank on acceptances outstanding, however, must be excluded from the loan base of the originating bank, since such liability merely represents the future extension of credit with respect to which no money has been advanced by the originating bank.

SEC. 9. DETERMINATION OF A REPRESENTATIVE LOAN BASE.

A bank may compute the addition to its reserve for bad debts on the basis of loans outstanding at the close of its taxable year, except that any loan outstanding on such date that is not representative of the bank's ordinary portfolio of outstanding customer loans must be excluded from the loan base. If a loan is entered into or acquired for the purpose (whether or not it is the primary purpose) of enlarging the otherwise available bad debt deduction, it will be presumed that the loan resulting from such transaction is not representative of the bank's ordinary portfolio of outstanding customer loans.

SEC. 10. EXTENT OF APPLICATION WITHOUT RETROACTIVE EFFECT.

The position stated in this Revenue Ruling clarifies certain questions that have arisen concerning computation of the loan base but does not represent a change in a previously published position of the Internal Revenue Service. It would, therefore, normally be applied to all open taxable years. However, in view of the nature of the deduction for additions to a reserve for bad debts, over-all tax deductions to taxpayers here involved would not be significantly affected by the timing of the application of this Revenue Ruling. Therefore, under the authority of section 7805(b) of the Code, the position stated herein will not be applied by the Service to deductions claimed for taxable years ending on or before November 30, 1968, to the extent that such deductions were based on inclusion of the following items in the loan base:

(1) Loans to other banks. See section 3 of this Revenue Ruling.

(2) Loans with respect to which the lender receives collateral in the nature of cash on deposit in the lending bank or another bank that is represented by a passbook, certificate of deposit or other similar instrument. See section 4.

(3) Loans to or loans insured or guaranteed by political subdivisions of a State government, except to the extent such loans are insured or guaranteed by a State government. See section 6.

(4) `Sales' or `loans' of Federal funds. See section 8.

(5) Commercial paper. See section 8.

The amount of the deduction for an addition to the reserve for bad debts for a taxable year must be based upon the amount contemporaneously entered on the taxpayer's books during the taxable year, or as soon as practicable after the close of the taxable year, and cannot be subsequently increased.

SEC. 11. TRANSITIONAL ADJUSTMENTS.

If the amount of a bank's outstanding loans for a taxable year ending after November 30, 1968, is less than the amount of loans outstanding at the close of the taxable year of the bank ending on or before November 30, 1968, solely as a result of the exclusion of the items in section 10, then such bank may maintain the dollar balance of its reserve as of the close of the taxable year ending on or before November 30, 1968, by making additions to its reserve equal to the net amount of bad debts charged to the reserve during the taxable year, subject to the overall limitation of section 6 of Revenue Ruling 65-92. However, no addition to its reserve for bad debts for the taxable year is permitted to a bank that computes its bad debt reserves under section 4 of Revenue Ruling 65-92, to the extent that such reserve for the taxable year would exceed 2.4 percent of loans outstanding computed without regard to exclusion of the items in section 10.

If the amount of a bank's outstanding loans for a taxable year ending after November 30, 1968, is less than the amount of loans outstanding as of the close of its taxable year preceding the year of change (see section 6 of Revenue Ruling 66-26), solely as a result of the exclusion of the items in section 10, then such bank may maintain the dollar balance of its reserve as of the close of its taxable year preceding the year of change by making additions to its reserve equal to the net amount of bad debts charged to the reserve during the taxable year, subject to the overall limitation of section 6 of Revenue Ruling 65-92.

If the decline in the loans outstanding for a taxable year is only partially as a result of the exclusion of the items in section 10, then the bank may make additions to its reserve for bad debts in the taxable year, to the extent of the net amount of bad debts charged to the reserve during the taxable year, that would be permitted had the excluded items been included in the loan base.

SEC. 12. TREATMENT OF EXCLUDED ITEMS.

Losses on worthless securities are not to be charged against the bad debt reserve established under Revenue Ruling 65-92. See section 7 of this Revenue Ruling. Insofar as a bank coming within the definition of section 581 of the Code is concerned, deductions for losses on securities may be taken either as specific bad debt losses or may be taken through the creation of a separate loss reserve on such securities established without respect to Revenue Ruling 65-92. See section 582(a) of the Code. Insofar as a bank that does not meet the definition of section 581 of the Code is concerned, deductions for losses on securities are to be treated as provided in section 165 of the Code. See section 582(a) of the Code and Revenue Ruling 68-524. Losses on all other items that are excluded from the loan base of banks using the uniform reserve ratio method of determining additions to a reserve for bad debts are not to be charged against the reserve but may be deducted as a specific debt loss under section 166 of the Code. See Revenue Ruling 68-3.

SEC. 13. EFFECT ON OTHER DOCUMENTS.

Revenue Ruling 63-122 is hereby clarified. Revenue Ruling 65-92, as supplemented by Revenue Ruling 66-26, and as modified by Revenue Ruling 68-524, is hereby further supplemented.

¹ Also released as News Release IR-947, dated Nov. 19, 1968.