Final Regs on Bad Debt Reserves of Large Banks

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains final income tax regulations relating to bad debt reserves of large banks. These regulations are necessary because the Tax Reform Act of 1986 repealed bad debt reserves for large banks. The regulations implement this repeal.

 EFFECTIVE DATE: The regulations are effective for taxable years beginning after December 31, 1986.

 FOR FURTHER INFORMATION CONTACT: Craig Wojay, (202) 622-3920 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1290. The estimated annual burden per respondent varies from 10 minutes to 20 minutes, depending on individual circumstances, with an estimated average of 15 minutes.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the IRS. Individual respondents may require greater or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer PC:FP, Washington, D.C. 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

This document provides final regulations on the repeal, for large banks, of the reserve method of accounting for bad debts that is allowed by section 585 of the Internal Revenue Code (Code). These regulations reflect Code section 585(c), which was added by section 901 of the Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085, 2375-2380 (1986), and amended by section 1009(a) of the Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, 102 Stat. 3342, 3445 (1988). These final regulations supersede related portions of 26 CFR 301.9100-7T (formerly 26 CFR 5h.5), which provides temporary regulations on the time and manner of making various elections under the Tax Reform Act of 1986.

 Proposed regulations under Code section 585(c) were published in the Federal Register on December 12, 1990 (55 FR 51124). No public hearing on these regulations was requested or held, but a number of written comments were received. After consideration of the comments, the proposed regulations are adopted as modified by this Treasury decision.

EXPLANATION OF PROVISIONS

 Code section 585(c) provides that large banks may not use the reserve method of section 585 for taxable years beginning after December 31, 1986. After this date, large banks must use the specific charge-off method of accounting for bad debts. Section 585(c) also provides procedures for large banks to use in changing from the reserve method of section 585 to the specific charge-off method. Section 585(c)(3) provides a recapture method of change, and section 585(c)(4) provides an elective cut-off method of change.

 The final regulations contained in this document implement section 585(c) by adding new sections 1.585-5 through 1.585-8 and by making conforming amendments to sections 1.585-1, 1.585-2 and 1.585-3. Section 1.585-5 states the general rule of denial of bad debt reserves for large banks. Section 1.585-6 provides guidance on the recapture method of change; section 1.585-7, on the cut-off method of change; and section 1.585-8, on making and revoking elections allowed under the regulations.

 The extent to which this Treasury decision reflects the comments received on the proposed regulations is discussed below.

SECTION 1.585-5: DENIAL OF BAD DEBT RESERVES FOR LARGE BANKS

 Section 1.585-5(a) requires a large bank to change to the specific charge-off method in the first taxable year beginning after 1986 for which it is a large bank (the disqualification year). Section 1.585-5(b) explains how to determine whether an institution is a large bank, and section 1.585-5(c) explains how to determine a bank's average total assets for purposes of applying the $500 million test of large bank status.

 SECTION 1.585-5(a): THRIFT INSTITUTIONS. Several commentators on the proposed regulations objected to a provision in proposed section 1.585-5(a) that prohibited an institution from following the rules of section 1.585-6 or section 1.585-7 if it had maintained a reserve under Code section 593, rather than section 585. Proposed regulations under section 593 (57 FR 1232 (1992)) address this issue, and section 1.585-5(a) has been modified to reflect the fact that those regulations, when finalized, will provide guidance. Final section 1.585-5(a) prohibits these institutions from following sections 1.585-6 and 1.585-7, "except as may be provided otherwise in regulations prescribed under section 593."

 SECTION 1.585-5(b)(1): ONCE A LARGE BANK. A commentator on the proposed regulations objected to the "once a large bank, always a large bank" rule that is provided by section 1.585-5(b)(1)'s reference to any preceding taxable year after 1986. However, Code section 585(c)(2) specifically requires this reference. Moreover, the Conference Committee on the Technical and Miscellaneous Revenue Act of 1988 rejected a proposed exception to this rule. H.R. Conf. Rep. No. 1104, 100th Cong., 2d Sess., Vol. II, at 243-244 (1988). For these reasons, the final regulations retain the "once a large bank" rule.

 SECTION 1.585-5(b)(1): SECTION 338 ELECTIONS. To clarify the application of the "once a large bank" rule, the final regulations provide guidance on the treatment of section 338 elections in determining large bank status. New Example 4 of section 1.585-5(b)(3) involves a corporation that purchases the stock of a bank and elects under section 338 to treat the purchase as an asset acquisition. Under section 338, the acquired bank is treated as a new corporation for purposes of subtitle A. Accordingly, the bank's prior status as a large bank does not cause it to be considered a large bank after its sale.

 SECTION 1.585-5(b)(2): TRANSFER OF LARGE BANK'S ASSETS. Several commentators focused on proposed section 1.585-5(b)(3), which applied the "once a large bank" rule to certain acquisitions of substantially all of a large bank's assets. In response to the comments, final section 1.585-5(b)(2)(iii) limits this provision primarily to acquisitions to which section 381(a) applies. Under final section 1.585-5(b)(2)(iv), other acquisitions of substantially all of a large bank's assets result in large bank treatment only if a principal purpose of the acquisition is to avoid treating the acquired assets as those of a large bank and the acquiror is related to the large bank whose assets are acquired, as specified in the regulations.

 SECTION 1.585-5(c)(2): DATES FOR DETERMINING AVERAGE TOTAL ASSETS. The final regulations also modify section 1.585-5(c), which defines a bank's average total assets for purposes of applying the $500 million test. As requested by a commentator, the final regulations give banks the option of determining their average total assets on a more frequent basis than quarterly. Under new section 1.585-5(c)(2)(i)(B), a bank may compute its average total assets for a year on the basis of its adjusted tax bases of assets held at the end of any regular interval more frequent than quarterly, such as bi- monthly, monthly, or weekly. A more frequent determination of assets generally produces a more accurate average for the year.

 SECTION 1.585-5(c)(3): FOREIGN CORPORATION'S ASSETS. Final section 1.585-5(c)(3)(ii) makes it clear that in determining the amount of a foreign corporation's total assets, all of its assets are taken into account, including those that are not effectively connected with the conduct of a banking business within the United States. Section 585(c)(2) applies the $500 million test to "all assets" of a bank or its parent-subsidiary controlled group, and section 1.585-6(d)(3)(i) provides the equivalent clarification for purposes of determining a bank's nonperforming loan percentage.

 SECTION 1.585-5(d): DISQUALIFICATION YEAR. In response to a comment, the final regulations also clarify the definition of the term disqualification year. A new example in section 1.585-5(d)(3) makes it clear that if a small bank becomes large because its stock is acquired by a large bank, the disqualification year of the acquired bank is its first taxable year ending after the acquisition date. Pursuant to section 1.585-8(d), the acquired bank is then entitled to make its own election regarding use of the recapture or cut-off method of change.

SECTION 1.585-6: RECAPTURE METHOD OF CHANGE

 Under the recapture method of change, a bank includes the balance of its bad debt reserve in income over a four-year period, and recapture is suspended for any taxable year in which the bank is financially troubled. Commentators on the proposed regulations focused on section 1.585-6(c), which explains the effects of a disposition of loans by a large bank that is using the recapture method, and section 1.585-6(d), which provides guidance for financially troubled banks.

 SECTION 1.585-6(c)(2): CESSATION OF BUSINESS. Proposed section 1.585-6(c)(2) provided that a large bank that ceases to engage in the banking business before completing recapture of its reserve must include in income the remainder of its section 481(a) adjustment in the taxable year of the cessation. Proposed section 1.585-6(c)(2) also provided that a bank would not be considered to have ceased to engage in the banking business if the cessation was the result of a section 381 transaction. Since the issuance of the proposed regulations, the Service, pursuant to section 446(e) and section 1.446-1(e), published uniform standards for accounting method changes that include guidance on when a taxpayer is considered to have ceased to engage in business for section 481(a) purposes. See Rev. Proc. 92-20, 1992-1 C.B. 685, 701. To be consistent with this uniform approach, final section 1.585-6(c)(2)(i) provides that whether a bank ceases to engage in the banking business generally is determined under the principles of section 1.446-1(e)(3)(ii) and its administrative procedures. In addition, final section 1.585-6(c)(2)(ii) provides a transition rule for section 381 transactions that occur, or for which a binding written commitment is entered into, on or before February 28, 1994. Under the transition rule, a bank that ceases to engage in the banking business as the result of such a transaction is not treated as ceasing to engage in this business. In response to comments, the final regulations also expand the examples in section 1.585-6(c)(4) to provide additional guidance on the tax consequences of section 381 transactions to which the transition rule applies.

 SECTION 1.585-6(d)(3)(ii): NONPERFORMING LOAN PERCENTAGE OF GROUP. Section 1.585-6(d)(3) provides rules for computing a bank's nonperforming loan percentage, which determines whether the bank is considered financially troubled. The numerator of this percentage is the amount of the bank's nonperforming loans, and the denominator is the amount of its equity. Under section 1.585-6(d)(3)(ii), if a bank is a member of a parent-subsidiary controlled group, the nonperforming loans and the equity of all members of the group that are financial institutions are treated as those of the bank. In response to a comment, the final regulations permit a bank to count the loans and equity of all members of the parent-subsidiary controlled group of which the bank is a member. A bank that computes its nonperforming loan percentage on this basis must do so for all taxable years, and any other bank member of the group must do the same.

 SECTION 1.585-6(d)(3)(iii) AND (iv): Amount reported to regulator. Proposed section 1.585-6(d)(3)(iii) defined a nonperforming loan essentially as any loan that is considered to be nonperforming by the holder's primary Federal regulatory agency. Similarly, proposed section 1.585-6(d)(3)(iv) defined a bank's equity as its equity (i.e., assets minus liabilities) as determined by the bank's primary Federal regulatory agency. In response to a comment, these sections have been revised to make it clear that the amount of a bank's nonperforming loans or equity is not determined by reference to the adjusted Federal income tax bases of assets, but rather by reference to amounts that are required to be reported to the primary Federal regulator.

 SECTION 1.585-6(d)(3)(iii)(A): TYPES OF NONPERFORMING LOANS. The final regulations also clarify the definition of a nonperforming loan by identifying specific types of loans that are considered nonperforming. As requested by commentators, and in accordance with the Conference Committee report on the Tax Reform Act of 1986 (page II-329), final section 1.585-6(d)(3)(iii)(A) provides that nonperforming loans include the following types of loans as defined by the Federal Financial Institutions Examination Council (FFIEC): loans that are past due 90 days or more and still accruing; loans that are in nonaccrual status; and loans that are restructured troubled debt. A loan is not considered to be nonperforming merely because it is past due, if it is past due less than 90 days.

 SECTION 1.585-6(d)(3)(iii)(B): DEFINITION OF LOAN. The final regulations also provide a definition of the term loan. This definition reflects the standards prescribed by the FFIEC. Accordingly, a troubled debt restructuring that is in substance a foreclosure or repossession is not considered a loan. The FFIEC treats "in substance" foreclosures and repossessions the same as formal foreclosures and repossessions; collateral that is considered foreclosed or repossessed is treated as an asset other than a loan. The final regulations provide a special rule for certain securities and bank deposits that are an integral part of a restructuring of troubled loans to a foreign government.

 SECTION 1.585-6(d)(3)(iii): ACCRUAL OF INTEREST. A commentator suggested that the definition of a nonperforming loan that is contained in section 1.585-6(d)(3)(iii) should be used to determine whether interest income on a loan must continue to be accrued under Code section 451. This issue is outside the scope of section 585(c) and therefore is not addressed in these final regulations.

 SECTION 1.585-6(d)(4): ESTIMATED TAX OF FINANCIALLY TROUBLED BANKS. Section 1.585-6(d)(4) provides relief from certain penalties for failure to pay estimated tax. Essentially, this section waives the penalty for failure to pay estimated tax in cases where a bank that is financially troubled in one quarter (and therefore does not pay quarterly estimated tax attributable to recapture of its reserve) is not financially troubled for the year as a whole (and thus has underpaid its estimated tax). In response to comments, section 1.585-6(d)(4) has been revised to provide that the determination of whether a bank is financially troubled, for purposes of waiving the penalty for failure to pay an installment of estimated tax, is to be based on the bank's nonperforming loan percentage at the time the installment is due. In effect, final section 1.585-6(d)(4) allows a bank to obtain relief from penalties on the basis of its financial status as of the end of the most recent period for which it is required to report to its primary Federal regulator. New Example 3 in section 1.585-6(d)(5) illustrates the operation of this provision.

SECTION 1.585-7: ELECTIVE CUT-OFF METHOD OF CHANGE

 Under the cut-off method of change, a bank continues to maintain its bad debt reserve for loans that it held when it became a large bank (pre-disqualification loans), but it may not deduct new additions to the reserve. If the reserve balance at the end of any taxable year exceeds the amount of the bank's outstanding pre- disqualification loans, the bank must include the amount of the excess in income for that year. Commentators on the proposed regulations focused on section 1.585-7(b), which provides guidance on maintaining a reserve for pre-disqualification loans, and section 1.585-7(d), which explains the effects of a disposition of loans by a large bank that is using the cut-off method.

 SECTION 1.585-7(b)(1): LOSSES FROM SALE OF LOANS. Section 1.585-7(b)(1) requires a bank to charge against its cut-off reserve any losses resulting from its pre-disqualification loans, including losses resulting from the sale or other disposition of these loans. A commentator objected to applying this requirement to losses from the disposition of loans. However, Code section 585(c)(4)(B) specifically requires that "any losses" resulting from pre- disqualification loans be charged against the reserve. Removing this requirement for losses resulting from a disposition of loans would allow banks using the cut-off method to obtain current deductions for pre-disqualification loans that become partially or wholly worthless by selling or otherwise disposing of the loans without charging the losses against the reserve. For these reasons, the requirement is retained.

 SECTION 1.585-7(b)(2): POST-DISQUALIFICATION INCREASE IN LOAN BALANCE. Another commentator suggested that section 1.585-7(b)(2), which defines a pre-disqualification loan, should be expanded to provide that if the balance of such a loan is increased during or after the disqualification year, the amount of the increase is treated as a pre-disqualification loan. However, neither section 585(c) nor its legislative history provides support for this approach. For this reason, the final regulations do not take the approach suggested by the commentator. Instead, section 1.585-7(b)(2) has been clarified by providing that if the amount of a pre- disqualification loan is increased during or after the disqualification year, the amount of the increase is not treated as a pre-disqualification loan.

 SECTION 1.585-7(d)(2): SMALL BANK'S ACQUISITION OF LARGE BANK'S ASSETS. Another commentator requested guidance on the consequences of a section 381 transaction in which a small bank that maintains a bad debt reserve acquires the assets of a large bank that is using the cut-off method of change, if the acquiror remains small after the acquisition and continues to use the reserve method. New section 1.585-7(d)(2)(ii) and new Example 5 in section 1.585-7(e) explain these consequences. In this case, the large bank's reserve immediately before the section 381 transaction carries over to the acquiror, but the acquiror does not continue the cut-off procedure begun by the large bank. If the six-year moving average amount for all of the newly acquired loans exceeds the balance of the reserve that carries over, the acquiror increases this balance by the amount of the excess. Any such increase in the reserve results in a negative section 481(a) adjustment that must be taken into account as required under section 381.

 SECTION 1.585-7(d)(3): DISPOSITIONS INTENDED TO CHANGE STATUS. Section 1.585-7(d)(3) provides a special rule for dispositions of pre-disqualification loans that are intended to change the status of the loans. The rule applies only if a bank disposes of a "significant amount" of loans, and a commentator suggested that a significant amount be defined. However, a significant amount of loans varies from bank to bank. No fixed dollar amount or percentage is an appropriate measure of significance for all banks. Therefore, the final regulations do not define this term.

SECTION 1.585-8: MAKING AND REVOKING ELECTIONS

 Certain elections are allowed under sections 1.585-6 and 1.585-7. A bank may elect to use the cut-off method of change instead of the recapture method, and a bank that uses the recapture method may elect to recapture more than 10 percent of its reserve in its first year of recapture. Commentators on the proposed regulations focused on the time for making and revoking these elections.

 SECTION 1.585-8(a) AND (c): TIME FOR MAKING AND REVOKING ELECTIONS. Section 1.585-8(a) requires any election to be made by the later of the date that is 60 days after these final regulations are published, or the due date (taking extensions into account) of the electing bank's tax return for the year for which the election is made. Section 1.585-8(c) does not allow an election to be freely revoked after the final date for making the election. Commentators suggested that this time period for making and revoking elections should be extended for banks that become large more than 60 days after these final regulations are published. However, the time period provided for these banks in the regulations is the time period ordinarily provided by the Service for making and revoking elections when final regulations are in effect. Taxpayers ordinarily are not permitted to change elections merely to reduce their tax liability. Therefore, the final regulations do not modify the time period for making and revoking elections.

 SECTION 1.585-8(e): CERTAIN ELECTIONS MADE OR REVOKED BY AMENDED RETURN. A new section 1.585-8(e) applies to elections that are sought to be made or revoked by amended return on or before February 24, 1994. To make or revoke such an election, amended returns must be filed for intervening taxable years if necessary to report tax liability in a manner consistent with the making or revoking of the election.

SPECIAL ANALYSES

 It has been determined that this Treasury Decision is not a significant regulatory action as defined in Executive Order 12866. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for these regulations was submitted to the Small Business Administration for comment on its impact on small business.

LIST OF SUBJECTS

26 CFR part 1

 Income taxes, Reporting and recordkeeping requirements. 26 CFR part 301

 Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements. 26 CFR part 602

 Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1, 301, and 602 are amended as follows:

PART 1 -- INCOME TAX

Paragraph 1. The authority citation for part 1 is amended by adding a citation in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Sections 1.585-5 through 1.585-8 also issued under 26 U.S.C. 585(b)(3).

Par. 2. Section 1.585-1 is amended as follows:

1. The first sentence of paragraph (a) is amended by removing "166(c)" and adding in its place "585(a) (or, for taxable years beginning before January 1, 1987, section 166(c))".

2. The seventh sentence of paragraph (a) is amended by removing "166(c) and the regulations thereunder" and adding in its place "585 (or, for taxable years beginning before January 1, 1987, section 166(c)) and the regulations under section 166".

3. The tenth sentence of paragraph (a) is amended by removing "(a), (b), and (c)".

4. A sentence is added at the end of paragraph (a).

5. Paragraph (b) is revised.

6. The additions and revisions read as follows:

SECTION 1.585-1 RESERVE FOR LOSSES ON LOANS OF BANKS.

(a) * * * For rules relating to large banks, see sections 1.585-5 through 1.585-8.

(b) APPLICATION OF SECTION -- (1) IN GENERAL. Except as provided in paragraph (b)(2) of this section, section 585 and this section apply to the following financial institutions --

(i) Any bank (as defined in section 581 and the regulations thereunder) other than a mutual savings bank, domestic building and loan association, or cooperative bank, to which section 593 applies; and

(ii) Any corporation to which paragraph (b)(1)(i) of this section would apply except for the fact that it is a foreign corporation and in the case of any such foreign corporation, the rules provided by section 585(a) and (b), this section, sections 1.585-2, 1.585-3, and 1.585-4 apply only with respect to loans outstanding the interest on which is effectively connected with the conduct of a banking business within the United States.

(2) EXCEPTION. For taxable years beginning after December 31, 1986, section 585(a) and (b) and this section do not apply to any large bank (as defined in section 1.585-5(b)). For these years, a large bank may not deduct any amount under section 585 or any other section for an addition to a reserve for bad debts.

Par. 3. In section 1.585-2, the last sentence of paragraph (d)(3) is amended by adding "585(a)(1) or former section" immediately before "166(c)".

Par. 4. Section 1.585-3 is amended as follows:

1. The first sentence of paragraph (a) is amended by removing "166(c)" and adding in its place "585(a) (or, for taxable years beginning before January 1, 1987, section 166(c))".

2. The first sentence of paragraph (b) is amended by removing "166(c)" and adding in its place "585(a) (or, for taxable years beginning before January 1, 1987, section 166(c))".

3. The second and third sentences of paragraph (b) are amended by removing "166(c)" and adding in its place "585(a) (or former section 166(c))".

Par. 5. Sections 1.585-5, 1.585-6, 1.585-7 and 1.585-8 are added to read as follows:

SECTION 1.585-5 DENIAL OF BAD DEBT RESERVES FOR LARGE BANKS.

(a) GENERAL RULE. For taxable years beginning after December 31, 1986, a large bank (as defined in paragraph (b) of this section) may not deduct any amount under section 585 or any other section for an addition to a reserve for bad debts. However, for these years, except as provided in section 1.585-7, a large bank may deduct amounts allowed under section 166(a) for specific debts that become worthless in whole or in part. Any large bank that maintained a reserve for bad debts under section 585 for the taxable year immediately preceding its disqualification year (as defined in paragraph (d)(1) of this section) must follow the rules prescribed by section 1.585-6 or section 1.585-7 for changing from the reserve method of accounting for bad debts that is allowed by section 585, to the specific charge-off method of accounting for bad debts, in its disqualification year. However, except as may be provided otherwise in regulations prescribed under section 593, the rules prescribed by sections 1.585-6 and 1.585-7 do not apply to a large bank that maintained a reserve for bad debts under section 593 for the taxable year immediately preceding its disqualification year.

(b) LARGE BANK -- (1) GENERAL DEFINITION. For purposes of this section, a large bank is any institution described in section 1.585-1(b)(1)(i) or (ii) if, for the taxable year (or for any preceding taxable year beginning after December 31, 1986) --

(i) The average total assets of the institution (determined under paragraph (c) of this section) exceed $500,000,000; or

(ii) The institution is a member of a parent-subsidiary controlled group (as defined in paragraph (d)(2) of this section) and the average total assets of the group exceed $500,000,000.

(2) LARGE BANK RESULTING FROM TRANSFER BY LARGE BANK -- (i) IN GENERAL. If a corporation acquires the assets of a large bank (as defined in this paragraph (b)) in an acquisition to which paragraph (b)(2)(ii), (iii) or (iv) of this section applies, the acquiring corporation (the acquiror) is treated as a large bank for any taxable year ending after the date of the acquisition in which it is an institution described in section 1.585-1(b)(1)(i) or (ii).

(ii) TRANSFER OF SIGNIFICANT PORTION OF ASSETS WHERE CONTROL IS RETAINED. This paragraph (b)(2)(ii) applies to any direct or indirect acquisition of a significant portion of a large bank's assets if, after the acquisition, the transferor large bank owns more than 50 percent (by vote or value) of the outstanding stock of the acquiror. For this purpose, stock of an acquiror is considered owned by a transferor bank if the stock is owned by any member of a parent- subsidiary controlled group (as defined in paragraph (d)(2) of this section) of which the bank is a member, by any related party within the meaning of section 267(b) or 707(b), or by any person that received the stock in a transaction to which section 355 applies.

(iii) TRANSFER TO WHICH SECTION 381 APPLIES. This paragraph (b)(2)(iii) applies to any acquisition to which section 381(a) applies if, immediately after the acquisition, the acquiror's principal method of accounting for bad debts (determined under section 1.381(c)(4)-1(c)(2)) with respect to its banking business is the specific charge-off method. In applying section 1.381(c)(4)- 1(c)(2) for this purpose, the following rules apply: a transferor large bank is considered to use the specific charge-off method for all of its loans immediately before the acquisition; an acquiror is considered to use a reserve method for all of its loans immediately before the acquisition; and all banking businesses of the acquiror immediately after the acquisition are treated as one integrated business. See sections 1.585-6(c)(3) and 1.585-7(d)(2) for rules on the treatment of assets acquired from large banks in section 381(a) transactions.

(iv) TRANSFER OF SUBSTANTIALLY ALL ASSETS TO RELATED PARTY. This paragraph (b)(2)(iv) applies to any direct or indirect acquisition of substantially all of a large bank's assets if the transferor large bank and the acquiror are related parties before or after the acquisition and a principal purpose of the acquisition is to avoid treating the acquired assets as those of a large bank. A transferor bank and an acquiror are considered to be related parties for this purpose if they are members of the same parent-subsidiary controlled group (as defined in paragraph (d)(2) of this section) or related parties within the meaning of section 267(b) or 707(b).

(3) EXAMPLES. The following examples illustrate the principles of this paragraph (b):

EXAMPLE 1. Bank M, a calendar year taxpayer, is an institution described in section 1.585-1(b)(1)(i). For its taxable year beginning on January 1, 1987, M has average total assets of $600 million. Since M's average total assets for 1987 exceed $500 million, M is a large bank for that year. Pursuant to section 1.585-5(d)(1), 1987 is M's disqualification year. If M maintained a bad debt reserve under section 585 for its immediately preceding taxable year (1986), M must change in 1987 to the specific charge-off method of accounting for bad debts, in accordance with section 1.585-6 or section 1.585-7.

EXAMPLE 2. Assume the same facts as in Example 1. Also assume that in 1988 M disposes of a portion of its assets and, as a result, M's average total assets for taxable year 1988 fall to $400 million. M remains a large bank for taxable year 1988 and succeeding taxable years, since its average total assets for a preceding taxable year (1987) beginning after December 31, 1986, exceeded $500 million.

EXAMPLE 3. Bank P, a calendar year taxpayer, is an institution described in section 1.585-1(b)(1)(i). P has average total assets of $300 million for its taxable year beginning on January 1, 1988. For the same year, P is a member of a parent-subsidiary controlled group (within the meaning of section 1.585-5(d)(2)) that has average total assets of $800 million. In February 1989, the group sells its stock in P to several individual investors. P is a large bank for taxable year 1988 because it is a member of a group described in section 1.585-5(b)(1)(ii) for that year. P also is a large bank for taxable year 1989 and succeeding taxable years because it was a member of a group described in section 1.585-5(b)(1)(ii) for a preceding taxable year (1988) beginning after December 31, 1986.

EXAMPLE 4. Assume the same facts as in Example 3, except that P's stock is purchased by a corporation that is not a large bank under section 1.585-5(b). Also assume that the purchasing corporation elects under section 338 to treat the stock purchase as an asset acquisition. Under section 338, P is considered to have sold all of its assets on the purchase date and is treated as a new corporation that purchased these assets on the next day. Since P is treated as a new corporation, its prior membership in a group described in section 1.585-5(b)(1)(ii) does not cause it to be treated as a large bank for taxable years ending after the date of its sale by the group. However, P may be treated as a large bank because of new membership in such a group or pursuant to section 1.585-5(b)(1)(i) or (b)(2).

EXAMPLE 5. Bank Q is a large bank, within the meaning of section 1.585-5(b)(1), for its taxable year beginning on January 1, 1988, and hence for all later years. On March 1, 1989, Q transfers $200 million of its $600 million of assets to Bank R, a newly created subsidiary, in a transaction to which section 351 applies; these assets are R's only assets. On the same day, Q then spins off R in a transaction to which section 355 applies. After these transactions, the shareholders of Q own more than 50 percent of R's outstanding stock. Although R's average total assets do not exceed $500 million, R becomes a large bank on March 1, 1989, pursuant to section 1.585-5(b)(2)(ii). These transactions do not affect Q's status as a large bank.

EXAMPLE 6. Bank S is a large bank, within the meaning of section 1.585-5(b)(1)(ii), for its taxable year beginning on January 1, 1987. As a result, S changes to the specific charge- off method of accounting for bad debts in that year. Bank T, which is not a large bank under section 1.585-5(b), uses the reserve method of accounting for bad debts. On June 30, 1988, T acquires substantially all of S's assets in a transaction to which section 381(a) applies. Immediately before the acquisition, S's banking business has total assets of $200 million, and T's has total assets of $250 million. To determine whether T is a large bank under section 1.585-5(b)(2)(iii) for taxable years ending after the acquisition, it is necessary to determine T's principal method of accounting for bad debts with respect to its banking business immediately after the acquisition. This determination requires an application of section 1.381(c)(4)-1(c)(2). For this purpose, T's original and acquired banking businesses are treated as an integrated business. Applying section 1.381(c)(4)-1(c)(2), it is determined that the business's principal method of accounting for bad debts immediately after the acquisition is the reserve method. Hence, the acquisition does not cause T to become a large bank under section 1.585-5(b)(2)(iii).

(c) AVERAGE TOTAL ASSETS -- (1) IN GENERAL. For purposes of paragraph (b)(1) of this section, and except as otherwise provided in paragraph (c)(3)(ii) of this section, the average total assets of an institution or group for any taxable year are determined by --

(i) Computing, for each report date (as defined in paragraph (c)(2) of this section) within the taxable year, the amount of total assets (as defined in paragraph (c)(3) of this section) held by the institution or group as of the close of business on the report date;

(ii) Adding these amounts; and

(iii) Dividing the sum of these amounts by the number of report dates within the taxable year.

(2) REPORT DATE -- (i) INSTITUTIONS -- (A) IN GENERAL. A report date for an institution generally is the last day of the regular period for which the institution must report to its primary Federal regulatory agency. However, an institution that is required to report to its primary Federal regulatory agency more frequently than quarterly may choose the last day of the calendar quarter as its report date, and an institution that is required to report to its primary Federal regulatory agency less frequently than quarterly must choose the last day of the calendar quarter as its report date. If an institution does not have a Federal regulatory agency, its primary State regulatory agency is considered its primary Federal regulatory agency for purposes of this paragraph (c)(2)(i)(A). In the case of a short taxable year that does not otherwise include a report date, the first or last day of the taxable year is the institution's report date for the year.

(B) ALTERNATIVE REPORT DATE. In lieu of the report date prescribed by paragraph (c)(2)(i)(A) of this section, for any taxable year an institution may choose as its report date the last day of any regular interval in the taxable year that is more frequent than quarterly (such as bi-monthly, monthly, weekly, or daily).

(ii) GROUPS. If all members of a parent-subsidiary controlled group have the same taxable year, a report date for the group is the report date, determined under paragraph (c)(2)(i) of this section, for any one member of the group that is an institution described in section 1.585-1(b)(1)(i) or (ii). The same report date must be used in applying paragraph (b)(1)(ii) of this section to all members of the group for a taxable year. If all members of a parent-subsidiary controlled group do not have the same taxable year, a report date for the group must be determined under similar principles.

(iii) MEMBER OF GROUP FOR ONLY PART OF TAXABLE YEAR. If an institution is a member of a parent-subsidiary controlled group for only part of a taxable year, paragraph (b)(1)(ii) of this section is applied to the institution for that year on the basis of the group's average total assets for the portion of the year that the institution is a member of the group. Thus, only the group's report dates (as determined under paragraph (c)(2)(ii) of this section) that are included in that portion of the year are taken into account in determining the group's average total assets for purposes of applying paragraph (b)(1)(ii) of this section to the institution. If no report date of the group is included in that portion of the year, the first or last day of that portion of the year must be treated as the group's report date for purposes of this paragraph (c)(2)(iii).

(3) TOTAL ASSETS -- (i) ALL CORPORATIONS. The amount of total assets held by an institution or group is the amount of cash, plus the sum of the adjusted bases of all other assets, held by the institution or group. For this purpose, the adjusted basis of an asset generally is its basis for Federal income tax purposes, determined under sections 1012, 1016 and other applicable sections of the Internal Revenue Code. In determining the amount of total assets held by a group, any asset of a member of the group that is an interest in another member of the group is not to be counted.

(ii) FOREIGN CORPORATIONS. In determining the amount of total assets held by a foreign corporation, all of the corporation's assets are taken into account, including those that are not effectively connected with the conduct of a banking business within the United States. In the case of a foreign corporation that is not engaged in a trade or business in the United States, the adjusted basis of an asset must be determined substantially in accordance with United States tax principles as provided in regulations under section 964. In the case of a foreign corporation that is engaged in a trade or business in the United States, the amount of its average total assets for a taxable year (within the meaning of paragraph (c)(1) of this section) is the amount of the corporation's average worldwide assets used for purposes of computing the interest expense deduction allowable under section 882 and section 1.882-5 for the taxable year.

(4) ESTIMATED ADJUSTED TAX BASES -- (i) IN GENERAL. The amount of the adjusted Federal income tax bases (tax bases) of assets held on a report date may be estimated, for purposes of applying paragraph (c)(3) of this section. This estimate must be based on the adjusted bases of the assets on that date as determined by reference to the asset holder's books and records maintained for financial reporting purposes (book bases). The estimate must reflect any change in the ratio between the asset holder's tax and book bases of assets that occurs during the taxable year, and the estimate must assume that this change occurs ratably. If an institution or group member estimates the tax bases of assets held on any report date during a taxable year, it must do so for all assets (other than cash) held on that report date, and it must do so for all other report dates during the year. However, the tax bases of assets may not be estimated for any report date that is the first or last day of the taxable year or that is determined under paragraph (c)(2)(i)(B) of this section.

(ii) FORMULAS. The estimated amount of the tax bases of assets held on any report date during a taxable year is based on the following variables: the total book bases of the assets on the report date (B); the asset holder's tax/book ratio as of the close of the preceding taxable year (R); and the result (whether positive or negative) obtained when R is subtracted from the asset holder's tax/book ratio as of the close of the current taxable year (Y). For purposes of determining R and Y, an asset holder's tax/book ratio is the ratio of the total tax bases of all of the holder's assets (other than cash), to the total book bases of those assets. If an asset holder's taxable year is the calendar year and its report date is the last day of the calendar quarter, its estimated tax bases of assets held on the first three report dates of the year are determined under the following formulas:

 1st Report Date = B x (R + 1/4Y)

EXAMPLE 1. Bank U is a fiscal year taxpayer, and its fiscal year ends on January 31. U reports to its primary Federal regulatory agency as of the last day of the calendar quarter. U does not choose under section 1.585-5(c)(2)(i)(B) a report date more frequent than quarterly. Thus, U's report dates under section 1.585-5(c)(2)(i)(A) are March 31, June 30, September 30, and December 31. For its taxable year beginning on February 1, 1987, U has total assets (within the meaning of section 1.585-5(c)(3)) of $480 million on March 31, $490 million on June 30, $510 million on September 30, and $540 million on December 31. Thus, pursuant to section 1.585-5(c)(1), U's average total assets for its taxable year beginning on February 1, 1987, are $505 million.

EXAMPLE 2. Bank W is a calendar year taxpayer, and its report date (within the meaning of section 1.585-5(c)(2)(i)(A)) is the last day of the calendar quarter. Pursuant to section 1.585-5(c)(4), W chooses to estimate the tax bases of its assets for 1990. Therefore, W must estimate the tax bases of all of its assets (other than cash) for its first three report dates in 1990. Since W's fourth report date (December 31) is the last day of its taxable year, the tax bases of its assets may not be estimated for this date. The adjusted tax bases of all of W's assets (other than cash) are $450z on December 31, 1989, and $480z on December 31, 1990. The book bases of those assets are $500z on December 31, 1989; $520z on March 31, 1990; $540z on June 30, 1990; $560z on September 30, 1990; and $600z on December 31, 1990. Applying the formulas provided in section 1.585-5(c)(4)(ii), W's tax/book ratio as of the close of 1989 (R), is 0.9 (450z/500z). W's tax/book ratio as of the close of 1990 is 0.8 (480z/600z). Thus, Y is -0.1. The estimated adjusted tax bases of all of W's assets (other than cash) on the first three report dates of 1990 are as follows:

 1st = B x (R + 1/4Y)

(1) DISQUALIFICATION YEAR. A bank's disqualification year is its first taxable year beginning after December 31, 1986, for which the bank is a large bank within the meaning of paragraph (b) of this section.

(2) PARENT-SUBSIDIARY CONTROLLED GROUP. A parent-subsidiary controlled group includes all of the members of a controlled group of corporations described in section 1563(a)(1). The members of such a group are determined without regard to whether any member is an EXCLUDED MEMBER described in section 1563(b)(2), a foreign entity, or a commercial bank.

(3) EXAMPLE. The following example illustrates the principles of this paragraph (d):

EXAMPLE. Bank X is a large bank within the meaning of section 1.585-5(b)(1)(i). Bank Y is not a large bank under section 1.585-5(b), and it maintains a bad debt reserve under section 585. In 1988, X purchases all of the stock of Y. If the acquisition causes Y to become a member of a parent- subsidiary controlled group described in section 1.585-5(b)(1)(ii), Y is a large bank beginning in its first taxable year that ends after the date of the acquisition. Pursuant to section 1.585-5(d)(1), this year is Y's disqualification year. Y must change in this year to the specific charge-off method of accounting for bad debts, in accordance with section 1.585-6 or section 1.585-7.

SECTION 1.585-6 RECAPTURE METHOD OF CHANGING FROM THE RESERVE METHOD OF SECTION 585.

(a) GENERAL RULE. This section applies to any large bank (as defined in section 1.585-5(b)) that maintained a reserve for bad debts under section 585 for the taxable year immediately preceding its disqualification year (as defined in section 1.585-5(d)(1)) and that does not elect the cut-off method set forth in section 1.585-7. Except as otherwise provided in paragraphs (c) and (d) of this section, any bank to which this section applies must include in income the amount of its net section 481(a) adjustment (as defined in paragraph (b)(3) of this section) over the four-year period beginning with the bank's disqualification year. If a bank follows the rules prescribed by this section, its change to the specific charge-off method of accounting for bad debts in its disqualification year will be treated as a change in accounting method that is made with the consent of the Commissioner. Paragraph (b) of this section specifies the portion of the net section 481(a) adjustment to be included in income in each year of the recapture period; paragraph (c) of this section provides rules on the effect of disposing of loans; and paragraph (d) of this section provides rules on the suspension of recapture by financially troubled banks.

(b) FOUR-YEAR SPREAD OF NET SECTION 481(a) ADJUSTMENT -- (1) IN GENERAL. If a bank to which this section applies does not make the election allowed by paragraph (b)(2) of this section, the bank must include in income the following portions of its net section 481(a) adjustment in each year of the four-year recapture period: 10 percent in the bank's disqualification year; 20 percent in its first taxable year after its disqualification year; 30 percent in its second taxable year after its disqualification year; and 40 percent in its third taxable year after its disqualification year.

(2) ELECTION TO INCLUDE MORE THAN 10 PERCENT IN DISQUALIFICATION YEAR. A bank to which this section applies may elect to include in income, in its disqualification year, any percentage of its net section 481(a) adjustment that is larger than 10 percent. Any such election must be made at the time and in the manner prescribed by section 1.585-8. If a bank makes such an election, the bank must include in income the remainder, if any, of its net section 481(a) adjustment in the following portions: 2/9 of the remainder in the bank's first taxable year after its disqualification year; 1/3 of the remainder in its second taxable year after its disqualification year; and 4/9 of the remainder in its third taxable year after its disqualification year. For this purpose, the remainder of a bank's net section 481(a) adjustment is any portion of the adjustment that the bank does not elect to include in income in its disqualification year.

(3) NET SECTION 481(a) ADJUSTMENT. For purposes of this section, the amount of a bank's net section 481(a) adjustment is the amount of the bank's reserve for bad debts as of the close of the taxable year immediately preceding its disqualification year. Since the change from the reserve method of section 585 is initiated by the taxpayer, the amount of the bank's bad debt reserve for this purpose is not reduced by amounts attributable to taxable years beginning before 1954.

(4) EXAMPLES. The following examples illustrate the principles of this paragraph (b):

EXAMPLE 1. Bank M is a large bank within the meaning of section 1.585-5(b). M's disqualification year is its taxable year beginning on January 1, 1989, and M maintained a bad debt reserve under section 585 for the preceding taxable year. Pursuant to section 1.585-5(a), M must change from the reserve method of accounting for bad debts to the specific charge-off method in its disqualification year. M does not elect the cut- off method set forth in section 1.585-7. Thus, M must follow the recapture method set forth in this section 1.585-6. M's net section 481(a) adjustment, as defined in section 1.585-6(b)(3), is $2 million. M does not make the election allowed by section 1.585-6(b)(2). Pursuant to section 1.585-6(b)(1), M must include the following amounts in income: $200,000 in taxable year 1989; $400,000 in 1990; $600,000 in 1991; and $800,000 in 1992.

EXAMPLE 2. Assume the same facts as in Example 1, except that M elects under section 1.585-6(b)(2) to recapture 55 percent of its net section 481(a) adjustment in its disqualification year. Pursuant to section 1.585-6(b)(2), M must include the following amounts in income: $1,100,000 in taxable year 1989; $200,000 in 1990; $300,000 in 1991; and $400,000 in 1992.

(c) EFFECT OF DISPOSING OF LOANS -- (1) IN GENERAL. Except as provided in paragraphs (c)(2) and (c)(3) of this section, if a bank to which this section applies sells or otherwise disposes of any of its outstanding loans on or after the first day of its disqualification year, the disposition does not affect the bank's obligation under this section to include in income the amount of its net section 481(a) adjustment, and the disposition does not affect the amount of this adjustment.

(2) CESSATION OF BANKING BUSINESS -- (i) IN GENERAL. If a bank to which this section applies ceases to engage in the business of banking before it is otherwise required to include in income the full amount of its net section 481(a) adjustment, the bank must include in income the remaining amount of the adjustment in the taxable year in which it ceases to engage in the business of banking. For this purpose, and except as provided in paragraph (c)(2)(ii) of this section, whether a bank ceases to engage in the business of banking is determined under the principles of section 1.446-1(e)(3)(ii) and its administrative procedures.

(ii) TRANSITION RULE. A bank that ceases to engage in the business of banking as the result of a transaction to which section 381(a) applies is not treated as ceasing to engage in the business of banking if, on or before March 30, 1994, either the transaction occurs or the bank enters into a binding written agreement to carry out the transaction.

(3) CERTAIN SECTION 381 TRANSACTIONS. This paragraph (c)(3) applies if a bank to which this section applies transfers outstanding loans to another corporation on or after the first day of the bank's disqualification year (and before it has included in income the full amount of its net section 481(a) adjustment) in a transaction to which section 381(a) applies, and under paragraph (c)(2)(i) or (ii) of this section the transferor bank is not treated as ceasing to engage in the business of banking as a result of the transaction. If this paragraph (c)(3) applies, the acquiring corporation (the acquiror) steps into the shoes of the transferor with respect to using the recapture method prescribed by this section and assumes all of the transferor's rights and obligations under paragraph (b) of this section. The unrecaptured balance of the transferor's net section 481(a) adjustment carries over in the transaction to the acquiror, and the acquiror must complete the four-year recapture procedure begun by the transferor. In applying this procedure, the transferor's taxable year that ends on or includes the date of the acquisition and the acquiror's first taxable year ending after the date of the acquisition represent two consecutive taxable years within the four-year recapture period.

(4) EXAMPLES. The following examples illustrate the principles of this paragraph (c):

EXAMPLE 1. Bank P is a bank to which this section 1.585-6 applies. P's disqualification year is its taxable year beginning on January 1, 1989, and P recaptures 10 percent of its net section 481(a) adjustment in that year pursuant to section 1.585-6(b)(1). In July 1990 P disposes of a portion of its loan portfolio in a transaction to which section 381(a) does not apply, and P continues to engage in the business of banking. Pursuant to section 1.585-6(c)(1), the disposition does not affect P's obligation under section 1.585-6(b)(1) to recapture the remainder of its net section 481(a) adjustment in 1990, 1991 and 1992. Nor does the disposition affect the amount of the adjustment.

EXAMPLE 2. Assume the same facts as in Example 1, except that P ceases to engage in the business of banking in 1990, as determined under the principles of section 1.446-1(e)(3)(ii) and its administrative procedures. Pursuant to section 1.585-6(c)(2)(i), in 1990 P must include in income the remaining 90 percent of its net section 481(a) adjustment.

EXAMPLE 3. Assume the same facts as in Example 1, except that P's 1990 disposition of loans is a transaction to which section 381(a) applies, P ceases to engage in the business of banking as a result of the transaction, and P's taxable year ends on the date of the transaction. Thus, in the transaction, P transfers substantially all of its loans to an acquiring corporation (Q). Q is a calendar year taxpayer. Because the transaction occurred before March 30, 1994, the transition rule of section 1.585-6(c)(2)(ii) applies, and P is not treated as ceasing to engage in the business of banking. Pursuant to section 1.585-6(c)(3), Q steps into P's shoes with respect to using the recapture method prescribed by section 1.585-6. The unrecaptured balance of P's net section 481(a) adjustment carries over to Q in the section 381(a) transaction, and Q must complete the four-year recapture procedure begun by P. Pursuant to sections 1.585-6(b) and 1.585-6(c)(3), P includes 20 percent of its net section 481(a) adjustment in income in its taxable year ending on the date of the section 381(a) transaction, and Q includes 30 percent of the adjustment in income in 1990 and 40 percent in 1991.

EXAMPLE 4. Assume the same facts as in Example 3. Assume also that Q becomes a large bank under section 1.585-5(b) as a result of the transaction and maintained a bad debt reserve immediately before the transaction. Q must change to the specific charge-off method for all of its loans in the first taxable year that it is a large bank. Thus, Q not only completes the recapture procedure begun by P but also follows the rules prescribed by section 1.585-6 or section 1.585-7 with respect to its own reserve.

EXAMPLE 5. Assume the same facts as in Example 3. Assume also that Q is not a large bank after the transaction and properly establishes a bad debt reserve for the loans it receives in the transaction. This establishment of the reserve results in a new negative section 481(a) adjustment. Thus, Q not only completes the recapture procedure begun by P but also takes into account the new negative adjustment as required under section 381.

(d) SUSPENSION OF RECAPTURE BY FINANCIALLY TROUBLED BANKS -- (1) IN GENERAL. Except as provided in paragraph (d)(2) of this section, a bank that is financially troubled (within the meaning of paragraph (d)(3) of this section) for any taxable year must not include any amount in income under paragraphs (a) and (b) of this section for that taxable year and must disregard that taxable year in applying paragraphs (a) and (b) of this section to other taxable years. See paragraph (d)(4) of this section for rules on determining estimated tax payments of financially troubled banks, and see paragraph (d)(5) of this section for examples illustrating this paragraph (d).

(2) ELECTION TO RECAPTURE. A bank that is financially troubled (within the meaning of paragraph (d)(3) of this section) for its disqualification year may elect to include in income, in one taxable year, any percentage of its net section 481(a) adjustment that is greater than 10 percent. This election may be made for the bank's disqualification year, for the first taxable year after the disqualification year in which the bank is not financially troubled (within the meaning of paragraph (d)(3) of this section), or for any intervening taxable year. Any such election must be made at the time and in the manner prescribed by section 1.585-8. A bank that makes this election must include an amount in income under paragraphs (a) and (b) of this section in the year for which the election is made (election year) and must not disregard this year in applying paragraphs (a) and (b) of this section to other taxable years. Such a bank must follow the rules of paragraph (b)(2) of this section in applying paragraph (b) of this section to later taxable years, treating the election year as the disqualification year for purposes of applying paragraph (b)(2) of this section. However, if the bank is financially troubled for any year after its election year, the bank must not include any amount in income under paragraphs (a) and (b) of this section for the later year and must disregard the later year in applying paragraphs (a) and (b) of this section to other taxable years.

(3) DEFINITION OF FINANCIALLY TROUBLED -- (i) IN GENERAL. For purposes of this section, a bank is considered financially troubled for any taxable year if the bank's nonperforming loan percentage for that year exceeds 75 percent. For this purpose, a bank's nonperforming loan percentage is the percentage determined by dividing the sum of the outstanding balances of the bank's nonperforming loans (as defined in paragraph (d)(3)(iii) of this section) as of the close of each quarter of the taxable year, by the sum of the amounts of the bank's equity (as defined in paragraph (d)(3)(iv) of this section) as of the close of each such quarter. The quarters for a short taxable year of at least 3 months are the same as those of the bank's annual accounting period, except that quarters ending before or after the short year are disregarded. If a taxable year consists of less than 3 months, the first or last day of the taxable year is treated as the last day of its only quarter. In lieu of determining its nonperforming loan percentage on the basis of loans and equity as of the close of each quarter of the taxable year, a bank may, for all years, determine this percentage on the basis of loans and equity as of the close of each report date (as defined in section 1.585-5(c)(2), without regard to section 1.585-5(c)(2)(i)(B)). In the case of a bank that is a foreign corporation, all nonperforming loans and equity of the bank are taken into account, including loans and equity that are not effectively connected with the conduct of a banking business within the United States.

(ii) PARENT-SUBSIDIARY CONTROLLED GROUPS -- (A) IN GENERAL. If a bank is a member of a parent-subsidiary controlled group (as defined in section 1.585-5(d)(2)) for the taxable year, the nonperforming loans and the equity of all members of the bank's financial group (as determined under paragraph (d)(3)(ii)(B) of this section) are treated as the nonperforming loans and the equity of the bank for purposes of paragraph (d)(3)(i) of this section. However, any equity interest that a member of a bank's financial group holds in another member of this group is not to be counted in determining equity. Similarly, any loan that a member of a bank's financial group makes to another member of the group is not to be counted in determining nonperforming loans. All banks that are members of the same parent-subsidiary controlled group must (for all taxable years that they are members of this group) determine their nonperforming loan percentage on the basis of the close of each quarter of the taxable year, or all must (for all such taxable years) determine this percentage on the basis of the close of each report date (as determined under section 1.585-5(c)(2)(ii), applied without regard to section 1.585-5(c)(2)(i)(B)).

(B) FINANCIAL GROUP -- (1) IN GENERAL. All banks that are members of the same parent-subsidiary controlled group must (for all taxable years that they are members of this group) determine their financial group under paragraph (d)(3)(ii)(B)(2) of this section, or all must (for all such taxable years) determine their financial group under paragraph (d)(3)(ii)(B)(3) of this section.

(2) FINANCIAL INSTITUTION MEMBERS OF PARENT-SUBSIDIARY CONTROLLED GROUP. A bank's financial group, determined under this paragraph (d)(3)(ii)(B)(2), consists of all financial institutions within the meaning of section 265(b)(5) (and comparable foreign financial institutions) that are members of the parent-subsidiary controlled group of which the bank is a member.

(3) ALL MEMBERS OF PARENT-SUBSIDIARY CONTROLLED GROUP. A bank's financial group, determined under this paragraph (d)(3)(ii)(B)(3), consists of all members of the parent-subsidiary controlled group of which the bank is a member.

(iii) NONPERFORMING LOAN -- (A) IN GENERAL. For purposes of this section, a nonperforming loan is any loan (as defined in paragraph (d)(3)(iii)(B) of this section) that is considered to be nonperforming by the holder's primary Federal regulatory agency. Nonperforming loans include the following types of loans as defined by the Federal Financial Institutions Examination Council: loans that are past due 90 days or more and still accruing; loans that are in nonaccrual status; and loans that are restructured troubled debt. A loan is not considered to be nonperforming merely because it is past due, if it is past due less than 90 days. The outstanding balances of nonperforming loans are determined on the basis of amounts that are required to be reported to the holder's primary Federal regulatory agency. For purposes of this paragraph (d)(3)(iii)(A), a holder that does not have a Federal regulatory agency is treated as Federally regulated under the standards prescribed by the Federal Financial Institutions Examination Council.

(B) LOAN. For purposes of paragraph (d)(3)(iii)(A) of this section, a loan is any extension of credit that is defined and treated as a loan under the standards prescribed by the Federal Financial Institutions Examination Council. (Accordingly, a troubled debt restructuring that is in substance a foreclosure or repossession is not considered a loan.) In addition, a debt evidenced by a security issued by a foreign government is treated as a loan if the security is issued as an integral part of a restructuring of one or more troubled loans to the foreign government (or an agency or instrumentality thereof). Similarly, a deposit with the central bank of a foreign country is treated as a loan if the deposit is made under a deposit facility agreement that is entered into as an integral part of a restructuring of one or more troubled loans to the foreign country's government (or an agency or instrumentality thereof).

(iv) EQUITY. For purposes of this section, the equity of a bank or other financial institution is its equity (i.e., assets minus liabilities) as required to be reported to the institution's primary Federal regulatory agency (or, if the institution does not have a Federal regulatory agency, as required under the standards prescribed by the Federal Financial Institutions Examination Council). The balance in a reserve for bad debts is not treated as equity.

(4) ESTIMATED TAX PAYMENTS OF FINANCIALLY TROUBLED BANKS. For purposes of applying section 6655(e)(2)(A)(i) with respect to any installment of estimated tax, a bank that is financially troubled as of the due date of the installment is treated as if no amount will be included in income under paragraphs (a) and (b) of this section for the taxable year. For this purpose, a bank is considered financially troubled as of the due date of an installment of estimated tax only if its nonperforming loan percentage (computed under paragraph (d)(3) of this section) would exceed 75 percent for a short taxable year ending on that date. For purposes of computing this nonperforming loan percentage, the ending of such a short taxable year would not cause the last day of that year to be treated as the last day of a quarter of the taxable year.

(5) EXAMPLES. The following examples illustrate the principles of this paragraph (d):

EXAMPLE 1. Bank R is a bank to which this section 1.585-6 applies. R's disqualification year is its taxable year beginning on January 1, 1987. R is not financially troubled (within the meaning of section 1.585-6(d)(3)) for taxable year 1987 or for any taxable year after 1989, but it is financially troubled for taxable years 1988 and 1989. Since R is not financially troubled for its disqualification year, R must include an amount in income under section 1.585-6(a) and (b) for that year (taxable year 1987). R may make the election allowed by section 1.585-6(b)(2) for that year. Since R is financially troubled for taxable years 1988 and 1989, pursuant to section 1.585-6(d)(1) R does not include any amount in income under section 1.585-6(a) and (b) for these years, and it treats taxable years 1990, 1991 and 1992 as the first, second and third taxable years after its disqualification year for purposes of applying section 1.585-6(a) and (b).

EXAMPLE 2. Assume the same facts as in Example 1, except that R is financially troubled for taxable year 1987 (its disqualification year). R may make the election allowed by section 1.585-6(d)(2) for 1987 (the disqualification year), for 1990 (the first year after the disqualification year in which R is not financially troubled), or for 1988 or 1989 (the intervening years). R elects to include 60 percent of its net section 481(a) adjustment in income in 1987. Thus, the remainder of the adjustment, for purposes of applying the rules of section 1.585-6(b)(2), is 40 percent. R must include in income 2/9 of the remainder in 1990, 1/3 of the remainder in 1991, and 4/9 of the remainder in 1992.

EXAMPLE 3. Bank S, which is not a member of a parent- subsidiary controlled group, is a bank to which this section 1.585-6 applies. S's disqualification year is its taxable year beginning on January 1, 1987. S determines its nonperforming loan percentage under section 1.585-6(d)(3) on a quarterly basis. S is not financially troubled for taxable year 1987 and includes 10 percent of its net section 481(a) adjustment in income in that year. S's outstanding balance of nonperforming loans (as defined in section 1.585-6(d)(3)(iii)) is $80 million on March 31, 1988; $68 million on June 30, 1988; and $59 million on September 30, 1988. The amount of S's equity (as defined in section 1.585-6(d)(3)(iv)) is $100 million on each of these three dates. Thus, S's nonperforming loan percentage, computed under section 1.585-6(d)(3), would be 80 percent (80/100) for a short taxable year ending on April 15 or June 15, 74 percent [(80+68) / 200] for a short taxable year ending on September 15, and 69 percent [(80+68+59) / 300] for a short taxable year ending on December 15. Since S's nonperforming loan percentage for a short taxable year ending on April 15 or June 15 would exceed 75 percent, pursuant to section 1.585-6(d)(4) S is considered financially troubled as of these dates. Thus, S is treated as if no amount will be included in income under section 1.585-6(a) and (b) for the year for purposes of applying section 6655(e)(2)(A)(i) with respect to the installments of estimated tax that are due on April 15, 1988, and June 15, 1988. However, since S's nonperforming loan percentage for a short taxable year ending on September 15 or December 15 would not exceed 75 percent, S is not considered financially troubled as of these dates. Thus, S is treated as if 20 percent of its net section 481(a) adjustment will be included in income under section 1.585-6(a) and (b) for the year for purposes of applying section 6655(e)(2)(A)(i) with respect to the installments of estimated tax that are due on September 15, 1988, and December 15, 1988.

SECTION 1.585-7 ELECTIVE CUT-OFF METHOD OF CHANGING FROM THE RESERVE METHOD OF SECTION 585.

(a) GENERAL RULE. Any large bank (as defined in section 1.585-5(b)) that maintained a reserve for bad debts under section 585 for the taxable year immediately preceding its disqualification year (as defined in section 1.585-5(d)(1)) may elect to use the cut-off method set forth in this section. Any such election must be made at the time and in the manner prescribed by section 1.585-8. If a bank makes this election, the bank must maintain its bad debt reserve for its pre-disqualification loans, as prescribed in paragraph (b) of this section, and the bank must include in income any excess balance in this reserve, as required by paragraph (c) of this section. The bank may not deduct, for its disqualification year or any subsequent taxable year, any amount allowed under section 166(a) for pre- disqualification loans (as defined in paragraph (b)(2) of this section) that become worthless in whole or in part, except as allowed by paragraph (b)(1) of this section. However, except as provided in paragraph (d)(3) of this section, the bank may deduct, for its disqualification year or any subsequent taxable year, amounts allowed under section 166(a) for loans that the bank originates or acquires on or after the first day of its disqualification year and that become worthless in whole or in part. If a bank makes the election allowed by this paragraph (a), its change to the specific charge-off method of accounting for bad debts in its disqualification year does not give rise to a section 481(a) adjustment.

(b) MAINTAINING RESERVE FOR PRE-DISQUALIFICATION LOANS -- (1) IN GENERAL. A bank that makes the election allowed by paragraph (a) of this section must maintain its bad debt reserve for its pre- disqualification loans (as defined in paragraph (b)(2) of this section). Except as provided in paragraph (d)(3) of this section, the bank must charge against the reserve the amount of any losses resulting from these loans (including losses resulting from the sale or other disposition of these loans), and the bank must add to the reserve the amount of recoveries with respect to these loans. In general, the reserve must be maintained in the manner provided by former section 166(c) of the Internal Revenue Code and the regulations thereunder. However, after the balance in the reserve is reduced to zero, the bank is to account for any losses and recoveries with respect to outstanding pre-disqualification loans under the specific charge-off method of accounting for bad debts, as if the bank always had accounted for these loans under this method. (2) Definition of pre-disqualification loans. For purposes of this section, a pre-disqualification loan of a bank is any loan that the bank held on the last day of its taxable year immediately preceding its disqualification year (as defined in section 1.585-5(d)(1)). If the amount of a pre-disqualification loan is increased during or after the disqualification year, the amount of the increase is not treated as a pre-disqualification loan.

(c) AMOUNT TO BE INCLUDED IN INCOME WHEN RESERVE BALANCE EXCEEDS LOAN BALANCE. If, as of the close of any taxable year, the balance in a bank's reserve that is maintained under paragraph (b) of this section exceeds the balance of the bank's outstanding pre- disqualification loans, the bank must include in income the amount of the excess for the taxable year. The balance in the reserve is then reduced by the amount of this excess. See paragraph (d) of this section for rules on the application of this paragraph (c) when a bank disposes of loans.

(d) EFFECT OF DISPOSING OF LOANS -- (1) IN GENERAL. Except as provided in paragraphs (d)(2) and (d)(3) of this section, if a bank that makes the election allowed by paragraph (a) of this section sells or otherwise disposes of any of its outstanding pre- disqualification loans, the bank is to reduce the balance of its outstanding pre-disqualification loans by the amount of the loans disposed of, for purposes of applying paragraph (c) of this section.

(2) SECTION 381 TRANSACTIONS. If a bank that makes the election allowed by paragraph (a) of this section transfers outstanding pre-disqualification loans to another corporation in a transaction to which section 381(a) applies, the acquiring corporation (the acquiror) must follow the rules of paragraph (d)(2)(i) or (ii) of this section.

(i) ACQUIROR COMPLETES CUT-OFF METHOD OF CHANGE. Except as provided in paragraph (d)(2)(ii) of this section, the acquiror steps into the shoes of the transferor in the section 381(a) transaction with respect to using the cut-off method of change. Thus, the transferor's bad debt reserve immediately before the section 381(a) transaction carries over to the acquiror, and the acquiror must complete the cut-off method begun by the transferor. For purposes of completing the transferor's cut-off method, the acquiror's balance of outstanding pre-disqualification loans immediately after the section 381(a) transaction is the balance of these loans that it receives in the transaction, and the acquiror assumes all of the transferor's rights and obligations under this section.

(ii) ACQUIROR USES RESERVE METHOD. If the acquiror is not a large bank (within the meaning of section 1.585-5(b)) immediately after the section 381(a) transaction and uses a reserve method of accounting for bad debts attributable to the pre-disqualification loans (and any other loans) received in the transaction, the acquiror does not step into the shoes of the transferor with respect to using the cut-off method of change. The transferor's bad debt reserve immediately before the section 381(a) transaction carries over to the acquiror, but the acquiror does not continue the cut-off method begun by the transferor. If the six-year moving average amount (as defined in section 1.585-2(c)(1)(ii)) for all of the loans received in the transaction exceeds the balance of the reserve that carries over to the acquiror, the acquiror increases this balance by the amount of the excess. Any such increase in the reserve results in a negative section 481(a) adjustment that is taken into account as required under section 381.

(3) DISPOSITIONS INTENDED TO CHANGE THE STATUS OF PRE- DISQUALIFICATION LOANS. This paragraph (d)(3) applies if a bank that makes the election allowed by paragraph (a) of this section sells, exchanges, or otherwise disposes of a significant amount of its pre- disqualification loans (as defined in paragraph (b)(2) of this section) and a principal purpose of the transaction is to avoid the provisions of this section by increasing the amount of loans for which deductions are allowable under the specific charge-off method. If this paragraph (d)(3) applies, the District Director may disregard the disposition for purposes of paragraphs (b)(1) and (d)(1) of this section or treat the replacement loans as pre-disqualification loans. If loans are so treated as pre-disqualification loans, no deductions are allowable under the specific charge-off method for the loans, except as provided in paragraph (b)(1) of this section, and the disposition that causes the loans to be so treated may be disregarded for purposes of paragraphs (b)(1) and (d)(1) of this section. If a bank sells pre-disqualification loans and uses the proceeds of the sale to originate new loans, this paragraph (d)(3) does not apply to the transaction.

(e) EXAMPLES. The following examples illustrate the principles of this section:

EXAMPLE 1. Bank M is a bank that properly elects to use the cut-off method set forth in this section 1.585-7. M's disqualification year is its taxable year beginning on January 1, 1987. On December 31, 1986, M had outstanding loans of $700 million (pre-disqualification loans), and the balance in its bad debt reserve was $10 million. M must maintain its reserve for its pre-disqualification loans in accordance with section 1.585-7(b), and it may not deduct any addition to this reserve for taxable year 1987 or any later year. For these years, M may deduct amounts allowed under section 166(a) for loans that it originates or acquires after December 31, 1986, and that become worthless in whole or in part.

EXAMPLE 2. Assume the same facts as in Example 1. Also assume that in 1987 M collects $150 million of its pre- disqualification loans, M determines that $2 million of its pre- disqualification loans are worthless, and M recovers $1 million of pre-disqualification loans that it had previously charged against the reserve as worthless. On December 31, 1987, the balance in M's bad debt reserve is $9 million ($10 million - $2 million + $1 million), and the balance of its outstanding pre- disqualification loans is $548 million ($700 million - $150 million - $2 million).

EXAMPLE 3. Assume the same facts as in Examples 1 and 2. Also assume that on December 31, 1990, the balance in M's bad debt reserve is $5 million and the balance of its outstanding pre-disqualification loans is $25 million. In 1991 M collects $21 million of its outstanding pre-disqualification loans and determines that $1 million of its outstanding pre- disqualification loans are worthless. Thus, on December 31, 1991, the balance in M's bad debt reserve is $4 million ($5 million - $1 million), and the balance of its outstanding pre- disqualification loans is $3 million ($25 million - $21 million - $1 million). Accordingly, M must include $1 million ($4 million - $3 million) in income in taxable year 1991, pursuant to section 1.585-7(c). On January 1, 1992, the balance in M's reserve is $3 million ($4 million -$1 million).

EXAMPLE 4. Assume the same facts as in Examples 1 through 3. Also assume that in 1992 M transfers substantially all of its assets to another corporation (N) in a transaction to which section 381(a) applies, and N is treated as a large bank under section 1.585-5(b)(2) for taxable years ending after the date of the transaction. Pursuant to section 1.585-7(d)(2)(i), N steps into M's shoes with respect to using the cut-off method. M's bad debt reserve immediately before the section 381(a) transaction carries over to N, and N must complete the cut-off procedure begun by M. For this purpose, N's balance of outstanding pre-disqualification loans immediately after the section 381(a) transaction is the balance of these loans that it receives from M.

EXAMPLE 5. Assume the same facts as in Examples 1 through 4, except that N is not treated as a large bank after the section 381(a) transaction. Also assume that N uses the reserve method of section 585 and plans to use this method for all of the loans it acquires from M (including loans that were not pre- disqualification loans). Pursuant to section 1.585-7(d)(2)(ii), M's bad debt reserve immediately before the section 381(a) transaction carries over to N in the transaction; however, N does not continue the cut-off procedure begun by M and does not treat any loan as a pre-disqualification loan. If the six-year moving average amount (as defined in section 1.585-2(c)(1)(ii)) for all of N's newly acquired loans exceeds the balance of the reserve that carries over to N, N increases this balance by the amount of the excess. Any such increase in the reserve results in a negative section 481(a) adjustment that is taken into account as required under section 381.

SECTION 1.585-8 RULES FOR MAKING AND REVOKING ELECTIONS UNDER SECTIONS 1.585-6 AND 1.585-7.

(a) TIME OF MAKING ELECTIONS -- (1) IN GENERAL. Any election under section 1.585-6(b)(2), section 1.585-6(d)(2) or section 1.585-7(a) must be made on or before the later of --

(i) February 28, 1994; or

(ii) The due date (taking extensions into account) of the electing bank's original tax return for its disqualification year (as defined in section 1.585-5(d)(1)) or, for elections under section 1.585-6(d)(2), the year for which the election is made.

(2) NO EXTENSION OF TIME FOR PAYMENT. Payments of tax due must be made in accordance with chapter 62 of the Internal Revenue Code. However, if an election under section 1.585-6(b)(2), section 1.585-6(d)(2) or section 1.585-7(a) is made or revoked on or before February 24, 1994 and the making or revoking of the election results in an underpayment of estimated tax (within the meaning of section 6655(a)) with respect to an installment of estimated tax due on or before the date the election was so made or revoked, no addition to tax will be imposed under section 6655(a) with respect to the amount of the underpayment attributable to the making or revoking of the election.

(b) MANNER OF MAKING ELECTIONS -- (1) IN GENERAL. Except as provided in paragraph (b)(2) of this section, an electing bank must make any election under section 1.585-6(b)(2), section 1.585-6(d)(2) or section 1.585-7(a) by attaching a statement to its tax return (or amended return) for its disqualification year or, for elections under section 1.585-6(d)(2), the year for which the election is made. This statement must contain the following information:

(i) The name, address and taxpayer identification number of the electing bank;

(ii) The nature of the election being made (i.e., whether the election is to include in income more than 10 percent of the bank's net section 481(a) adjustment under section 1.585-6(b)(2) or (d)(2) or to use the cut-off method under section 1.585-7); and

(iii) If the election is under section 1.585-6(b)(2) or (d)(2), the percentage being elected.

(2) Certain tax returns filed before December 29, 1993. A bank is deemed to have made an election under section 1.585-6(b)(2) or (d)(2) if the bank evidences its intent to make an election under section 585(c)(3)(A)(iii)(I) or section 585(c)(3)(B)(ii) for its disqualification year (or, for elections under section 1.585-6(d)(2), the election year), by designating a specific recapture amount on its tax return or amended return for that year (or attaching a statement in accordance with section 301.9100-7T(a)(3)(i) of this chapter), and the return is filed before December 29, 1993. A bank is deemed to have made an election under section 1.585-7(a) if the bank evidences its intent to make an election under section 585(c)(4) for its disqualification year by attaching a statement in accordance with section 301.9100-7T(a)(3)(i) of this chapter to its tax return or amended return for that year, and the return is filed before December 29, 1993.

(c) REVOCATION OF ELECTIONS -- (1) ON OR BEFORE FINAL DATE FOR MAKING ELECTION. An election under section 1.585-6(b)(2), section 1.585-6(d)(2) or section 1.585-7(a) may be revoked without the consent of the Commissioner on or before the final date prescribed by paragraph (a)(1) of this section for making the election. To do so, the bank that made the election must file an amended tax return for its disqualification year (or, for elections under section 1.585-6(d)(2), the year for which the election was made) and attach a statement that --

(i) Includes the bank's name, address and taxpayer identification number;

(ii) Identifies and withdraws the previous election; and

(iii) If the bank is making a new election under section 1.585-6(b)(2), section 1.585-6(d)(2) or section 1.585-7(a), contains the information described in paragraphs (b)(1)(ii) and (b)(1)(iii) of this section.

(2) AFTER FINAL DATE FOR MAKING ELECTION. An election under section 1.585-6(b)(2), section 1.585-6(d)(2) or section 1.585-7(a) may be revoked only with the consent of the Commissioner after the final date prescribed by paragraph (a)(1) of this section for making the election. The Commissioner will grant this consent only in extraordinary circumstances.

(d) ELECTIONS BY BANKS THAT ARE MEMBERS OF PARENT-SUBSIDIARY CONTROLLED GROUPS. In the case of a bank that is a member of a parent-subsidiary controlled group (as defined in section 1.585-5(d)(2)), any election under section 1.585-6(b)(2), section 1.585-6(d)(2) or section 1.585-7(a) with respect to the bank is to be made separately by the bank. An election made by one member of such a group is not binding on any other member of the group.

(e) ELECTIONS MADE OR REVOKED BY AMENDED RETURN ON OR BEFORE FEBRUARY 28, 1994. This paragraph (e) applies to any election that a bank seeks to make under paragraph (b) of this section, or revoke under paragraph (c) of this section, by means of an amended return that is filed on or before February 28, 1994. To make or revoke an election to which this paragraph (e) applies, a bank must file amended returns for all taxable years after the taxable year for which the election is made or revoked by amended return, to any extent necessary to report the bank's tax liability in a manner consistent with the making or revoking of the election by amended return.

PART 301 -- PROCEDURE AND ADMINISTRATION

Par. 6. The authority citation for part 301 is amended by removing the first entry for "Section 301.9100-7T" and adding an entry to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 301.9100-7T also issued under 26 U.S.C. 42(f)(1), 42(g)(1), 42(i)(2), 42(j)(5), 48(b)(2), 56(f)(3)(B), 83(c)(3), 141(b)(9), 142(d)(1), 142(d)(4)(B), 143(k)(9)(D)(iii), 145(d), 147(b)(4)(A), 165(l)(1), 168(b)(5), 168(f)(1), 168(g)(7), 168(h)(6)(F)(ii), 216(b)(3), 263(i), 263A(d)(3), 382(l)(5)(H), 448(d)(4), 453C(b)(2)(B), 453C(e)(4), 468B, 469(j)(9), 474, 616(d), 617(h), 1059(c)(4), 2632(b)(3), 2652(a)(3), 3121(w)(2), 4982(e)(4), and 7701(b). * * *

Par. 7. Section 301.9100-7T is amended as follows:

1. The table in paragraph (a)(1) is amended by removing the two entries for "901(a)".

2. The table in paragraph (a)(4)(ii) is amended by removing the entry for "901(a)".

PART 602 -- OMB CONTROL NUMBER UNDER THE PAPERWORK REDUCTION ACT

Par. 8. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 9. Section 602.101(c) is amended by adding the following entry to the table:

SECTION 602.101 OMB Control Numbers.

* * * * *

(c) * * *

 CFR part or section                     Current OMB