IRS Utilizes the Industry Issue Resolution Program to Resolve the Insurance Industry Bad Debt Issue

The Internal Revenue Service (“IRS”) is getting serious about resolving resource-intensive examination issues with taxpayers in specific industries through its Industry Issue Resolution Program (IIR Program) described in Revenue Procedure 2003-36. Over the last several years, the IRS has utilized the IIR Program to resolve a number of industry-specific issues with taxpayers. Recent IIR resolutions have included repair and capitalization issues in the power generation and transmission and wireless telecommunications industries, and inventory issues in retail industries. One of the latest successful IIRs disposes of a significant insurance industry issue. On July 30, 2012, the Large Business and International (“LB&I”) Division of the IRS published a Commissioner’s Directive memorandum to LB&I examiners outlining a safe harbor approach under which insurance companies may report bad debt deductions under Internal Revenue Code (“I.R.C.”) § 166 to reflect the partial worthlessness of eligible loan-backed and structured securities that are subject to Statement of Statutory Accounting Principles 43R. This article provides a top-level explanation of the bad debt IIR process and what the safe harbor guidance provides. The authors were part of the team that participated in the IIR process on behalf of the insurance industry.

THE INSURANCE INDUSTRY BAD DEBT ISSUE

In 2008 and 2009, insurance companies reported large investment losses as a result of the financial crisis. Many life and property-casualty insurance companies had invested heavily in residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”) and direct mortgages. For example, the American Council of Life Insurers (“ACLI”) reported that as of Dec. 31, 2008, life insurance companies held in their general accounts approximately $530 billion in agency and non-agency mortgage-backed securities (“MBS”) and $338 billion more in farm, residential and commercial mortgages. As the crisis unfolded, insur- ance companies suffered significant credit losses as these structured instruments and mortgages became worthless in whole or in part. The National Association of Insurance Commissioners (“NAIC”) has reported that in the years 2008 through 2010, insurance companies reported $26.8 billion in Other-Than-Temporary-Impairments (“OTTIs”) and valuation adjustments in non-agency RMBS alone. Most of these RMBS losses occurred in 2008 ($9.2 billion) and 2009 ($14.7 billion). Additional significant losses occurred in CMBS and mortgages.

The financial crisis resulted in significant tax reporting issues for insurance companies concerning partial worthlessness deductions. Throughout the early to mid-2000s, many insurance companies reported partial worthlessness deductions under I.R.C. § 166 consistent with their statutory OTTIs on RMBS, CMBS, mortgages and other instruments that are eligible for partial worthlessness deductions. To be eligible for a partial worthlessness deduction, the instrument must be a debt and must not be a security as defined in I.R.C. § 165(g)(2) (i.e., the instrument must be a non-security).6 The definition of a security under § 165(g)(2) includes debts with interest coupons or in registered form that are issued by a corporation, government or political subdivision thereof. Under this test, eligible non-security debts include many MBS and direct mortgages. While the treatment of these partial bad debts had been an examination issue in IRS audits of insurance companies for most of the preceding decade, the 2008 financial crisis increased the stakes exponentially. As it unfolded, the most significant tax deductions involved regular interests in Real Estate Mortgage Investment Conduits (“REMIC regular interests”), which encompass both RMBS and CMBS investments. A specific code provision (I.R.C. § 860B) mandates that REMIC regular interests are treated as debts for all federal tax purposes for the holder. Additionally, REMIC regular interests are issued by trusts (not corporations, governments or political subdivisions) and therefore are not securities under I.R.C. § 165(g)(2).