Industry Issue Resolution Pilot Program under Notice 2000-65
Financial Services Issues

Contents | Introduction | I | II | III

Problem Loans - Accrual of Interest Income

The courts have held that lenders may cease accruing interest on loans, where the loan has not been charged-off, where they can substantiate that there is no reasonable expectancy of payment. The IRS approach has been to apply an uncollectibility standard, on a loan by loan basis.⁵ The IRS has not accepted any given number days of delinquency constitutes substantiation for uncollectibility. In contrast, for bank regulatory and financial statement purposes, loans are put in non-accrual status based on delinquency for a stated number of days, unless the loan is well secured and in the process of collection. Thus, IRS examinations begin with amount of non-accrual income in the bank’s annual report and challenge the taxpayer to show on a loan by loan basis that the accrued but unpaid interest is uncollectible. Unlike bad debt charge-offs, the tax regulations do not contain any mechanism for avoiding the loan by loan factual analysis in the case of non-accruals.

The 1991 study the Treasury Department considered whether it would be appropriate to have a conclusive presumption for non-accrual loans based on bank regulatory standards.⁶ The Treasury concluded that the regulatory standard for non-accrual could not serve as a proxy for the tax standard. Nonetheless, the practical problems remain, imposing major costs on bank taxpayers and IRS agents. We believe the pilot program provides an opportunity for both the Service and the industry to revisit the topic and seek to fashion either a conformity rule or at least a safe harbor that can significantly reduce the factual disputes.

By analogy, a recent IRS Chief Counsel memorandum for District Counsel⁷ on the bad debt conformity election may point the way to a possible conformity rule for non-accruals. The memorandum indicates that reliance by IRS on a bank regulatory rule based on the amount of time that a loan has been delinquent is appropriate in some cases. The memorandum cites affirmatively the 1991 Treasury study in part and states, "[h]igh volume loans are subject to automatic charge-off procedures" and therefore a deduction based on the conformity election is appropriate after the applicable time period passes. The memorandum notes, however, that the conformity election can be revoked by IRS based on excessive charge-offs, which may be evidenced by an unusually high recovery rate for such loans. We would suggest that if a fixed amount of time is, in some cases, adequate to justify a charge-off of the loan, then it is equally appropriate to use delinquency as a basis for non-accrual. In many cases, if a borrower were to make subsequent payments, the amounts are required by the note to be applied to the unpaid principal, before being applied to unpaid interest. A conformity rule for non-accruals could be conditioned on a maximum rate of recoveries as compared with industry averages, thereby protecting the Service from an unduly conservative lender.

Contents | Introduction | I | II | III