SSAP 43R and Tax Standards for Partial Worthlessness Deductions

In September 2009, the NAIC adopted Statement of Statutory Accounting Principles 43R (SSAP 43R), providing guidance effective as of Sept. 30, 2009, for the impairment of loan-backed and structured securities. SSAP 43R replaced SSAP 98, which was an amendment to SSAP 43 and SSAP 99 paragraph 13. The adoption of SSAP 43R, and the movement away from the fair value approach of SSAP 98, may facilitate claims of partial bad debts under Internal Revenue Code section 166 for debts that do not qualify as securities for tax purposes. This is because the new SSAP isolates credit-related impairments (potentially available for bad debt treatment) from interest- related impairments (that the Internal Revenue Service (IRS) is likely to challenge if claimed as a tax deduction).

SSAP 43R requires a charge against current statutory earnings for Other-Than-Temporary impairments that are credit-related to the extent the discounted expected cash flows are less than book value. It requires a further impairment to fair value and a charge against current earnings only if the company has the intent to sell the instrument or does not have the ability to hold it until recovery. In the latter situation, the standard requires the company to disclose the amount of the impairment to fair value that is interest-related.

The Other-Than-Temporary impairments insurance companies have recorded for instruments such as REMIC regular interests under SSAP 43R and earlier standards may be eligible for partial worthlessness deductions of debts held by insurance companies. Under the tax standards, a taxpayer that holds a business debt that is not considered a security under section 165(g) has the discretion to take a tax deduction for partial worthlessness rather than wait until disposition or total worthlessness to realize the tax loss. Partial worthlessness deductions are advantageous for both timing and character. The timing benefit arises because the alternative, which applies to securities under section 165(g), is to wait either until the taxpayer sells the instrument or until the instrument becomes wholly worthless. The character benefit arises because partial worthlessness deductions are charged against ordinary income, whereas losses on disposition, and in some cases losses on total worthlessness, are capital losses. Capital losses can be used only to offset capital gains and are subject to expiration after five tax years if not used.

Thus, taxpayers have a strong incentive to claim partial worthlessness deductions for impairments they have charged off their books. In order to qualify for a partial worthlessness deduction, the taxpayer must prove that the instrument is partially worthless and the deduction is limited to the amount the taxpayer has charged off as worthless on its books. The tax standard for proving partial worthlessness is relatively stringent, but insurance companies may have fewer proof problems than other taxpayers because they may be able to take advantage of a conclusive presumption in the Treasury Regulations that applies to banks and other similarly regulated industries. Under the conclusive presumption, at Treasury Regulation section 1.166-2(d), a regulated company’s book charge-off is presumed correct if it is made under established policies and procedures of the regulator and if the regulator confirms this fact in writing upon its first examination of the company’s books for the year of the charge-off. Recently, many insurance companies have requested their state insurance departments to send them charge-off letters to comply with the Treasury Regulations, and several state regulators have sent the requested letters.