loan-workouts

NOVEMBER 7-9, 2012 DISNEY CONTEMPORARY HOTEL | ORLANDO

47th

annualBANK & CAPITAL MARKETSTAX INSTITUTE

47th

annualBANK & CAPITAL MARKETS TAX INSTITUTE

WWW.BANKTAXINSTITUTE.COM

LOAN WORKOUTSNutcracker Ballroom November 9th, 9:15am – 10:30am

47th ANNUAL BANK & CAPITAL MARKETS TAX INSTITUTE DISNEY CONTEMPORARY HOTEL

Speakers:

JOHN KINSELLA

DENISE SCHWIEGER

TONY WELBURN

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Bank & Capital Markets Tax Institute

Loan Workouts

John Kinsella – US Bancorp

Denise Schwieger – KPMG LLP

Tony Welburn – KPMG LLP

© 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING, OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

Notwithstanding anything to the contrary set forth herein, you (and your employees, representatives, or agents) may disclose to any and all persons, without limitation of any kind, the tax treatment or tax structure of any transaction, and all materials of any kind (including opinions or other tax analyses) that are provided to you by KPMG LLP related to such tax treatment and tax structure, effective immediately upon commencement of discussions with KPMG LLP.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

© 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative (“KPMG International”), a Swiss entity.

Agenda

Removing Loans from the Balance Sheet

Loan Sales

Structured Sales

Loan Modifications

Significant Modifications under Treas. Reg. Section 1.1001-3

A/B Note Structure

Foreclosures

Types of Foreclosure and Related Tax Issues

Tax Controversy Issues Surrounding Foreclosures and Foreclosure Property

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Removing Loans From The Balance Sheet

Loan Sales


Is debt instrument an ordinary or capital asset in the hands of the seller?

Section 1221(a)(1) – stock in trade/inventory

Section 1221(a)(4) – for sale of property or services rendered

Exception to capital asset treatment for debt instruments for certain types of taxpayers:

Securities dealers section 475(a)

Electing securities traders under section 475(f)

Banks and certain other financial institutions under section 582(c)

Character


Section 582(c) provides ordinary treatment for gains and losses on the sale or exchange of debt instruments by a bank (bank defined to include banks, foreign banks to the extent the gains and losses are ECI, thrifts, small business investment companies and business development entities (as defined in section 582(c)(2)(B)).

If the single owner of a business entity is a bank… then the special rules applicable to banks under the Internal Revenue Code will continue to apply to the single owner as if the wholly owned entity were a separate entity. Treas. Reg. § 301.7701-2(c)(2)(ii).

For non-bank affiliates (e.g., REITs, investment companies, partnerships, etc.) to whom the bank might sell or transfer loans, general tax law principles apply.

Character

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Sale of Existing Non-Performing Loans

Has the company had an “ownership change” within the three year testing period that could subject any losses to the section 382 limitation?

Sale of Acquired Non-Performing Loans

Were the non-performing loans previously acquired as part of a transaction subject to section 382?

Potential Loss Limitations (Section 382)


In the event of an “ownership change,” Section 382 generally places a limit on the amount of NOLs, certain recognized built-in losses, and other tax attributes arising before the change that may be used to offset taxable income after the ownership change. Section 382 does not restrict the recognition of NOLs or other tax attributes arising after the ownership change date.

The Section 382 annual limitation is generally computed by taking the pre-change equity value of the entity multiplied by the IRS published long term tax-exempt interest rate. That is, pre-change losses can only be used to offset post-change income to the extent of the Section 382 limitation.

An ownership change occurs when there is a more than 50% shift in the equity ownership of a loss corporation, measured through 5 percent shareholders, during any rolling three year period.

Section 382 subjects built-in losses on the date of the ownership change to limitation if they are recognized (an “RBIL”) during a five year recognition period.

Potential Loss Limitations (Section 382)

Removing Loans From The Balance Sheet

Structured Sales

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LLC / Partnership Structure

Selling BankBuyer

(LLC Entity)

3rd Party Servicer

Cash

LLC InterestNPAs / Equity

Cash / Note Rec./LLC interest

Investor

Servicing Fees

Loan Servicing



The “Selling Bank” may enter into an LLC / partnership structure with a third party whereby the Bank transfers its non-performing asset (NPA) portfolio to a partnership in exchange for cash, a note receivable, or equity, or any combination thereof.

Depending on the form of the transaction, generally for tax purposes, the initial transaction may be treated as either:

A non-taxable capital contribution (Section 721);

A taxable sale (Section 1001); or

Partially both.

If the Selling Bank receives cash and/or a note receivable in partial or full exchange for its NPAs, the Selling Bank generally recognizes sales treatment.

If the Selling Bank receives a capital interest in the LLC/partnership, the transaction could be considered a non-taxable capital contribution.

In the event that the Selling Bank receives both cash/note receivable and a capital interest in the LLC, the Selling Bank may have a partial sale and partial capital contribution. The related adjusted tax basis of the transferred assets, partnership interest and any resulting tax gain or loss will have to be allocated.



The character of the non-performing loans will not automatically be afforded ordinary treatment under Section 582(c) applicable to Banks.

If the Selling Bank is related to the partnership (i.e. if the Selling Bank owns more than 50% of the capital interest, or the profits interest, in the partnership), any loss realized on the sale of the NPAs may be deferred until such time that the property is sold to an unrelated third party (Section 267, Section 707(b)).

Following the sales treatment, the partnership will need to consider the various “buyer side” issues associated with distressed debt portfolios:

Market discount

Nonaccrual interest

Charge-offs

REO expense capitalization

Loan modifications

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Loan Modifications

Section 1.1001-3


Section 1.1001-3

A bank may modify the terms of a loan agreement to increase the borrower's chances of paying or for other reasons

- Home Affordable Modification Program (“HAMP”)

If the modification of debt is a significant modification, it will be treated as a taxable exchange

The modified debt instrument must materially differ from the original debt instrument either in kind or extent


Significant Modifications

Bank debt modifications that may result in a “significant modification” include:

Change in rate

Principal forbearance

Principal reduction

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What is a “Modification?”

Any change of a legal right or obligation of the issuer or the holder

Can occur from the parties’ direct agreement or from their conduct


What is not a Modification?

Generally, a modification does not include a change under the terms of the instrument

Exceptions

A change in obligor (addition or deletion)

A change in recourse nature of obligation

A change that results in instrument no longer being debt (unless holder converts debt into equity)

A change as a result of an option (possessed by either party) unless it is unilateral

For holder options, it is not reasonably expected to result in delay or reduction of a scheduled payment

Failure of the issuer to perform

Holder agrees to stay collection or waive an acceleration clause if it lasts not more than two years

Period of good faith negotiations during a bankruptcy proceeding


When is a modification “Significant?”

General Rule – When the legal rights or obligations are altered in an economically significant manner

The regulations provide specific rules for five types of modifications that apply instead of the general rule

- Change in yield

- Change in timing of payments

- Change in obligor or security

- Change in the nature of a debt instrument

- Change in accounting or financial covenants

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Cumulating Factors

Changes that occur over time may be evaluated together to see if they would be significant had they occurred at the same time

For modifications that fall outside of the 5 specific rules, modifications are considered collectively

Modifications tested under the 5 specific rules are not considered collectively, but assume all such changes have been made before testing


Consequences of a Debt-for-Debt Exchange

Holder

Amount realized generally equals the issue price of the new debt. (section 1.1001-1(g))

Gain or loss not recognized in a recapitalization.

Holder may have OID going forward.

Issuer:

Potential COD if the adjusted issue price of the old debt is greater than the issue price of the new debt. (See section108(e)(10))

Bond repurchase premium if issue price of new debt is greater than adjusted issue price of old debt. Bond repurchase premium may need to be spread over term of new debt. (See section 1.163-7(c))

Possible OID deductions going forward.

Need to retest for AHYDO and under other interest disallowance provisions


Consequences of a Debt-for-Debt Exchange

Section1.166-3(a)(3) provides a special “deemed charge-off” rule for significantly modified loans that have been subject to a partial charge-off prior to the modification.

The deemed charge-off is equal to the lesser of:

- The gain recognized on the modification; or

- The amount by which the tax basis of the modified debt exceeds the greater of:

- The fair market value of the modified debt, or

- The amount of the modified debt recorded on the taxpayer's books and records

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Loan Modifications

A&B Notes


A&B Note Structure

The lender modifies a single debt into two tiers of debt

A Note – A performing loan that has a lower principal amount than the original debt

B Note – A new loan for part or all of the principal reduction agreed to on the A note.

The B Note generally ensures that the lender can recover some of the forgiven principal in the event the property value improves over time


A&B Note Structure

Lender: ABC Bank

Borrower :Home LLC

Maturity Date: 10/1/2014

Principal: $14,000,000

Interest : 4%

ORIGINAL LOAN

A NOTE

At the time of the note split the total principal and accrued but unpaid interest equaled $14,550,555

Lender: ABC Bank

Borrower :Home LLC



Interest : 5.3%

B NOTE

Lender: ABC Bank

Borrower :Home LLC



Interest : 1.7%

Performing

Non-Performing

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Deterioration in Issuer’s Financial Condition

Regulations under section 1.1001-3 were finalized on January 6, 2011

Clarify that any deterioration in the financial condition of the issuer is generally not taken into account to determine if the modified instrument is debt

This exception does not apply to debt modifications where a new obligor has been substituted or a co-obligor has been added or deleted

Taxpayers may rely on the final regulations for alterations occurring on or before January 6, 2011

Foreclosures

Types of Foreclosures and Related Tax Issues


Foreclosures

A holder of debt may decide to exercise its right to take control or ownership of the collateral securing the loan through foreclosure action

Types of Foreclosure

Judicial Foreclosure Sale

Non-Judicial Foreclosure sale

Deed in Lieu of Foreclosure

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Foreclosures

Foreclosure or Deed in Lieu of Foreclosure are the standard forms of collection on defaulted loans

Depending on state, may result in discharge of debt instrument

May still be recourse obligation against the borrower, in which case the loan is not discharged.

Some states allow the use of trust deeds (or deeds of trust) instead of mortgages.

In trust deeds a third party (the trustee) holds the legal title to the property securing the loan between the lender/(bank) and the borrower.

Foreclosure with a deed of trust is generally non-judicial while a foreclosure with a mortgage is generally judicial (i.e., involves a court action).


Foreclosures

Foreclosures (judicial or non-judicial) result in sale of the mortgaged property to the bank lender or to another bidder

If purchased by another bidder, the bank is entitled to a bad debt deduction to the extent of the excess of the bank’s basis in the debt (including accrued but unpaid interest) over the amount for which the property is sold (assuming the remaining debt is worthless) (section1.166-6(a))

If purchased by the bank, there is a two-step calculation(section 1.166-6(b)):

- Bad debt deduction (computed as the difference between the bid price and the basis in loan)

- Gain or loss on acquisition of the property (computed as the difference between FMV of property and the amount of the loan applied to the bid price)


Deed In Lieu Of Foreclosure

In the context of a deed in lieu of foreclosure, the exact form of the transaction depends on the state law treatment, but the tax consequences will generally be the same as a foreclosure sale where the lender acquires the property.

A primary difference is that there will be no bid in a deed in lieu of foreclosure. Thus, the FMV of the property will have to be determined through a valuation or similar exercise.

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Section 1.166-6 versus 1271

Section 1.166-6 Sale of mortgaged or pledged property.

a) Deficiency deductible as bad debt—

1) Principal amount. If mortgaged or pledged property is lawfully sold (whether to the creditor or another purchaser) for less than the amount of the debt, and the portion of the indebtedness remaining unsatisfied after the sale is wholly or partially uncollectible, the mortgagee or pledgee may deduct such amount under section 166(a)(to the extent that it constitutes capital or represents an item the income from which has been returned by him) as a bad debt for the taxable year in which it becomes wholly worthless or is charged off as partially worthless. See § 1.166–3.

Section 1271 Treatment of amounts received on retirement or sale or exchange of debt instruments

a) General rule. For purposes of this title—

1) Retirement. Amounts received by the holder on retirement of any debt instrument shall be considered as amounts received in exchange therefor.


Sale of Foreclosure Property

When property is later sold by bank, need to consider character of gain or loss

Banks generally treat gain or loss as ordinary.

Need to determine if:

– Property is being used in a trade or business (e.g., rental property); or

– The entity holding the property is in the trade or business of selling foreclosure property, or the property is held for sale to customers in the ordinary course of the holder’s trade or business.

– See Revenue Ruling 74-159; Kanawha Valley Bank; Girard Trust; Corn Exchange Bank.

Foreclosures

Tax Controversy Issues Surrounding Foreclosure Property

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Expenses Related to Foreclosure Property

Whether Borrower's costs paid after the foreclosure should be added to the basis in the foreclosure property.

Treatment of expenses related to foreclosure property

Section 263A applies to real or personal property described in section 1221(a)(1) which is acquired by the taxpayer for resale.

If section 263A applies, then direct costs of such property and the property’s allocable share of indirect costs are capitalized.

Query whether property “acquired” for resale


Tax Controversy Issues Surrounding Foreclosure Property

Whether foreclosure costs should be added to the basis in the foreclosure property or whether they are currently deductible.

Fair market value of foreclosure property for purposes of measuring the bad debt deduction.

Costs to sell the property

Questions?

loan-workouts

Documents

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tax structure

business entity

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whollyowned entity

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