Part I. Rulings — Internal Revenue Bulletin 2007-21

Section 118.—Contribu- tions to the Capital of a Corporation

26 CFR 1.118–1: Contributions to the capital of a corporation.

Contributions to the capital of a corporation; nonshareholder contribu- tions. This ruling provides that payments received by a corporation under the federal universal service support mechanisms do not represent a nonshareholder contribution to capital under section 118(a) of the Code. The federal universal service support mechanisms are funded by contributions from telecommunications carriers. Telecommunications carriers receive support payments to provide discounted telecommunications services or telecommunication services in high cost areas.

Rev. Rul. 2007–31

ISSUE

Is universal service support received by a corporation under the universal service support mechanisms a nonshareholder contribution to capital under section 118(a) of the Internal Revenue Code?

FACTS

The federal universal service support mechanisms are required by 47 U.S.C. § 254. The Federal Communication Commission (Commission) is required to establish periodically the services to be supported by federal universal service support mechanisms. 47 U.S.C. § 254(c)(1). The Commission has established that the following services be supported by federal universal service support mechanisms: (1) voice grade access to the public switched network; (2) local usage; (3) dual tone multi-frequency signaling or its functional equivalent; (4) single-party service or its functional equivalent; (5) access to emergency services; (6) access to operator services; (7) access to interexchange service; (8) access to directory assistance; and (9) toll limitations for qualifying low-income consumers. 47 C.F.R. § 54.101(a). An eligible telecommunications carrier must

offer each of the services in order to receive federal universal service support. 47 C.F.R. § 54.101(b).

The Universal Service Administrative Company (Administrator) administers the federal universal service support mechanisms. 47 C.F.R. § 54.701. The Administrator is responsible for administering the following federal universal support mechanisms: (1) the high cost support mechanisms described in 47 C.F.R. part 54, subpart D; (2) the low income support mechanisms described in 47 C.F.R. part 54, subpart E; (3) the schools and libraries support mechanism described in 47 C.F.R. part 54, subpart F; (4) the rural health care support mechanism described in 47 C.F.R. part 54, subpart G; (5) the interstate access universal support mechanism described in 47 C.F.R. part 54, subpart J; and (6) the interstate common line support mechanism described in 47 C.F.R. part 54, subpart K. 47 C.F.R. § 54.702(a). The Administrator is responsible for billing contributors, collecting contributions to the universal service support mechanisms, and disbursing universal service support funds. 47 C.F.R. § 54.702(b).

The federal universal service support mechanisms are funded by contributions from telecommunications carriers. Every telecommunications carrier that provides interstate telecommunications services must contribute, on an equitable and nondiscriminatory basis, to the specific, predictable, and sufficient mechanisms established by the Commission to preserve and advance universal service. 47 U.S.C. § 254(d). Entities that provide interstate telecommunications services to the public, or to such classes of users as to be effectively available to the public, for a fee will be considered telecommunications carriers providing interstate telecommunications services and must contribute to the universal service support mechanisms. 47 C.F.R. § 54.706(a). Federal universal service contribution costs may be recovered through interstate telecommunications-related charges to end users. 47 C.F.R. § 54.712(a).

In order to receive support, an eligible telecommunications carrier first must provide the supported services. The univer

sal service support provided pursuant to 47 C.F.R. part 54, subparts D, J, and K (identified above) ensures that consumers in all regions of the nation have access to and pay rates for telecommunication services that are reasonably comparable to those in urban areas. The universal service support provided by 47 C.F.R. part 54, subparts E, F, and G (identified above) allows carriers to provide discounted, or reduced, rates to low income consumers, schools and libraries, and rural health care providers. The amount of federal universal service support received depends on either the discount offered to the targeted customers or the cost of providing service (the carrier’s revenue requirement) in high cost areas. For financial accounting purposes, the Commission requires all carriers to record their federal universal service support receipts as revenue.

All carriers that receive universal service support must use that support only for the provision, maintenance, and upgrading of facilities and services for which the universal service support is intended. 47 U.S.C. § 254(e) and 47 C.F.R. § 54.7. This includes, for example, the ability to use the funds to reduce intrastate rates, to cover operating expenses (billing and marketing expenses) associated with the supported services, and to upgrade the facilities for the supported services. Annual certifications are required to be filed with the Administrator and the Commission with respect to universal service support from certain universal service support mechanisms stating that all universal service support received from such mechanisms will be used only for the provision, maintenance, and upgrading of facilities and services for which the support is intended.

LAW AND ANALYSIS

Section 118(a) of the Code provides that in the case of a corporation, gross income does not include any contribution to the capital of the taxpayer. The committee reports accompanying the enactment of what is now section 118(a) indicate that the provision was intended to codify the existing law that had developed through administrative and court decisions on the subject.

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concluded that irrespective of the public benefit of reduced unemployment that occurred as a result of the payments, the payments constituted direct compensation for training services and thus could not be considered a contribution to capital.

As provided in section 1.118–1 and stated by the Supreme Court in Detroit Edison and Chicago, Burlington & Quincy R.R., compensation in exchange for a specific quantifiable service constitutes taxable income, not a capital contribution. Indeed, the Court in Brown Shoe premised its decision that inducement payments by community groups to a private corporation for relocating and building a factory constituted a capital contribution, based on the specific absence of customers and payment for services. Conversely, these are precisely the factors that are present in the universal service support. There is a clear nexus between the universal service support and the provision of universal telecommunications services by the carriers. The motivation underlying the universal service support is to compensate the carriers for the shortfall in operating income for providing services at a discount to certain customers and/or providing services to customers in high cost areas at below cost rates. The universal service support is predicated on the carriers providing the mandated universal service and is an integral part of the government’s mandate to insure that universal service is provided.

In addition, the universal service support does not satisfy the five characteristics of a nonshareholder contribution to capital set forth in Chicago, Burlington & Quincy R.R., because the universal service support: (1) does not necessarily become a permanent part of the carrier’s working capital structure because the support is not limited to the acquisition of capital assets and can be used to pay current expenses; (2) is made for specific, quantifiable telecommunication services to telecommunication customers of the carrier; (3) is not bargained for because the universal service support mechanisms are a unilateral government program and the method of participation by carriers is mandated (despite any certification requirements); (4) does not benefit the carrier commensurate with the value of the support because the support payments merely maintain the carrier’s viability; and (5) does not neces

H.R. Rep. No. 1337, 83d Cong., 2d Sess. 17 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 18 (1954). Section 1.118–1 of the Income Tax Regulations includes within the meaning of a contribution to capital, a contribution by a nonshareholder and cites as examples of nonshareholder contributions to capital: the value of land and other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities. However, the exclusion from gross income does not apply to any money or property transferred to the corporation in consideration for goods or services rendered.

In Detroit Edison Co. v. Commis- sioner, 319 U.S. 98 (1943), 1943 C.B. 1019, the Supreme Court held that payments by prospective customers to an electric power company that were used by the company to construct the facilities necessary to deliver electricity to the customers were not nonshareholder contributions to capital. The Court found that the motivation for the prospective customers’ contributions was to obtain electric services from the power company and, therefore, the contributions were payment for services. 319 U.S. at 102, 1943 C.B. at 1021.

In contrast, Brown Shoe Co. v. Com- missioner, 339 U.S. 583 (1950), 1950–1 C.B. 38, held that money and property contributions by community groups to induce a shoe company to locate or expand its factory operations in the contributing communities were nonshareholder contributions to capital. The Court reasoned that when the motivation of the contributors is to benefit the community at large and the contributors do not anticipate any direct benefit from their contributions, the contributions are nonshareholder contributions to capital. 339 U.S. at 591, 1950–1 C.B. at 41.

The Court again considered this issue in United States v. Chicago, Burlington & Quincy R.R., 412 U.S. 401 (1973), 1973–2 C.B. 428. In that case, the Court set forth the following five characteristics of a nonshareholder contribution to capital: (1) the contribution must become a permanent part of transferee’s working capital structure; (2) the contribution may not be compensation, such as a direct payment

for a specific, quantifiable service provided for the transferor by the transferee; (3) the contribution must be bargained for; (4) the asset transferred foreseeably must result in benefit to the transferee in an amount commensurate with its value; and (5) the asset ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect. 412 U.S. at 413, 1973–2 C.B. at 432. In reaching its conclusion that the improvements at issue did not qualify as contributions to capital, the Court reasoned:

Although the assets were not payments for specific, quantifiable services performed by CB&Q for the Government as a customer, other characteristics of the transaction lead us to the conclusion that, despite this, the assets did not qualify as contributions to capital. The facilities were not in any real sense bargained for by CB&Q. Indeed, except for the orders by state commissions and the government subsidies, the facilities would not have been constructed at all. 412 U.S. at 413–14, 1973–2 C.B. at 432. In Texas & Pacific Railway Co. v. United States, 286 U.S. 285 (1932), XI–1 C.B. 263, the Court held that payments received by a railroad company from the federal government did not constitute a contribution to capital and thus were includible in income. The Court noted the Transportation Act of 1920 provided for payments representing a guarantee of minimum operating income to compensate the railroad during the transition from federal control to private ownership. The Court reasoned that the payments did not represent capital contributions:

Here they were to be measured by a deficiency in operating income, and might be used for the payment of dividends, of operating expenses, of capital charges, or for any other purpose …. The Government’s payments were not in their nature bounties, but an addition to a depleted operating revenue consequent upon a federal activity. 286 U.S. at 290, XI–1 C.B. at 265. In Deason v. Commissioner, 590 F.2d 1377 (5th Cir. 1979), the Fifth Circuit held that payments received from the Department of Labor for job training for unemployed individuals were not a contribution to capital under section 118. The court affirmed the opinion of the Tax Court, which

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sarily generate additional income for the carrier because the support is not limited to the acquisition of capital assets that will generate additional income for the carrier, but can be used to pay current expenses or to replace capital assets.

The holdings in Texas Pacific and Deason also are illustrative in this context. In Texas Pacific, the federal government provided payments to fulfill a statutory public purpose and yet because of the inherent nature of the transaction as reimbursement for deficiencies in operating income, the payments did not warrant capital contribution treatment. In Deason, the federal government made payments that served the public goal of reducing unemployment. Despite the existence of a public benefit derived from the payment, the court concluded that the payments were compensation for services and therefore ineligible as a capital contribution. Similarly, although a public purpose is served by payment of the universal service support, and the payor is not the consumer of the universal telecommunications services, the universal service support is nonetheless compensation to the carriers for the provision of universal telecommunications services.

HOLDING

Universal service support received by a corporation under the universal service support mechanisms is not a nonshareholder contribution to capital under section 118(a) of the Code.

DRAFTING INFORMATION

The principal author of this revenue ruling is David McDonnell of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mr. McDonnell at (202) 622–3040 (not a toll-free call).

Section 166.—Bad Debts

A revenue ruling providing guidance as to the period in which a bank that has elected the conformity method of accounting under regulations section 1.166–2(d)(3) can treat uncollected interest as worthless. See Rev. Rul. 2007-32, page 1278.

Section 199.—Income Attributable to Domestic Production Activities

26 CFR 199–9: Application of section 199 to pass- thru entities for taxable years beginning on or before May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005. (Also § 1.199–3T.)

Income attributable to domestic pro- duction activities; qualifying in-kind partnerships. This ruling provides that a partnership engaged in the extraction and processing of minerals within the United States is a qualifying in-kind partnership for purposes of section 199 of the Code. Each partner of a qualifying in-kind partnership is treated as having manufactured, produced, grown, or extracted (MPGE) property MPGE by the partnership that is distributed to that partner.

Rev. Rul. 2007–30

This revenue ruling designates the extraction and processing of minerals (as defined in § 1.611–1(d)(5) of the Income Tax Regulations) as an activity within § 1.199–9(i)(2)(iii) and § 1.199–3T(i)(7)(ii)(C) of the temporary Income Tax Regulations. A partnership engaged solely in an activity or industry designated by the Secretary will be a qualifying in-kind partnership under §§ 1.199–9(i)(2) and 1.199–3T(i)(7)(ii).

Pursuant to §§ 1.199–9(i)(1) and 1.199–3T(i)(7)(i), each partner of a qualifying in-kind partnership is treated as having manufactured, produced, grown, or extracted (MPGE) property MPGE by the partnership that is distributed to that partner.

Sections 1.199–9(i)(2) and 1.199–3T(i) (7)(ii) provide that a qualifying in-kind partnership includes a partnership engaged solely in the extraction, refining, or processing of oil, natural gas, petrochemicals, or products derived from oil, natural gas, or petrochemicals in whole or in significant part within the United States; or the production or generation of electricity in the United States. Under §§ 1.199–9(i)(2)(iii) and 1.199–3T(i)(7)(ii)(C), a qualifying in-kind partnership may include a partnership engaged solely in an activity or industry designated by the Secretary by publication in the Internal Revenue Bulletin.

By this revenue ruling, the Internal Revenue Service designates the extraction and processing of minerals (as defined in § 1.611–1(d)(5)) as an activity within §§ 1.199–9(i)(2)(iii) and 1.199–3T(i)(7)(ii)(C). Accordingly, a partnership engaged solely in the extraction and processing of minerals within the United States will be a qualifying in-kind partnership under §§ 1.199–9(i)(2) and 1.199–3T(i)(7)(ii).

EFFECTIVE DATE

This revenue ruling is effective for taxable years beginning after December 31, 2004, the effective date of § 199. However, for taxable years beginning before June 1, 2006, a taxpayer may apply this revenue ruling only if the taxpayer applies §§ 1.199–1 through 1.199–8 to that taxable year.

DRAFTING INFORMATION

Section 446.—General Rule for Methods of Accounting

A revenue ruling requiring an accrual method bank with a reasonable expectation of receiving future payments on a loan to include accrued interest (determined under regulations section 1.446–2) in gross income for the taxable year in which the right to receive the interest becomes fixed, notwithstanding bank regulatory rules that prevent accrual of the interest for regulatory purposes. See Rev. Rul. 2007-32, page 1278.

A revenue procedure providing the procedure under which a bank may change its method of accounting for uncollected interest to an elective safe harbor method based on the bank’s collection experience. See Rev. Proc. 2007-33, page 1289.

Section 451.—General Rule for Taxable Year of Inclusion

A revenue procedure providing an elective safe harbor method of accounting for a bank’s uncollected interest based on the bank’s collection experience. See Rev. Proc. 2007-33, page 1289.

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become 90 days past due. Nonetheless, X reasonably expects the borrower to continue making some but not all payments on the loan.

On January 16, 2007, the uncollected accrued interest on Loan A is $9,000 ($8,000 attributable to the calendar year ending December 31, 2006, and $1,000 attributable to the period January 1, 2007 through January 16, 2007). Prior to January 17, 2007, X recognized the $9,000 as income for regulatory financial statement purposes. During the period January 17, 2007 through December 31, 2007, an additional $23,000 of accrued interest becomes due on Loan A.

Pursuant to federal banking rules, on January 16, 2007, X reverses the $9,000 of uncollected accrued interest that had previously been recognized by making adjustments to appropriate income statement and balance sheet accounts for regulatory financial statement purposes. In addition, federal banking rules do not permit X to recognize as income any of the $23,000 accrued interest attributable to the period January 17, 2007 through December 31, 2007. On January 1, 2008, X receives a $31,000 payment on Loan A. For regulatory financial statement purposes, X characterizes the $31,000 payment as a recovery of principal rather than a recovery of accrued interest. Therefore, X does not recognize any of the $31,000 payment as interest income for regulatory financial statement purposes.

X’s supervisory authorities, in connection with the most recent examination of X’s regulatory financial statements and lending practices, have determined that X maintains and applies standards that are consistent with federal banking rules.

LAW AND ANALYSIS

Issue 1.

Section 1.446–2 provides rules for determining the amount of accrued interest (other than interest described in § 1.446–2(a)(2)) that is generated on a loan over time for federal income tax purposes.

Section 1.446–2(a)(1) provides that the period in which a taxpayer recognizes accrued interest (determined under § 1.446–2(b) or § 1.446–2(c)) in gross

26 CFR 1.451–1: General rule for taxable year of inclusion. (Also: Part I, §§ 166, 446; 1.166–2, 1.446–1, 1.446–2.)

Accrual of interest. This ruling requires an accrual method bank with a reasonable expectancy of receiving future payments on a loan to include accrued interest (determined under regulations section 1.446–2(a)(2)) in gross income for the taxable year in which the right to receive the interest becomes fixed, notwithstanding bank regulatory rules that prevent accrual of the interest for regulatory purposes. The ruling also provides guidance as to the period in which a bank that has elected the conformity method of accounting under regulations section 1.166–2(d)(3) can treat uncollected interest as worthless. Rev. Rul. 81–18 distinguished.

Rev. Rul. 2007–32

ISSUES

If federal banking rules require a bank to suspend the recognition of certain uncollected “accrued interest” as defined in § 1.446–2 of the Income Tax Regulations as income for regulatory financial statement purposes should the bank also cease recognizing uncollected accrued interest into income for federal income tax purposes?
If a bank uses a conformity method of accounting as provided for in § 1.166–2(d) but does not recognize uncollected accrued interest as income for regulatory financial statement purposes, when should the bank recognize a worthless debt with respect to uncollected accrued interest for federal income tax purposes?
If a bank receives payments on a loan where the bank for federal income tax purposes either (i) previously recognized the uncollected accrued interest as income and subsequently deducted the accrued interest receivable as a worthless debt under section 166 or (ii) did not recognized the uncollected accrued interest on the loan as income, how should the payments be characterized for federal income tax purposes?

FACTS

X corporation is a bank as defined in § 1.166–2(d)(4)(i). X determines its tax

able income using an accrual method of accounting and files its federal income tax returns on a calendar year basis. Loans made by X are subject to § 1.446–2, which determines the amount of “accrued interest” related to each loan for federal income tax purposes.

X is subject to regulatory supervision by federal banking authorities (“supervisory authorities”) and is required to prepare regulatory financial statements that comply with federal banking rules. For regulatory financial statement purposes, unless a loan is both well secured and in the process of collection, federal banking rules generally require that X suspend the recognition into income of uncollected accrued interest on a loan and reverse any previously recognized uncollected interest income if:

(i) the loan is maintained on a cash basis because of deterioration in the borrower’s financial condition;

(ii) payment in full of principal or interest is not expected; or

(iii) payment of principal or interest has been in default for a period of 90 days or more.

Under federal banking rules, a loan may be considered a bankable asset ( i.e., not written off for regulatory financial statement purposes) even if accrued interest on the loan is no longer being recognized as income (or was previously recognized and subsequently charged off) for regulatory financial statement purposes. In this revenue ruling, the loan is referred to as a “non-accrual loan receivable.”

In general, federal banking rules require a bank such as X to apply any payment received on a non-accrual loan receivable to reduce its recorded investment in the loan ( i.e., treat all monies that come in on the loan as a collection of loan principal) to the extent necessary to eliminate doubt as to collectibility. Therefore, for regulatory financial statement purposes, X characterizes any payment received on a non-accrual loan receivable as a payment of principal rather than a payment of the outstanding accrued interest on the loan until the remaining principal on the non-accrual loan receivable is considered to be fully collectible.

On January 16, 2007, X classifies Loan A as a non-accrual loan receivable for regulatory financial statement purposes because an amount of principal or interest has

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income is determined under the taxpayer’s regular method of accounting.

Section 451(a) provides that the amount of any item of gross income is included in gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for in a different period.

In the case of an accrual method taxpayer, § 1.451–1(a) provides that income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. See also § 1.446–1(c)(1)(ii).

As an accrual method taxpayer, X generally is required to recognize accrued interest determined under § 1.446–2 into gross income for the taxable year in which all the events have occurred which fix the right to receive such interest and the amount thereof can be determined with reasonable accuracy. See § 1.451–1(a). Under the “all events” test, a taxpayer’s right to receive income becomes fixed on the earlier of the date that: (1) payment is earned through performance; (2) payment is due; or (3) payment is actually received. Rev. Rul. 84–31, 1984–1 C.B. 127. An amount of accrued interest determined pursuant to § 1.446–2 satisfies the “reasonable accuracy” requirement of § 1.451–1(a).

Although federal banking rules do not permit X to recognize accrued interest related to a non-accrual loan receivable as income for regulatory financial statement purposes, regulatory accounting rules are not controlling for federal income tax purposes. See Old Colony R. Co. v. Commis- sioner, 284 U.S. 552, 562 (1932).

“A fixed right to a determinable amount does not require accrual, however, if the income is uncollectible when the right to receive the income item arises. Accrual of income is not required when a fixed right to receive arises if there is not a reasonable expectancy that the claim will ever be paid.” European Am. Bank & Trust Co. v. United States, 20 Cl. Ct. 594, 605 (1990) (footnotes omitted), aff’d per curiam, 940 F.2d 677 (Fed. Cir. 1991); see also Jones Lumber Co. v. Commissioner, 404 F.2d 764, 766 (6th Cir. 1968) (stating that “[t]he right to receive . . . determines the accrual of income unless, at the time the right arises, there exists a reasonable doubt as to

its collectibility”); Koehring Co. v. United States, 421 F.2d 715, 721 (Ct. Cl. 1970) (stating that “a reasonable doubt as to the collectibility of a debt is a sufficient reason to justify its nonaccrual as income”); Rev. Rul. 80–361, 1980–2 C.B. 164 (citing Jones Lumber Co., supra. )

The “no reasonable expectancy of payment” exception to the fundamental rules of income accrual is strictly construed. “For accrual of income to be prevented, uncertainty as to collection must be substantial.” European Am. Bank & Trust Co., 20 Cl. Ct. at 605. To treat an item as non-accruable because of doubtful collectibility, the cases generally have required substantial evidence as to the financial instability or insolvency of the debtor. See Jones Lumber Co., 404 F.2d at 766. This substantiation requirement has been applied on a loan by loan basis.

Temporary financial difficulty of a debtor cannot support non-recognition of income absent the existence of real doubt regarding ultimate payment. Koehring Co., 421 F.2d 715, 721–722; see also Harmont Plaza Inc. v. Commissioner, 64 T.C. 632, 650 (1975), aff’d, 549 F.2d 414 (6 ^th Cir. 1977) (stating that “the fact that a lapse of time is contemplated before actual satisfaction is possible does not constitute the requisite doubtful collectibility”). If there is some doubt regarding receipt of payment but a reasonable person would have an expectancy of payment, then an accrual method taxpayer is required to recognize the income.

When an income item is properly accrued and subsequently becomes uncollectible, a taxpayer’s remedy is by way of a bad debt deduction under section 166 rather than through elimination of the accrual. Rev. Rul. 80–361. See also § 1.166–1(e) (relating to a bad debt deduction for uncollected income items included as income for the taxable year in which the bad debt deduction is claimed or for a prior taxable year); section 585 (allowing certain banks to deduct additions to a reserve for bad debts in lieu of the bad debt deduction provided by section 166) and § 1.585–2(e)(2) (excluding interest that has not been included in gross income from a loan used to determine additions to the reserve for bad debts). This rule is applicable even when the item is accrued and becomes uncollectible during the same taxable year. Spring City

Foundry Co. v. Commissioner, 292 U.S. 182 (1934). See also Atlantic Coast Line Railroad Co. v. Commissioner, 31 B.T.A. 730, 751 (1934), acq., XIV–2 C.B. (1935). Rev. Rul. 81–18, 1981–1 C.B. 295, addressed an accrual basis savings and loan association operating on a calendar year for federal income tax purposes. On its 1978 income tax return, the savings and loan recognized into income uncollected accrued interest on a loan. However, no interest payments were ever received on the loan. On January 30, 1979, the savings and loan charged off the previously recognized 1978 accrued interest for regulatory financial accounting purposes and recognized a bad debt deduction for federal income tax purposes. The charge-off was made pursuant to then existing Federal Home Loan Bank Board (FHLBB) regulations. The FHLBB regulations required that interest be treated as uncollectible if any portion of the interest was due but uncollected for a period in excess of 90 days. FHLBB examiners, upon their first audit of the savings and loan after the charge-off, confirmed that the charge-off was properly recognized for regulatory financial statement purposes and made in accordance with established policies of the FHLBB. The ruling considered two issues: (1) whether the savings and loan’s claim for the uncollected 1978 interest was worthless for purposes of recognizing a section 166 bad debt deduction; and (2) whether the savings and loan was required under section 451 and § 1.451–1(a) to recognize the uncollected accrued interest on the nonperforming loan for periods after December 31, 1978 under the accrual method of accounting. The ruling concluded that for federal income tax purposes, the savings and loan’s claim to the 1978 uncollected accrued interest was a worthless debt for purposes of section 166. The ruling also concluded that the savings and loan was not required to recognize any uncollected accrued interest on the loan after December 31, 1978.

Unlike the situation in Rev. Rul. 81–18, where no payments on the loan were made and there was no reasonable expectation of payment, in this revenue ruling X reasonably expects the borrower to continue making some but not all payments on Loan A. Therefore, the borrower’s default on Loan A only demonstrates that timely repayment is not

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2006 and $24,000 of uncollected accrued interest in 2007).

Issue 3.

In general, § 1.446–2(e) provides that each payment made on a loan (other than payments of additional interest or similar charges with regard to amounts that are not paid when due) is treated as a payment of interest to the extent of any accrued interest that is uncollected on the date the payment becomes due. The interest characterization provided for in § 1.446–2(e) applies to all payments made on a loan regardless of the taxpayer’s overall method of accounting. For example, the interest characterization provided for in § 1.446–2(e) would apply to a payment on a loan for which the uncollected accrued interest was not previously recognized as income for federal income tax purposes. Similarly, the interest characterization provided for in § 1.446–2(e) would apply to a payment on a loan for which the uncollected accrued interest was previously recognized as income for federal income tax purposes and subsequently deducted as a worthless debt under the taxpayer’s method of accounting.

Under § 1.166–1(f), any amount attributable to a recovery of a bad debt, or of a portion of a bad debt, which was allowed as a deduction from gross income in a prior taxable year, is included in gross income for the taxable year of recovery, except to the extent that the recovery is excluded from gross income under the provisions of section 111 and § 1.111–1.

On January 1, 2008, X receives a $31,000 payment on Loan A. For regulatory financial statement purposes, X characterizes the $31,000 as a payment of loan principal. However, under § 1.446–2(e), X is required to characterize any payment received on Loan A (other than payments of additional interest or similar charges with regard to amounts that are not paid when due) as a payment of interest for federal income tax purposes to the extent there is uncollected accrued interest outstanding on Loan A.

Immediately prior to the receipt of the $31,000 payment on January 1, 2008, the uncollected accrued interest on Loan A is $32,000 ($8,000 attributable to 2006 and $24,000 attributable to 2007). Therefore, § 1.446–2(e) requires that X characterize

occurring. The late payment of interest by itself is not sufficient to demonstrate that X has no reasonable expectation of payment of the accrued interest related to Loan A. Under these circumstances, the “no reasonable expectancy of payment” exception to the general accrual rule does not apply. See Koehring Co., 421 F.2d at 721–722 ; Harmont Plaza Inc., 64 T.C. at 650. As an accrual method taxpayer, X is required to recognize the $8,000 of uncollected 2006 accrued interest as income in X’s 2006 taxable year for federal income tax purposes. X is also required to recognize the $24,000 of uncollected 2007 accrued interest in X’s 2007 taxable year. The result is the same regardless of whether the bank uses a conformity method of accounting provided for in § 1.166–2(d).

Issue 2.

Section 166(a)(1) provides that a deduction shall be allowed for any debt that becomes worthless during the taxable year. In addition, section 166(a)(2) provides a deduction for “partially worthless debts” not in excess of the part charged off in the taxpayer’s books and records within the taxable year to the extent the Commissioner is satisfied that the debt is recoverable only in part. A deduction for a worthless debt arising from an item of taxable income shall be allowed only if the item is recognized as taxable income during the taxable year in which the deduction is claimed or a prior taxable year. See § 1.166–1(e).

In general, there is no bright line test for determining the period in which a debt becomes worthless. However, § 1.166–2(d) permits a bank subject to supervision by federal banking authorities to use a conformity method of accounting to determine when a debt becomes worthless. Under a conformity method, debts that are charged off, in whole or in part, for regulatory purposes are conclusively presumed to become worthless for federal income tax purposes at the time of the regulatory charge off. Under a conformity method of accounting, the bank is allowed to recognize a bad debt deduction for the taxable year in which a debt is conclusively presumed to have become worthless. See § 1.166–2(d)(3)(ii)(A)(2).

In connection with the most recent examination of X’s regulatory financial statements, X’s supervisory authorities have determined that X maintains and applies standards that are consistent with federal banking rules. See Rev. Proc. 92–84, 1992–2 C.B. 489 (providing the form for the determination). Therefore, X satisfies the express determination requirement of § 1.166–2(d)(3)(iii)(D).

Various procedures can be used by a bank to classify a debt, or portion thereof, as a loss asset described in § 1.166–2(d)(3)(ii)(C). Rev. Rul. 2001–59, 2001–2 C.B. 585. On January 16, 2007, X reverses the recognition of the $9,000 of pre-January 17, 2007 uncollected accrued interest as interest income on Loan A ($8,000 of 2006 interest and $1,000 of interest for the period January 1, 2007 through January 16, 2007) for regulatory financial statement purposes. X’s reversal of the accrual of $9,000 of uncollected pre-January 17, 2007 accrued interest, removes the interest receivable from X’s books and records for regulatory financial statement purposes. Under federal banking rules, the $9,000 interest receivable is treated as an uncollectible asset of such little value that its inclusion as a bankable asset is not warranted. The reversal of the accrual of the $9,000 of interest receivable constitutes a charge off of the interest receivable as a loss asset for purposes of § 1.166–2(d)(3)(ii)(C).

For regulatory purposes, X does not recognize as income any of the $23,000 of accrued interest attributable to the period January 17, 2007 through December 31, 2007 because X’s right to the $23,000 of accrued interest has such little value that recognition of the accrued interest receivable as a bankable asset is not warranted. Under these circumstances, X’s failure to recognize the $23,000 of accrued interest for regulatory financial statement purposes is tantamount to recognizing the accrued interest as income and immediately charging off the uncollected accrued interest receivable as a loss asset.

As a result of X’s conformity method of accounting under § 1.166–2(d), X will be entitled to claim a worthless debt deduction under section 166 in X’s tax year ending December 31, 2007 for the $32,000 of uncollected accrued interest on Loan A ($8,000 of uncollected accrued interest in

May 21, 2007 1280 2007–21 I.R.B.

Rev. Rul. 2007–33

ISSUE

If a real estate investment trust (REIT) recognizes foreign currency gain in a section 988 transaction, to what extent is that gain qualifying income for purposes of the REIT income tests under § 856(c) of the Internal Revenue Code?

FACTS

R, a corporation with the U.S. dollar as its functional currency, has elected, and qualifies, to be treated as a REIT under subchapter M of Chapter 1 of the Code. R invests both in real property from which R derives rental income and in debt instruments that are partially or fully secured by mortgages on real property.

Some of the leases of the real estate that R owns provide for rents to be paid in euros. For some of these leases, R recognizes rental income for federal income tax purposes before receiving the corresponding rent payments. R ’s rental income from these euro-denominated leases is described in § 856(c)(2)(C) and in § 856(c)(3)(A).

Some of the mortgage loans that R acquires are denominated in euros, and both principal and interest under these loans are payable in euros. R ’s interest income from these euro-denominated loans is described in § 856(c)(2)(B) and in § 856(c)(3)(B).

R ’s activities of investing in rent-producing real estate and in mortgage loans are not subject to § 987. Therefore, if the euro changes in value against the dollar, payments of rent under the leases of the real estate and periodic payments made under the mortgage loans may generate foreign currency gain or loss under § 988. See § 1.988–2(b).

During its taxable year, R recognized rental income on the euro-denominated leases, interest income on the euro-denominated mortgage loans, and section 988 gain on payments received under the leases and the mortgage loans.

LAW AND ANALYSIS

To qualify as a REIT for a taxable year, at least 95 percent of an entity’s gross income must be “derived from” the types of income listed in § 856(c)(2), and at least 75 percent of its gross income must be

the $31,000 payment on Loan A as a payment of interest for federal income tax purposes. The characterization of the $31,000 payment as interest under § 1.446–2(e) would be the same regardless of whether: (i) X had not yet recognized the $32,000 of uncollected accrued interest on Loan A as income under its method of accounting for federal income tax purposes, (ii) X had recognized the $32,000 of uncollected accrued interest on Loan A as income for federal tax purposes but subsequently deducted the interest receivable as a bad debt under section 166 under its method of accounting, or (iii) X used a conformity method of accounting under § 1.166–2(d).

HOLDINGS

X is required to recognize in gross income the uncollected accrued interest on Loan A for federal income tax purposes notwithstanding that federal banking rules required X to suspend the recognition of accrued interest on Loan A into income for regulatory financial statement purposes. For the taxable year ending December 31, 2006, X must recognize in gross income the $8,000 of uncollected accrued interest on Loan A that was generated during 2006. For the taxable year ending December 31, 2007, X must recognize in gross income the $24,000 of uncollected accrued interest on Loan A that was generated during
X must recognize the uncollected accrued interest as gross income in 2006 and 2007 regardless of whether X has elected a conformity method of accounting under § 1.166–2(d)(3) to determine when a debt becomes worthless.
As X uses a conformity method of accounting under § 1.166–2(d), X’s $32,000 accrued interest receivable related to Loan A ($8,000 of uncollected accrued interest in 2006 and $24,000 of uncollected accrued interest in 2007) is considered worthless for purposes of section 166 in the year the amount is charged off for regulatory financial statement purposes. Therefore, for federal income tax purposes, X is allowed a worthless debt deduction for the $32,000 of uncollected accrued interest written off for regulatory financial statement purposes in the tax year ending December 31, 2007.
X is required to characterize the $31,000 payment received on Loan A in

2008 as a payment of interest for federal income tax purposes. The result would be the same whether (i) X had not yet recognized the $32,000 of uncollected accrued interest on Loan A as gross income under its method of accounting for federal income tax purposes, (ii) X had recognized the $32,000 of uncollected accrued interest on Loan A as gross income for federal tax purposes but subsequently deducted the receivable as a bad debt under section 166, or (iii) X used a conformity method of accounting under § 1.166–2(d). If X had previously deducted the $32,000 of uncollected accrued interest as a bad debt for federal income tax purposes then the subsequent $31,000 payment on the loan will be characterized as a partial recovery of that bad debt.

EFFECT ON OTHER RULINGS

Rev. Rul. 81–18 is distinguished with regard to when interest accrues for federal income tax purposes.

DRAFTING INFORMATION

The principal author of this revenue ruling is Timothy Sebastian of the Office of the Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Mr. Sebastian (202) 622–7417.

Section 856.—Definition of Real Estate Investment Trust

A notice provides that if a REIT recognizes currency gain under section 987, the REIT may apply the principles of the proposed regulations under section 987 that were issued on September 7, 2006, to determine whether the currency gain is derived from income described in section 856(c)(2) or (3). See Notice 2007-42, page 1288.

26 CFR 1.856–2: Limitations. (Also § 988; 1.988–2.)

Real estate investment trust (REIT) foreign currency. This ruling provides that section 988 gain that is recognized by a REIT will be qualifying income under section 856(c)(2) or (3) of the Code to the extent that the underlying income so qualifies.

2007–21 I.R.B. 1281 May 21, 2007

HOLDING

If section 988 gain is recognized with respect to income recognized by a REIT, the gain qualifies under § 856(c)(2) or (3) to the extent that the underlying income so qualifies.

DRAFTING INFORMATION

The principal author of this revenue ruling is Jonathan D. Silver of the Office of Associate Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling, contact Jonathan D. Silver at (202) 622–3930 (not a toll-free call).

Section 987.—Branch Transactions

Section 988.—Treatment of Certain Foreign Currency Transactions

A revenue ruling holds that if section 988 gain is recognized with respect to income recognized by a REIT, the gain qualifies under section 856(c)(2) or (3) to the extent that the underlying income so qualifies. See Rev. Rul. 2007-33, page 1281.

Section 1035.—Certain Exchanges of Insurance Policies

26 CFR 1.1035–1: Certain exchanges of insurance policies. (Also § 72.)

Section 1035; certain exchanges of in- surance policies. A taxpayer’s receipt of a check issued by an insurance company under a non-qualified annuity contract is treated as a taxable distribution, even if the check is endorsed to a second insurance company for the purchase of a second annuity. The transaction is not characterized as a tax-free exchange under section 1035(a)(3) of the Code unless there is a direct exchange or assignment of the original contract.

“derived from” the types of income listed in § 856(c)(3). Gains from foreign currency are not specifically enumerated in § 856(c)(2) or (c)(3).

Section 988(c)(1) defines a “section 988 transaction” as any transaction described in § 988(c)(1)(B) if the amount which the taxpayer is entitled to receive (or is required to pay) by reason of such transaction is denominated in terms of a nonfunctional currency or is determined by reference to the value of one or more nonfunctional currencies. Under § 988(c)(1)(B)(i), a section 988 transaction includes the acquisition of a debt instrument or becoming the obligor under a debt instrument. Under § 988(c)(1)(B)(ii), a section 988 transaction also includes accruing (or otherwise taking into account) any item of gross income or receipts which is received after the date on which so accrued or taken into account.

Section 988(b)(1) provides that the term “foreign currency gain” means any gain from a section 988 transaction to the extent that such gain does not exceed gain realized by reason of changes in exchange rates on or after the booking date (as defined in § 988(c)(2)) and before the payment date (as defined in § 988(c)(3)).

Rev. Rul. 74–191, 1974–1 C.B. 170, holds that otherwise-qualifying assets do not fail to satisfy § 856(c)(4) merely because the assets are foreign:

Neither section 856 of the Code nor the regulations thereunder restrict the term “real estate assets” to those located within the United States. Accordingly, it is held that, for purposes of section 856(c), the term “real property” includes land or improvements thereon located outside the United States and the term “mortgages on real property” includes a security interest which, under the laws of the jurisdiction in which the property is located, is the legal equivalent of a mortgage or deed of trust in the United States. 1974–1 C.B. at 170. It follows from this holding both that rents on foreign real property qualify under § 856(c)(2)–(3) to the same extent that they would qualify if the property were located in the United States and that interest on foreign mortgage loans qualifies under § 856(c)(2)–(3) to the same extent that it would qualify if the loans were governed by United States

law and the property were located in the United States. Thus, foreign situs of a REIT’s assets does not necessarily prevent the REIT from satisfying the income and asset tests of § 856(c), which must be met in order to qualify as a REIT. Rev. Rul. 74–191, however, does not address the treatment of foreign currency gain that may result from investing in real property or other assets that produce income denominated in a currency other than the taxpayer’s functional currency.

The legislative history describing the tax treatment of REITs indicates that the central concern behind the gross income restrictions in § 856(c) is that a REIT’s gross income should largely be composed of passive income. For example, H.R. Rep. No. 2020, 86th Cong., 2d Sess. 4 (1960) at 6, 1960–2 C.B. 819, 822–23 states, “One of the principal purposes of your committee in imposing restrictions on types of income of a qualifying real estate investment trust is to be sure the bulk of its income is from passive income sources and not from the active conduct of a trade or business.”

Although § 856(c) describes the sources of REIT qualifying income, neither the statute nor its legislative history describes what it means for income to be “derived from” those sources. Because of the close nexus, however, between section 988 gain on payments received by a REIT and the income from which that payment is derived, the section 988 gain qualifies under § 856(c)(2) or (3) to the extent that the underlying income does. Thus, for example, if interest income recognized by R qualifies under § 856(c)(2) or (3), then so does the 988 gain from that interest income. Similarly, if an item of income qualifies as rents from real property for purposes of § 856(c)(3)(C), then, for purposes of § 856(c)(3), section 988 gain with respect to that income is derived from a type of income listed in § 856(c)(3)(A)–(H). Cf. Rev. Rul. 92–56, 1992–2 C.B. 153 (concluding that a regulated investment company’s (RIC’s) receipt of a reimbursement of an investment advisory fee was “derived from” the RIC’s business of investing in stock, securities, or foreign currencies and was therefore qualifying income under the “other income” provision of § 851(b)(2)).

May 21, 2007 1282 2007–21 I.R.B.

Rev. Rul. 2007–24

ISSUE

If a Taxpayer receives a check from a life insurance company under a non-qualified annuity contract, does the endorsement of the check to a second company as consideration for a second annuity contract qualify as a tax-free exchange under § 1035(a)(3) of the Internal Revenue Code?

FACTS

A, an individual, owned a non-qualified annuity contract issued by IC1, a life insurance company. In 2007, A requested that IC1 issue directly to IC2, another life insurance company, a check as consideration for a new annuity contract to be issued by IC2 . A intended the transaction to be treated as a tax-free exchange under § 1035. IC1 refused to do so and, instead, issued a check to A. A did not deposit the check, but instead endorsed it to IC2 as consideration for a new annuity contract.

LAW AND ANALYSIS

Section 72(a) provides that, except as otherwise provided in Chapter 1 of the Internal Revenue Code, gross income includes any amount received as an annuity under an annuity contract. Under § 72(e), amounts received under an annuity contract, but not as an annuity, generally are included in gross income to the extent allocable to income on the contract. That is, they are taxed on an income-first ba

sis. Section 72(e)(5)(E) provides that this rule applies to any amounts received on the complete surrender, redemption, or maturity of an annuity contract.

Section 1035(a)(3) provides that no gain or loss is recognized on the exchange of an annuity contract for another annuity contract. The legislative history of § 1035 explains that § 1035 provides non-recognition treatment for taxpayers who have “merely exchanged an [annuity contract] for another better suited to their needs and who have not actually realized gain.” H. Rep. 1337, 83d Cong., 2d Sess. 81 (1954). Under § 1.1035–1, the contracts exchanged must relate to the same insured, and the obligee or obligees under the contract received in the exchange must be the same as those under the original contract.

In Rev. Rul. 72–358, 1972–2 C.B. 473, a taxpayer who owned a life insurance contract issued by one insurance company assigned the contract, prior to its maturity, to a second insurance company in exchange for a variable annuity contract issued by the second company. The ruling concludes that, pursuant to § 1035, no gain or loss is recognized on the exchange. Similarly, Rev. Rul. 2002–75, 2002–2 C.B. 812, concludes that an individual’s assignment of an annuity contract issued by one insurance company to a second insurance company, which then deposits the cash surrender value of the assigned contract into a pre-existing annuity contract owned by the same taxpayer, qualifies as a tax-free exchange under § 1035.

In the present case, there was no actual exchange of annuity contracts; nor

did A assign the IC1 contract to IC2 ; nor was there a direct transfer from IC1 to IC2 of the cash value of the old contract in exchange for the new contract. Instead, IC1 disbursed a check to A, which A, in turn, endorsed to IC2 as consideration for a new contract. Neither § 1035 nor the regulations make any special provision for the purchase of an annuity contract with amounts distributed to the policyholder under another contract. Because the annuity contract was a non-qualified contract, no rollover provision, such as § 403(a)(4), applied to the amount received from IC1 . Accordingly, the amount that A received from IC1 under the first annuity contract is taxable in 2007 to the extent set forth in § 72(e).

HOLDING

If a Taxpayer receives a check from a life insurance company under a non-qualified annuity contract, the endorsement of the check to a second company as consideration for a second annuity contract does not qualify as a tax-free exchange under § 1035(a)(3). Instead, the amount received is taxable to the extent set forth in § 72(e).

DRAFTING INFORMATION

The principal author of this revenue ruling is Josephine H. Firehock of the Office of Associate Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling, contact Josephine H. Firehock at (202) 622–3970 (not a toll-free call).

2007–21 I.R.B. 1283 May 21, 2007