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Current Tax Topics
Roger Poulin, Principal
Proposed FASB Lease Accounting Changes
Nick Ireland, Senior Manager
Recap on New Allowance Disclosures
Matt Prunier, Manager

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• Deducting OREO Carrying Costs
• There have been a growing number of examinations in which the
IRS has sought the capitalization of OREO carrying costs
• The IRS argument is based upon an assertion that the OREO property is “inventory” acquired for resale and, consequently,
§263A requires all carrying costs to be capitalized to the basis of the individual properties (which would permit them to be deducted upon disposal of the applicable properties)
• The IRS position appears to be coordinated
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(continued)
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• Deducting OREO Carrying Costs
• The taxpayer argument in support of deducting these costs as they are incurred is based upon an assertion that the
OREO properties are not, in fact, “inventory”
• Instead, the properties are acquired in the ordinary course of the loan relationship in order to mitigate the potential loss on the worthless debt obligation, not to be sold at a profit
• Such an argument would support the deduction of the OREO carrying costs as an ordinary and necessary business deduction under §162
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– When charge-off occurs
– There exists no reasonable expectation at the time of accrual that the items of income will be collected
(Rev. Rul. 80-361 also see Rev. Rul. 2007-32)
– For example, where it can be demonstrated that the borrower was insolvent at the time the right to accrue the interest arose
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• For banks under IRC Sec. 581:
– Partial bad debt
– Bad debt conformity election (Reg. 1.166-2(d)(3))
– Rev. Rul. 2007-32
– Safe harbor method of nonaccrual interest (Rev. Proc. 2007-
33)
• General rules apply in absence of these special elections (Reg. 1.166-2(a))
– Based on all “pertinent evidence”
– Legal action not required
– Bankruptcy generally indication of worthlessness
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§1.166-2(d)(3))
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(continued)
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– For new banks – automatic change (as opposed to manual) for first election
– Cut-off approach, so no Sec. 481(a) adjustment
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• Deals with accrued but uncollected interest when the bank has made conformity election under Reg. §1.166-2(d)(3)
• Extends conformity election to nonaccrual interest
• Holds that without a conformity election:
– Accrued but unpaid interest must be recognized for tax purposes, even when loan is charged-off, when some expectation of payment
– Remedy is bad debt deduction for accrued but unpaid interest in year of charge-off
– Subsequent payment goes to interest first
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• The 50% bonus depreciation provisions have been extended for qualified property placed in service before 1/1/2013
• However, the bonus depreciation amount is increased to 100% for qualified property acquired after 9/8/2010 and placed in service before
1/1/2012
• Guidance is provided in Revenue Procedure 2011-
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(continued)
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• Qualified property for both provisions generally includes all depreciable fixed assets and software, but does not include buildings and their structural components
• However, certain leasehold improvements made to the interior of a leased building may qualify if the building is more than three years old
• Bonus depreciation only applies to new property (not used), but §179 applies to both new and used property
• Cost segregation opportunities abound for construction projects, especially those placed into service in 2011 and
2012
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Bonus Depreciation - Maine Capital Investment Credit
• For tax years beginning in 2011 and 2012, Maine will allow a credit equal to 10% of federal bonus depreciation claimed by businesses for new property placed in service in this State
• Credit is nonrefundable, but unused amounts may be carried forward for 20 years
• The bonus depreciation upon which the credit is based must be added-back for
Maine purposes (except for composite filings addressed later)
• Credit is subject to recapture if the property is not used in Maine for 12 months after being placed in service.
Section 179 – Conforms to federal in 2011
• Beginning in 2011, Maine will follow federal law regarding Sec. 179 depreciation.
The maximum deduction for 2011 will be $500,000
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Seed Capital Credit
• Program administered by the Finance Authority of Maine (FAME)
• Investments made prior to 1/1/2012 - a tax credit certificate may be issued by
FAME in an amount not more than 40% of the cash actually invested in an eligible Maine business in any calendar year, or in an amount not more than 60% of the cash actually invested in any one calendar year in an eligible Maine business located in a high-unemployment area, as determined by FAME
• For investments made or after January 1, 2012, a tax credit certificate may be issued to an investor other than a private venture capital fund in an amount not more than 60% of the amount of cash actually invested in an eligible Maine business in any calendar year
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(continued)
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Eligible Business
• Must be located in Maine
• It must be a manufacturer: must provide a product or service that is sold or rendered, or is projected to be sold or rendered, predominantly outside of the
State; must be engaged in the development or application of advanced technologies; must be certified as a visual media production company Program administered by FAME
• Must have annual gross sales of $3MM or less
• The operation of the business must be the full-time professional activity of the principal owner
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(continued)
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Eligible Investments/Investors
• Aggregate investment eligible for tax credits may not be more than $5MM for any one business as of the date of issuance of a tax credit certificate
• Investment for which any individual is applying for a tax credit certificate may not be > $500K in any one business (can be invested over 3 consecutive calendar years). (This does not limit other investment by any applicant for which no tax credit certificate is being sought.)
• The principal owner / principal owner's spouse are not eligible for a credit
• A tax credit certificate may not be issued to a parent, brother, sister or child of a principal owner
• Investors qualifying for the credit must each own < 1/2 of the business
• The investment must be at risk for 5 years
• Specific rules apply for investments through private venture capital funds
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(continued)
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Utilization of Credits
• Credit calculated / approved by FAME – shown on Certificate issued
• Must be used 25% per year
• Amount used cannot exceed 50% of tax liability before the credit
• Carry forward of 15 years
• Investments made through private venture capital funds after 1/1/2012 may be eligible for refundable credits. (Specific rules apply. Credit to be calculated by FAME.)
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PTDZ Income Tax Credit Basics
• Tier 1 business location (other than Cumberland or York Counties) – 100% credit in years 1 – 5; 50% credit in years 6 – 10
• Tier 2 location – 100% credit in years 1 – 5
• Credit is calculated by computing an apportionment percentage – PTDZ payroll & property of business activity / total payroll & property of business activity – multiplied by tax = credit. (Also compute credit against ME minimum tax)
• When calculating percentage attributable to PTDZ activity from a PTE, make sure to include the shareholder’s PTDZ eligible wages in the PTDZ income allocable to him/her
• No carry forward
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Tax Credit
• Applies to qualified expenditures made from 1/1/2008 – 12/31/2023
• Credit equal to 25% of the taxpayer's certified qualified rehabilitation expenditures for which a tax credit is claimed under Section 47 of the Code for a certified historic structure located in ME (a copy of Part 3 of the Historic Preservation Certification
Application signed by the Nat’l. Park Service and federal form 3468 must be attached); or
• 25% of the certified qualified rehabilitation expenditures of a taxpayer who incurs not less than $50,000 and up to $250,000 in certified qualified rehabilitation expenditures in the rehabilitation of a certified historic structure located in ME and who does not claim a credit under the Code, Section 47 (a copy of Part 3 of the small project rehab certification application signed by the ME Historic Preservation Commission must be attached.)
• Credit increased to 30% for a certified affordable housing project
• Total credit limited to $5MM
• Credit fully refundable equally over 4 years
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Tax Credit
• Modeled after Federal NMTC program
• Administered by FAME
• Maine credit of up to 39% to investors in qualified community development entities
– investments on or after 1/1/2012
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Credit taken over 7 years
– 0% in years 1 and 2, 7% year 3, 8% years 4 through 7
• Taxpayers may elect to make the credit refundable, or carry forward for up to 20 years
• Recapture rules apply
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Awaiting guidance from MRS and FAME
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• FASB and IASB are jointly working on several new standards. Why?
– The Boards’ desire to improve existing U.S. GAAP and
IFRS
– To reduce the “gap” between U.S. GAAP and IFRS to allow for less pain if U.S. does move to IFRS in the future
• Lease accounting is one of four remaining major areas in which FASB and the IASB are trying to reach convergence in standards.
• A separate but related project to the SEC’s potential adoption of IFRS.
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• Original Exposure Draft was issued in August 2010.
• Original target date was June 2011.
• Hundreds of comment letters and significant outreach
• The Boards have punted issuance several times as the topic has been debated at just about every meeting since
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(continued)
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• The key redeliberations topics relate to:
– Scopes (leases of inventory or of internal use software)
– Definition and measurement
– Accounting for modifications/extinguishments, subleases, and leasehold improvements
– Presentation and disclosure
– Transition and effective date
• The revised exposure draft is expected to be released in second half of 2012.
• We’ll just have to stay tuned.
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• Lessees will record all leases on their balance sheet –similar to how lease accounting is currently done for capital leases
– Liability will be recorded for lease obligations
– Asset will be recorded for right-to-use asset, which will be amortized
– Interest expense will be recorded relating to the obligations using the effective interest method
– There will be some shortcuts allowed for short term leases
– New disclosures
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• Current GAAP – Operating
– Balance Sheet
– Income Statement n/a
Rent expense
• Current GAAP – Capital
– Balance Sheet
– Income Statement
• Proposed – All leases
– Balance Sheet
– Income Statement
Asset and liability
Depreciation and interest expense
Right-to-use asset and liability
Amortization and interest expense
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• Lease obligation liability
– Record at present value of lease payments
– Recognize interest using the effective interest method
• Right-to-use asset
– Generally equal to obligation liability plus initial direct expense minus lease incentives
– Amortize over the shorter of the lease term or estimated useful life.
Most entities will probably use SL method.
– Assess for any indications of impairment at each reporting period
– If purchase option is likely to be exercised then amortize over useful life.
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• Measure the present value using:
– An ‘expected outcome’ technique
– A discount rate at the lessee’s incremental borrowing rate
• Need to include the following in lease payments:
– Estimated contingent rents payable
– Estimated amounts payable under residual value guarantees
– Estimated expected payments to lessor under nonrenewal optional penalties
– Exercise price of purchase option ( only if lessee has significant economic incentive to exercise the option)
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• The lease payments should include the following:
– Payments that depend on an index rate
– Payments that meet a high recognition threshold - such as reasonably certain
• Reassess estimates at each reporting period
• Differences between actual and estimated payments:
– If the changes relate to current period then record in the P&L
– If the changes relate to future periods then adjust the balance sheet
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(continued)
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• Many comment letters relate to disagreements with the
Exposure Draft’s treatment of:
– The “expected outcome approach”
– Uncertainty of payments
• Subsequent deliberations decisions on contingent rents:
– Eliminate “expected outcome approach” and use the “best estimate” approach instead
– Do not include contingent rent based on usage
– Do include contingent rent based on index
– Do include payments that meet a high recognition threshold
(reasonably certain)
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• What is the appropriate lease term?
– The longest possible term that is more-likely-than-not to occur (>50%)
– Consideration must be given to all relevant factors:
• History
• Existence of renewal options and renewal rates
• Termination penalties
• Importance of underlying leased asset(s) to lessee’s operations
• Significance of leasehold improvements
• Many comment letters relate to disagreements with the
Exposure Draft’s definition of lease term:
– Recognizing amounts that don’t meet the definition of a liability
– It’s highly subjective – potential for manipulation
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• Certain shortcuts will be allowed
• Short-term lease = maximum possible term, including any renewal options, of 12 months or less
• Exposure Draft says that lessees may elect to measure lease assets and liabilities on an undiscounted basis
• Subsequent deliberations decision – lessees may elect to treat an operating lease
– No right-of-use asset or lease liability recognized
– Recognize payments on a SL basis
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• There will be no “grandfathering”
• All existing leases will be recognized using a “simplified retrospective approach”
– Adjust opening balance equity for the prior period as if policy has been applied from the beginning (of the earliest period presented)
• Operating leases
– Liability = to the PV of the remaining lease payments
– Discount rate = to the incremental borrowing rate on the date of application
– Adjust right-of-use asset for any prepaid or accrued lease payments
• Capital leases
– Carry forward existing liability and asset balances
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• Balance sheet
– Present the liability on its own line
– Present the right-to-use asset in with PP&E but separately from nonleased assets
• Income statement
– Present amortization and interest expense from other amortization and interest expense (either in the P&L or footnotes)
• Cash Flows
– Present lease payments as financing activities and show them separately
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• Your Bank
– Start addressing and analyzing now
– The “grossing-up” of the balance sheet will negatively impact riskbased capital ratios.
– Differences between tax and book could result in DTA or DTLs
– Adjustments for changes in estimates will result in increased balance sheet volatility
– Different expense profile – instead of having a SL of expense there will be more expense recorded earlier and less later (due to interest on the unwinding of the liability)
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(continued)
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• Your Borrowers
– Could have a detrimental impact on working capital ratios
– Potentially could have significant impacts on covenant compliance both good and bad
• Increased EBITDA
• Worsened financial statement ratios such as net worth ratio
– Increased balance sheet volatility
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• All entities, both public and nonpublic with financing receivables.
– For public entities, effective for periods ending on or after December 15, 2010
– For non-public entities, effective for periods ending on or after December 15, 2011
• Excludes
– Short-term trade accounts receivable
– Receivables measured at fair value / measured at the lower of cost or fair value.
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Quoted from the ASU:
“This Update is intended to provide additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses.”
What this means for you:
No new accounting requirements, rather a significant expansion of disclosure.
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Provide disclosures which allow the reader to evaluate:
1.
The nature of credit risk inherent in the entity’s portfolio of financing receivables
2. How that risk is analyzed and assessed in arriving at the allowance for credit losses
3. The changes and reasons for those changes in the allowance for credit losses
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- A rollforward schedule of the allowance for credit losses on a portfolio segment basis
- For each portfolio segment the related recorded investment in financing receivables
- The nonaccrual status of financing receivables by portfolio segment
- Impaired financing receivables by portfolio segment
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• Credit quality indicators of financing receivables by portfolio segment
• The aging of past due financing receivables by portfolio segment
• The nature and extent of troubled debt restructurings that occurred during the period by portfolio segment
• The nature and extent of financing receivables modified as troubled debt restructurings within the past 12 months that defaulted during the reporting period
• Significant purchases and sales of financing receivables during the reporting period by portfolio segment
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Beginning
Charge-offs
Recoveries
Provision
Ending
Individually evaluated for impairment
Collectively evaluated for impairment
Loans Ending
Individually evaluated for impairment
Collectively evaluated for impairment
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Consumer Commercial
Loans
Commercial
Mortgage
2
-
-
(1)
1
8
(2)
1
4
11
6
(2)
1
5
10
Residential
4
(1)
-
1
4
Unallocated
-
1
1
-
2
-
1
2
9
4
6
1
3
-
2
Total
21
(5)
2
10
28
7
21
100
-
100
1,100
400
700
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1,000
500
500
400
100
300
-
-
-
2,600
1,000
1,600
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Consumer
Commercial loans
Commercial mortgages
Residential
Total
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30+ 60+ 90+ Past
Due
10 10 20
150 100 50 300
200 50 50 300
35 5 10 50
395 165 110 670
Current Total
80 100
800 1,100
700 1,000
350 400
1,930 2,600
+90
Accrual
-
-
-
10
10
As of December 31, 2011, loans on nonaccrual status consisted of the following:
Commercial loans
Commercial mortgages
50
50
100
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Pass
Watch
Special Mention
Substandard
Doubtful
Loss
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Commercial
Loans
500
300
150
150
-
-
1,100
Commercial
Mortgages
450
350
100
50
50
-
1,000
Total
950
650
250
200
50
-
2,100
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Performing
Non-performing
Consumer
100
-
100
Residential
400
-
400
Total
500
-
500
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With allowance:
Commercial loans
Commercial mortgages
Residential
With no allowance:
Commercial loans
Commercial mortgages
Residential
Total
Commercial loans
Commercial mortgages
Residential
Recorded
Investment
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Unpaid
Principal
Allowance Average
Investment
100
50
10
100
50
10
2
4
1
90
50
15
300
450
90
400
500
100
320
450
100
420
500
110
2
4
1
-
-
-
290
440
80
380
490
95
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• Negative provision for some categories
• Consistency between the “buckets”
• Negative, change, or size of unallocated
• >90 days past due and still accruing
• Recorded investment versus unpaid principal balance
• Data gathering
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Roger Poulin, CPA
Principal
207-791-7123 rpoulin@bnncpa.com
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Baker Newman Noyes
280 Fore Street
Portland, ME 04101-4177
207-879-2100
Nick Ireland, CPA
Senior Manager
207-791-7521 nireland@bnncpa.com
Matt Prunier, CPA
Manager
207-791-7527 mprunier@bnncpa.com
Visit our website at: www.bnncpa.com
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