Financial institutions may be subject to new rules for amortizing intangibles.

With the large number of bank consolidations and reorganizations, the treatment of acquired customer-based intangibles takes on particular significance. On Jan. 9, 1997, the IRS released proposed regulations under Secs. 167(f) and 197 that provide definitions and rules for amortizing a broad class of intangible property that banks and other financial institutions may acquire in the course of business operations. Generally, the regulations are proposed to be effective on the date that final regulations are published in the Federal Register.

Sec. 167 permits taxpayers to depreciate or amortize the cost of property used in a trade or business or held for the production of income, if the property has a limited useful life and it may be determined with reasonable accuracy. Formerly, intangible items such as goodwill (specifically excluded from depreciation under Sec. 167) and going concern value could not be depreciated because they lacked an ascertainable life. Generally, Sec. 197, added by the Omnibus Budget Reconciliation Act of 1993, provides a method for depreciating and amortizing certain intangible assets, called "Sec. 197 intangibles," over a 15-year period.

Bank consolidations raise all of the traditional issues with acquired intangibles, such as goodwill and going concern value. In addition, the treatment of certain "customer-based intangibles," including mortgage servicing rights, is of particular significance for financial institutions. A customer-based intangible is any asset with value resulting from the future provision of goods or services pursuant to relationships with customers in the ordinary course of business. Customer-based intangibles subject to Sec. 197 specifically include the deposit bases of financial institutions. Thus, Prop. Regs. Sec. 1.197-2(b)(6) includes rules for amortizing amounts paid for the value represented by existing checking accounts, savings accounts, escrow accounts and other similar items of a financial institution. In addition, Prop. Regs. Sec. 1.1972(c)(11) states that servicing contracts are Sec. 197 intangibles. Thus, mortgage servicing rights acquired as part of the purchase of a trade or business are treated as intangibles within the meaning of Sec. 197, and must be written off over 15 years.

Congress carved out special treatment, however, for certain mortgage servicing rights. Under Sec. 167(f)(3), the cost of a pool of mortgage servicing rights (a bulk purchase) related to residential loans is treated as attributable to a depreciable asset and written off over nine years, provided the purchase is not part of the acquisition of a trade or business. No amortization is permitted for mortgage servicing rights treated for tax purposes as stripped coupons separate from the mortgage that are debt instruments. Thus, there are three categories of mortgage servicing rights with differing treatment: bulk purchases of mortgage servicing rights, subject to nine-year amortization; mortgage servicing acquired as part of a trade or business, with 15-year amortization; and stripped coupons subject to treatment as a debt instrument, for which no amortization is allowed (but whose basis is recovered under the OID rules).

One significant feature of the proposed regulations may affect a financial institution's treatment of mortgage servicing rights acquired as a bulk purchase. Under Sec. 197, if an intangible purchased as part of a trade or business is disposed of, no loss may be recognized and the bases of other intangible assets acquired in the business purchase are adjusted to account for the loss Thus, amortization is not accelerated on the sale of the mortgage servicing contract or when the underlying mortgages are prepaid. In contrast, under Sec. 167, if a mortgage servicing contract acquired in a bulk purchase is retired, no rules require that the basis be attributed to another asset. If the acquirer treats the acquisition of the pool of servicing rights as the acquisition of separate mortgage servicing assets, the basis attributable to each asset may be recovered at disposition as a loss. Thus, the acquirer may accelerate the depreciation period if the underlying mortgages are paid off or if servicing rights on some of the mortgages are sold prior to the end of the nine-year period.

Prop. Regs. Sec. 1.167(a)-14, however, would treat a bulk purchase of mortgage servicing rights subject to Sec. 167(f) amortization as a purchase of a single asset. If some, but not all, of the mortgage servicing rights are sold or some of the mortgages in the pool are prepaid, no loss will be recognized by reason of the prepayment, and the adjusted basis of the pool will be unaffected by the loss. Thus, rather than permitting loan-by-loan accounting, Prop. Regs. Sec. 1.167(a)-14(d) would treat bulk purchases of mortgage servicing rights similar to the treatment accorded mortgage servicing rights acquired as part of a trade or business purchase.

Clearly, this raises a concern for financial institutions using loan-by-loan accounting. First, amortization could be delayed. Further, if the regulations are adopted as final, a financial institution using loan-by-loan accounting may be required to file for a change in accounting method within 180 days of the beginning of the institution's tax year to conform to the final regulations.

The proposed regulations provide other special rules for the treatment of Sec. 197 intangibles that may affect current treatment of mortgage servicing rights that are Sec. 197 intangibles For example, Prop. Regs. Sec. 1.1972(d) states that an amortizable Sec. 197 intangible is not a capital asset; if such an intangible is held for one year, however, it may qualify as property used in a trade or business (as defined in Sec. 1231). If mortgage servicing rights are eligible for Sec. 1231 treatment, a financial institution may not treat a hedge of its exposure as a hedge for tax purposes; tax hedges are limited to hedges of items that will always be ordinary in character. Under current law, the character of income from the sale of mortgage servicing rights is not clear. Because of the lack of guidance in this area, the IRS should consider further clarification in the final regulations.

From Chuck Wheeler, J.D., and Carol A. Schwartz, J.D., Washington, D.C.