HOLDERS OF REMIC INTERESTS MAY NOT USE INVENTORY METHOD OF ACCOUNTING, IRS RULES.

Rev. Rul. 95-81

ISSUE

If a taxpayer holds residual interests in Real Estate Mortgage Investment Conduits (REMICs), may the taxpayer use an inventory method under section 471 of the Internal Revenue Code to account for the interests?

FACTS

X is a financial institution. As part of its business, X holds "residual interests" (as defined in section 860G(a)(2)) in REMICs. X acquires residual interests either through transfers from other parties or through the formation of REMICs. To form a REMIC, X exchanges a pool of real estate mortgages for the "regular interests" (as defined in section 860G(a)(1)) and residual interests in the REMIC. Without regard to how it acquires the residual interests, X holds some of the residual interests for investment and holds the remainder for sale to customers in the ordinary course of business.

LAW AND ANALYSIS

Inventory accounting is governed principally by sections 446 and 471. Section 446(a) states the general rule that taxable income is to be computed by a taxpayer under the method of accounting it regularly uses in keeping its books. Section 446(b), however, provides that if a taxpayer's accounting method does not clearly reflect income, the computation of taxable income is made under such method as, in the Secretary's opinion, does clearly reflect income.

Section 471 provides that, whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by that taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting income. The Commissioner has authority under section 471 to disallow the use of inventories if the use of inventories is not in conformity with the best accounting practice in the trade or business or if the use of inventories would not clearly reflect income.

Under sections 446 and 471, the Commissioner has wide discretion in determining whether an inventory method clearly reflects income, and that determination will not be overturned unless it is "clearly unlawful." Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979), 1979-1 C.B. 167, 171 (quoting Lucas v. American Code Co., 280 U.S. 445, 449 (1930), IX-1 C.B. 314, 315).

Sections 860A through 860G set forth comprehensive rules for the treatment of REMICs and for the treatment of persons who hold interests in REMICs. In general, a REMIC holds a pool of real estate mortgages that is used to support the issuance of regular interests, which are treated as debt. A REMIC may issue numerous classes of regular interests. In addition, a REMIC must issue one and only one class of residual interest.

The income of a REMIC is not ordinarily taxable to the REMIC itself. Instead, section 860C(a) allocates to the residual interest holders ratable, daily portions of the taxable income or net loss of the REMIC, determined for each quarter. In most cases, part of this income, referred to as "excess inclusion," cannot be offset by losses. Specifically, under section 860E(a), the taxable income of a residual interest holder (other than a financial institution described in section 860E(a)(2)) must be no less than the holder's excess inclusion for the taxable year. A holder's excess inclusion for any calendar quarter is generally the excess of the income allocated to the residual interest under section 860C(a) over the income that would have accrued on the residual interest if it had yielded, from the time of its issuance, 120 percent of the long-term Federal rate.

Section 860C(d) requires that a residual interest holder adjust the basis in its interest to account for certain events. See also section 1.860C-1(b) of the Income Tax Regulations. A holder increases basis for the taxable income allocated to the holder under section 860C(a), including any part of that income constituting excess inclusion. In addition, basis is increased for certain contributions made to the REMIC. Conversely, a holder decreases basis for its share of the REMIC's net losses and for any distributions from the REMIC.

Congress intended that the provisions of sections 860A through 860G, which include the provisions for taxing REMIC income and for adjusting the basis of residual interests, be "the exclusive set of rules for the treatment of all transactions relating to the REMIC and of holders of interests therein." 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-230 (1986), 1986-3 (Vol. 4) C.B. 230. In addition, section 860E embodies a Congressional mandate to tax currently a residual holder's excess inclusion. Using an inventory method to account for residual interests undermines these Congressional directives. It not only introduces other rules for the treatment of holders of residual interests but also may prevent current taxation of the holders' excess inclusions. These directives are not undermined, however, by treating REMIC residual interests, where appropriate, as property being held primarily for sale to customers in the ordinary course of business for purposes of sections 1221(1).

HOLDING

If a taxpayer holds residual interests in REMICs, the taxpayer may not use an inventory method under section 471 to account for those interests. Therefore, X cannot use an inventory method to account for any of its residual interests.

PROSPECTIVE APPLICATION

Under section 7805(b), this revenue ruling will not be applied to require a change in method of accounting for taxable years beginning before January 1, 1995.

APPLICATION

A taxpayer required to change its method of accounting to comply with this revenue ruling must secure the consent of the Commissioner in accordance with the requirements of section 1.446-1(e) and Rev. Proc. 92-20, 1992-1 C.B. 685. A taxpayer filing a Form 3115 pursuant to this revenue ruling should either type or legibly print the following statement at the top of page 1 of the Form 3115: "FILED UNDER REV. RUL. 95-81." It is anticipated that, as one condition of granting the consent to change, the Commissioner will require that any adjustment under section 481 be taken into account no later than the taxable year in which the taxpayer disposes of the residual interest giving rise to the adjustment.

The change in method of accounting must be made for the taxpayer's first taxable year beginning on or after January 1, 1995 (the "required year of change"). If this year is a short taxable year ending on or before December 24, 1995, the taxpayer may instead treat its first taxable year ending after December 24, 1995, as the required year of change. For taxpayers that file the Form 3115 under this revenue ruling on or before March 25, 1996, the Commissioner hereby waives the requirement that the Form 3115 be filed within 180 days after the beginning of the required year of change.

In requesting a change in method of accounting for the required year of change, a taxpayer under examination, before an appeals office, or before a federal court may file the Form 3115 for that year without regard to the window periods described in section 6 of Rev. Proc. 92-20, without obtaining the consent of the district director under section 6.06 of Rev. Proc. 92-20, and without obtaining permission from an appeals officer or counsel for the Government under sections 4.02 and 4.03 of Rev. Proc. 92-20. In these cases, the taxpayer will receive the same terms and conditions in section 5 of Rev. Proc. 92-20 for taxpayers not under examination, provided the taxpayer furnishes a copy of the Form 3115 to the examining agent, appeals officer, or the counsel for the Government no later than the date the Form 3115 is filed with the National Office.

Any method of accounting not in compliance with this revenue ruling is designated as a Designated B method of accounting and will be treated as a Category A method of accounting for any taxable year beginning on or after January 1, 1996. As stated above, however, in no event will the taxable year of change be earlier than the first taxable year beginning on or after January 1, 1995.

DRAFTING INFORMATION

The principal author of this revenue ruling is Will Cejudo of the Office of Assistant Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling, contact Mr. Cejudo on (202) 622-4016 (not a toll free call).