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ACLI Seeks Clarification of Diversification Requirements

JUL. 26, 2019

ACLI Seeks Clarification of Diversification Requirements

DATED JUL. 26, 2019
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July 26, 2019

Mr. Stephen Clinton
Senior Advisor
Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220

Ms. Katherine A. Hossofsky
Attorney Advisor CC:FI&P:Br4
Internal Revenue Service
1111 Constitution Ave, N.W.
Washington, DC 20224

Ms. Alexis MacIvor
Branch Chief CC:FI&P:Br4
Internal Revenue Service
1111 Constitution Ave, N.W.
Washington, DC 20224

Mr. Michael S. Novey
Associate Tax Legislative Counsel, XLC
Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220

Mr. Jeffrey Roderick
Special Counsel to the Associate Chief Counsel
Internal Revenue Service
1111 Constitution Ave, N.W., 3547 IR
Washington, DC 20224

Ms. Angela Walitt
Attorney Advisor, XLC
Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220

Re: Follow up on Rev. Proc. 2018-54

Ladies and gentlemen:

On behalf of the American Council of Life Insurers ("ACLI"),1 thank you for reaching out to us for feedback on Rev. Proc. 2018-54, which addresses the application of the diversification requirements of section 817(h) to life insurance company segregated asset accounts that invest in Uniform Mortgage Backed Securities (UMBS) issued by Fannie Mae and Freddie Mac. At our meeting on May 3, we discussed features of Rev. Proc. 2018-54 that pose challenges to taxpayers who purchase UMBS in the "To-Be-Announced" (TBA) market and are required to satisfy those requirements. As explained at the meeting, those challenges would be eliminated if, instead of using a "deemed issuance percentage," the procedure permitted the holder of a UMBS to look-through to the underlying mortgages for purposes of testing diversification under section 817(h).

There is ample support for this approach. In service of other important policies, the Service and Treasury already look through certain mortgage backed securities in order to treat them as real estate assets of a REIT, and as real property loans of a domestic building and loan association. See, e.g., Rev. Rul. 84-10, 1984-1 C.B. 155; Rev. Rul. 74-300, 1974-1 C.B. 169; and Rev. Rul. 71-399, 1971-2 C.B. 433. It is unclear to us why a similar treatment should not apply to UMBS contracts generally for purposes of applying the diversification requirements of section 817(h).

We have attached to this letter an outline that explains how such an approach would work. The outline also explains how the approach is consistent with general tax principles, the congressional intent of section 817(h), the existing look-through rules, and the existing treatment of government securities for other purposes. We hope these materials are helpful, and we would be pleased to provide any additional information or feedback you might find useful.

Sincerely,

Regina Rose
American Council of Life Insurers
Washington, DC

Cc:
Peter Phelan
Alexander Jackson
David Kautter
Jeffrey Van Hove
Krishna Vallabhaneni
Michael Desmond
Diana Imholtz

Attachment


7.26.19

Section 817(h) and Uniform Mortgage Backed Securities
Outline of Potential New Rules

Rev. Proc. 2018-54 provides special, elective rules for applying section 817(h) to segregated asset accounts (Separate Accounts) that acquire Uniform Mortgage Backed Securities (UMBS) in the “to-be-announced” (TBA) market. Taxpayers appreciate the intent behind the guidance, but have concerns over its administrability and its lack of provisions addressing “unsettled” TBA contracts. This paper outlines a potential alternative approach that would address these concerns, consistently with the purpose of the original guidance and the intent of section 817(h). The approach focuses on the fact that UMBS are structured as trusts that are treated as grantor trusts for federal income tax purposes.

Look-Through Approach

  • Look-through for UMBS — Separate Accounts would be allowed to “look through” the grantor trust structures that are utilized in UMBS.

    • Separate Accounts would be treated for section 817(h) purposes as owning an interest in each of the individual mortgage loans within the grantor trust. Each of those mortgage loans, in turn, would be treated as a debt obligation of the individual mortgage borrower.

    • This is consistent with (1) the treatment of pooled mortgage structures as grantor trusts under current law, and (2) the current regulations under section 817(h), which look through grantor trusts in very analogous circumstances involving Treasury securities.

  • Look-through for unsettled TBAs for UMBS — Separate Accounts would be allowed to determine the issuer of unsettled TBAs for UMBS the same way they do for the UMBS themselves, by looking through to the individual mortgage loans.

    • This is consistent with the treatment of derivatives in analogous circumstances, where the

    • “issuer” of the derivative is the same as the issuer of the referenced security.

  • Simplifying assumptions — A few simplifying assumptions would be necessary to facilitate taxpayers' administration of the new rule. Specifically, with respect to UMBS and unsettled TBAs for UMBS, the Separate Account could assume that:

    • The number of unique mortgage borrowers within a UMBS pool (or within an anticipated UMBS pool involved in a pending TBA trade) is equal to the notional value of the UMBS divided by a specified loan limit.1

    • All the mortgages in the pool (or the anticipated pool involved in a TBA trade) are for the same amount, and

    • The individual mortgage loans are not aggregated with any other securities that the Separate Account is treated as holding.

  • Limited scope — To address any governmental concerns over potential unintended consequences of this approach:

    • The Separate Account's combined investments in UMBS (acquired through the TBA market or otherwise),2 unsettled TBA contracts for UMBS, and all other Fannie Mae and Freddie Mac securities could not exceed 70% of the account's total value.

    • The Separate Account would need to satisfy the concentration limits above 70% that otherwise apply under the current regulations. Thus, no more than 80% of the value of the total assets of the Separate Account could be represented by the securities listed immediately above plus any other asset, and no more than 90% could be represented by the securities listed immediately above plus any two assets. The result would be that the Separate Account would need to hold at least 4 assets at concentration levels that are generally consistent with the current diversification standards.3

    • The new rules would expressly provide that no inference is intended with respect to the treatment of other types of securities or transactions, including the question of who is the “issuer” of any type of derivative instrument relating to a security. In other words, taxpayers could not directly or indirectly rely on the new rules for any purpose other than the section 817(h) treatment of UMBS transactions.

  • Consistency with current law and congressional intent — As discussed below, the proposal is consistent with the federal income tax treatment of pooled mortgage securities generally, the congressional intent of section 817(h), and the current regulations under that section.

Legal Analysis

  • General tax principles — The proposed look-through approach is consistent with the federal income tax treatment of pooled mortgage securities generally.

    • For at least 49 years, it has been well-settled law that pooled mortgage securities are treated as “grantor trusts” governed by the rules in sections 671 et seq.4

    • As a general matter, the grantors of such a trust are treated as owning the trust's assets for federal income tax purposes, and the trust is not treated as a separate taxpayer.5 The grantors determine their income “as if the trust had not been created.”6

    • The IRS guidance is explicit that, by operation of the grantor trust rules, each investor in a pooled mortgage security is treated as owning an interest in each of the mortgages within the pool. This includes Fannie Mae and Freddie Mac pooled mortgage securities, and where the investor in the pool is a REIT or similar entity that is subject to special asset-related requirements in the Code, the investor's ownership interests in the individual mortgage obligations within the pool count towards satisfying those requirements.7

    • Thus, treating a Separate Account that acquires UMBS as acquiring an interest in each of the underlying mortgage loans for purposes of section 817(h) is clearly consistent with long-standing general tax law principles.

    • In addition, as discussed below, such treatment of UMBS for Separate Accounts would not conflict with any of the statutory provisions in section 817(h) or the congressional intent underlying those provisions, especially in light of the constraints included in the proposed approach. Indeed, the current regulations already extend look-through treatment to grantor trusts in analogous circumstances involving pooled Treasury securities, even when beneficial interests in those trusts are not limited to Separate Accounts.

    • As a result, it would be appropriate for the Treasury Department to issue targeted guidance to apply this limited look-through treatment to UMBS.

  • Congressional intent of section 817(h) — Congress intended that section 817(h) would “deny annuity or life insurance tax treatment for contracts: (1) that are equivalent to investments in one or a relatively small number of particular assets . . .; (2) that invest in one or a relatively small number of publicly available mutual funds; (3) that invest in one or a relatively small number of specific properties . . .; or (4) that invest in a nondiversified pool of mortgage type investments.”8 The proposed new rule would not subvert this intent in any way and would ensure that it continues to be achieved.

    • The current regulations require a Separate Account to hold at least 5 investments. Thus, the Treasury Department necessarily has determined that 5 investments is not a “relatively small number.”

    • A Separate Account that elects to utilize the new rule would be required to hold at least 3 investments in addition to any UMBS, unsettled TBAs for UMBS, or any other Fannie or Freddie securities. Thus, even if UMBS, etc., were viewed as a single investment (rather than as an investment in each of the underlying mortgages in the pool as proposed herein), the Separate Account would still hold at least 4 investments under the proposed new rule.

    • Congress did not specify the minimum number of investments a Separate Account must hold. Rather, Congress broadly delegated this determination to the Treasury Department. If the Treasury Department concluded that 5 investments would suffice, it is difficult to imagine why 4 would violate the congressional intent per se, especially in light of the proposal's limited scope and the larger public policy goals that FHFA's Single Security Initiative aims to achieve. In other words, it is within the scope of the congressional delegation of authority for the Treasury Department to adopt a rule that requires a minimum of 4 investments rather than 5, which is essentially what the proposal would do, in a very narrow and limited circumstance at that.

    • Furthermore, a careful reading of the legislative history quoted above suggests that Congress may have viewed mortgage-type investments differently than other investments. Each reference to a non-mortgage investment in the quoted passage focuses on prohibiting investments in “one or a relatively small number of” such investments. In contrast, the sole reference to mortgage investments focuses on prohibiting them from being a “nondiversified pool.”

      • This suggests that Congress was more concerned with the diversified nature of the mortgage pools themselves, rather than the number of different entities pooling them.

      • Such a concern reflects the general look-through nature of pooled mortgage investments for federal income tax purposes. The IRS described that treatment in numerous rulings before Congress enacted section 817(h), so Congress must have known how they were treated when it described them in the legislative history.

      • UMBS do not implicate the concern expressed in the legislative history. Rather, they are highly diversified because they reflect the mortgage obligations of many different individual borrowers. Simply put, UMBS are not the “nondiversified pool[s] of mortgage type investments” that Congress meant to limit.

  • Existing look-through rules — The proposed new rule would be consistent with how the current regulations treat grantor trusts in highly analogous circumstances involving pooled Treasury securities. In those circumstances, the regulations already extend look-through treatment to grantor trusts, even though the trusts are not “insurance dedicated.”

    • Section 817(h)(4) provides look-through treatment for two types of investment entities: RICs and trusts. For such treatment to apply under the statute, beneficial interests in the RIC or trust must be limited to insurance company general or separate accounts and to fund managers.

    • Despite the foregoing statutory rule, the regulations extend look-through treatment to any grantor trust when substantially all of the trust's assets are Treasury securities.9

      • This treatment applies even if beneficial interests in the trust are not limited as the statute requires. For example, if members of the general public invest in such a grantor trust alongside a Separate Account, the Separate Account can nonetheless look through the trust for purposes of section 817(h).

      • Furthermore, this treatment applies for variable annuities as well as life insurance. This means the regulation is not a by-product of the special rule in the statute for variable life insurance contracts supported by Treasury securities.10 Rather, the regulation applies broadly to any grantor trust that invests substantially in Treasury securities.11

      • Those who participated in the regulatory process for section 817(h) in the 1980s may recall that the foregoing rule was intended to facilitate investments such as Treasury Investment Growth Receipts (TIGRs) and Certificates of Accrual on Treasury Securities (CATs), which were first offered around the same time. Such investments are structured and operate similarly to UMBS and other pooled mortgage securities.

      • As a result, UMBS are highly analogous to a type of investment to which the Treasury Department has already extended look-through treatment without regard to the “beneficial interest” limitations that Congress otherwise imposed on trusts seeking such treatment.

      • If the Treasury Department thought this was an appropriate interpretation despite the statutory constraints on look-through treatment, then surely the Treasury Department could likewise conclude that the new look-through rule proposed herein is appropriate, especially in light of the proposal's constraints and the broader public policy goals in play.

    • Additional examples of the Treasury Department extending look-through treatment to situations that Congress did not explicitly contemplate are:

      • The statute states that look-through treatment is available for RICs and trusts, but the regulations also extend such treatment both to REITs and partnerships.12

      • The statute says that look-through treatment is available only if beneficial interests in the RIC or trust are limited to insurance company general or separate accounts and to fund managers, but the regulations allow beneficial interests to be held by qualified retirement plans, 529 plans, foreign pension plans, and Puerto Rican separate accounts as well.13

      • The point of these examples is that the Treasury Department has repeatedly applied its regulatory authority under section 817(h) in a way that extends look-through treatment beyond the scope that Congress explicitly contemplated in the statute or even the legislative history. As a result, such treatment can properly be extended to grantor trust UMBS structures as proposed herein, even though the statute and legislative history do not expressly contemplate doing so.

  • Existing treatment of government securities — Section 817(h)(6) provides that in determining whether a Separate Account is adequately diversified, each U.S. government agency or instrumentality shall be treated as a separate issuer. The regulations generally define government security as “any security issued or guaranteed or insured by the United States or an instrumentality of the United States.”14

    • Congress added Section 817(h)(6) to the Code in 1988 to overturn a contrary position that the Treasury Department had taken in the proposed and temporary regulations, which would have treated all government securities as a single investment and thereby preclude government bond investment strategies under variable insurance products. Thus, the statutory rule was intended to facilitate government bond funds, not as a constraint. The final regulations reflect this statutory change.15

    • Prior to the foregoing statutory change, the proposed and temporary regulations included a special transition rule that relieved pooled mortgage securities from the harsh treatment of government securities that the Treasury Department had proposed.16 That relief, which was repeated in the final regulations,17 excluded Fannie and Freddie pooled mortgage securities from the definition of government security, so that they would not be subject to the proposed “single investment” rule until after a specified transition period. Again, this shows that prior government actions in this area have been aimed as facilitating, not precluding, investments in pooled mortgage securities.

    • The proposal herein focuses on extending look-through treatment to the grantor trusts that are utilized in UMBS investment structures. In other words, even though government-sponsored entities Fannie Mae or Freddie Mac guarantee some or all aspects of the UMBS they issue as participation interests in the grantor trusts, the trusts themselves would be essentially ignored for purposes of section 817(h) and the underlying mortgage loans would not be treated as “government securities.” To the extent that the Treasury Department determines that UMBS or the underlying mortgage loans would need to be carved out of the existing definition of “government securities” to facilitate the proposed look-through approach, the history recounted above clearly demonstrates that such action is within the scope of the Treasury Department's regulatory authority.

  • Existing treatment of derivatives — Extending the proposed new rule to unsettled TBA contracts for UMBS also is supported by long-standing IRS guidance under the RIC diversification rules of section 851(b)(3).18 Although there is no comparable guidance under section 817(h), the regulations contemplate reliance on the RIC rules for issues that the section 817(h) regulations do not address.19 Furthermore, if the Treasury Department has any concerns about taxpayers applying the look-through concept to derivatives more broadly, the proposed new rule will expressly preclude such interpretations by providing that no inference is intended with respect to the treatment of other types of transactions, including the question of who is the “issuer” of any type of derivative instrument relating to a security. Thus, the proposal (1) is consistent with the only analogous guidance the IRS has issued, and (2) would not expand that guidance beyond unsettled TBAs for UMBS.

Conclusion

The look-through approach described herein would fulfill the purpose of Rev. Proc. 2018-54, which is to preclude potential disruption of the capital markets that otherwise could arise due to uncertainties involving the treatment of UMBS under section 817(h). The proposal also would address taxpayer concerns with the original guidance, and would do so consistently with general tax law principles, the congressional intent of section 817(h), and the current regulations under that section. Indeed, the Treasury Department already has adopted a very similar rule in the current regulations to address a highly analogous situation involving a different type of pooled security. In short, the proposal makes sense and should be adopted.

FOOTNOTES

1The American Council of Life Insurers (ACLI) advocates on behalf of 280 member companies dedicated to providing products and services that promote consumers' financial and retirement security. 90 million American families depend on our members for life insurance, annuities, retirement plans, long-term care insurance, disability income insurance, reinsurance, dental and vision and other supplemental benefits. ACLI represents member companies in state, federal, and international forums for public policy that supports the industry marketplace and the families that rely on life insurers' products for peace of mind. ACLI member represent 95% of industry assets in the United States. Learn more at www.acli.com.

1Fannie Mae and Freddie Mac have different maximum loan limits for different markets. The new rule would designate one of those limits as the assumption to use in the formula described above. A higher limit would produce a smaller number of presumed borrowers, and vice versa.

2If the proposal is adopted, it will be important for the same look-through treatment to apply to UMBS regardless of whether they are acquired through the TBA market or otherwise. Absent such consistency, the proposal would present the same types of administrative difficulties that have led taxpayers to eschew the guidance in Rev. Proc. 2018-54. In particular, because UMBS are assigned the same CUSIP number regardless of how they are acquired, taxpayers would find it difficult or impossible to differentiate them on the basis of how they were acquired.

3See Treas. Reg. section 1.817-5(b).

4See Rev. Rul. 70-544, 1970-2 C.B. 6; Rev. Rul. 70-545, 1970-2 C.B. 7; Rev. Rul. 71-399, 1971-2 C.B. 433; Rev. Rul. 72-376, 1972-2 C.B. 647; Rev. Rul. 74-169, 1974-1 C.B. 147; Rev. Rul. 74-221, 1974-1 C.B. 365; Rev. Rul. 74-300, 1974-1 C.B. 169; Rev. Rul. 77-349, 1977-2 C.B. 20; Rev. Rul. 80-96, 1980-1 C.B. 317; and Rev. Rul. 84-10, 1984-1 C.B. 155.

5See, e.g., Rev. Rul. 85-13, 1985-1 C.B. 184.

6Rev. Rul. 57-390, 1957-2 C.B. 326.

7See supra note 4.

8H.R. CONF. REP. NO. 98-861, at 1055 (1984).

9Treas. Reg. section 1.817-5(f)(2)(ii).

10See section 817(h)(3) and Treas. Reg. section 1.817-5(b)(3). Indeed, the legislative history suggests that, in the case of an investment entity that invests in Treasury securities, the special rule for Treasury securities and life insurance contracts was intended to be available only if the entity satisfies the beneficial interest limitations of section 817(h)(4). See Staff of the J. Comm. on Tax'n, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., at 608 (J. Comm. Print 1985) (describing the look-through rules in section 817(h)(4) and stating that “[a]lthough not clear in the statute, a similar rule was intended with respect to variable life insurance based on Treasury securities. That is, a segregated asset account can invest in a fund of Treasury securities in which all of the beneficial interests are owned by insurance companies or the segregated asset account underlying the variable life insurance contract can own the Treasury securities directly.”).

11The rule was not included in the proposed regulations, but was added to the final regulations. The preamble to the latter states that “[t]he final regulations include an additional look-through rule for trusts, substantially all of the assets of which are Treasury securities. Under this rule, Treasury securities are still treated as such, even though they are held through a custodial arrangement that is treated as a grantor trust.” T.D. 8242, 1989-1 C.B. 215, at 216.

12Treas. Reg. section 1.817-5(f)(2)(i).

13Treas. Reg. section 1.817-5(f)(3)(iii)-(vi).

14Treas. Reg. section 1.817-5(h)(1)(i).

15Treas. Reg. section 1.817-5(b)(1)(ii)(B).

16See Treas. Reg. section 1.817-5T(i)(2)(iii). See also T.D. 8101, 1986-2 C.B. 97 (preamble to temporary and proposed regulations).

17See Treas. Reg. section 1.817-5(i)(2)(iii).

18See, e.g., Rev. Rul. 83-69, 1983-1 C.B. 126 (a RIC that purchases publicly-traded call options on the securities of a corporation is treated as if it had purchased the underlying securities for purposes of section 851(b)(3)); GCM 37233 (Aug. 25, 1977) (relating to Rev. Rul. 83-69); GCM 39708 (Nov. 16, 1987) (similar regarding option on a stock index); GCM 39700 (Nov. 16, 1987) (similar regarding over-the-counter options).

19See Treas. Reg. section 1.817-5(h)(10) (cross-referencing section 851(b)(3) for the meaning of terms used in the section 817(h) regulations).

END FOOTNOTES

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