Freddie Mac Criticizes Widely Held Fixed Investment Trust Regs

[1] On August 12, 1998, the IRS proposed regulations regarding reporting requirements for widely held fixed investment trusts. The purpose of these regulations was to simplify the information reporting regulations applicable to widely held fixed investment trusts and make the reporting regime for such widely held fixed investment trusts similar to general Form 1099 reporting.

[2] On November 13, 1998, Freddie Mac sent in a comment letter on the proposed regulations. A copy of the comment letter is attached. The comment letter points out Freddie Mac's general support for the proposed regulations but describes two specific areas of the proposed regulations that impose uncertain and unnecessary requirements.

[3] The purpose of this letter is to reinforce the message of our previous comment letter and to point out the link between the previous comments and recordkeeping burden. More specifically, if final regulations incorporating Freddie Mac's comments are promulgated we do not believe that there would be a significant recordkeeping burden imposed on Freddie Mac and similarly situated entities. The records required to be maintained by such regulations would basically coincide with items already maintained and made available to investors. If, however, final regulations were promulgated without incorporating Freddie Mac's comments, we anticipate a significantly increased recordkeeping burden. As pointed out in the letter, such an approach would be impossible to fulfill because of the uncertainty around just which information would be required to be maintained and reported. In such case, it is very difficult to estimate with accuracy the recordkeeping burden imposed.

[4] Accordingly, we believe that our previous comments are relevant not only in response to the proposed regulations but also address ways to minimize recordkeeping burden and improve the accuracy of the burden estimates.

[5] Thank you for your attention to these comments. If you have any questions, please contact Thomas A. McKenna, Assistant General Counsel, at (703) 714-3038 or me at (703) 71-3150.

Sincerely yours,

[6] This letter is in response to the request for comments to the recently proposed regulations on reporting requirements for widely held fixed investment trusts. In furtherance of its Congressional mandate to help maintain the secondary mortgage market, Freddie Mac is the trustee of participation certificates ("PCs") representing interests in pools of mortgages with a current outstanding principal balance in excess of $635 billion. These PCs and other similar interests would constitute widely held fixed investment trusts under the proposed regulations. Accordingly, Freddie Mac is directly and significantly affected by the proposed regulations and by any final regulations which will be issued.

[7] In general, we welcome the proposed regulations and regard them as a positive step in the development of an efficient and effective information reporting system for widely held fixed investment trusts. There are some specific areas, however, in which the proposed regulations would impose uncertain and unnecessary reporting obligations on trustees. It is important that these areas be addressed before any final regulations are promulgated.

[8] Freddie Mac would like to focus its comments on two specific areas of the proposed regulations: (1) reporting the gross proceeds from the disposition of a trust asset and (2) reporting the accrual of market discount for a widely held fixed investment trust that holds a pool of debt instruments subject to section 1272(a)(6)(C)(iii) of the Code.

[9] (1) The proposed regulations require the trustee to report, if any trust asset has been sold or otherwise disposed of, the gross proceeds received by the trust for the trust asset, the date of sale or disposition of the trust asset, and the percentage of that trust asset that has been sold or disposed of, among other things. See Prop. Reg. See. 1.671-4(j)(2)(ii)(D), (3)(ii)(D). In the "Explanation of Provisions", the IRS and Treasury requested comments on whether the approach taken in the proposed regulations is effective, or whether a different approach would be more effective. In addition, the IRS and Treasury requested comments on whether, for trusts consisting of fungible assets, an aggregate approach would be more appropriate.

[10] The purpose of the proposed reporting requirement is to enable unit interest holders to calculate gain or loss on the disposition of a trust asset. This requirement may have some utility for certain widely held fixed investment trusts, but it would have no benefit in the case of Freddie Mac PCs or similar arrangements which consist of large numbers of essentially homogeneous mortgages. Freddie Mac recommends that this reporting requirement be treated as fulfilled where, in the case of a fixed investment trust consisting of fungible assets, the trustee makes available information such that the unit investment holder can calculate the portion of its principal that has been recovered in any period. With this information, the holder can calculate the appropriate gain or loss, or accrual of premium or discount for such period. In such a case, the purpose behind the reporting requirement is met without imposing an unnecessary and uncertain reporting obligation on trustees.

[11] To understand this recommendation, it may be useful to explain certain practical aspects of PCs guaranteed by Freddie Mac. Such PCs consist of hundreds, or even thousands, of essentially homogeneous mortgages. Each PC investor is treated as owning a pro rata beneficial interest in each mortgage backing a particular PC. Payments to a PC investor are calculated under the pool factor method. At the creation of the PC, the PC has a pool factor of 1.0. Early in each month thereafter, Freddie Mac publishes a truncated seven-digit decimal which, when multiplied by the original principal amount of the PC, will equal its remaining principal amount. A PC investor who owns a PC on the last business day of a month ("record date") receives interest at the PC coupon rate on the outstanding principal balance measured by the pool factor for that month, and receives principal equal to the difference between the pool factor for that month and the pool factor for the subsequent month, in each case multiplied by the PC investor's percentage of ownership in the PC. For example, an investor who held a PC on March 31 will receive on April 15, interest at the PC coupon based on the March pool factor and principal equal to the difference between the March and April pool factors. Accordingly, based on the published pool factors and the PC investor's percentage of ownership in a PC, the PC investor knows its precise entitlement to payments of interest and principal on a given payment date.

[12] The payment of principal to the PC investor represents all principal paydowns received with respect to the mortgages for the given month. These paydowns mostly reflect scheduled payments of principal and prepayments of principal made by the underlying mortgagors. Freddie Mac does not believe that the proposed regulations intend to treat principal paydowns as dispositions triggering the reporting requirement because these are merely payments according to the terms of the mortgages. It is also possible that principal paydowns may reflect amounts from either the repurchase of a defective mortgage or the purchase of a convertible mortgage pursuant to a purchase agreement. Freddie Mac does not believe that these sales should trigger the reporting requirement either. First, in determining the taxable income or loss of a REMIC, the REMIC regulations treat the proceeds from such dispositions as payments on the underlying mortgages. See Reg. See. 1.860G-2(d)(2), (g)(1)(ii). Second, there is no purpose served by separately reporting such sales. As described above, the PC investor knows exactly how much principal it has received and, as a practical matter, each dollar of principal is fungible to the PC investor. Accordingly, no useful purpose is served by such reporting for PCs or similar arrangements.

[13] For the reasons stated, any final regulations should make clear that any reporting requirement for sales of trust assets shall be treated as fulfilled when the fixed investment trust holds fungible assets and the trustee makes available information for the holder to calculate the holder's return of principal for a given period.

[14] (2) The proposed regulations require a trustee to report certain market discount information in the case of a widely held fixed investment trust that holds a pool of debt instruments subject to section 1272(a)(6)(C)(iii) of the Code. See Prop. Reg. Sec. 1.671- 4(j)(3)(ii)(F), (6)(ii). The "Explanation of Provisions" states that the IRS and Treasury request comments on whether similar information reporting requirements should be extended to all widely held investment trusts.

[15] Our concern with this area of the proposed regulations arises from the fact that the scope of section 1272(a)(6)(C)(iii) is not entirely clear. In addition, once the scope of the section is made clear, there are certain technical and mechanical questions about how the section should be implemented. Until these scope and implementation issues are resolved, it is impossible for a trustee to fulfill the reporting requirement set forth in the proposed regulations. Accordingly, this reporting requirement must be held in abeyance until there is sufficient guidance relating to the scope and implementation of section 1272(a)(6)(C)(iii). Freddie Mac is willing to work with the IRS and Treasury in developing the necessary guidance.

[16] In the Taxpayer Relief Act of 1997 (the "Act"), Congress amended section 1272(a)(6) of the Code to require the use of the prepayment assumption catch-up method to determine accrual of original issue discount on "any pool of debt instruments the yield on which is affected by reason of prepayments." The amendment is effective for tax years beginning after August 5, 1997. It is clear from the legislative history of the Act, H.R. Rep. 220, 105th Cong. 1st Sess. At 522 (the "1997 Conference Report"), that Congress was focused on the accrual of interest payable on certain pools of credit card receivables. In the case of credit card receivables, if an amount of debt is paid within a certain grace period, no interest is charged on that amount. An accrual method holder of such debt was not required to accrue interest until the grace period had expired. Congress determined that it was necessary to prevent holders of receivables whose grace period spanned two taxable years from deferring interest income until the second year. To prevent such results, Congress determined that the prepayment assumption catch-up method should be applied. "Thus, under the [Act], if a taxpayer holds a pool of credit card receivables that require interest to be paid if the borrowers do not pay their accounts by a specified date, the taxpayer would be required to accrue interest or OID on such pool based upon a reasonable prepayment assumption regarding the timing of the payments of the accounts in the pool." 1997 Conference Report at 522; see also Notice 97-67 (November 14, 1997) (under amended section 1272(a)(6), a "taxpayer is not permitted to assume that all of its credit card holders will pay their balances by the date specified in the grace period provision of the credit card agreement, and, based on this assumption, defer the inclusion of grace period interest.")

[17] It is relatively clear that section 1272(a)(6)(C)(iii) applies only to credit card receivables and other debt instruments which provide for a grace period during which payment of interest is not required, particularly in light of the legislative history. The section applies only to "debt instruments the yield on which may be affected by reason of prepayments". Mortgages and similar debt instruments typically are issued at par or near par and do not provide for a grace period. Consequently, the yield with respect to a mortgage is not affected by reason of prepayments by the borrower. Accordingly, a pool of mortgages should not be subject to section 1272(a)(6)(C)(iii). If the IRS and Treasury agree that the scope of the provision is limited to certain pools of credit card receivables, then Freddie Mac believes that the market discount reporting requirement of the proposed regulations will not have any effect on Freddie Mac's obligation as a trustee. It would be appropriate for the IRS and Treasury to give some public indication that the scope of the provision is so limited.

[18] Let us assume for the sake of argument that, notwithstanding the literal language of the statute, the legislative history and the lack of any other guidance, section 1272(a)(6)(C)(iii) should be read to apply to a purchased PC at a price other than par. It would be impractical for Freddie Mac to fulfill the reporting requirement contemplated in the proposed regulations because it would require the use of a reasonable prepayment assumption. It is worth noting that, when Congress required the use of a prepayment catch-up assumption for REMICs in 1986, Congress also tied this requirement to the prepayment assumption used in pricing the REMIC. See H.R. Rep. No. 841, 99th Cong., 2d Sess. II-238, 239 (1986). A REMIC is required to describe the prepayment assumption relating to its regular interests in its first tax return, and to attach to the return a statement supporting the selection of the prepayment assumption. See Reg. Sec. 1.860D- 1(d)(2)(iii). In contrast to REMICs, there is no prepayment assumption formally assigned to a fixed investment trust for tax purposes, leaving open the question of what prepayment assumption to use for tax reporting purposes. In the absence of further guidance, the proposed regulations could be read to require different prepayment assumptions for different investors with respect to the same PC. This would be unworkable, particularly for book entry securities such as PCs. Further, as currently drafted, the proposed regulations could be read to require use of a prepayment assumption in reporting on a PC which is currently outstanding but was issued before the enactment of these regulations and/or the enactment of section 1272(a)(6). Therefore, it is impractical, without further guidance, for Freddie Mac or any other trustee to fulfill the reporting requirement of the proposed regulations if section 1272(a)(6)(C)(iii) were to apply to PCs or similar instruments.

[19] As described above, the scope of section 1272(a)(6)(C)(iii) should be clarified. Once the scope of the provision is clarified, there will be technical and mechanical questions about the implementation of the provision. Until there is guidance on the scope and implementation of the provision, it is impractical for Freddie Mac and similarly situated trustees to comply with this portion of the reporting requirements of the proposed regulations. Once the scope and implementation of the provision are clarified it will then be necessary to provide sufficient time for trustees to modify their systems in order to be able to comply with the provision. Only after this has been accomplished would it be appropriate to require that such amounts be reported. Freddie Mac is willing to work with the IRS and Treasury in developing guidance with respect to the scope and implementation of section 1272(a)(6)(C)(iii).

[20] Thank you for you attention to these comments. If you have any questions, please contact Thomas A. McKenna, Assistant General Counsel, at (703) 714-3038 or me at (703) 714-3150.

Sincerely yours,