Wells Fargo Comments on OID Accrual Regs

Background

On August 25, 2004, the Internal Revenue Service published proposed regulations that would change the tax accrual periods for certain types of REMIC regular interests (REG-108637-03). Under current law, the tax accrual periods for REMIC regular interests, as interpreted by the most tax professionals, are structured to mirror the payment dates on those instruments. However, many regular interests provide for a lag of up to 31 days between the record date and the payment date for principal and interest payments. The proposed regulations would shift the tax accrual periods for regular interests to match their record dates in cases where there is a lag between an instrument's record and payment dates, as long as the lag does not exceed 31 days.

The Internal Revenue Service has articulated two reasons for proposing the new regulations: (1) to eliminate underreporting of income assumed to occur during the first tax accrual period for regular interests that have a significant lag between their record and payment dates; and (2) to mitigate the investor confusion that results from this lag and the consequent mismatching of interest accruals for tax and legal entitlement purposes. The remainder of this letter sets out our comments on the proposed regulations and our thoughts about whether a change in the tax accounting rules relating to REMIC regular interests is necessary or appropriate.

Summary of Comments

• We do not believe that any change in tax accrual periods for REMIC regular interests is necessary. The current tax accounting rules do not result in any systematic underreporting of taxable income or shifting of taxable income between holders. Moreover, the current tax accounting rules provide the most accurate accrual of income and expense because payment date based accrual periods most closely reflect the economics of a debt obligation as a stream of cash flows and are not subject to manipulation. We believe that investor purchase prices of both large and small investors are commonly based on the economics of the transactions. A more economically effective change would be to encourage or require the market to align bond accrual periods with the payment dates.

• If the Internal Revenue Service decides that a change in the tax accrual period rules is necessary, we strongly recommend that tax accrual periods be aligned with bond accrual periods, rather than with record dates. Alignment of tax accrual periods with bond accrual periods will result in reporting qualified stated interest to investors in a manner that may reduce any investor confusion. On the other hand, because record dates must fall on business days, basing tax accrual periods on record dates will produce accrual periods of slightly different lengths (e.g., varying between 27 and 34 days), which will cause new sources of investor confusion as well as create operational and systems issues.

• We believe that any change made to the tax accrual period rules for REMIC regular interests should apply equally to all debt obligations that are subject to I.R.C. § 1272(a)(6), which generally present the same interest and OID reporting issues as REMIC regular interests.

• We request that the effective date for any new tax accrual period rules be delayed to accommodate the extensive operating systems changes that will be necessary to implement the new rules. In particular, we request that any regulation requiring record date based accrual periods apply only to REMIC regular interests and other instruments subject to I.R.C. § 1272(a)(6) issued eighteen months or more after the date that final regulations are published in the Federal Register.

The federal income tax accounting rules that apply to debt instruments generally provide that interest and original issue discount ("OID") accrual periods be structured to match up with interest payment dates.¹ This approach provides for the most accurate accrual of income and expense for two reasons. First, the calculation of the true economic yield to maturity of, and the resulting accrual of economic income on, a debt obligation is based on a present-valuing of the cash flows expected to be received on the obligation, which means that the computation is based on the dates that cash flows are received (i.e., the payment dates), rather than on record dates or legal accrual periods (hereinafter referred to as "bond accrual periods"). Said another way, record dates and bond accrual periods do not accurately reflect the economics of a debt obligation to the extent that they deviate from payment dates. Second, tax accrual periods based on payment dates are not subject to manipulation because they are based on actual payments of cash, whereas tax accrual periods based on bond accrual periods or record dates potentially could be manipulated in ways that might create concerns on the part of the Internal Revenue Service. Thus, the current tax accounting rule that matches payment dates and tax accrual periods is well grounded from an economic and tax policy perspective.

Our understanding is that two reasons have been proffered for changing the current tax accrual period rules for REMIC regular interests. The first is to eliminate systematic underreporting of income assumed to occur during the first tax accrual period for regular interests that have a significant lag between their legal and tax accrual periods. It has been asserted that REMIC tax administrators are reporting too few days of qualified stated interest or OID accrual during the initial tax accrual period (i.e., the period beginning on the issue-date and ending on the first payment date (or the day before)) and are improperly shifting income to the final accrual period ending on the final payment date. We, however, do not believe that there is any systematic underreporting of interest or OID or shifting of income between holders under the current methodology.

The delay between record and payments dates with which the Internal Revenue Service is concerned occurs primarily in the case of fixed-rate regular interests. These regular interests typically provide for calendar month bond accrual periods, record dates on the last business day of each calendar month and payment dates that range from the 15th to the 25th day of the following month. Fixed-rate regular interests generally are issued with accrued interest from the first day of the month in which they are issued. Variable-rate regular interests, in contrast, normally have record dates that fall on the business day before the related payment date and bond accrual periods that begin on the prior payment date (or the issue date in the case of the first accrual period) and end on the day before the related payment date.² Accordingly, with most variable-rate regular interests, there is only a de minimis lag between record and payment dates. In addition, such variable-rate regular interests generally are issued "flat," which means without any accrued interest.

Under current tax rules, we, along with other REMIC tax preparers, calculate interest and OID accruing on fixed-rate regular interests during the initial accrual period as follows. We first determine a yield to maturity using the methodology of I.R.C. § 1272(a)(6) and based on tax accrual periods that match up with either scheduled or actual payment dates. The issue price includes all accrued interest that is paid by the investors at closing. Most fixedrate regular interests provide for the payment of thirty days of interest on the first payment date. However, the period from the issue date until. the first payment date generally is less than thirty days. Consequently, if a regular interest has qualified stated interest, only the portion of the first interest payment that is attributable to the short period between the issue date and the first payment date (i.e., a number of days of interest equal to the number of days in the short period) is reported as qualified stated interest. The remainder is reported as a return of issue price. If a regular interest has OID, the amount of OID and qualified stated interest (if any) that is allocable to the first accrual period is based on the actual number of days between the issue date and the first payment date. Again, if the amount of the first interest payment exceeds the amount of qualified stated interest accruing during the first accrual period, the remainder is treated as a return of issue price. Thus, we believe that most REMIC tax preparers are properly calculating the amount of interest and OID that accrues during the first tax accrual period.

Because all holders of REMIC regular interests must use the accrual method to account for income with respect to the regular interest,³ if a fixed-rate regular interest is sold in the secondary market and the trade date falls between a record date and the related payment date, the seller is required to report interest and OID) accruing through the trade date, and the purchaser all interest and OID accruing thereafter.⁴ The seller's interest and OID accruals increase its tax basis in the regular interest. For tax purposes, the sale price includes both the amount paid by the purchaser and the payment received after the trade date to which the seller is entitled as a result of owning the regular interest on the related record date. Our understanding of the market is that investors price regular interests and other debt obligations by present-valuing the stream of cash flows expected to be received on the obligation on the payment dates. Thus, assuming that the market is efficient, when the trade date falls between a record date and the related payment date, the price that the purchaser will be willing to pay for a regular interest will be reduced to reflect the fact that the seller will be entitled to the first payment received after the trade date. In other words, the market price that results from an efficient market will put the seller and the purchaser in essentially the same economic position as if the purchaser were entitled to receive the portion of the first interest payment after the trade date that is economically attributable to the period between the trade date and the date on which that payment is made. Accordingly, there is no systematic underreporting of taxable income by either the seller or the purchaser or shifting of taxable income from an original investor to later secondary market purchasers.

The second reason proffered for changing the current tax accrual period rules is to mitigate any investor confusion that results from the mismatching of interest accruals for tax and legal entitlement purposes. We recognize that there may be some lingering confusion among retail investors as a result of the discrepancy between bond accrual periods and record dates on one hand and tax accrual periods on the other hand. Based on our experience, however, we respectfully submit that the vast majority of the investment community understands and has adapted to this discrepancy over the eighteen years that the current tax accounting methodology has been in use. hi addition, we are aware of several industry resources, such as treatises and prospectuses, from which investors can gain a greater understanding of the tax reporting methodology applicable to REMIC regular interests. We note that our tax department has no record of ever receiving any letters of complaint or inquiry from any investor regarding confusion or dissatisfaction with the current tax reporting methodology. Furthermore, if there really were significant confusion or dissatisfaction in the marketplace with the mismatch between bond accrual and tax accrual periods for fixed-rate regular interests, REMIC issuers surely would have responded by voluntarily changing bond accrual periods and record dates to align them with tax accrual periods and payment dates. The feasibility of this change is demonstrated by the close alignment of bond and tax accrual periods and record and payment dates in the case of variable-rate regular interests. Consequently, while we are sensitive to investor concerns, we believe that claims of widespread investor confusion are overstated.

Based on the foregoing, we respectfully submit that maintaining the current tax accrual period rules for REMIC regular interests is the best course of action. As described above, the current rules do not result in any systematic underreporting of income or shifting of income between holders. In addition, any minimal benefit from the proposed regulations in terms of reducing investor confusion would be outweighed by the loss of economic accuracy in calculating income accruals and the increased potential for abusive manipulation of accrual periods. Moreover, the same reduction in investor confusion could be achieved without modifying the tax accrual periods by changing bond accrual periods and record dates on fixedrate regular interests to follow the variable-rate regular interest model.⁵ This change could be effected either voluntarily by the issuer community or through an Internal Revenue Service mandate that requires the realignment of bond accrual periods and record dates to match tax accrual periods. We also want to point out that the cost of changing tax accounting systems and training tax return personnel will be significant, We estimate that the direct and indirect costs that we would incur to bring our tax reporting systems into compliance with the rules of the proposed regulations could exceed $500,000. We do not believe this added expense will properly resolve investor concerns and, therefore, requiring tax administrators to incur a cost of this magnitude is not warranted under the circumstances. Accordingly, we recommend that the proposed regulations be withdrawn and the current tax accrual period rules be maintained.

Use of Bond Accrual Period Rather Than Record Date

If, despite the foregoing, the Internal Revenue Service still believes that a change in the tax accrual period rules for REMIC regular interests is necessary, and absent a securities industry initiative to align bond accrual periods and record dates with payment dates, we strongly recommend that tax accrual periods be aligned with bond accrual periods, rather than with record dates, and that payments be deemed to occur at the end of the bond accrual period for all calculation and reporting purposes. Such a change would reduce any investor confusion by aligning the investor's expectation based on the stated accrual period with the reported taxable interest income

A record date is a defined term within every transaction. For bonds that accrue on the calendar month basis, a record date is generally the final business day of the calendar month. For bonds that accrue from payment date to the day before the next payment date, the record date is defined as the last business day before the payment date. Within a bond accrual period, interest can continue accruing from the record date until the end of the bond accrual period.⁶ Because the record date must be a business day, it may precede the last day of the month by up to three days. Consequently, requiring that each tax accrual period end on a record date will create accrual periods of varying lengths from month to month (e.g., varying from 27 to 34 days). The varying lengths will make reporting of interest accruals more confusing to investors and computations of interest and OID accruals significantly more difficult from a systems standpoint than if tax accrual periods correspond to bond accrual periods.

If the intention of the proposed rule is to incorporate only the record date of the final payment into calculations, since the final payment date is not fixed, cashflow models will need to project the final record date, and as a result, there will be constant changes to the length of the final accrual periods.

In addition, our RIEMIC tax accounting systems currently do not capture record date information. As discussed below, if record date based accrual periods are required, we will need a substantial transition period to reconfigure our systems to conform to the new rules.

Furthermore, the cost of reconfiguring our systems will be significantly increased over the cost that would be incurred if tax accrual periods were aligned with bond accrual periods.

Extend Changes to All Section 1272(a)(6) Obligations

We believe that any change made to the tax accrual period rules for REMIC regular interests should apply equally to all debt obligations that are subject to I.R.C. § 1272(a)(6). Non-REMIC collateralized debt obligations ("CDOs") generally present the same interest and OID reporting issues as REMIC regular interests under I.R.C. § 1272(a)(6). In addition, fixed-rate CDOs normally have the same delay between bond accrual periods and payment dates as fixed-rate REMIC regular interests. Moreover, tax preparers use the same systems to prepare tax reporting information for REMIC regular interests and CDOs. To avoid the cost and inefficiencies inherent in maintaining parallel tax accounting systems, we request that any change made to the tax accrual period rules for REMIC regular interests be extended to all instruments subject to I.R.C. § 1272(a)(6). We also suggest that aligning the reporting methodologies for all instruments subject to I.R.C. § 1272(a)(6) will reduce investor confusion that might result from divergent rules.

Prospective Application and Delayed Effective Date

We agree with the Internal Revenue Service that any new tax accrual period rules should apply only prospectively and should not affect REMIC regular interests issued before the date that the final regulations are published in the Federal Register. If the proposed regulations are adopted, we request a delayed effective date that will provide REMIC tax administrators with adequate time to complete the systems changes necessary to implement the new accrual regime without creating unnecessary costs or business risks. The new rules should apply only to regular interests issued after the delayed effective date.

The necessary delay period will depend on whether the new methodology uses information already captured by our reporting systems (i.e., bond accrual periods) or information not currently captured by our reporting systems (i.e., record dates). If the final regulations use record date to record date accrual periods, we believe that it will take up to eighteen months to complete the system changes necessary to comply with the new reporting methodology. Well Fargo's REMIC tax reporting system is tightly integrated with its bond reporting system (i.e., the system that it uses to report bond cash flows and other economic information to investors) and relies on a combination of both internally and externally managed software. Enhancements invariably require making changes to both sets of software, carefully avoiding any unintended impact on the bond reporting system, and performing extensive testing before implementation. If new logic must be built into the software to capture additional information as would be the case with record date based accrual periods, the time necessary to implement and test the change would be substantial and could range up to eighteen months. Development, testing and implementation will need to be coordinated carefully so as to avoid disrupting ongoing bond and tax reporting for existing transactions or interfering with critical business initiatives. We believe that the delayed implementation of the new foreign withholding regulations provides a valid precedent for an effective date delay of this magnitude.⁷ Accordingly, we request that any regulation requiring record date based accrual periods apply only to REMIC regular interests and other instruments subject to I.R.C. § 1272(a)(6) issued eighteen months or more after the date that final regulations are published in the Federal Register.

We appreciate this opportunity to provide comments on this proposed regulation and would be happy to provide any furher information that would be helpful to the Internal Revenue Service in its consideration of this important issue.

² There is no operational or economic reason behind this difference between fixed-rate and variable-rate regular interests. The calendar month bond accrual period for fixed-rate regular interests developed and became the market convention during a time when REMICs issued predominately fixed-rate regular interests, presumably driven by the idea of symmetry with the accrual period for the underlying mortgages. As REMICs began to issue more variable-rate regular interests, market pressure from the broader variable-rate debt instrument market forced them to conform to the characteristics of other variable-rate debt instruments. Thus, because variable-rate debt instruments in general have record dates that fall on the business day before the related payment date and are issued without any accrued interest, similar market conventions developed for variable-rate regular interests.

³ I.R.C. § 860B(b).

⁴ Treas. Reg. §§ 1.61-7(d), 1.446-2.

⁵ By aligning the bond accrual period with the payment dates, two additional investor discrepancies are resolved. Firstly, investors will always know the balance of the bond being purchased. Currently, with a lag between bond accrual and payment dates, there is a significant range of days during which a purchaser will actually be unaware of the balance of the bond purchased. During these days, the purchaser will be unaware of the amount of interest accruing on the bond. Secondly, any OID reported to each investor during the holding period will be more properly aligned with the principal payments used to calculate OID.

⁶ We note that we have experienced transactions in which record dates do not align with bond accrual periods. Although this is a small minority of deals, if the Internal Revenue Service decides to align tax accrual periods with bond accrual periods, it may be necessary to require that record dates be consistent with bond accrual periods so that no tax accrual period extends materially beyond the final record date.

⁷ Final regulations on withholding for payments to foreign persons were issued in October 1997, with a delayed effective date of January 1, 1999, to enable withholding agents to make the administrative and operating systems changes necessary to comply with the regulations. T.D. 8734 (October 14, 1997). The Internal Revenue Service found it necessary to amend the regulations twice to provide a further delay in the effective date to allow both taxpayers and the government to complete the systems changes necessary to implement the new withholding regime. The effective date initially was extended to January 1, 2000, and then was delayed further to January 1, 2001. See T.D. 8804 (December 31, 1998); T.D. 8856 (December 30, 1999).