Firm Raises Technical Problems Linked to Proposed Regs on Patented Transactions

This letter is submitted to provide comments to the Treasury Department and the Internal Revenue Service (the "Service") on the regulation regarding reportable transactions, Treas. Reg. § 1.6011-4.

We appreciate the continued efforts by the Treasury Department and the Service to clarify and simplify the regulations regarding reportable transactions. We believe, however, that the following represent remaining technical problems with the current version of the regulations:

Current Law

On August 3, 2007, the Treasury Department and the Service issued final regulations under section 6011, Treas. Reg. § 16011-4, to modify the rules relating to the disclosure of reportable transactions. See T.D. 9350 (August 3, 2007).

Every taxpayer that has participated in a "reportable transaction" and that is required to file a tax return must attach to its return for the taxable year a disclosure statement. Treas. Reg. § 1.6011-4(a). The term "transaction" includes all of the factual elements relevant to the expected tax treatment of any investment, entity, plan or arrangement and includes any series of steps carried out as part of a plan. Treas. Reg. § 1.6011-4(b)(1). Reportable transactions currently include six types of transactions: listed transactions, confidential transactions, transactions with contractual protection, loss transactions, transactions of interest and proposed patented transactions.²Id. and Prop. Reg. § 1.6011-4(b)(7). A transaction will not be considered a reportable transaction, however, or will be excluded from any individual category of reportable transactions if the Commissioner makes a determination by published guidance that the transaction is not subject to the reporting requirements of Treas. Reg. § 1.6011-4. See Treas. Reg. § 1.6011-4(b)(8)(i).

Comments Regarding Loss Transactions

In the case of a subchapter C corporation, a "loss transaction" is any transaction resulting in a taxpayer claiming a section 165 loss of at least $10 million in any single taxable year or $20 million in any combination of taxable years (without taking into account offsetting gains or other income or limitations). Treas. Reg. § 1.6011-4(b)(5)(i), (iii). For this purpose, a section 165 loss includes an amount deductible pursuant to a provision that treats a transaction as a sale or other disposition or otherwise results in a deduction under section 165. Treas. Reg. § 1.6011-4(b)(5)(iii)(B). Certain losses under section 165 from the sale or exchange of an asset with a '"qualifying basis" are not taken into account in determining whether a transaction is a loss transaction, provided that the asset is not, among other things, an interest in a passthrough entity, within the meaning of section 1260(c)(2), other than a REMIC regular interest. Rev. Proc. 2004-66, 2004-2 C.B. 966, sec. 4.02(1)(b), modifying and superseding Rev. Proc. 2003-24, 2003-1 C.B. 599.

In general, a taxpayer's basis in an asset (less adjustments for any allowable depreciation, amortization, or casualty loss) is a qualifying basis if the basis of the asset is equal to, and is determined solely by reference to, the amount (including any option premium) paid in cash by the taxpayer for the asset and for any improvements to the asset. See Rev. Proc. 2004-66, section 4.02(2)(a). Special rules exist for assets whose basis is determined under sections 358, 1014, 1015, and 1031(d). See id., section 4.02(2). A taxpayer's basis in an asset is a qualifying basis if the basis of the asset is adjusted under section 1272(d)(2) or section 1278(b)(4), provided that the taxpayer's basis in the asset immediately prior to the adjustment was otherwise a qualifying basis. Id., sec. 4.02(2)(g).

In addition, under Rev. Proc. 2004-66, any loss to which section 475(a) or section 1256(a) applies is not taken into account in determining whether a transaction is a loss transaction.³Id., sec. 4.03(3). Further, a loss arising from a hedging transaction described in section 1221(b), if the taxpayer properly identifies the transaction as a hedging transaction, or from a mixed straddle account under Treas. Reg. § 1.1092(b)-4T, is not taken into account in determining whether a transaction is a loss transaction. Id., sec. 4.03(5).

I. The qualifying basis rule should apply to interests in fixed investment trusts.

As stated above, the exception from the definition of loss transactions for the sale or exchange of an asset with a qualifying basis is not available for assets that constitute interests in passthrough entities within the meaning of section 1260(c)(2). See Rev. Proc. 2004-66, sec. 4.02(1)(b). An interest in a passthrough entity generally includes interests in a regulated investment company, a real estate investment trust, an S corporation, a partnership, a trust, and a REMIC. See section 1260(c)(2), The Service has excluded REMIC regular interests, as defined in section 860G(a)(1), from the exception for interests in a passthrough entity from the qualifying basis rule. See Rev. Proc. 2004-66, 2004-2 C.B. 966, sec. 4.02(1)(b).

We believe that, for purposes of the reportable transaction rules, a taxpayer should be allowed to have a qualifying basis in an interest in a fixed investment trust as defined under Treas. Reg. § 301.7701-4(c). It is clear that, for tax purposes, when an entity qualifies as a fixed investment trust, an interest holder is considered to be the tax owner of his or her proportionate share of assets of the trust. One very common example of an interest in a fixed investment trust is a participation certification ("PC") or mortgage-backed security ("MBS"). A PC or MBS represents an undivided ownership interest in a pool of residential mortgages.⁴ The Service has issued several published and private rulings concerning the tax treatment of PCs and MBS.⁵ Under these rulings, it is clear that for tax purposes, the PC or MBS holder is considered to be the tax owner of his or her proportionate share of the underlying mortgages and the principal and interest paid thereon.

We can see no appropriate reason for the distinction between REMIC regular interests and interests in fixed investment trusts with respect to the qualifying basis rule. In addition, we can see no appropriate reason for the distinction between a holder of a single loan, who may have a qualifying basis in the loan, and the holder of a pool of loans held in a fixed investment trust, who is treated as owning a proportionate share of each underlying loan. Accordingly, we respectfully request that the Service expand the qualifying basis exception to apply to interests in fixed investment trusts.⁶

2. The qualifying basis rule should apply to securities purchased at a premium.

A taxpayer's basis in an asset is a qualifying basis if the basis of the asset is adjusted under section 1272(d)(2) or section 1278(b)(4), provided that the taxpayer's basis in the asset immediately prior to the adjustment was otherwise a qualifying basis. See Rev. Proc. 2004-66, sec. 4.02(2)(g). By way of background, sections 1272(d)(2) and 1278(b)(4) provide that a taxpayer shall increase the basis of any debt instrument in his hands by the amount included in his gross income as original issue discount, pursuant to section 1272, or market discount, pursuant to section 1278. As a result, a taxpayer may satisfy the qualifying basis exception where its basis in the asset has been adjusted to reflect the amortization of original issue or market discount. Based on the limited scope of the adjustment rule, a basis that has been adjusted to reflect the inclusion of premium, however, is not a qualifying basis. We see no reason for treating assets whose basis was adjusted to reflect the amortization of original issue or market discount differently from assets whose basis was adjusted to reflect the amortization of premium.

Accordingly, we respectfully request that the Service expand the qualifying basis exception to include assets whose bases were adjusted to reflect premium amortization.

The exception first requires that the loss arise from a hedging transaction described in section 1221(b). Section 1221(b) provides that a hedging transaction means "any transaction entered into by the taxpayer in the normal course of the taxpayer's trade or business primarily (i) to manage risk of price changes or currency fluctuations with respect to ordinary property which is held or to be held by the taxpayer, (ii) to manage the risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred by the taxpayer, and (iii) to manage such other risks as the Secretary may prescribe in regulations."

The second part of the exception requires that the taxpayer must "properly identif[y] the transaction as a hedging transaction." Section 1221(a)(7) requires that, to result in ordinary gain or loss, a hedging transaction must be "clearly identified as such before the close of the day on which it was acquired, originated or entered into (or such other time as the Secretary may by regulations prescribe)." Treasury regulation section 1.1221-2(f) sets forth the requirements of same-day identification of hedging transactions and substantially contemporaneous identification of the hedged item. In Treas. Reg. § 1.1221-2(g)(2), the inadvertent error provision states that if a taxpayer does not make an identification that satisfies the requirements of Treas. Reg. § 1.1221-2(f), the taxpayer may treat gain or loss from the transaction as ordinary income or loss under the general rule for hedging transactions if: (a) the transaction is a hedging transaction; (b) the failure to identify the transaction was due to inadvertent error; and (c) all of the taxpayer's hedging transactions in all open years are being treated as hedging transactions under section 1221(a)(7) on either original or, if necessary. amended returns. We are aware of no administrative or common law authority that explains the meaning of the phrase "properly identifies" as used in the exception. We believe, however, that "proper identification" in the hedging context should refer to a taxpayer's identification of a transaction as a hedging transaction in situations where the transaction does qualify as such. See section 1221(b)(2)(B).

Accordingly, we respectfully request that the Service clarify that the requirement to "properly identif[y] the transaction as a hedging transaction" includes an identification by a taxpayer of a hedging transaction pursuant to the inadvertent error provision of Treas. Reg. § 1.1221-2(g).

Comments regarding Transactions with Contractual Protection

In 2007, the Service issued guidance excluding from the category of transactions with contractual protection transactions in which a refundable or contingent fee is related to the low-income housing credit under section 42(a), as well as several other credits. See Rev. Proc. 2007-20, 2007-7 I.R.B. 517, sec 4.02(4). However, an exception is not provided for transactions in which the refundable or contingent fee is related to the rehabilitation credit under section 47.

A taxpayer's investment in a low-income housing tax credit (LIHTC) partnership typically consists of a limited partnership interest in an upper tier partnership (the "Fund" partnership), which in turn invests in numerous lower tier "project" partnerships that invest in housing projects eligible for LIHTCs. Many of the housing projects also qualify for the rehabilitation credit under section 47. Each Fund partnership passes through the taxpayer's share of the partnership's tax credits. As part of its investment, a taxpayer makes capital contributions to the Fund partnerships, which are used to pay various fees, including amounts potentially used to pay fees for tax advice. In addition, the Fund partnerships invest capital contributions in project partnerships, which are used to pay fees of the project general partner, including amounts potentially used to pay fees for tax advice. A taxpayer may be entitled to a refund of part of its investment (including amounts potentially used to pay fees for tax advice) if the amount ultimately invested in housing projects eligible for LIHTCs turns out to be less than originally expected. Because the taxpayer's investment could potentially be refunded, the investment could be construed as a transaction with contractual protection.

Rev. Proc. 2007-20 provides relief for investments in projects that are eligible only for LIHTCs. It does not provide relief for investments in projects that qualify for both LIHTCs and rehabilitation credits. We can see no meaningful distinction between transactions in which a refundable or contingent fee is related to the low-income housing credit under section 42(a) and those in which a refundable or contingent fee is related to the rehabilitation credit under section 47(a).

Accordingly, we respectfully request that the relief from the contractual protection category contained in Rev. Proc. 2007-20 be extended to include transactions in which the refundable or contingent fee also is related to the rehabilitation credit under section 47.

General Comments

Accordingly, there should be an exception from the disclosure requirement for transactions examined under audit or agreed upon in a closing agreement between the taxpayer and the Service.

² Treas. Reg. § 1.6011-4, as amended on August 3, 2007, formally removed significant book-tax difference transactions and transactions with a brief asset holding period from the categories of reportable transactions. See T.D. 9350 (August 3, 2007).

³ Rev. Proc. 2003-24 exempted from the loss transition determination losses arising from any mark-to-market treatment of an item under section 475 or section 1256, but required that the taxpayer compute its loss by using a qualifying basis or a basis resulting from previously marking the item to market, or that the taxpayer compute its loss by making appropriate adjustments for previously determined mark-to-market gain or loss. Id., sec. 4.03(3). The old rule still applies to losses arising from any mark-to-market treatment of an item under section 475(f), section 1296(a), Treas. Reg. § 1.446-4(e), Treas. Reg. § 1.988-5(a)(6), or Treas. Reg. § 1.1275-6(d)(2).

⁴ For example, each PC entitles its holder to principal payments on the mortgages underlying the PC, in an amount equal to the face amount of the PC, and each PC also entities the holder to periodic payments of the interest paid on the holder's share of the underlying mortgages.

⁵See, e.g., Rev. Rul. 71-399, 1971-2 C.B. 433 ("The arrangement described [that is, PCs created by FHI.MC] does not create an association taxable as a corporation, but constitutes a trust. The certificate holders are owners of the trust under Subpart F, of Subchapter J of the Code. Each certificate holder is treated as the owner of an undivided interest in the entire trust (corpus as well as ordinary income).") and Rev. Rul. 70-544, 1970-2 C.B. 6 (similar rulings for "straight pass-through" certificates guaranteed by the Government National Mortgage Association that represent a proportionate interest in mortgage pool). For subsequent rulings, see Rev. Rul. 84-10, 1984-1 C.B. 155; Rev. Rul. 81-203, 1981-2 C.B. 137; Rev. Rul. 80-96, 1980-1 C.B. 317, Rev. Rul. 77-349, 1977-2 C.B. 20; Rev. Rul. 74-300, 1974-1 C.B. 169; Rev. Rul. 72-376,1972-2 C.B. 647; and Rev. Rul. 70-545, 1970-2 C.B. 7.

⁶ The Service also should clarify that section 4.02(l)(d) of Rev. Proc. 2004-66, which prevents any asset that has "been separated from any portion of the income it generates" from qualifying as an asset with a qualifying basis, does not apply to the retention of servicing and guarantee fees from interest payable on the underlying loans of a fixed investment trust. Under the Service's traditional rulings, it is clear that the arrangement for the payment of servicing and guarantee fees does not separate the ownership of the loans underlying the trust from the ownership of any part of the income generated by those loans.