Freddie Mac Urges Status Quo on Accrual Periods for REMIC Regular Interests

The proposed regulations provide a special rule for defining the period over which OID and QSI are to be accrued. For these purposes, the proposed regulations state that the initial accrual period begins on the date of issuance of the REMIC regular interest and that the final accrual period ends on the final record date of that REMIC regular interest. As explained in the preamble, "by shifting the entire tax accrual schedule, this special rule allocates all QSI and OID to the period between the issue date and the final record date of the instrument and none to the period between the final record date and final payment date."

For the reasons stated below, we believe that the existing accrual periods are appropriate. Any potential problem resulting from the delay between the record date and the payment date is confined to situations where REMIC regular interests are transferred and we believe that this problem can best be addressed through the issuance of guidance by the IRS and the Treasury Department.

A. Initial Holder

We believe that there is no problem with the existing OID concerning accrual periods as they relate to initial holders of REMIC regular interests. As noted in the Wells Fargo comment letter, the existing accrual periods track actual payment dates and, thus, result in the most accurate accrual of income and expense for each period from an economic perspective. The existing rules are, in this manner, entirely consistent with the overall approach of the OID rules which is to accrue income on a constant yield basis as determined by actual cash payments. In contrast, the approach taken by the proposed regulations; i.e., treating one or more payments as being made on the record date, would lead to an uneconomic result.

We understand that there is a concern that some servicers may not be reporting any OID or QSI during the period from the issue date to the first payment date ("the initial delay period"). We are not aware of any servicer who is not in compliance with the existing rules and therefore is failing to report any income during the initial delay period. Certainly, Freddie Mac reports accruals on REMIC regular interests for the short period beginning on the issue date, and continuing through the final payment date. Comment letters submitted by or on behalf of Fannie Mae, Wells Fargo, and KPMG indicate that the industry follows a similar practice. In fact, there does not appear to be a reasoned legal basis for not reporting any accruals during the initial delay period.

In short, we recommend that the existing tax accrual periods for REMIC regular interests remain unchanged. To the extent there is a concern that some servicers may not be reporting any income during the initial delay period, we recommend that the IRS and the Treasury Department issue guidance clarifying that this practice is impermissible.

B. Transfers to Secondary Holders

Additionally, the IRS and the Treasury Department have expressed two concerns regarding the tax treatment of subsequent holders of REMIC regular interests under the existing tax rules. First, there is a concern that, as a result of the delayed accrual system, "too much QSI and OID is allocated to the last secondary purchaser of the REMIC regular interest." Second, "because of principal payments, the holder will earn interest on a declining principal balance, while the lagging tax accruals will be based on a higher principal amount between the record dates and payment dates in many instances."

In terms of the first concern, in the absence of principal paydowns, the existing rules appropriately address the treatment of transfers to secondary holders. The servicer is required to report the interest amount for an entire accrual period and the initial and secondary holders are required to compute their respective accruals based on the number of days in the accrual period that each held the REMIC regular interest.

We agree, however, that there is a problem caused by paydowns of principal which may cause the transferee to accrue an excessive amount of QSI and OID and cause the transferor to accrue an inadequate amount of QSI and OID. This overaccrual by the transferee results from accruing on overstated principal amounts during the payment delay periods. Specifically, where a secondary holder purchases a REMIC regular interest after a record date but before the following payment date, the secondary holder will be required to accrue income on the entire amount of the then-outstanding principal balance, including the portion of the principal balance that will be paid to the prior holder on the following payment date. Income with respect to such portion should not be accrued by the secondary holder. This income is economically attributable to the prior holder and should be accrued only by such holder. By disposing of the REMIC regular interest during the delay period, the prior holder is able to convert what otherwise would have been additional ordinary income into capital gain. The secondary holder, in contrast, may report too much ordinary income (and may recognize a capital loss with respect to the overreported amount).

This problem affecting transfers can be resolved by issuing narrow guidance that would require a prior holder not only to accrue interest through the date on which it disposes of the regular interest but also to accrue interest during the period from the disposition date to the following payment date with respect to the principal amount that it is entitled to receive on such payment date. Such guidance would farther provide that the subsequent holder would not be required to accrue interest during this period with respect to this principal amount.

C. Effective Dates

The solution proposed above would not change the reporting requirements with respect to REMIC regular interests. It would merely provide clarification to a holder with respect to its QSI and OID accrual in situations where a REMIC regular interest was transferred. Nevertheless, this may require system changes for holders that actively invest in and transfer such securities. In any event, whether you adopt our recommendations or issue other guidance, we request that you provide at least one year of advance notice prior to the effective date of any such guidance in order to accommodate any systems enhancements that may be required.