[Federal Register Volume 68, Number 139 (Monday, July 21, 2003)]
[Proposed Rules]
[Pages 43055-43058]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-18212]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-162625-02]
RIN 1545-BB73


Real Estate Mortgage Investment Conduits; Application of Section 
446 With Respect To Inducement Fees

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

[[Page 43056]]

proper timing and source of income from fees received to induce the 
acquisition of noneconomic residual interests in Real Estate Mortgage 
Investment Conduits (REMICs). The proposed regulations would apply to 
taxpayers who receive inducement fees in connection with becoming the 
holder of a noneconomic REMIC residual interest. This document also 
provides notice of a public hearing on the proposed regulations.

DATES: Written or electronic comments must be received by October 20, 
2003. Outlines of topics to be discussed at the public hearing 
scheduled for November 18, 2003, at 10 a.m. must be received by October 
28, 2003.

ADDRESSES: Send submissions to CC:PA:RU (REG-162625-02), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 4 p.m. to: CC:PA:RU (REG-162625-02), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit electronic 
comments via the IRS Internet site at: http://www.irs.gov/regs. The 
public hearing will be held in the IRS Auditorium, 1111 Constitution 
Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
John W. Rogers III at (202) 622-3950; concerning submissions of 
comments, the hearing, and/or to be placed on the building access list 
to attend the hearing, Treena Garrett, at (202) 622-7180 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) under sections 446(b) (relating to general 
rules for methods of accounting), 860C (relating to other definitions 
and special rules applicable to REMICs), and 863(a) (relating to 
special rules for determining source) of the Internal Revenue Code of 
1986 (Code). The proposed regulations prescribe certain accounting 
rules for taking an inducement fee into income over a period that is 
related to the period during which the applicable REMIC is expected to 
generate taxable income or net loss allocable to the holder of the 
noneconomic residual interest. The proposed regulations set forth two 
safe harbor methods of accounting for inducement fees. The proposed 
regulations also contain a rule clarifying that an inducement fee is 
income from sources within the United States.

Explanation of Provisions

    Final regulations governing REMICs, issued in 1992, contain rules 
governing the transfer of noneconomic residual interests. Those 
regulations do not, however, contain rules that address the 
transferee's treatment of the fee received to induce the acquisition of 
a REMIC noneconomic residual interest.
    An inducement fee is paid to a transferee of a noneconomic residual 
interest because, under sections 860C(a)(1) and 860E(a)(1) of the Code, 
the holder of a REMIC residual interest must take into account the 
REMIC's taxable income or net loss. The holder of a noneconomic 
residual interest will receive insufficient distributions to cover the 
resulting tax liabilities, and a transferee will, therefore, require an 
inducement fee to become the holder of the noneconomic residual 
interest.
    In its earlier years, a REMIC typically accrues more taxable 
interest income than deductible interest expense. As a result, in its 
earliest years, the REMIC will have net income (generally referred to 
as phantom income) taxable to the residual holder. This phenomenon 
generally will reverse, resulting in REMIC net loss (phantom loss) in 
later years.
    Following release of the final REMIC regulations, the IRS and the 
Treasury Department received requests for guidance on the proper method 
of accounting to be used by taxpayers for inducement fee income. The 
proposed regulations provide rules relating to the proper timing and 
source of income from an inducement fee received in connection with 
becoming the holder of a noneconomic residual interest in a REMIC.
    The proposed regulations provide that, to clearly reflect income, 
an inducement fee must be included in income over a period that is 
reasonably related to the period during which the applicable REMIC is 
expected to generate taxable income or net loss allocable to the holder 
of the noneconomic residual interest. The proposed regulations provide 
that an inducement fee generally may not be taken into account in a 
single tax year.
    The proposed regulations set forth two safe harbor methods of 
accounting for inducement fees. These safe harbor methods are:
    (1) A book method, under which an inducement fee is recognized for 
federal income tax purposes in the same amounts and over the same 
period in which that inducement fee is included in income by the 
taxpayer for financial reporting purposes, provided that the period is 
not shorter than the period over which the applicable REMIC is expected 
to generate taxable income; and
    (2) A method under which the inducement fee is recognized for 
federal income tax purposes ratably over the remaining anticipated 
weighted average life of the REMIC determined as of the time the 
noneconomic residual interest is transferred to the taxpayer. This 
method is based on rules in the final REMIC regulations for taking into 
account a REMIC sponsor's unrecognized gain or loss on a REMIC residual 
interest upon the formation of a REMIC.
    Additionally, the proposed regulations contain a rule that applies 
if a holder of a residual interest sells or otherwise disposes of the 
residual interest. Under this rule, the holder must take into account, 
at the time of the sale or other disposition, any unrecognized portion 
of the inducement fee for that residual interest. Transactions to which 
section 381(c)(4) applies are excluded from this rule because section 
381 and the regulations thereunder provide for the carryover of tax 
attributes, including methods of accounting. The IRS and the Treasury 
Department considered excluding other non-recognition transactions, 
such as contributions under sections 351 or 721. These other 
transactions, however, do not provide for the carryover of tax 
attributes. The proposed regulations, therefore, do not permit 
continued deferral of the unrecognized portion of an inducement fee 
following these other transactions.
    The proposed regulations also contain a rule clarifying that an 
inducement fee is income from sources within the United States.
    The IRS and the Treasury Department request comments on other 
possible safe harbor methods of accounting for these inducement fees. 
In particular, comments are requested on whether a safe harbor method 
that recognizes inducement fees proportionally to the anticipated 
future financing costs for funding the net tax liabilities of the 
noneconomic residual interest would be of general use to taxpayers and, 
if so, what factors should be used under that safe harbor method for 
determining a taxpayer's anticipated future financing costs.
    The proposed regulations state that the treatment of inducement 
fees is a method of accounting that must be applied consistently to all 
inducement fees received in connection with noneconomic REMIC residual 
interests. Thus, if a taxpayer uses a safe harbor

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method, the taxpayer must use that same safe harbor method for all 
inducement fees received in connection with any noneconomic REMIC 
residual interests held by the taxpayer.
    The proposed regulations regarding the timing for inclusion of 
inducement fees in income, if finalized as proposed, would apply for 
taxable years ending on or after publication of the final regulations 
in the Federal Register. The IRS and the Treasury Department request 
comments with respect to whether the applicability of the regulations 
should be limited to transactions arising on or after the effective 
date of these regulations and whether some delay in the effective date 
of these regulations is warranted.
    The proposed regulations clarifying the source of inducement fees, 
if finalized as proposed, would apply for taxable years ending on or 
after publication of the final regulations in the Federal Register.
    A taxpayer may not change its method of accounting for inducement 
fees without securing the prior consent of the Commissioner. The 
Commissioner may prescribe terms and conditions necessary to obtain the 
Commissioner's consent to effect a change in method of accounting and 
to prevent amounts from being duplicated or omitted. See sections 446 
and 481; Sec.  1.446-1(e)(3). The terms and conditions that may be 
prescribed by the Commissioner may include terms and conditions that 
require the change in method of accounting to be effected on a cut-off 
basis or with an adjustment under section 481(a). The IRS and the 
Treasury Department request comments on how best to effect any change 
in method of accounting necessitated by these regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and the Treasury Department specifically request comments 
on the clarity of the proposed rules and how they may be made easier to 
understand. The IRS and the Treasury Department also specifically 
request comments on the safe harbor methods provided in the regulations 
and suggestions for other possible safe harbor methods of accounting 
for these inducement fees. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for November 18, 2003, 
beginning at 10 a.m. in the IRS Auditorium, 1111 Constitution Avenue, 
NW., Washington, DC. Due to building security procedures, visitors must 
enter at the Constitution Avenue entrance. In addition, all visitors 
must present photo identification to enter the building. Because of 
access restrictions, visitors will not be admitted beyond the immediate 
entrance area more than 30 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (a signed original and eight (8) 
copies) by October 28, 2003. A period of 10 minutes will be allotted to 
each person for making comments. An agenda showing the scheduling of 
the speakers will be prepared after the deadline for receiving outlines 
has passed. Copies of the agenda will be available free of charge at 
the hearing.

Drafting Information

    The principal authors of these regulations are John W. Rogers III, 
Office of Associate Chief Counsel (Financial Institutions & Products), 
and Courtney L. Shepardson, Office of Division Counsel (Large and 
Midsize Business). However, other personnel from the IRS and the 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.446-6 also issued under 26 U.S.C 446 and 26 U.S.C. 
860G * * *

    Par. 2. Section 1.446-6 is added to read as follows:


Sec.  1.446-6  REMIC inducement fees.

    (a) Purpose. This section provides specific timing rules for the 
clear reflection of income from an inducement fee received in 
connection with becoming the holder of a noneconomic REMIC residual 
interest. An inducement fee must be included in income over a period 
reasonably related to the period during which the applicable REMIC is 
expected to generate taxable income or net loss allocable to the holder 
of the noneconomic residual interest.
    (b) Definitions. For purposes of this section--(1) Applicable 
REMIC. The applicable REMIC is the REMIC that issued the noneconomic 
residual interest with respect to which the inducement fee is paid.
    (2) Inducement fee. An inducement fee is the amount paid to induce 
a person to become the holder of a noneconomic residual interest in an 
applicable REMIC.
    (3) Noneconomic residual interest. A REMIC residual interest is a 
noneconomic residual interest if it is a noneconomic residual interest 
within the meaning of Sec.  1.860E-1(c)(2).
    (4) Remaining anticipated weighted average life. The remaining 
anticipated weighted average life is the anticipated weighted average 
life determined using the methodology set forth in Sec.  1.860E-
1(a)(3)(iv) applied as of the date of acquisition of the noneconomic 
residual interest.
    (5) REMIC. The term REMIC has the same meaning in this section as 
given in Sec.  1.860D-1.
    (c) General rule. All taxpayers, regardless of their overall method 
of accounting, must recognize an inducement fee over the remaining 
expected life of the applicable REMIC in a manner that reasonably 
reflects, without regard to this paragraph, the after-tax costs and 
benefits of holding that noneconomic residual interest.
    (d) Special rule on disposition of a residual interest. If any 
portion of an

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inducement fee received with respect to the acquisition of a 
noneconomic residual interest in an applicable REMIC has not been 
recognized in full by the holder as of the time the holder sells, or 
otherwise disposes of, that residual interest in the applicable REMIC 
(in a transaction other than a transaction to which section 381(c)(4) 
applies), then the holder must include the unrecognized portion of the 
inducement fee in income at that time.
    (e) Safe harbors. If inducement fees are recognized in accordance 
with a method described in this paragraph (e), that method complies 
with the requirements of paragraph (c) of this section.
    (1) The book method. Under the book method, an inducement fee is 
recognized in accordance with the method of accounting, and over the 
same period, that is used by the taxpayer for financial reporting 
purposes (including consolidated financial statements to shareholders, 
partners, beneficiaries, other proprietors and for credit purposes), 
provided that the inducement fee is included in income for financial 
reporting purposes over a period that is not shorter than the period 
during which the applicable REMIC is expected to generate taxable 
income.
    (2) The modified REMIC regulatory method. Under the modified REMIC 
regulatory method, the inducement fee is recognized ratably over the 
remaining anticipated weighted average life of the applicable REMIC as 
if the inducement fee were unrecognized gain being included in gross 
income under Sec.  1.860F-2(b)(4)(iii).
    (3) Additional safe harbor methods. The Commissioner, by revenue 
ruling or revenue procedure published in the Internal Revenue Bulletin, 
may provide additional safe harbor methods for recognizing inducement 
fees on noneconomic REMIC residual interests.
    (f) Method of accounting. The treatment of inducement fees is a 
method of accounting to which the provisions of sections 446 and 481 
and the regulations thereunder apply. A taxpayer is generally permitted 
to adopt a method of accounting for inducement fees that satisfies the 
requirements of paragraph (c) of this section. Once a taxpayer adopts a 
method of accounting for inducement fees, that method must be applied 
consistently to all inducement fees received in connection with 
noneconomic REMIC residual interests and may be changed only with the 
consent of the Commissioner, as provided by section 446(e) and the 
regulations and procedures thereunder.
    (g) Effective date. This section is applicable for taxable years 
ending on or after the date this document is published as a final 
regulation in the Federal Register.
    Par. 3. Section 1.860A-0 is amended by adding an entry in the 
outline for Sec.  1.860C-1(d) to read as follows:


Sec.  1.860A-0  Outline of REMIC provisions.

* * * * *


Sec.  1.860C-1  Taxation of holders of residual interests.

* * * * *
    (d) Treatment of REMIC inducement fees.
* * * * *
    Par. 4. Section 1.860C-1 is amended by adding paragraph (d) to read 
as follows:


Sec.  1.860C-1  Taxation of holders of residual interests.

* * * * *
    (d) For rules on the proper accounting for income from inducement 
fees, see Sec.  1.446-6.
    Par. 5. Section 1.863-0 is amended by:
    1. Adding an entry for Sec.  1.863-1(d).
    2. Redesignating the entry for Sec.  1.863-1(e) as Sec.  1.863-
1(f).
    3. Adding a new entry for Sec.  1.863-1(e).
    The additions read as follows:


Sec.  1.863-0  Table of contents.

* * * * *


Sec.  1.863-1  Allocation of gross income.

* * * * *
    (d) Scholarships, fellowship grants, grants, prizes and awards.
    (e) REMIC inducement fees.
* * * * *
    Par. 6. Section 1.863-1 is amended as follows:
    1. Paragraph (e) is revised.
    2. Paragraph (f) is added.
    The revision and addition reads as follows:


Sec.  1.863-1  Allocation of gross income under section 863(a).

* * * * *
    (e) REMIC inducement fees. An inducement fee (as defined in Sec.  
1.446-6(b)(2)) shall be treated as income from sources within the 
United States.
    (f) Effective dates. The rules of paragraphs (a), (b) and (c) of 
this section will apply to taxable years beginning after December 30, 
1996. However, taxpayers may apply the rules of paragraphs (a), (b) and 
(c) of this section for taxable years beginning after July 11, 1995, 
and on or before December 30, 1996. For years beginning before December 
30, 1996, see Sec.  1.863-1 (as contained in 26 CFR part 1 revised as 
of April 1, 1996). See paragraph (d)(4) of this section for rules 
regarding the applicability date of paragraph (d) of this section. 
Paragraph (e) of this section is applicable for taxable years ending on 
or after the date this document is published as a final regulation in 
the Federal Register.

Robert E. Wenzel,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 03-18212 Filed 7-18-03; 8:45 am]
BILLING CODE 4830-01-P