[Federal Register Volume 69, Number 164 (Wednesday, August 25, 2004)]
[Proposed Rules]
[Pages 52212-52217]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-19480]



[[Page 52212]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106679-04]
RIN 1545-BD18


Interest-Only REMIC Regular Interests

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Advance notice of proposed rulemaking.

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SUMMARY: This document describes and explains rules that the IRS and 
Treasury are considering and may propose in a notice of proposed 
rulemaking regarding the proper timing of income or deduction 
attributable to an interest-only regular interest in a Real Estate 
Mortgage Investment Conduit (REMIC). This document also invites 
comments from the public regarding these rules and other alternative 
rules. All materials submitted will be available for public inspection 
and copying.

DATES: Written or electronic comments must be received by November 23, 
2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-106679-04), room 
5203, Internal Revenue Service, PO Box 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:LPD:PR (REG-
106679-04), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at http://www.irs.gov/regs or via the Federal eRulemaking 
Portal at http://www.regulations.gov (indicate IRS and REG-106679-04).

FOR FURTHER INFORMATION CONTACT: Concerning submissions of comments, 
Treena Garrett (202) 622-7180; concerning the proposals, Dale S. 
Collinson, (202) 622-3900 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    The Tax Reform Act of 1986 (100 Stat. 2085) (1986-3 C.B. Vol. 1), 
created a new tax entity, the Real Estate Mortgage Investment Conduit 
(REMIC), that was designed to be the exclusive vehicle for the issuance 
of multi-class mortgage-backed securities. A REMIC may issue one or 
more classes of regular interests and must issue a single class of 
residual interest. Section 860B(a) of the Internal Revenue Code (Code) 
requires that a regular interest be treated as a debt instrument 
whether or not the interest would qualify as a debt instrument under 
general tax principles. The holders of the residual interest are 
required to take into account their proportionate share of the REMIC's 
taxable income or net loss.
    Prior to 1988, the holder of a REMIC regular interest was required 
to be entitled to a specified principal amount plus interest at a fixed 
or variable rate. The Technical and Miscellaneous Revenue Act of 1988 
(102 Stat. 3342) (1988 C.B. 1), permits the holder of a REMIC regular 
interest to receive interest that consists of a specified portion of 
the interest payments on qualified mortgages if the portion does not 
vary during the period the regular interest is outstanding. Section 
860G(a)(1)(B)(ii). The expanded definition of REMIC regular interest 
has allowed for the issuance of interest-only REMIC regular interests 
(REMIC IOs).
    A REMIC IO generally provides for a nominal (or zero) specified 
principal amount and stated interest consisting of a specified portion 
of the interest payments on mortgages held by the REMIC.\1\ Section 
860B(a) provides that a REMIC regular interest is taxed as a debt 
instrument. Nevertheless, a REMIC IO differs from a traditional debt 
instrument in that the aggregate of the amounts received by the holder 
of a REMIC IO may be less than the amount for which the instrument was 
issued. This may occur if the underlying mortgages are prepaid at an 
unexpectedly rapid rate. In that case, the amounts of interest paid on 
these mortgages will be less than expected, and the amounts payable to 
the holder of the REMIC IO will be correspondingly reduced. As a 
result, REMIC IOs present novel and difficult questions in the 
application of tax rules that were designed primarily to account for 
instruments that qualify as debt under traditional tax principles.
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    \1\ The terms of a REMIC may provide that the specified 
principal amount of a REMIC IO is zero. Although section 
860G(a)(1)(A) requires a regular interest ``unconditionally [to] 
entitle[] the holder to receive a specified principal amount (or 
other similar amount),'' Sec.  1.860G-1(a)(2)(iv) states, ``If an 
interest in a REMIC consists of a specified portion of the interest 
payments on the REMIC's qualified mortgages, no minimum specified 
principal amount need be assigned to that interest.''
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    Section 1275(d) authorizes regulations to modify the tax treatment 
prescribed by sections 163(e) and 1271 through 1275 (relating to 
original issue discount (OID)) if the statutory tax treatment does not 
carry out the purposes of those sections. The IRS and Treasury are 
considering whether to issue regulations, including regulations under 
the authority of section 1275(d), with respect to the tax treatment of 
REMIC IOs for issuers and initial- and secondary-market purchasers. 
This advance notice of proposed rulemaking sets out additional 
background information, including summary descriptions of possible 
approaches to the problems described below, and requests public 
comment.

Current Tax Treatment of REMIC IOs

    As noted, the terms of a REMIC IO generally provide both for stated 
interest consisting of a specified portion of the interest payments on 
mortgages held by the REMIC and also may provide for a nominal amount 
of specified principal. The tax rules currently applicable to a REMIC 
IO depend on whether the stated interest is treated as consisting 
entirely of interest or as being, in part, a return of the proceeds for 
which the instrument was issued.
    Some taxpayers believe that, if the stated interest is respected as 
interest, it generally is qualified stated interest (QSI) and so is not 
part of the stated redemption price at maturity (SRPM). As a result, 
because the specified principal due on the REMIC IO is, at most, 
nominal, a holder generally will have paid more than the amount payable 
when the REMIC IO matures, and thus there will be bond premium. On the 
other hand, if the interest payments are recast as, in part, a return 
of the proceeds for which the REMIC IO was issued, the portions so 
recast are included in the SRPM, and the instrument is issued with OID.
    Glick v. United States, 96 F. Supp. 2d 850 (S.D. Ind. 2000), 
weighed these competing analyses of a REMIC IO. The instrument at issue 
in the case had been issued for a little over $12 million. The terms of 
the instrument provided both for specified principal of $362,000, which 
was based on principal payments on the underlying mortgages, and for 
much larger expected amounts of stated interest, which were linked to, 
and contingent upon, interest payments on the underlying mortgages.
    Given the terms of the mortgages and the rate at which the 
mortgagors were, in the aggregate, expected to prepay their mortgages, 
the prospectus estimated total future cash flows under the REMIC IO of 
over $14 million. Basing its computation on the specified principal 
amount, the prospectus identified the resulting estimated interest rate 
on the REMIC IO as being 1006.7 percent. On the other hand, the 
prospectus further disclosed that, if a yield computation were to be 
based on the taxpayer's purchase price of over $12 million, the 
anticipated yield to maturity was just under 8 percent.

[[Page 52213]]

    Because of falling interest rates, the mortgages underlying the 
instrument were prepaid at an extremely fast rate, and the taxpayer 
recovered less than two thirds of the original investment.
    The Government argued that the instrument was issued at a discount 
and that the taxpayer's loss on the instrument was capital and would be 
recognized only in the year the instrument was retired. The taxpayer, 
on the other hand, claimed that the instrument was acquired at a 
premium and that ordinary deductions were allowable under section 171 
during the entire period that the taxpayer held the instrument. 
Explaining that it had resolved the question by ``[e]xamining the 
economic reality of the transaction,'' 96 F. Supp. 2d at 867, the court 
issued summary judgment for the Government.

Original Issue Discount

    REMIC regular interests are among the debt instruments for which 
the accrual of OID is calculated taking prepayments into account. This 
is accomplished by using a method commonly known as the prepayment 
assumption catch-up (PAC) method, which is provided in section 
1272(a)(6). Under this method, it is necessary to estimate first the 
rate at which any outstanding principal on the underlying mortgages 
will be prepaid and, then, the yield to maturity of the instrument. 
These estimates remain constant in all PAC method computations 
throughout the life of the instrument.
    In each accrual period, the daily accruals of OID are equal to the 
ratable portion of the excess (if any) of the sum of (1) the present 
value of the remaining payments under the debt instrument as of the 
close of the period (end-of-period present value) and (2) the payments 
during the accrual period that are included in the SRPM (accrual-period 
SRPM receipts), over the adjusted issue price of the debt instrument at 
the beginning of the period.\2\
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    \2\ For each period, interest income or expense with respect to 
the REMIC regular interest also includes accruals of QSI.
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    The end-of-period present value is calculated using the two 
estimates referred to above. First, the amount and time of the 
remaining payments are determined on the basis of both the specified 
principal actually outstanding at the end of the accrual period (taking 
into account any prepayments occurring before the close of the accrual 
period) and the previously estimated, static assumption about the rate 
at which any outstanding principal will be prepaid. Second, the present 
value of these remaining payments is determined by discounting them at 
the previously estimated original yield to maturity.
    A holder of an OID debt instrument includes in gross income the sum 
of the daily portions of the OID for each day during the taxable year 
on which it holds the debt instrument. An issuer's interest deduction 
for OID accruals is computed in a similar fashion.
    In the case of a traditional debt instrument that is issued with 
OID or a REMIC regular interest that is issued for less than its 
specified principal amount, prepayments increase the instrument's yield 
to maturity. Failure to anticipate prepayments would result in 
uneconomic deferred accrual of OID inclusions, and the holder would 
recognize capital gains when the instrument is finally sold or retired. 
To prevent such uneconomic deferral of OID inclusions, the PAC method, 
in each period, recognizes more OID than would be recognized if no 
anticipated prepayments were taken into account. However, the PAC 
method may result in uneconomic acceleration of OID accruals in certain 
circumstances.
    When section 1272(a)(6) became law, an instrument subject to it 
generally provided for payments of a fixed amount of specified 
principal, plus payments of QSI, which were based on the amount of 
principal still outstanding. If the issue price of the instrument was 
less than the specified principal, that difference resulted in a fixed 
amount of OID, which had to be accrued over the life of the instrument.
    For such an instrument, if actual prepayments occur at a slower 
rate than the original estimate, OID will be accrued more rapidly under 
the PAC method than the actual prepayment rate would justify. If 
prepayments are particularly slow, the OID remaining to be received at 
the end of a period may be greater than the excess of the original OID 
on the instrument over the amount of the OID that had been accrued in 
prior periods. As a result, the amount of OID for the current accrual 
period under the formula in the PAC method may be a negative number 
(Negative OID).\3\ This occurs if the adjusted issue price at the 
beginning of an accrual period (which reflects prior OID accruals) 
exceeds the sum of (1) the end-of-period present value and (2) the 
accrual-period SRPM receipts.
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    \3\ In 1986 Congress expressed its intent that Negative OID 
would not be currently recognized. For that reason, the term is used 
here to refer to a negative result for the computation required by 
the formula in the PAC method, not to an amount that is necessarily 
recognized for tax purposes.
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    Because the amount of OID to be received over the life of the 
instrument is fixed, and thus the OID that had been previously accrued 
will be received eventually, the premature accruals may be addressed by 
a period of nonaccrual of OID. An alternative approach would be to 
reverse the premature accruals by recognizing Negative OID in the 
current period and then to accrue the OID again later.
    In enacting the PAC formula, Congress expressed its intent that the 
rules implementing the PAC method would use a period of nonaccrual to 
correct possible premature accruals and would not accrue and recognize 
Negative OID.

    The conferees intend that in no circumstances would the method 
of accruing OID prescribed by the conference agreement allow for 
negative amounts of OID to be attributed to any accrual period. If 
the use of the present value computations prescribed by the 
conference agreement produce[s] such a result for an accrual period, 
the conferees intend that the amount of OID attributable to such 
accrual period would be treated as zero, and the computation of OID 
for the following accrual period would be made as if such following 
accrual period and the preceding accrual period were a single 
accrual period.

2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-239, 1986-3 (Vol. 4) 
C.B. 239. The IRS and Treasury understand that taxpayers generally 
comply with this intent not only for ordinary REMIC regular interests 
but also for REMIC IOs.
    The quoted expression of Congressional intent occurred before the 
1988 amendment permitting REMIC IOs. In the case of a REMIC regular 
interest that resembles a traditional debt instrument (such as the 
regular interests that existed before the 1988 amendment), a Negative 
OID computation is evidence that unexpectedly slow prepayments may have 
caused OID to accrue more rapidly than, in hindsight, it should have. 
In such a situation, disallowing Negative OID causes a timing issue. To 
the extent that OID has been overaccrued, the accrual period is 
extended until the computation for the extended accrual period produces 
a positive result. This future positive result of the computation has 
to occur eventually as principal on the debt instrument is repaid.
    By contrast, in the case of a REMIC IO, a Negative OID computation 
may occur because unexpectedly rapid prepayments reduce the amount of 
OID that will ever be received or paid under the terms of the 
instrument. Rather than the right amount of OID being accrued too fast, 
the wrong amount has been accrued. In the case of a REMIC IO, 
therefore, the prohibition against Negative OID may result in denying 
the holder current recognition of an overall actual loss that will not 
be reversed in

[[Page 52214]]

future periods and may only be realized upon the sale or maturity of 
the REMIC IO.
    There is also a corresponding distortion to the net income or net 
loss of the REMIC (and thus to the income or net loss of the holder of 
the residual interest). Even if one or more holders of the REMIC IOs 
sell their interests and recognize losses that correct their own 
overaccrual of OID income, nothing corrects the REMIC's overaccrual of 
OID deductions until the instrument is finally retired. This asymmetry 
may result in an understatement of the overall tax base attributable to 
income from mortgages held in REMICs (the total amount taxable to 
holders of REMIC regular interests and REMIC residual interests).

Market Discount

    Section 1276(b)(3) provides that the accrual of market discount on 
a debt instrument, the principal of which may be paid in installments, 
shall be determined under regulations. Regulations have not yet been 
issued.
    The legislative history of the Tax Reform Act of 1986, however, 
states that, until regulations are issued, if a debt instrument is 
issued with OID and the principal of the instrument may be paid in two 
or more installments, then holders of the instrument may elect to 
accrue market discount for the instrument either on a constant yield 
basis or in proportion to the OID accruals on the instrument. Under the 
latter method, the amount of market discount that accrues during an 
accrual period is determined by multiplying the total remaining amount 
of market discount on the instrument as of the beginning of the period 
by a fraction, the numerator of which is the amount of OID for the 
period and the denominator of which is the total remaining OID at the 
beginning of the period.\4\ See 2 H.R. Conf. Rep. No. 841, 99th Cong., 
2d Sess. II-842 (1986), 1986-3 (Vol. 4) C.B. 842. The IRS and Treasury 
understand that, under current practice, during any period for which 
the PAC method produces Negative OID, the numerator of the fraction is 
treated as zero, and no market discount is accrued. In some cases, this 
practice may uneconomically defer recognition of market discount.
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    \4\ If an instrument that provides for two or more principal 
payments is issued without OID, Congress intended for market 
discount to be accrued according to the same rule, but with stated 
interest playing the role of OID. See 2 H.R. Conf. Rep. No. 841, 
99th Cong., 2d Sess. II-842 (1986), 1986-3 (Vol. 4) C.B. 842.
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    If the rules in section 1272(a)(6) apply to a debt instrument 
(without regard to whether the instrument is issued with OID), this 
legislative history indicates that accruals of market discount on the 
instrument are to be determined using the same prepayment assumption as 
that used under section 1272(a)(6) (whether or not the taxpayer elects 
under section 1276(b)(2) to accrue market discount on a constant-yield 
basis). See id.
    The IRS and Treasury are aware of several possible methods, 
discussed below, for addressing the foregoing problems.

Instruments to Which New Rules Might Apply

    Because of the range of instruments to which section 1272(a)(6) 
applies and the breadth of the new accounting methods about which 
comment is being requested, any new method might not necessarily be 
limited to REMIC IOs. For example, a new method might apply to 
interest-only strips from fixed investment mortgage trusts. In 
addition, a new method might apply to all instruments that provide for 
disproportionately high interest payments (as defined in Sec.  1.860G-
1(b)(5)). Under this approach, the new rules would apply to REMIC 
regular interests whose issue price exceeds 125% of the specified 
principal amount and to similar non-REMIC interests.

Proposals Based on Existing Rules for Debt

PAC Method Without Prohibition on Recognizing Negative OID

    Although the PAC method may sometimes fail to clearly reflect the 
income of the holder or the issuer of a REMIC IO, the method is not 
without merit. The method is specifically designed to deal with debt 
instruments that are subject to prepayments, like traditional REMIC 
regular interests. Under the PAC method, if loans are actually prepaid 
faster than expected, the projected future cash flows are adjusted 
immediately to more accurately reflect income. To a large extent, the 
problems arising from the application of the PAC method to REMIC IOs 
arise from the prohibition against taking Negative OID into account.
    Because REMIC IOs did not exist when the 1986 legislative history 
discussing Negative OID was drafted, that discussion related to a 
Negative OID computation that would indicate that the affected 
taxpayers had accrued some OID too soon, rather than that they had 
accrued OID that would never be paid or received. Congress might have 
articulated a different intent concerning Negative OID if it had 
addressed the issue once REMIC IOs were permitted.
    Accordingly, the IRS and Treasury are considering whether to 
propose a regulation that would follow the section 1272(a)(6) formula 
in the current PAC method, except that the regulation would 
specifically allow holders of regular interests to accrue Negative OID 
deductions and would require the REMIC (and thus the holder of the 
REMIC residual interest) to accrue and recognize income from Negative 
OID.
    The considerations supporting recognition of Negative OID by 
initial purchasers may not apply with equal force to secondary-market 
purchasers. Secondary market prices are likely to reflect both 
prepayment history and revised expectations regarding future 
prepayments, with the result that the Negative OID deduction that might 
be appropriate for an initial purchaser may exceed any actual economic 
loss sustained by a particular secondary-market purchaser. The 
secondary-market purchaser's depressed purchase price, however, is 
likely to result in a substantial amount of market discount. See 
section 1278(a)(2). The rules for accruing Negative OID and market 
discount will have to be coordinated to produce a net result that is 
economically sensible.
    Accordingly, it may be appropriate either to develop explicit rules 
to effect this coordination or to limit recognition of Negative OID in 
the case of secondary-market purchasers. For example, recognition of 
accrued Negative OID might be limited to the aggregate of amounts that 
the secondary-market holder previously included in income as accrued 
OID or accrued market discount. However, in the case of a secondary-
market holder who has suffered a real economic loss on a REMIC IO, such 
a limitation could uneconomically defer recognition of that loss.
    Moreover, if a limitation on the allowance of Negative OID is 
applied to secondary-market purchasers, perhaps a similar limitation 
for initial purchasers will be needed to avoid disparate treatment of 
similarly situated holders (for example, initial purchasers and 
secondary-market purchasers that purchase shortly after original 
issuance at a price substantially the same as the issue price). 
However, such a limitation would also perpetuate many of the problems 
previously described.
    Any rule recognizing Negative OID would have to deal with a variety 
of collateral consequences, such as adjustments to the instrument's 
adjusted issue price and the holder's basis in the instrument to 
reflect any deduction for

[[Page 52215]]

Negative OID. Comments are requested concerning both the range of 
collateral consequences of recognizing Negative OID and the ways in 
which these consequences should be dealt with.

Allowing Section 166 Bad Debt Deduction

    Another way to more clearly reflect the income of holders of REMIC 
IOs would be to issue regulations under section 166 (which concerns 
deductions for bad debts). These rules might both determine when (prior 
to realization) a holder has sustained an economic loss and also allow 
a deduction for the loss under section 166.\5\ Section 166(a) provides 
a deduction for any debt that becomes wholly or partially worthless 
during the taxable year. Indeed, some holders of REMIC IOs have claimed 
deductions for partial worthlessness under section 166(a)(2) and Sec.  
1.166-3. The rules for determining worthlessness and partial 
worthlessness, however, were developed with reference to debts that 
become worthless or partially worthless because of the issuer's 
anticipated failure ever to make required payments, not because certain 
contingencies (such as rapid prepayments) have reduced the amounts 
required to be paid. Thus the existing regulations under section 166 
focus on whether a debt instrument is uncollectible and cannot be fully 
satisfied through foreclosure on collateral. See, for example, 
Sec. Sec.  1.166-2 and 1.166-6. By contrast, the existence of Negative 
OID for a REMIC IO is evidence that the amounts contractually owed 
under the terms of the instrument are being reduced, not that the 
holder cannot collect whatever amounts are so owed.
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    \5\ Section 165(g) allows a deduction for losses on worthless 
``securities,'' as defined in section 165(g)(2)(C). REMIC regular 
interests, however, fall outside this definition, because they are 
not issued by a government, a political subdivision, or a 
corporation. (Under section 860A(a), a REMIC is not treated as a 
corporation.)
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    Comments are invited regarding (1) whether, in the absence of any 
default by the issuer, the policy underlying the allowance of a 
deduction for worthlessness and partial worthlessness should be 
extended to a change in the amount that the issuer is required to pay, 
and (2) whether any rule allowing a deduction under section 166 can be 
extended to, or combined with, rules respecting corresponding income 
inclusions for REMICs and the timing of the inclusions.

Alternative Proposal Specific to REMIC IOs and Similar Instruments

    The foregoing discussion attempts to provide a method for 
recognizing interest income and deduction from a REMIC IO by altering 
an existing method applicable to traditional debt instruments. Although 
it may be possible to alter an existing method, doing so is difficult 
because existing methods are designed to apply to debt and a REMIC IO 
is unlike most debt. Furthermore, as previously indicated, altering an 
existing method often leads to collateral problems that must be 
addressed. Therefore, an alternative method created especially for 
REMIC IOs, and similar instruments, may better reflect the income and 
deductions for these instruments.
    Economically, a holder of a REMIC IO (like other investors) has 
invested cash in an instrument and expects to receive cash flows from 
that investment. What is distinctive about a REMIC IO is that the 
amount and duration of the cash flows are unknown at the time of making 
the investment. Given the economics of the REMIC IO, a method for 
distinguishing between receipt of income and recovery of the amount 
originally invested could be based on the projected (but uncertain) 
cash flows under the instrument and not on the expectation of a fixed 
return. The following method attempts to achieve that objective.
    First, the holder of a REMIC IO would include payments made on the 
REMIC IO in income as they are received. The holder would then be 
allowed an offset to any payments included in income for the period. 
The offset would be equal to an amount that bears the same ratio to the 
investment as the payments for the period bears to the total expected 
payments (based on a prepayment speed assumption). The total expected 
payments would be calculated each period, taking into account both an 
updated prepayment-speed assumption and any payments made on the REMIC 
IO. For this purpose, the investment is the total investment cost 
(i.e., the issue price).
[GRAPHIC] [TIFF OMITTED] TP25AU04.006

At the maturity of the IO, and perhaps at earlier times, a look-back 
regime may be appropriate to correct any under-or over-accrual of 
interest. See section 167(g)(2).
    For an example of this method, see the appendix.
    Comments are requested on two aspects of this IO-specific method in 
particular. First, can a variation of the method be applied to 
determine appropriate interest deductions for the REMIC? Second, in the 
typical REMIC IO, cash-flows start high and then decline to zero. For 
these instruments, the new method may clearly reflect income. One of 
the method's weaknesses, however, is that, unlike OID accrual 
generally, the method does not accrue OID prior to the receipt of the 
cash representing the OID. An issue exists as to what regime should 
apply if the application of existing regulations to tiered structures 
produces REMIC IOs the cash flows on which are not expected to begin 
until well after the issue date.

Secondary-Market Purchasers

    Unlike initial purchasers, taxpayers who acquire REMIC regular 
interests subsequent to issue may have to take into account not merely 
accruals of OID but a combination of OID and market discount or a 
combination of OID and acquisition premium. As discussed above, the 
issues concerning OID accruals and the possible recognition of Negative 
OID require separate consideration with respect to secondary-market 
acquisitions.
    The IRS and Treasury are considering alternative rules for the 
accrual of market discount attributable to REMIC IOs. One possible rule 
is to require accruals under a formula similar to the PAC method, 
including the use of a prepayment assumption and discount rate that 
remain static. However, instead of the projected prepayment speed and 
the projected yield to maturity being fixed as of the date on which the 
REMIC issues all of its regular interests, they would be fixed for a 
subsequently acquired REMIC IO at the time of the acquisition. 
Essentially a holder of a REMIC IO would apply the same methodology 
regardless of whether its acquisition was on the issue date (with the 
holder calculating OID based on estimates that were fixed on that date)

[[Page 52216]]

or on a subsequent date (with the holder calculating market discount 
based on estimates that were fixed on the subsequent acquisition date).
    If the amount of market discount is based on the revised issue 
price, as provided in section 1276(a)(2) and (4), the rules will need 
to integrate accrual of market discount (which will be specific to each 
holder) and accrual of OID (which will be the same for all holders). If 
the amount of market discount is based on remaining SRPM at the time of 
acquisition, accrual of the market discount will be a substitute for 
any OID accrual. In either case, a holder with any market discount will 
need substantial amounts of individualized data from the REMIC 
servicer. Comments are requested as to the REMIC servicer's ability to 
provide the necessary individualized data.
    It would be possible to revise the rules for accrual of market 
discount without adopting a rule recognizing Negative OID. As described 
above, however, if this recognition is permitted generally and is made 
available to secondary-market purchasers as well as initial purchasers, 
additional questions will be presented for secondary-market purchasers. 
These would include whether the amount of market discount should be 
redetermined and, if so, what the effect of that determination would be 
on collateral consequences of market discount such as the deferral of 
interest deductions under section 1277. One possibility would be to 
condition the recognition of Negative OID for secondary-market 
purchasers on an election by the holder to be taxable under the OID 
rules on both OID and market discount or premium. (See the election 
under Sec.  1.1272-3.)

Negative Yield Instruments

    The IRS and Treasury are aware that there are some REMIC IOs for 
which the prepayment speed that the servicer projected at the pricing 
date produces a projected negative yield. Arms-length investors do not 
voluntarily enter transactions with anticipated negative yields. 
Rather, such an investor may subjectively anticipate a different 
prepayment speed, or the investor may be ``making a bet'' on the 
occurrence of a prepayment scenario with a rate of return that more 
than compensates for its low probability of occurring. Mathematically, 
``discounting'' a cash flow at a negative yield produces a present 
value that is greater than the sum of the future values of the cash 
flow. Unmodified application of the PAC method would therefore be 
unreasonable because it would require the holder to include amounts in 
income that are based on unrealistically high deemed present values of 
future cash flows. Comments are requested on whether the PAC method 
should be altered by requiring the use of a discount rate that is no 
less than an economically reasonable discount rate or whether some 
other adjustment would be more appropriate.

Request For Comments

    The IRS and Treasury request comments on the desirability of 
adopting special rules for taxing REMIC IOs, high-yield REMIC regular 
interests, and apparent negative-yield instruments, and whether those 
special rules should also be applied to other similar instruments 
(including how to identify such similar instruments). Comments and 
suggestions are also requested regarding possible approaches to what 
additional special rules may be desirable, including the possible 
recognition of Negative OID, the formulation of special guidelines for 
the application of section 166 to REMIC IOs and similar instruments, 
and the adoption of a new alternative method applicable to REMIC IOs 
and similar instruments.
    Persons providing comments may want to consider, among other 
things, the following questions. Should recognition of Negative OID be 
limited to prior inclusions of OID, to prior inclusions of OID and 
market discount, or to some other amount? If any limit is imposed, 
should the limit apply to all holders or only to those who do not 
acquire their interests at original issue? If recognition of Negative 
OID by initial purchasers is limited to prior OID inclusions, should 
recognition of Negative OID be permitted for secondary-market 
purchasers to the extent of prior market discount inclusions as well as 
OID inclusions? If recognition of Negative OID is unlimited for initial 
purchasers, should it be limited for secondary-market purchasers? 
Should recognition of Negative OID for secondary-market purchasers 
result in a redetermination of a purchaser's market discount and, if 
so, should the redetermination affect the application of the interest 
deferral provisions in section 1277? Alternatively, is the situation 
addressed adequately by currently recognizing both Negative OID and 
currently accruing market discount? Should recognition of Negative OID 
by secondary-market purchasers be conditioned on an election to treat 
all discount and premium on the instrument as OID?

Nancy Jardini,
Deputy Commissioner for Services and Enforcement.

Appendix

Examples

Issue Price $8.97
Expected Yield 8.455%

    Expected Cash Flows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Year 0.......................................................     (8.97)
Year 1.......................................................       5.00
Year 2.......................................................       2.50
Year 3.......................................................       1.50
Year 4.......................................................       1.00
Year 5.......................................................       0.50
------------------------------------------------------------------------

    If pays as expected:

------------------------------------------------------------------------
                End  AIP                  Payments  Beg.  AIP     OID
------------------------------------------------------------------------
4.73...................................       5.00       8.97        .76
2.63...................................       2.50       4.73        .40
1.35...................................       1.50       2.63        .22
0.46...................................       1.00       1.35        .11
0......................................       0.50       0.46        .04
                                                              ----------
                                         .........  .........       1.53
------------------------------------------------------------------------
Actual Yield 8.455%.

    If pays faster than expected:

------------------------------------------------------------------------
                End  AIP                  Payments  Beg.  AIP     OID
------------------------------------------------------------------------
1.89...................................       5.00       8.97     (1.11)
1.05...................................       1.00       2.86     (0.35)
 0.54..................................       0.60       1.50     (0.19)
0.18...................................       0.40       0.72     (0.09)
0......................................       0.20       0.23     (0.03)
                                                              ----------
                                         .........  .........     (1.77)
------------------------------------------------------------------------
Actual Yield -12.397%.

    Holder's OID Income under Current Rules (w/ Negative OID 
prohibition):

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Year 1.......................................................          0
Year 2.......................................................          0
Year 3.......................................................          0
Year 4.......................................................          0
Year 5.......................................................          0
------------------------------------------------------------------------
1.77 loss at maturity.

    Holder's OID income under Proposal allowing Negative OID:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Year 1.......................................................  \1\(2.08)
Year 2.......................................................       0.16
Year 3.......................................................       0.09
Year 4.......................................................       0.05
Year 5.......................................................       0.02
------------------------------------------------------------------------
\1\ Loss.
Overall income (1.77).

Alternative Method Example

Examples

Investment/Issue Price $8.97
Expected Yield 8.455%
Total expected return: $10.50


[[Page 52217]]



Example 1

    Expected Cash Flows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Year 0.......................................................     (8.97)
Year 1.......................................................       5.00
Year 2.......................................................       2.50
Year 3.......................................................       1.50
Year 4.......................................................       1.00
Year 5.......................................................       0.50
------------------------------------------------------------------------

(Offset amounts in bold.)

Year 1

payments for year/total expected payments = 5/10.5 = .47
ratio multiplied by investment = .47(8.97) = 4.27

Year 2

2.5/10.5 = .23
.23(8.97) = 2.14

Year 3

1.5/10.5 = .143
.143(8.97) = 1.28

Year 4

1/10.5 = .095
.095(8.97) = .85

Year 5

.5/10.5 = .047
.047(8.97) = .43

[4.27 + 2.14 + 1.28 + .85 + .43 = 8.97]

Example 2

    If the expected return is not updated, the holder won't recover 
its investment.
    Actual Cash Flows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Year 0.......................................................     (8.97)
Year 1.......................................................       5.00
Year 2.......................................................       1.00
Year 3.......................................................       0.60
Year 4.......................................................       0.40
Year 5.......................................................       0.20
------------------------------------------------------------------------

Year 1

5/10.5 = .48
.48(8.97) = 4.27

Year 2

1/10.5 = .095
.095(8.97) = .85

Year 3

.6/10.5 = .06
.06(8.97) = .51

Year 4

.4/10.5 = .04
.04(8.97) = .34

Year 5

.2/10.5 = .02
.02(8.97) = .17

[4.27 + .85 + .51 + .34 + .17 = 6.14]

Example 3

    If you update the expected return after year 1:
    Actual Cash Flows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Year 0.......................................................     (8.97)
Year 1.......................................................       5.00
Year 2.......................................................       1.00
Year 3.......................................................       0.60
Year 4.......................................................       0.40
Year 5.......................................................       0.20
------------------------------------------------------------------------

Year 1

5/10.5 = .48
.48(8.97) = 4.27

    After year 1, total expected return is 7.20 (5 + 1 + .6+ .4 + 
.2):

Year 2

 1/7.2 = .14
.14(8.97) = 1.25

Year 3

.6/7.2 = .08
.08(8.97) = .75

Year 4

.4/7.2 = .06
.06(8.97) = .50

Year 5

.2/7.2 = .03
.03(8.97) = .25

[4.27 + 1.25 + .75 + .50 + .25 = 7.02]

    If the holder recalculates Year 1, using the new total expected 
return ((5/7.2)(8.97)) = 6.23), and takes into account the 
difference between that amount (6.23) and the amount calculated 
using the original expected return (4.27), which equals 1.96, the 
holder will recover its total investment.

[FR Doc. 04-19480 Filed 8-24-04; 8:45 am]
BILLING CODE 4830-01-P