[Federal Register Volume 71, Number 151 (Monday, August 7, 2006)]
[Proposed Rules]
[Pages 44600-44602]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-12789]
[[Page 44600]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-109367-06]
RIN 1545-BF52
Section 1221(a)(4) Capital Asset Exclusion for Accounts and Notes
Receivable
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 that clarify the
circumstances in which accounts or notes receivable are ``acquired * *
* for services rendered'' within the meaning of section 1221(a)(4) of
the Internal Revenue Code. This document also provides a notice of
public hearing on these proposed regulations.
DATES: Written or electronic comments must be received by November 6,
2006. Outlines of topics to be discussed at the public hearing
scheduled for November 7, 2006, must be received by October 17, 2006.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-109367-06), room
5203, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Alternatively, taxpayers may submit comments
electronically via the IRS Internet site at http://www.irs.gov/regs or
via the Federal eRulemaking Portal at http://www.regulations.gov (IRS-
REG-109367-06). The public hearing will be held in the New Carrollton
Auditorium, 5000 Ellin Road, Lanham, Maryland.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
K. Scott Brown (202) 622-3920 (not a toll-free number); concerning
submissions of comments, the hearing, and/or to be placed on the
building access list to attend the hearing, e-mail:
[email protected].
SUPPLEMENTARY INFORMATION:
Background and Explanation of Provisions
I. Section 1221(a)(4) Language, Legislative History, and Regulations
Section 1221 defines a capital asset as all property held by a
taxpayer unless specifically excepted. Section 1221(a)(4) treats
accounts or notes receivable acquired in the ordinary course of trade
or business for services rendered or from the sale of property
described in section 1221(a)(1) as ordinary assets.
Congress enacted section 1221(a)(4) in 1954 to correct a character
mismatch problem. Before its enactment, the value of accounts or notes
receivable acquired for rendering services or selling inventory was
taken into account by a taxpayer as ordinary income, but gain or loss
on a later disposition of the receivables was given capital treatment.
Section 1221(a)(4) corrected this mismatch by treating the accounts or
notes receivable as ordinary assets.
The legislative history confirms this limited focus by referring
explicitly to accounts and notes receivable acquired ``in payment for''
inventory or services rendered by the holder. The specific problem
being addressed by the enactment of section 1221(a)(4) was described in
the House Report:
Paragraph (4) is a new provision which excepts from the
definition of capital assets accounts or notes receivable acquired
in the ordinary course of trade or business for services rendered or
from the sale of property described in paragraph (1), that is, stock
in trade or inventory or property held for sale to customers in the
ordinary course of trade or business. This will change present law
treatment, for example, as follows: If a taxpayer acquires a note or
account receivable in payment for inventory or services rendered,
reports it as income and sells it at a discount, then this amendment
will provide ordinary loss treatment. Under present law such loss
treatment is only allowed if the taxpayer is also, in effect, a
dealer in such accounts or notes. Alternatively, the taxpayer may
sell the account or note for something more than the discounted
value that was originally reported. Under present law this
difference would be capital gain unless the taxpayer is such a
dealer. The amendment will cause such gain to be ordinary income.
H.R. Rep. No. 1337, 83d Cong., 2d Sess., A273-74 (1954).
The longstanding regulation interpreting section 1221(a)(4) also
confirms this limited focus. Section 1.1221-1(a) of the Income Tax
Regulations states that the term capital assets includes all classes of
property not specifically excluded by section 1221. Section 1.1221-
1(d), which addresses the section 1221(a)(4) exclusion, repeats the
statutory language of section 1221(a)(4) and then interprets it to
apply as follows:
Thus, if a taxpayer acquires a note receivable for services
rendered, reports the fair market value of the note as income, and
later sells the note for less than the amount previously reported,
the loss is an ordinary loss. On the other hand, if the taxpayer
later sells the note for more than the amount originally reported,
the excess is treated as ordinary income.
II. Expansion of Section 1221(a)(4)
Notwithstanding the above, section 1221(a)(4) has been applied more
expansively. The initial expansion occurred with respect to notes
obtained in loan originations. In Burbank Liquidating Corp. v.
Commissioner, 39 T.C. 999 (1963), acq. sub nom. United Assocs., Inc.,
1965-1 CB 3, aff'd. in part and rev'd. in part on other grounds, 335
F.2d 125 (9th Cir. 1964), the Tax Court held that mortgage loans
originated by a savings and loan association in the ordinary course of
its business were, in the hands of that association, ordinary assets
under section 1221(a)(4) because they were notes receivable acquired
for the service of making loans. In addition to acquiescing to the
decision, the Service relied upon Burbank Liquidating in a series of
revenue rulings treating loans made by commercial lenders (including
banks and REITs) as ordinary assets under section 1221(a)(4) when held
by the original lender. See Rev. Rul. 72-238 (1972-1 CB 65); Rev. Rul.
73-558 (1973-2 CB 298); Rev. Rul. 80-56 (1980-1 CB 154); Rev. Rul. 80-
57 (1980-1 CB 157). See Sec. 601.601(d)(2) of this chapter.
Historically, a lending transaction was sometimes thought of as
rendering a service to the borrower. See Rev. Rul. 70-540 (1970-2 CB
101); Rev. Rul. 69-188 (1969-1 CB 54); Rev. Rul. 68-6 (1968-1 CB 325).
That characterization, however, does not justify treating notes
acquired by an originator in a lending transaction as ordinary assets
under section 1221(a)(4). That treatment strains the language of the
statute because the notes are not issued by borrowers solely or even
predominantly for services rendered. Rather, the notes are, for the
most part, issued by the borrower to the lender in exchange for money.
Subsequently, the Tax Court further extended the application of
section 1221(a)(4) in Federal National Mortgage Association v.
Commissioner, 100 T.C. 541 (1993) (FNMA), by applying that provision to
notes that were purchased in transactions that the court considered
closely associated with the process of origination. Although FNMA was
not an originator, the court used the Burbank Liquidating analysis to
extend section 1221(a)(4) treatment to mortgages purchased by FNMA. The
court justified this result by pointing out that FNMA's purchasing
activity was undertaken in accordance with its statutorily defined
purpose ``to provide supplementary assistance to the secondary market
for home mortgages by providing a degree of liquidity for mortgage
investments.''
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FNMA, 100 T.C. at 545 (quoting the Housing Act of 1954, ch. 649, title
II, section 201, 12 U.S.C. 1716(a)). Because of this purpose, the court
concluded that the purchases were ``a service to the mortgage lending
business and the members thereof.'' Id. at 578.
The expansion of section 1221(a)(4) cannot be reconciled with
Congress' stated purpose for enacting the statute. Acquisition of notes
or mortgages using consideration other than services or section
1221(a)(1) property generally does not trigger current ordinary income
and so does not create a potential for the character mismatch that
concerned Congress when it enacted section 1221(a)(4).
The proposed regulation reflects a conclusion by the Treasury
Department and the IRS that the extension of section 1221(a)(4) to
notes acquired by a creditor in a lending transaction or to notes
purchased in the secondary market is inconsistent with Congressional
intent and is unsound as a matter of tax policy. In addition, the
interpretation of section 1221(a)(4) set forth in Burbank Liquidating
and FNMA impedes effective administration of the tax laws by causing
the status of the notes to hinge on judgments as to whether the lending
transaction or a subsequent secondary market purchase of the notes
provides a service to the borrower or the mortgage lending industry.
Reliance on judgments such as this fosters uncertainty and disputes.
Accordingly, the proposed regulation clarifies that an account or
note receivable is not described in section 1221(a)(4) if, in exchange
for the account or note receivable, the taxpayer provides more than de
minimis consideration other than services or property described in
section 1221(a)(1), or if the account or note receivable is not issued
by the party acquiring the services or property described in section
1221(a)(1). In particular, a note is not acquired for services within
the meaning of section 1221(a)(4) on the grounds that the taxpayer's
act of acquiring (including originating) the account or note receivable
constitutes, or includes, the provision of a service or services to the
issuer of the account or note receivable, to the secondary market in
which accounts or notes receivable of this sort may trade, or to the
participants in that market.
Effect on Other Documents
Rev. Rul. 72-238 and Rev. Rul. 73-558 are not determinative with
respect to future transactions because these rulings apply to taxable
years beginning before July 12, 1969, and were superseded by section
582(c) of the Internal Revenue Code of 1986. Accordingly,
simultaneously with the publication of these proposed regulations,
those rulings are being declared obsolete. When final regulations are
published, the IRS will determine whether Rev. Rul. 80-56 and 80-57
should similarly be declared obsolete.
Proposed Effective Date
These regulations are proposed to apply to accounts or notes
receivable acquired after the date the final regulations are published
in the Federal Register.
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 regulation does not impose a collection of information on small
entitles, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply. Pursuant to section 7805(f) of the Code, this notice of proposed
rule making 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 written comments (a signed original
and eight (8) copies) or electronic comments that are submitted timely
to the IRS. The Treasury Department and IRS invite comments on the
proposed effective date, on the impact of the proposed regulation on
hedging practices of lending institutions or other taxpayers to which
section 582(c) does not apply, and on appropriate measures to deal with
that impact. Comments are specifically requested from taxpayers in the
acceptance finance, debt collection, factoring and personal finance
industries on any impact that the proposed regulation may have. The
Treasury Department and the IRS also specifically request comments on
the clarity of the proposed rules and how they can be made easier to
understand. All comments will be available for public inspection and
copying.
A public hearing has been scheduled for November 7, 2006, beginning
at 10 a.m. in the New Carrollton Auditorium, 5000 Ellin Road, Lanham,
Maryland. 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 written or
electronic 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 17, 2006. 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 author of these proposed regulations is K. Scott
Brown, Office of the Associate Chief Counsel (Financial Institutions
and Products). However, other personnel from the IRS and 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 continues to read,
in part, as follows:
Authority: 26 U.S.C. 7805 * * *.
Par. 2. Section 1.1221-1 is amended as follows:
1. Paragraph (e) is redesignated as (f).
2. A new paragraph (e) is added.
The addition reads as follows:
Sec. 1.1221-1 Meaning of terms.
(e)(1) An account or note receivable is not described in section
1221(a)(4) if--
(i) In acquiring the account or note receivable, the taxpayer
provides more than de minimis consideration other than services or
property described in section 1221(a)(1); or
(ii) The obligor under the account or note receivable is a person
other than the person acquiring the services or property described in
section 1221(a)(1).
[[Page 44602]]
(2) In particular, an account or note receivable is not described
in section 1221(a)(4) on the grounds that the taxpayer's act of
acquiring (including originating) the account or note receivable
constitutes, or includes, the provision of a service or services to the
issuer of the account or note receivable, to the secondary market in
which accounts or notes receivable of this sort may trade, or to the
participants in that market. If a lender, however, separately invoiced
reasonable fees for services that the lender rendered to the borrower
in connection with a lending transaction and if the lender received as
evidence of the obligation to make payment of those fees an account or
note receivable that is separate from the debt instrument that was
originated in the lending transaction, then this paragraph (e)(2) does
not prevent the separate account or note receivable from being
described in section 1221(a)(4).
(3) This paragraph (e) applies to accounts or notes receivable
acquired after the date the final regulations are published in the
Federal Register.
* * * * *
Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E6-12789 Filed 8-4-06; 8:45 am]
BILLING CODE 4830-01-P