[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]



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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).

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    (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