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Individual Tax

IRS provides election to allow certain investors to meet diversification requirement

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

Rev Proc 2018-54, 2018-45 IRB

In a Revenue Procedure, IRS has provided guidance and procedural rules for taxpayers that hold investments in one or more segregated asset accounts on which variable contracts are based. The guidance and rules allows these taxpayers to elect to treat certain mortgage-backed securities as having deemed issuers for purposes of the diversification requirements of Code Sec. 817(h) (the deemed-issuance-ratio election).

Background on diversification requirement. Code Sec. 817(h) provides that a variable contract (other than a pension plan contract) that is otherwise described in Code Sec. 817 and that is based on a segregated asset account will not be not treated as an annuity, endowment, or life insurance contract for any period (and any later period) for which the investments made by the account are not adequately diversified. A segregated asset account consists of all assets the investment return and market value of each of which must be allocated in an identical manner to any variable contract invested in any of such assets. (Reg § 1.817-5(e))

Reg § 1.817-5(b)(1) provides that the investments of a segregated asset account are considered adequately diversified only if a set percent of the value of the total assets of the account is represented by any one, two, three, or four investments (for example, no more than 70% of the value of the total assets of the account is represented by any two investments). All securities of the same issuer are treated as a single investment. (Reg § 1.817-5(b)(1)(ii)(A)) Under Reg § 1.817-5(c)(1), an account is treated as adequately diversified for a calendar quarter if it satisfies the requirements of Reg § 1.817-5(b) on the last day of the calendar quarter or within 30 days after that last day.

Under Code Sec. 817(h)(6), for purposes of determining whether a segregated asset account is adequately diversified, each U.S. Government agency or instrumentality is treated as a separate issuer.

Reg § 1.817-5(f)(1) provides a look-through rule for assets held through certain investment companies, partnerships, or trusts. For this purpose, the term “investment company, partnership, or trust” refers to a regulated investment company (RIC), a real estate investment trust (REIT), a partnership, or a trust that is treated under Code Sec. 671 through Code Sec. 679 as owned by the grantor or another person. The look-through rule generally applies to an investment company, partnership, or trust in which all the beneficial interests are held by one or more segregated accounts and for which public access to the entity is available exclusively through the purchase of a variable contract. If the look-through rule applies, a beneficial interest in an investment company, partnership, or trust is not treated as a single investment of a segregated asset account.

Background on the Single Security Initiative. Under the direction of the Federal Housing Finance Agency (FHFA), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae, and together with Freddie Mac, the GSEs) will develop a common mortgage-backed security (the Single Security Initiative). As part of the Single Security Initiative, key features and terms of Freddie Mac’s securities will be aligned with those of Fannie Mae’s securities to create new Uniform Mortgage Backed Securities (UMBS). UMBS will be issued by both GSEs with substantially similar terms. UMBS would trade primarily in the “To-Be-Announced” (TBA) market.

As part of the Single Security Initiative, the GSEs will combine their programs for fixed-rate Participation Certificates (PCs, i.e., mortgage-backed securities currently issued by Freddie Mac) and Mortgage-Backed Securities (MBSs, i.e., similar securities currently issued by Fannie Mae) into a new single mortgage-backed security program in which both GSEs will issue UMBS having substantially similar features and terms, including identical remittance cycles. Once UMBS begin trading in the TBA market, the parameters for unstipulated TBA trades in UMBS will exclude specification of the issuer. As a result, investors that acquire UMBS in unstipulated TBA trades will not know the issuer (Fannie Mae or Freddie Mac) until the security to be delivered is identified 48 hours prior to settlement.

Thus, suppose that an insurance company enters into unstipulated TBA trades to acquire GSE securities for inclusion in a segregated asset account on which one or more contracts issued by the company are based. Once the Single Security Initiative is effective, such a company will not know until 48 hours before settlement the issuers of the UMBS to be delivered to it under the contract. If the account is already heavily invested in securities issued by one of the GSEs, the TBA contract may require acceptance of additional securities of that issuer — an acceptance that may jeopardize the segregated asset account’s satisfaction of the diversification requirements of Code Sec. 817(h) and its regs.

New guidance. Rev Proc 2018-54 allows a taxpayer to make a deemed-issuance-ratio election with respect to its generic GSE securities. (Rev Proc 2018-54, Section 5) A “generic GSE security” is a TBA-eligible GSE security that a buyer acquires by taking delivery pursuant to a TBA trade in which, at the time that the buyer entered into the TBA contract, the buyer had no way of knowing the actual issuer(s) of the securities to be delivered under the contract.

For purposes of applying Code Sec. 817(h) and its regs, the following consequences apply to the extent that an electing taxpayer’s generic GSE securities either: (a) are held in a segregated asset account on which a variable contract issued by the taxpayer is based; or (b) are treated under Reg § 1.817-5(f) as being held in a segregated asset account on which a variable contract issued by some other person is based: (Rev Proc 2018-54, Section 6.01)

…If an electing taxpayer holds a generic GSE security, that security is deemed to be issued in part by Fannie Mae and in part by Freddie Mac. Except to the extent provided in Rev Proc 2018-54, Section 6.02(2), the portions deemed issued by each are determined by the deemed-issuance ratio that was applicable to the year in which the taxpayer entered into the TBA contract under which the generic GSE security was to be delivered. It is irrelevant which GSE is the actual issuer of the generic GSE securities that are delivered under the TBA contract. (Rev Proc 2018-54, Section 6.02(1))

…In the case of a taxpayer that is a buyer by virtue of being a successor entity (as defined in Rev Proc 2018-54, Section 3.04(2)), if such a taxpayer acquired a generic GSE security in the succession transaction, then the security retains the same deemed-issuance ratio in that taxpayer’s hands that it had in the hands of the predecessor. (Rev Proc 2018-54, Section 6.02(2))

…As long as the electing taxpayer continues to hold a generic GSE security, the security’s deemed-issuance ratio remains constant. Thus, (1) as an electing taxpayer’s generic GSE securities pay down, the remaining balance of each retains its deemed-issuance ratio, regardless of any pre-payments or foreclosures made on the generic GSE securities and the actual issuers of remaining generic GSE securities; (2) if the electing taxpayer disposes of some of its generic GSE securities, the deemed-issuance ratio of each remaining generic GSE security does not vary. (Rev Proc 2018-54, Section 6.02(3))

…If a generic GSE security held by an electing taxpayer is aggregated into a pool of mortgage-backed securities as part of a GSE resecuritization program and new securities are issued, then the issuer of the new security is the known GSE that issued the resecuritization security, and the deemed-issuance ratio no longer applies to the old security in its role as a component of the resecuritization pool. To the extent a new resecuritization security is delivered into a generic TBA trade (with the issuer unknown by the taxpayer at the trade date), a taxpayer that has made a deemed-issuance-ratio election treats the resecuritization security consistent with the deemed-issuance rule. (Rev Proc 2018-54, Section 6.02(4))

…At least three weeks prior to the start of each calendar year, FHFA will determine and publicize the deemed-issuance ratio that electing taxpayers are to use for TBA contracts entered into during that calendar year. FHFA will determine this ratio based on the ratio of TBA-eligible securities issued by Fannie Mae and Freddie Mac during a 24-month period ending not earlier than October 31 immediately preceding the year to which the new ratio will apply. The ratio must be two whole numbers. FHFA may round the observed ratio in the data to whatever extent FHFA considers appropriate, provided that the rounded ratio to be used is further from 50-50 than the actual observed data. (Rev Proc 2018-54, Section 6.02(5))

Making the election. A deemed-issuance-ratio election must be made in a statement attached to the taxpayer’s income tax return for the first tax year for which the taxpayer wants the election to apply. The statement must be titled “Section 817(h) Deemed-Issuance-Ratio Election.” The statement must indicate that the taxpayer elects the deemed-issuance-ratio election (as described in Rev Proc 2018-54) and must include the taxpayer’s name, address, and TIN. If the common parent (or agent) of a group of corporations filing a consolidated return is making the election on behalf of one or more members of the consolidated group, the parent must indicate the name, address, and taxpayer identification number of each consolidated group member for which the election is being made. (Rev Proc 2018-54, Section 7.01)

A deemed-issuance-ratio election is applicable to all of the electing taxpayer’s generic GSE securities acquired under TBA contracts that were entered into for quarters ending in the year specified in the election and for quarters ending in all subsequent taxable years for which the election is effective. (Rev Proc 2018-54, Section 7.02)

A deemed-issuance-ratio election is revocable only with IRS’s prior written consent. To request such consent, the electing taxpayer (or successor) must submit a request for a private letter ruling in accordance with the provisions of Rev Proc 2018-1, 2018-1 IRB 1 (or its then-applicable successor). (Rev Proc 2018-54, Section 7.03)

Effective date. Rev Proc 2018-54 is effective for elections with respect to quarters ending on or after the date on which investors can first enter into TBA contracts that do not specify the issuer of the GSE securities that may be delivered under it. (Rev Proc 2018-54, Section 8)

References: For the diversification requirements for variable contracts, see FTC 2d/FIN ¶E-5054.

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