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Recent Financial Products
Developments
Jeff Callender
Partner
Deloitte Tax LLC
June 25, 2008
Agenda
Prop. Reg. 1.1221-1(e) withdrawal
Debt market turmoil and tax straddles
Other developments
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Proposed Reg. 1.1221-1(e)
Withdrawal
Burbank Liquidating Corp.
 In Burbank Liquidating, the Tax Court in March
1963 considered whether mortgage loans
originated by Burbank in its trade or business were
acquired “for services” such that they were within
the scope of sec. 1221(4) (current 1221(a)(4))
 The Tax Court concluded that such mortgage loans
were “for services”, because the “business of a
savings and loans company could properly be
described as “rendering the service of making
loans.””
 Ninth Circuit court affirmed this holding in July
1964.
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Fannie Mae
 Tax Court in June 1993 directly considered whether
the “for services” rationale of Burbank Liquidating
should apply to Fannie Mae’s facts.
 Unline the taxpayer in Burbank, Fannie Mae did not
originate loans, but instead purchased mortgages
and mortgage-related securities in the secondary
markets to further its US Government chartered
purpose of providing liquidity to the mortgage
markets (i.e., to the originators of mortgage loans).
 Tax Court held that the mortgages and related
securities in Fannie Mae’s portfolio were acquired
“for services” with the meaning of sec. 1221(4)
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Proposed Reg. sec. 1.1221-1(e)
 On August 7, 2006, the Treasury Dept. and the IRS
published this proposed regulation under sec. 1221(a)(4).
 These proposed regulations sought to “clarify” the
circumstances in which accounts or notes received are
“acquired … for services rendered”.
 Defined to not include the acquisition of a note in the
provision of services to the secondary market (i.e. the
Fannie Mae fact pattern).
 The Proposed Reg. was effectively a public statement that
Treasury and the IRS were not going to follow the Fannie
Mae case because they believed it was not Congress’ intent
and was bad tax policy.
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Withdrawal of the Proposed Regs
 Treasury/IRS withdrawal of the Proposed Regs was
announced April 22, 2008 (published as
Announcement 2008-41 on May 12, 2008).
 Overwhelming positive response from taxpayers
and practitioners.
 In Announcement, Treasury/IRS stated that they
would not challenge tax return positions that apply
existing law re sec. 1221(a)(4), including positions
based on Burbank Liquidating and Fannie Mae.
 Treasury/IRS will continue to study this area and
may issue guidance in the future.
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Debt market turmoil and
tax straddles
Sec. 1092 – Tax straddles
 Tax straddle defined as offsetting positions which
effect a “substantial diminution” of risk of holding
the other position (in property “of a type” that is
actively traded).
 Significant discussion as to how much risk
reduction is required in order to form a tax straddle.
 Various views abound, but most conservative view
is to use a standard similar to the “substantial
authority” opinion standard, i.e. 35 – 50% risk
reduction is enough to constitute a straddle.
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Client straddle question – March 2007
 Client hedge fund was pursuing a strategy of
acquiring certain debt and mortgage pools and
mortgage backed securities and reducing the
interest rate risk by entering into interest rate
swaps.
 Client maintained that they were reducing only a
small percentage of the overall risk of their
investments, and therefore did not have straddles.
 Client provided stress tests of various risks,
including interest rate, liquidity and counterparty
risks, increasing and decreasing the basis point
stresses by 50 bp increments.
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Tax straddle – Conclusion, March 2007
 After reviewing the client produced stress tests of
all the types of risks, we agreed that reducing the
interest rate risk using swaps only reduced a small
fraction, like around 5 -8%, of the overall risk, and
thus we agreed that there were no tax straddles.
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Tax straddles – Final result
 Unfortunately, the client’s assertions and our
conclusions were born out with the debt market
turmoil starting in the second half of 2007.
 The fund suffered severe liquidity losses and closed
in early 2008.
 Moral of the story: Don’t assume that if a debt
security has interest rate exposure removed with
interest rate swaps, that a straddle is always
formed. The debt market turmoil we are
experiencing is proving that there are many other
types of risk that must be taken into account.
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Other Developments
Speaker information
 Jeff Callender, 212-436-3465,
[email protected]
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