Mortgage warranty reserves are not section 475 losses

Plain-English summary

A mortgage originator and seller recorded aggregate reserves for contractual obligations to repurchase defective mortgages or indemnify purchasers when representations and warranties were breached. It treated those reserves as section 475 mark-to-market losses, arguing that purchasers had acquired separate put options along with the mortgages. Chief Counsel concluded that the warranty and remedy provisions were integral to the mortgage sale contracts, not independent derivative financial instruments or severable options. The taxpayer was bound by the sale form it had chosen, and the reserve losses could not be claimed as section 475 losses.

Ruling snapshot

• Question: Were reserves for mortgage repurchase and indemnity obligations mark-to-market losses on securities under section 475?
• Outcome: Advice given, the reserves were not section 475 losses
• Key authorities: IRC §§ 461(h), 475(c); Treas. Reg. §§ 1.461-1(a)(2), 1.461-4

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 201529006
Release Date: 7/17/2015
CC:FIP:B06:GECho
POSTF-131767-14

UILC: 475.05-00

date: April 08, 2015

to: Jack Forsberg, Senior Counsel
(Large Business & International)

from: Patrick White, Senior Counsel
(Financial Institutions & Products)

subject: Treatment of Warranty Obligation Reserve As Section 475 Losses

This Chief Counsel Advice responds to your request for assistance dated January 8,
2015. This advice may not be used or cited as precedent.

LEGEND

Taxpayer = -------------------------------------
Year 1 = -------
Year 2 = -------

ISSUE

Whether the book reserve losses reported by Taxpayer with respect to its repurchase
and indemnity obligations arising from the breach of mortgage sale contract warranty
and representations (W&R Obligations) were properly treated as section 475 mark-to-
market losses on securities.

CONCLUSION

The book reserve losses reported by Taxpayer from its repurchase and indemnity
obligations arising from the breach of W&R Obligations were not properly treated as
section 475 mark-to-market losses on securities.

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FACTS

Taxpayer originated and sold mortgages prior to and during years under audit to private
investors and other large purchasers. Under the terms of the sales contracts or other
relevant documents, purchasers were generally entitled to force the repurchase of the
mortgages by Taxpayer and/or pursue other indemnification from Taxpayer to
compensate for Taxpayer’s (or other originator’s) breach of warranties and
representations that caused the value of the mortgages to be materially and adversely
impaired. Typically asserted defects included those involving failures to follow proper
underwriting or valuation standards. Taxpayer made numerous representations and
warranties related to the appraisal, insurance, underwriting and general quality of the
mortgage loans and the underlying mortgaged property.

The agreements generally prescribed procedures by which Taxpayer had to make
purchasers whole for any material breach, including providing purchasers the right to
demand Taxpayer to repurchase defective mortgages and indemnify the purchaser for
costs. Some purchasers had a formal process by which they would request review of
mortgage files associated with defective mortgages. The full process allowed for
appeals and the negotiation over remedies, independent of forcing the repurchase of
defective mortgages. Taxpayer expended considerable resources challenging
repurchase demands, frequently averting repurchase with its appeals.

The parties to the representative agreement stipulated that Taxpayer’s obligations to
cure, substitute or repurchase defective mortgage loans and to indemnify the purchaser
constituted the sole remedies respecting Taxpayer’s breach of its warranties. The
agreement stipulated that, unless otherwise agreed to by the purchaser and Taxpayer,
the repurchase price was the stated principal balance of the relevant mortgage, unpaid
stated interest, plus all reasonable and necessary costs incurred by the purchaser that
arose from the breach. Any cause of action related to breach of the W&R Obligations
accrued upon (a) discovery of the breach by the purchaser or notice given by Taxpayer,
(b) failure by Taxpayer to cure or repurchase, and (c) demand by the purchaser that
Taxpayer comply with the agreement.

The representative agreement expressly stated that Taxpayer’s intent was to undertake
a sale of mortgages and not the issuance of a debt instrument or the sale of another
security. It further stated that the parties intended to treat the transactions for
accounting and Federal income tax purposes as sales of mortgage loans. The
agreement made provision for payment of the purchase price of mortgage loans at
closing, but not for the payment of premium for the purchase of options. Consistent
therewith, the W&R Obligations were not reported or described as securities in
Taxpayer’s public reporting.

For book purposes, Taxpayer estimated and reported an aggregate loss reserve for its
W&R Obligations. In calculating the reserve, which it determined on an undiscounted
basis, Taxpayer evaluated trends in defaults, repurchase demand activity, successful

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appeal rates, actual losses, market conditions, and such other factors that it judged
significant.

Taxpayer’s Position -- Taxpayer contends that the W&R Obligations were securities
under section 475(c)(2)(E). In filing its Year 1 and Year 2 returns, Taxpayer took the
position that its aggregate reported book loss reserve for its W&R Obligations
represented section 475 mark-to-market losses on securities. Taxpayer maintains that,
“as part of each sale, the purchaser acquires a derivative right to put the loans back to
Taxpayer for originations that are defective and breach the representations and
warranties in the sales contracts.” In essence, Taxpayer contends that the sales
contract remedies, which include the right of a purchaser of mortgages to demand
repurchase for breach, should be viewed as separate securities upon which gain or loss
is determined under section 475.1 It follows from Taxpayer’s argument that the
purchasers of the mortgages not only acquired the mortgages in the sales contract but
also purchased separate put options on such mortgages.

LAW AND ANALYSIS

For an accrual basis taxpayer to properly claim a deduction for a liability, the liability
must be incurred; that is, it must meet the all events test and economic performance
requirements in section 461(h) and Treas. Reg. § 1.461-1(a)(2). A liability is incurred in
the taxable year in which (1) all the events have occurred that established the fact of the
liability, (2) the amount of the liability can be determined with reasonable accuracy, and
(3) economic performance has occurred with respect to the liability. Treas. Reg. §§
1.461-1(a)(2) and 1.461-4.2

A securities dealer is generally required by section 475(a)(2) to mark any security which
it holds at the close of the taxable year so that such dealer recognizes any gain or loss
as if such security were sold for its fair market value on the last business day of such
taxable year. Section 475(a) requires that proper adjustment shall be made in the

1
It is not known whether Taxpayer would contend that the W&R Obligations should be viewed as puts on
pools of mortgages or, perhaps more consistent with the definition of an option, a series of options on
each sold mortgage in a pool.
2
The reserve for warranty losses on the sale of the mortgages would not be properly treated as either a
deduction or reduction of sales price. See Bell Electric Co. v. Commissioner, 45 T.C. 158, 166 (1965)
th
(declining to follow Schuessler v. Commissioner, 230 F.2d 722 (5 Cir. 1956)):

[T]he basic question is simply whether a taxpayer may exclude from current income amounts
actually received or accrued merely because future expenditures may offset such amounts in part
or in whole. The statute does not permit the deferral of such income to be offset in a later year by
expenses incurred in that later year; nor does it permit the same result to be reached by
excluding a portion of the receipts from current income through the medium of crediting such
excluded amounts to a reserve for future expenditures which are thus in effect deducted prior to
the time they are actually made or incurred.

See generally United States v. General Dynamics, 481 U.S. 239 (1987).

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amount of any gain or loss subsequently realized for gain or loss taken into account by
the mark.

A dealer in securities is defined by section 475(c)(1) to be a taxpayer who regularly
purchases securities from or sells securities to customers in the ordinary course of a
trade or business or regularly offers to enter into, assume, offset, assign or otherwise
terminate positions in securities with customers in the ordinary course of a trade or
business.

Section 475(c)(2) broadly defines the term “security.” As relevant here, a security
includes a note, bond, debenture, or other evidence of indebtedness as described in
section 475(c)(2)(C). Under section 475(c)(2)(E), a security further includes an
evidence of an interest in, or a derivative financial instrument in any security described
in section 475(c)(2)(C), or any currency, including any option, forward, contract, short
position, and any similar financial instrument in such a security or currency.

The W&R Obligations Were Not Section 475 Securities

The W&R Obligations were not securities described in section 475.

Taxpayer Should Not Be Permitted To Disavow the Form of Its Transaction

Taxpayers generally are bound to the form of their transactions. See Commissioner v.
National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974). The Service,
however, is not necessarily so bound and can make adjustments to reflect a transaction’s
true substance. Gregory v. Helvering, 293 U.S. 465, 469-70 (1935); Knetsch v. United
States, 364 U.S. 361, 366 (1960); Interlochen Co. v. Commissioner, 232 F.2d 873, 877
(4th Cir. 1956) ("[T]he Commissioner or the courts may look through the form of a
transaction to the substance thereof," but the choice to disregard its classification of a
transaction "does not lie with the taxpayer").

In form, Taxpayer’s W&R Obligations were standard provisions in mortgage sales
contracts designed to provide purchasers compensation for Taxpayer’s failure to deliver
mortgages of the quality that the purchasers bargained for. The W&R Obligations were
material and integral to the sales contracts, not independent financial instruments,
investments, positions or bets on the value of those mortgages. The value of the W&R
Obligations was generally derived from the mortgage loans, but that value was not
realizable but for a breach by Taxpayer of a relevant obligation, discovery and failure to
cure. Thus, unlike the value of options or similar derivative financial instruments, the
value of the W&R Obligation is generally driven by non-market forces including things
like discovery of a breach, failure to cure, negotiations and the quality of appeal
arguments.

Neither the W&R Obligation terms nor any others in the representative agreement
suggest that the parties intended that a separate option (or more aptly, a series of

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separate options) or other similar derivative financial instrument was independently
entered into, either for Federal income tax purposes or otherwise. Rather, the
representative contract specified that the only consideration paid was specifically for the
sale of mortgages. No separate option premium was paid. Consistent therewith, the
contract included a representation by Taxpayer that it had determined that the
disposition of the mortgage loans pursuant to the agreement would be afforded sale
treatment for accounting and tax purposes.

Remedy or Damage Provision Rights Are Not Considered Options

Courts have repeatedly rejected the notion that rights to liquidated or other damages in
a bilateral sales contract cause such contracts to be treated as options.

The Tenth Circuit opinion in W.A. Drake v. Commissioner, 145 F.2d 365 (10th Cir. 1944)
is perhaps the most analogous and instructive case to the facts at hand as it involved a
seller of property claiming that a sales contract that included unwind and liquidated
damage provisions should be treated as an option. The taxpayer in W. A. Drake sold a
farm pursuant to a contract of sale that contained a liquidated damages provision that
gave the taxpayer, as the seller, the right to keep any sales proceeds paid up to the
point of the purchaser’s breach of its obligation to make ongoing timely payment of
deferred sale proceeds, at which time the purchaser would be obligated to return the
farm to the taxpayer. The taxpayer claimed that the purchaser had merely entered into
an option to purchase the property, as the purchaser’s default caused the property to be
returned to the taxpayer. The Tenth Circuit was not convinced. The court looked to the
“entire contract”3 to conclude that the sales contract created enforceable obligations and
was more than just a mere option to purchase. In particular, it stated that, “the right to
cancel [unwind the sale] in the event of default by [the purchaser] did not convert an
otherwise binding contract into an option contract.” Further, the ability of the purchaser
to default and forfeit only the property and proceeds previously remitted was not viewed
as a put option.

Other courts have been consistently unreceptive to characterizing executory sales
contracts as options based on the operation of damage provisions in those contracts.
More particularly, courts have not confused the right to accept or pay liquidated
damages as indicating that an otherwise executory bilateral contract should be
characterized as an option. The Service failed in United States Freight Co. v. U.S., 422
F.2d 887 (Ct. Cl. 1970), to convince the U.S. Court of Claims that a taxpayer that had
forfeited a $500,000 down payment as liquidated damages for its failure to go forward
with a bilateral sales contract caused the contract to be an option contract. The court
held that the agreement was not an option because options are rights possessed under
a unilateral contract and do not arise under failures from bilateral contracts. The Court

3
At the lower court level, the Tax Court in W. A. Drake rejected the apparent contention by the taxpayer
that the sale transaction should be severed into discrete parts. The Tax Court stated that it was not
impressed by taxpayer’s argument that the sale could be broken up into several parts, concluding that the
transaction was only the sale of the farm. W. A. Drake v. Commissioner, 3 T.C. 33, 38 (1944).

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of Claims stated, “It is also clear that the insertion of a provision for liquidated damages
in the event of plaintiff’s breach did not convert the bilateral contract into an option.” Id.
at 895.4
The W&R Obligations Are Not Severable Put Options

Generally, the Service and courts have refused to treat embedded rights in contracts or
financial instruments as options. The bifurcation of convertible debt into debt and an
option on equity was rejected by the Court of Appeals for the Second Circuit in Chock
Full O’ Nuts Corp. v. U.S., 453 F.2d 300 (2d Cir. 1971). The taxpayer therein argued
that the convertible bonds could be bifurcated because convertible debt is analogous to
bond-warrant investment units, which have been recognized under the tax law to
contain two distinct and divisible obligations. The court rejected the taxpayer’s argument
because bond-warrant investment unit components are sold separately on the market,
whereas convertible bonds are indivisible units. Chock Full O’ Nuts, 453 F.2d at 305.
Further, the court stated that a holder could exercise a bond-warrant investment unit
without forfeiting the bond, while a holder of a convertible bond must forfeit the bond in
order to exercise the conversion feature.

Similarly, the Tax Court in Hunt Foods and Indus., Inc. v. Commissioner, 57 T.C. 633
(1972) rejected the claim by a taxpayer, a corporate issuer of convertible debt, that it
could effectively bifurcate convertible debt into both debt and an option so as to allocate
part of the debt issuance proceeds to the option feature. Hunt Foods, 57 T.C. at 634.
The court rejected the corporation’s contention, stating that an investment unit contains
two separate securities: an obligation and an option, which are legally and physically
independent of one another and have their own separate markets. Id. at 642. By
contrast, the court viewed the convertible debt to be a single security because the debt
and option features did not have physical and legal independence and could not be sold
separately. Cf. Rev. Rul. 88-31, 1988-1 C.B. 302 (a put option that was issued as part
of an investment unit was considered a separate item of property where it was
separately transferrable after a short period of time); Rev. Rul. 2003-97, 2003-2 C.B.
380.

In the case at hand, the W&R Obligations were physically and legally dependent and
intertwined with the sales contracts. The W&R Obligations were not designed to be
separately assignable and they would not have existed but for the sales contracts. The
W&R Obligations and associated remedy rights preserved the value of the bargain
struck in the sales contracts, making the terms mutually interdependent. Any attempt to
bifurcate the contracts into sales of the mortgages plus options would be inconsistent
with the terms of the contracts and economic realities.5

4
See also Halle v. Commissioner, 83 F.3d 649 (4th Cir. 1996)(the ability to walk away from a sales
contract by forfeiting a deposit, though resembling an option, is merely part of a bilateral sales contract).
5
The court in Hunt Foods also expressed concern that bifurcating the convertible debt would have been
“contrary to the practice that has apparently generally been followed throughout the years and ignores the
realities of a convertible debenture.” Id. at 641. A similar concern would arise here if warranty provisions
in sales contracts were viewed as separate items of property independent from the sales contracts as the

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Based on the above, the W&R Obligations were not section 475 securities; therefore,
the W&R Obligation reserve losses were not permitted to be taken as section 475 mark-
to-market losses by Taxpayer during the years in question.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

No opinion is being expressed on any aspects of this issue except as addressed above.
Thus, this should not be read to express or imply an opinion on the treatment of
contingent options under the Federal income tax law. Further, this advice does not
express an opinion on whether Taxpayer’s estimated aggregate loss reserves would be
considered to be an accurate determination of its mark-to-market losses even if the
W&R Obligations were considered section 475 securities.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call Grace Cho at (202) 317-4424 if you have any further questions.

Patrick White
Senior Counsel, Branch 6
Office of Associate Chief Counsel
(Financial Institutions and Products)

cc: --------------------------------------------

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established tax accounting for expenses of satisfying sale warranties would be upended for section 475
dealers and traders.