How were GNMA mortgage-backed security interest receipts apportioned when the underlying mortgagors could not be identified?

Plain-English summary

When the underlying mortgagors could not be identified, 15.78% of GNMA mortgage-backed security interest was treated as a Texas receipt for taxable capital.

Rule 3.549(e)(13)(D) sourced interest and dividends from GNMA, FNMA, and FHLMC mortgage-backed securities by the location of the payor. If the payor could not be determined, the rule assigned 15.78% to Texas.

The taxpayer argued that the private financial institution issuing a modified pass-through security should be treated as the payor because it was directly obligated to make monthly principal and interest payments even when mortgagors were delinquent. The Comptroller rejected that position.

The agency maintained its longstanding view that a GNMA security holder owned an undivided beneficial interest in the underlying mortgage pool. It therefore concluded that the issuer was not the payor and instructed the auditors to apply Rule 3.549(e)(13)(D).

The ruling request, including its legal and accounting arguments for the opposite result, is appended to the official response in the original text below. Those arguments are not the agency's holding.

Currency note: The response addresses only the former taxable-capital component. Texas replaced that tax with the margin tax effective January 1, 2008.

What this means for you

Holders of historical agency mortgage-backed securities

Under the former rule, inability to identify underlying mortgage payors triggered a fixed Texas percentage rather than treating the securities issuer as payor.

Tax professionals

Separate the Comptroller's short ruling from the taxpayer's lengthy appended submission. The agency expressly declined to change its interpretation.

Common questions

Q: Did Texas treat the private issuer as payor?
A: No.

Q: What happened when underlying mortgagors were unknown?
A: 15.78% of interest or dividends was treated as a Texas receipt.

Q: Which tax component did the letter address?
A: Taxable capital only.

Citations and references

• 34 Tex. Admin. Code Sec. 3.549(e)(13)(D)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9907277L

Original ruling text

July 20, 1999

Dear **:

Your firm has requested a ruling on the proper methodology for apportioning the
interest receipts from Government National Mortgage Association (GNMA)
mortgage-backed modified pass-through securities when the identity of the
underlying mortgagors is unknown. Your request relates only to the taxable
capital component of the Texas franchise tax.

The applicable rule is Franchise Tax Rule 3.549(e)(13)(D), which provides the
following:

Dividends and/or interest received from Government National Mortgage
Association (GNMA), Federal National Mortgage Association (FNMA), and Federal
Home Loan Mortgage Corporation (FHLMC) mortgage-backed securities or
certificates are apportioned based on the location of the payor. When the payor
cannot be determined, l5.78% of the interest or dividend will be considered a
Texas receipt.

As you know, this rule is based on the belief by the Comptroller's office based
on information provided by industry when the rule was developed that the holder
of a GNMA mortgage-backed security owns an undivided beneficial interest in the
underlying pool of mortgages. We have reviewed your materials and conducted
additional research on GNMA mortgage-backed securities and have found no reason
to change the agency's position that the holder of a GNMA mortgage-backed
security owns an undivided beneficial interest in the underlying pool of
mortgages. As we also discussed in our prior meetings, the applicable provision
of Franchise tax Rule 3.549 (e)(13)(D) represents agency longstanding policy
and it has been this agency's experience with this provision that it has never
been challenged.

For these reasons, we conclude that the issuer is not the payor and Rule
3.549(e)(13)(D) should be applied to the audit in progress on CORPORATION.

Should you have further questions, please feel free to contact me.

Sincerely,

Karey W. Barton
Director, Tax Policy

cc: Bryant Lomax, Manager, Tax Policy
Teresa Comer, Supervisor, Franchise Tax
Laura Biemer/Rosie Garcia, ** Audit

November 5, 1998

BY FEDERAL EXPRESS

Ms. Teresa Comer

111 West 6th Street
Austin, Texas 78701

Dear Ms. Comer:

This letter follows our recent telephone conversations in which we requested
your office to consider the proper methodology for apportioning income from
Government National Mortgage Association ("GNMA") mortgage-backed modified
pass-through securities for Texas franchise tax purposes. As will be shown
below, we submit that an investor in such securities should utilize the
location of payor test, treating the issuer as the payor.

BACKGROUND

GNMA is authorized by section 306(g) of Title III of the National Housing Act
to guarantee the timely payment of the principal of and interest on, these
securities, which are based on and backed by a pool composed of mortgages.
These financial instruments, commonly known as "Ginnie Maes," are issued by
private financial institutions ("issuers"), which are obligated to make timely
payment of the principal and interest to the holders.

The securities at issue are "modified pass-through securities" that provide for
monthly payment by the issuer to the holder regardless whether the individual
mortgagors in the pool make timely payment. See 24 C.F.R Section 320.5(a)[1].
The prospectuses for such securities at issue provide that "[i]n any event, the
Issuer will pay to the holders monthly installments of not less than the
interest due on the securities at the rate specified in the security, together
with any scheduled installments of principal whether or not collected from the
mortgagor .... "[2]

If the individual mortgagors are delinquent, the issuer must cover the
shortfall with its own funds, and may pursue remedies against the mortgagor or
the mortgage guarantor, but has no rights against GNMA. GNMA does not guarantee
the individual mortgagor's obligations to the issuer, but rather guarantees to
the holder of the certificates the issuer's obligation to make timely payment
of the principal and interest due under the certificates. "The purpose of the
guarantee, and the function of GNMA, . . . is to attract investors into the
mortgage market by minimizing the risk of loss." Rockford Life Ins. Co. v.
Illinois Dep't of Revenue, 482 U.S. 182, 185, 107 S.Ct. 2312, 96 L.Ed2d 152
(1987). However, "[t]he duty to make monthly payments of principal and interest
to the investors falls squarely on the issuer of the certificate." Id.

QUESTIONS PRESENTED

The issue is the proper methodology for apportioning the interest receipts from
mortgage-backed modified pass-through securities when the identity of the
underlying mortgagors is unknown. The applicable rule, 34 TEX. ADMIN. CODE
Section 3.549(e)(13)(D)[3] provides that:

Dividends and/or interest received from Government National Mortgage
Association (GNMA), Federal National Mortgage Association (FNMA), and Federal
Home Loan Mortgage Corporation (FHLMC) mortgage-backed securities or
certificates are apportioned based on the location of the payor. When the payor
cannot be determined, 15.78% of the interest or dividend will be considered a
Texas receipt.

We submit that the proper interpretation of the rule in the case of modified
pass-through securities is that the issuer rather than the individual mortgagor
is the "payor" for Franchise tax apportionment purposes.

The status of the issuer rather than the individual mortgagor as the actual
"payor" is established by: (i) the issuer's personal responsibility for payment
of principal and interest to the holder in the event that the individual
mortgagor fails to make timely payment; (ii) the risks assumed by the issuer,
and (iii) the stringent requirements imposed upon issuers of Ginnie Maes by
GNMA. Furthermore, the authorities consistently treat Ginnie Maes as securities
-- that is, as indirect interests in, or derivatives of, the underlying
mortgages. Therefore, the actual payor on such derivative financial instruments
is the issuer, rather than the individual mortgagor.

AUTHORITIES

A. Rockford Life Ins. Co. v. Illinois Dep't of Revenue, 482 U.S. 182, 107
S.Ct. 2312, 96 L.Ed2d 152 (1987).[4]

In Rockford, the issue before the Supreme Court was whether the GNMA guarantee
backing the mortgage pool securities is an "obligation of the United States,"
such that the instruments would be exempt from state and local taxation under
31 U.S.C. Section 742 (1976 ed.). The Court held that such mortgage-backed
securities are not obligations of the United States:

"[A]s the certificate provides, it is the issuer that bears the primary
obligation to make timely payments-the United States' obligation is secondary
and contingent."

Rockford, 482 U.S. at 188. The Court characterized GNMA's responsibility as an
"indirect, contingent, and unliquidated promise," and held that "[t]he duty to
make monthly payments of principal and interest to the investors falls squarely
on the issuer of the certificate." Id. at 185 (emphasis added). The Supreme
Court's holding that the issuer had the direct obligation to make payment under
the certificates establishes that the issuer is the "payor."

B. Ginnie Mae 5500.1 Guide

The Ginnie Mae Guide ("Guide")[5] published by the Department of Housing and
Urban Development delineates the requirements for issuers of mortgage-backed
securities. In its sole discretion, GNMA reviews applications from lenders and
grants issuer status, provides approved issuers with commitment authority,
approves issuances of securities, and monitors issuers once they are approved
to issue securities. Guide, ch. 1, at 4. For the life of the mortgage pool, the
issuer has many responsibilities, including servicing the mortgages,
administering the securities, remitting timely payments of principal, interest,
and other required amounts to security holders monthly, and submitting periodic
reports to GNMA. Each month the issuer must submit to GNMA an accounting report
showing the aggregate remaining principal balance as of the end of the
preceding month. Id. at 8.

An issuer is also subject to several eligibility requirements, as set forth in
chapter 2 of the Guide. An applicant must be an approved FHA mortgagee in good
standing; the underwriting, origination, and servicing of mortgage loans must
be a principal element of the applicant's business; the applicant must meet
certain management capability standards, including facility, management staff,
and accounting requirements; the applicant must have a fidelity bond and a
mortgagee errors and omissions policy meeting specified requirements; each
applicant must provide its audited annual financial statements for the three
most recent fiscal years; the applicant must have a certain minimum net worth;
the applicant must have in place a quality control plan for underwriting,
originating, and servicing mortgage loans and for secondary marketing; and the
applicant must have an anti-discrimination policy. GNMA may also specify
additional requirements for applicants.

Each issuer also assumes many risks and liabilities, as set forth in chapter 5
of the Guide. For example, if an issuer is in default, GNMA has the right to
declare a default on all of the issuer's pools and the pools of any affiliate
of the issuer that has executed a Cross-Default agreement; issuers must use
their own funds to cover any shortfall in the mortgage pool; issuers are
responsible for all pool administration costs; if GNMA declares a default and
extinguishment, the issuer's rights in the pool are completely extinguished;
and the issuer must pay certain miscellaneous expenses, including major
property losses not covered by insurance, losses due to legal proceedings, such
as condemnation, and any other loss or expense for which reimbursement is not
specifically provided.

The procedures, standards and criteria set forth in the Guide make clear that
the issuer is the party legally obligated to make payments of principal and
interest to the investors. Moreover, the Guide specifically treats the
certificates as securities, not as direct interests in the underlying mortgages
comprising the pool.

C. Financial Accounting Standards Board

The financial accounting treatment of certificates also dictates that they be
treated as securities, not as mortgages.

Statement of Financial Accounting Standards No. 91, Accounting for
Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases, issued December 1986 ("Statement 91"), sets
forth accounting standards to be applied to such mortgage-backed certificates.
Statement 91 also treats these certificates as securities, stating that "the
accounting for . . . debt securities such as . . . loan-backed securities (such
as pass-through certificates, collateralized mortgage obligations, and other
so-called 'securitized' loans) is also addressed by this Statement."[6]

Further, Statement of Financial Accounting Standards No. 115, Accounting for
Certain Investments in Debt and Equity Securities, issued May 1993 ("Statement
115") addresses the accounting and reporting for investments in equity
securities that have readily determinable fair value and for all investments in
debt securities. Generally, Statement 115 requires that such securities be
marked to market for financial accounting purposes. This is contrary to the
financial accounting treatment for mortgages, which simply requires that
mortgages receivable be reported at their then outstanding principal balances,
subject to a reserve for bad debts.[7]

The initial summary of Statement 115 specifically notes the distinction between
individual mortgage loans and mortgage-backed securities: "This Statement does
not apply to unsecuritized loans. However, after mortgage loans are converted
to mortgage-backed securities, they are subject to its provisions." (Emphasis
added.)

The Financial Accounting Standards Board treatment of mortgage-backed
securities makes clear that they are treated as securities and not as
mortgages. Such accounting treatment confirms that the issuer of the security
should be treated as the payor for franchise tax purposes.

We trust the foregoing provides the information you need. Of, course, should
you have any questions or require any additional information, please advise.

Very truly yours

cc: ** [Firm]

[FOOTNOTES:]

[1] A copy of 24 C.F.R. Section 320.5(a) is attached as Exhibit A.
[2] Copies of sample Ginnie Mae prospectuses are attached as Exhibit B.
[3] A copy of Section 3.549 is attached as Exhibit C.
[4] A copy of the Rockford opinion is attached as Exhibit D.
[5] A copy of the relevant portions of the Guide is attached as Exhibit E.
[6] A copy of Statement 91 is attached as Exhibit F.
[7] A copy of Statement 115 is attached as Exhibit G.