On October 16, 2018, the Internal Revenue Service (IRS) released Rev. Proc. 2018-54,1 which addresses the treatment of a new mortgage-backed security under the diversification rules of IRC § 817(h). This new security, called a Uniform Mortgage Backed Security (UMBS), is scheduled to be issued by both Fannie Mae and Freddie Mac (the government-sponsored entities or GSEs) beginning in June 2019. UMBSs issued by both GSEs will have substantially uniform terms and will replace mortgage-backed instruments currently issued by Fannie Mae and Freddie Mac that have different terms.2
Like the current mortgage-backed instruments issued by the GSEs, UMBSs primarily will be sold pursuant to TBA contracts at a current market price for future delivery. UMBSs issued by the GSEs will be sold pursuant to “Generic TBAs,” which will be uniform for both GSEs. Unlike mortgage-backed instruments currently issued by the GSEs, the identity of the GSE issuing particular UMBSs pursuant to a Generic TBA will not be disclosed until 48 hours prior to delivery.
For segregated asset accounts and insurance-dedicated investment funds supporting non-qualified variable life insurance and annuity contracts (variable contracts) that need to comply with the diversification requirements of IRC § 817(h), the delayed disclosure of the identity of the UMBS issuer could pose a problem. In testing for compliance with the percentage tests set forth in Treas. Reg. § 1.817-5(b), Treas. Reg. § 1.817-5(b)(1)(ii)(A) requires that all investments issued by the same issuer be aggregated and treated as a single investment. For this purpose, each GSE is treated as a separate issuer.3 Absent some form of relief, a segregated asset account or insurance-dedicated fund, particularly one that invests heavily in mortgage-backed securities, could discover, at a point too late to enable it to be brought into compliance, that its aggregate holdings of UMBSs issued by one or both of the GSEs caused it to exceed the percentage tests.
Rev. Proc. 2018-54 provides relief from this potential problem and is applicable to (1) insurance companies’ variable contracts, and (2) insurance-dedicated funds qualifying for look-through treatment under Treas. Reg. § 1.817-5(f)(2). These entities will be permitted to elect to treat GSE-issued UMBSs delivered under all Generic TBAs entered into in a particular calendar year as having been issued in part by Fannie Mae and in part by Freddie Mac, regardless of the actual ultimate issuer, based upon a deemed-issuance ratio for such calendar year.4
The deemed-issuance ratio will be announced for each calendar year by the FHFA at least three weeks before the beginning of the calendar year, based on the actual ratios of UMBSs issued by each of the GSEs pursuant to Generic TBAs for the 24-month period ending on October 31 of the preceding calendar year. The deemed-issuance ratio will continue to apply even after the GSE-issued UMBSs have been delivered and the identity of the actual issuer of each GSE-issued UMBS is known.
An election under Rev. Proc. 2018-54 to apply the deemed-issuance ratio to GSE-issued UMBSs acquired pursuant to Generic TBAs must be made in a statement attached to the electing taxpayer’s income tax return for the first taxable year for which the taxpayer wants the election to apply. The statement must be titled “Section 817(h) Deemed-Issuance-Ratio Election” and include certain information specified in section 7 of Rev. Proc. 2018-54. The election will apply for subsequent taxable years and is revocable only with prior written IRS consent obtained through a private letter ruling.
The guidance provided in 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.”
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Eversheds Sutherland Observation: Rev. Proc. 2018-54 does not provide guidance concerning the application of the diversification rules of IRC § 817(h) to Generic TBAs prior to the delivery of the UMBSs to be delivered under such Generic TBAs. As a result, life insurance companies and insurance-dedicated funds that hold Generic TBAs at the end of a calendar quarter will need to consider the appropriate treatment of such contracts based on existing guidance. |
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1 2018-45 IRB.
2 The new UMBSs are being developed pursuant to the Single Security Initiative of the Federal Housing Finance Agency (FHFA), which is designed to enhance the marketability of mortgage-backed securities.
3 See IRC § 817(h)(6) and Treas. Reg. § 1.817-5(h)(1). Treas. Reg. § 1.817-5(b) generally provides that the investments of an insurance company segregated asset account supporting variable contracts will be considered adequately diversified for purposes of that section and IRC § 817(h) only if: no more than 55% of the value of its total assets is represented by any one investment; no more than 70% of the value of its total assets is represented by any two investments; no more than 80% of the value of its total assets is represented by any three investments; and no more than 90% of the value of its total assets is represented by any four investments. Testing for compliance is on a calendar quarter basis, with a 30-day grace period after the end of a calendar quarter. Certain insurance-dedicated investments may qualify for look-through treatment under Treas. Reg. § 1.817-5(f)(2), so that the compliance of segregated asset accounts investing in such funds with the diversification requirements is tested based on the composition of such funds’ portfolios.
4 The deemed-issuance ratio may not apply in situations where UMBSs are aggregated into a pool as part of a GSE resecuritization program. See section 6.04 of Rev. Proc. 2018-54.
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