The IRS released Notice 2007-17, 2007-12 IRB in late February. The notice sets forth "a model for a new IRS pilot program seeking public input on guidance projects."
The bar associations and individual tax practitioners have frequently provided input on guidance projects in the past. In many cases, that input has included draft rules and examples, as well as the drafter's explanation of the rationales for the various rules, safe harbors and exceptions proposed. The IRS has always responded rather slowly, however, in order to sift through the important issues, permit internal debate to develop its own rules and reveal the problems with the proposed rules, and to address concerns that particular interest groups may not be interested in.
Now, the IRS and Treasury are creating an expedited format for interested parties to submit proposed guidance that will cover transactions in which those parties have a particular interest (and particular knowledge), in a "narrow, technical area of the tax law". After interested parties submit draft rules with requested supportive documentation, the interested party would likely be asked to "meet informally with personnel from the IRS and Treasury". The notice indicates that this would be handled "within the requirements of the Federal Advisory Committee Act", although "the IRS does not intend to form advisory committes during this process." Id. The Federal Advisory Committee Act provides for open meetings of agency advisory committees, with records of discussions available to the public that is unable to attend.
The Notice creates a pilot program by asking for submissions in respect of changes to the REMIC (real estate mortgage investment conduit) rules regarding modifications of commercial loans. REMICs are securitization vehicles that hold mortgage loans. If a REMIC complies with various restrictive rules regarding types of assets permitted to be held, interests permitted to be issued and activities permitted to be undertaken, the REMIC will not be subject to tax. Section 860A. If not, there may be confiscatory REMIC-level taxes on "prohibited transactions" and even failure of REMIC status resulting in entity-level taxation as a corporation. The REMIC rules permit sponsors to create tranches of financial instruments called "regular interests" that are given statutory characterization as debt for tax purposes. Section 860B. Interest and principal on the underlying mortgage loans are divided up and paid out on regular interests according to very detailed technical rules. See, e.g., Treas. Regs. 1.860G-1. Every REMIC must also have a "residual interest": any holder of such an interest must take into account the "daily portion" of the REMIC's taxable income--which may include "phantom income." Section 860C.
REMICS were intended by statute to be self-amortizing pools of loans and not active businesses engaged in originating loans or buying and selling loans to take advantage of market conditions to recognize gains or losses. Therefore, significant modifications are treated as exchanges of obligations and are "prohibited transactions" under the rules, unless they satisfy one of a limited number of exceptions set out in 1.860g-2(b)(3) (changes occasioned by default or reasonable foreseeable default; assumption of the obligation; waiver of a due-on-sale or due-on-encumbrance clause; or conversion of an interest rate pursuant to the terms of the mortgage).
Of course, as the REMIC market has grown, and as the investment banks have become more and more sophisticated in slicing and dicing mortgage loans to create unique products to attract investors, the demand for greater flexibility has also grown. There are only a small number of tax practitioners with the expertise to develop complex REMIC products, and the IRS is unlikely to be able to match that expertise or even adequately review many (if any) REMICs to verify that they comply with the rules.
So is it a good step to have those same REMIC tax experts propose new rules to permit greater flexibility in REMICS? I tend to think not for several reasons. First, the IRS should consider the problem resulting from the power of the first draft. The person who writes the rules has the deepest understanding of the way the rules work. The IRS is already operating with limited resources in dealing with tax shelters in the securitization area, so it will put the government at a disadvantage to try to understand the technicalities of rules written by outsiders.
Second, letting tax practitioners--who operate on a daily basis under a prevalent "tax minimization norm"--be the ones to design the rules might mean that the rules would have custom-designed loopholes ready to be exploited. As Paul Light said, "it's not the fox guarding the hen house; it's the fox designing the hen house." See David Cay Johnston, IRS Letting Tax Lawyers Write Rules, NY Times (Mar. 9, 2007).
(The REMIC area is a good example of this tax minimization norm at work. Tax practitioners have in the past have created aggressive shelters to avoid the technical application of some of the REMIC rules, such as casting off the residual "phantom income" on foreign owners through use of partnerships. Various modifications of the REMIC rules were necessary to stop such tax shelters short. )
Third, there is a catch-22 for the government whenever it uses private resources to do government work. Accepting the idea that guidance is so desperately needed that the government must ask private tax practitioners to develop it, especially in technical areas that require considerable expertise, will make it even harder for the government to develop the technical expertise it needs. There will always be those in Congress who will push for privatizing functions and cutting government resources, as we've seen over the last six years. Farming out the development of technical guidance looks like an initial step in privatizing regulatory development. That would be a shame, because tax regulations must be developed with a view to overall fairness.
Fourth, the pilot program clearly invites too-close relationships between submitting interested parties and those developing the regulations. Informal meetings may mean private meetings, even though the Federal Advisory Committee Act requires notice and opportunity for public to attend actual advisory committee meetings. The agencies note that they do not expect actually to create advisory committees, and so it appears they are reserving their ability to treat the interrelationships informally. Too cozy a relationship between interested parties seeking a favorable regulation and IRS officials could lead to a captured agency.
Fifth, there is a danger that interested parties will band together to submit a single, monolithic proposal that represents the affected industry regulatory wishlist and allows the IRS little room to manuveur in devising final regulations. Without having considered the area on its own first, the IRS will be at a disadvantage. It will not have thought through the problems, so it will not have the insights gained from that process to help it in examining the proposals proferred by the industry group. That lack of independent thinking may result in the IRS's being unable to see ways in which the rules are warped in favor of the special interest group.
All in all, the pilot program seems problematic. Certainly there have been times in the past when the IRS has benefited from proposals from interested parties for particular rules, and the IRS can definitely benefit from more explicit sharing of background information about industry standards and practices. But I think there is a danger in creating a program whose aim is to have interested parties develop technical rules exactly in those areas where the parties are pushing for specific (taxpayer-friendly) guidance and where the IRS has not yet developed its own ideas about the appropriate boundaries for guidance.
Addendum: Senate Finance Committee ranking members Baucus and Grassley have written Treasury to express their concerns about the pilot program. See the press release and letter.
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