New final IRS/Treasury regulations defining the source of income from qualified “fails” expands the scope of a temporary regulation related to Treasury fails to agency mortgage-backed securities and debt.
“The Treasury Department and the IRS have determined that the same source rule should apply to fails charges incurred with respect to agency debt and agency MBS as to fails charges on Treasuries,” IRS/Treasury indicated in their final regulation and removal of temporary regulations as published in the Federal Register Tuesday.
Under the regulations, the source of income from a qualified fails charge is “generally determined by reference to the residence of the taxpayer that is the recipient of the qualified fails charge income, with two exceptions.”
One exception is qualified fails charge income earned by “a qualified business unit of a taxpayer that is sourced to the country in which the QBU is engaged in a trade or business.”
The other is qualified fails charge income “that arises from a transaction the income from which is effectively connected to a United States trade or business…sourced in the United States and treated as effectively connected to the conduct of a United States trade or business.”
The regulations note that for tax purposes, Fannie Mae, Freddie Mac and Ginnie Mae do not issue agency MBS.
The Internal Revenue Service and Treasury Department also indicated in the final regulation that they “are considering whether separate guidance is needed on the source of income attributable to certain payments, other than qualified fails charges, that arise in securities lending transactions or repurchase transactions.”
Persistent Treasury delivery failures during market turbulence led the Treasury Market Practices Group and the Securities Industry and Financial Markets Association to publish a trading practice governing Treasury fails in 2008. A fail occurs when a promise to deliver securities by the settlement date cannot be fulfilled. The trading practice provided a mechanism for compensating a non-failing party.
Subsequently the Treasury and IRS issued temporary proposed regulations that established source rules for a fails charge paid with respect to a Treasury with the provision that the IRS would “not challenge the position taken by a taxpayer or a withholding agent that a fails charge paid to a Treasury on or before Dec. 31, 2010 is not subject to U.S. gross basis taxation.”
Treasury/IRS had noted in the preamble to the temporary regulations that “no trading practice existed [previously] for fails charges on securities other than Treasuries, but that if a fails charge trading practice pertaining to other securities was endorsed by the TMPG or an agency of the United States government, the Treasury Department and the IRS would consider whether the source rule in the regulations should be extended to those fails charges.”
The TMPG endorsed a trading practice for Fannie Mae, Freddie Mac and Federal Home Loan Bank debentures, as well as pass-through agency MBS guaranteed by Fannie, Freddie or Ginnie Mae beginning this month.
