United States: IRS: Indemnity Obligations Are Not Securities Subject To Mark-To-Market

The IRS concluded in a chief counsel advice (CCA) memorandum that indemnification obligations related to originated mortgages did not constitute a security subject to Section 475.

In CCA 201529006, the taxpayer was a dealer in securities under Section 475(c) that originated and sold mortgages to private investors and other large purchasers. Under the terms of the sales contracts, the purchasers were generally entitled to force the taxpayer to repurchase mortgages and/or pursue other indemnification for breach of warranties and representations that caused the value of the mortgages to be materially and adversely impaired (the indemnification obligation). The repurchase price related to the indemnification obligation was the stated principal balance and unpaid stated interest of the relevant mortgage, and all reasonable and necessary costs incurred by the purchaser from the breach.

For book purposes, the taxpayer estimated and reported an aggregate loss reserve related to the indemnification obligation. The taxpayer contended that the indemnification obligations were securities under Section 475(c)(2)(E) subject to mark-to-market because the indemnification obligation constitutes a put option held by the purchasers to sell the mortgages to the taxpayer.

Section 475(a) requires dealers in securities to mark-to-market securities with certain exceptions provided under Section 475(b). For Section 475(a) purposes, the term "mark-to-market" means that a dealer must treat a security, which is held on the last day of its taxable year, as if it were sold on the last business day of the taxable year for an amount equal to its fair market value, and the appropriate gain or loss must be recognized for such taxable year.

The definition of a security for Section 475 purposes includes debt (Section 475(c)(2)(C)) and a derivative in a debt including an option (Section 475(c)(2)(E)).

The IRS concluded that the indemnification obligations did not constitute securities subject to Section 475(a) because they were embedded in the sale contract of the relevant mortgages and did not constitute a severable put option. See W.A. Drake v. Commissioner, 146 F.2d 365 (10th Cir. 1944), and Chock Full O' Nuts Corp. v. U.S., 453 F.2d 300 (2nd Cir. 1971).

The IRS emphasized that the indemnification obligations would not have existed except for the sales contracts and that any attempt to bifurcate them into sales of the mortgages plus options would be inconsistent with the terms of the contracts and the economic realities.

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