United States: IRS Issues Private Letter Ruling Regarding REMIC Trustees Entering Into Settlement Agreements

On December 31, 2015, the IRS released PLR 201601005 (dated April 8, 2015), which addressed the previous uncertainty on the ability of Trustees in real estate mortgage investment conduit (REMIC) transactions to enter into settlement agreements with a mortgage originator or master servicer on a large-scale basis, as opposed to a deal-by-deal basis, for certain breaches of representations and warranties made by such parties relating to the mortgage loans securitized in such REMICS and the receipt of an allocable share of such settlement funds by the different REMICs (the "Taxpayers"). While this PLR addressed several specific technical issues, the IRS generally found that the Taxpayers would not lose their status as REMICs due to the Trustee's execution of such settlement agreements and the receipt of a portion of these settlement funds to different REMICs.

Each Taxpayer's governing documents contained what appear to be typical representations and warranties from the seller ("Seller") of the mortgage loans, which generally included that such mortgage loans were underwritten materially in accordance with certain underwriting guidelines. Similarly, the governing documents also imposed on the "Master Servicer" certain servicing obligations, which in part required that such mortgage loans be serviced and administered in accordance to "customary and usual standards of prudent mortgage loan servicers." Multiple years after the Taxpayers' formation, certain institutional investors (the "Investors") claimed that mortgage loans sold to the Taxpayers did not comply with the representations and warranties that the Seller had provided in the governing documents, and thus the Investors claimed that the Seller had breached such representations and warranties. The asserted breaches were partially based on early defaults and foreclosure rates for the mortgage loans, on certain publicly disclosed emails regarding alleged evidence of such breaches and on settlements reached with various states. Under the governing documents, the Seller would have been required to cure any breach of representations and warranties within a set amount of days. It was alleged that such breaches were not cured. Similarly, the Investors brought claims of breach against the Master Servicer, claiming in part that the Master Servicer had also breached certain provisions of the related governing documents.

The trustee (on behalf of the several different REMICs) eventually entered into a settlement agreement with the proper parties relating to these alleged breaches. Pursuant to this settlement agreement, the Taxpayers were to be allocated certain settlement proceeds (each an "Allocable Share"), calculated taking into the account the "net losses" of each Taxpayer, as were calculated under the settlement agreement. The trustee generally distributed the allocable shares to the Investors as if such Allocable Share was a "subsequent recovery," which was generally defined in the governing documents as an unexpected amount that a REMIC may receive with respect to a mortgage loan. If the concept of a subsequent recovery was not contained in the governing documents, then the payment of such Allocable Share was distributed as if it was an unscheduled payment of principal. The settlement agreement also contained certain servicing "improvements and remedies" to be implemented on a going-forward basis. Of particular note is that many of these "defective mortgage loans" remained in the REMICs and the Master Servicer would continue to service and collect pursuant to customary servicing guidelines.

The Taxpayers sought several rulings from the IRS related to the receipt of these settlement proceeds. First, the Taxpayers requested rulings that none of the following would cause any Taxpayer to fail to qualify as a REMIC: (i) the execution of the settlement agreement, (ii) the method for determining the Allocable Share, (iii) the receipt of an Allocable Share or (iv) the reductions of any amounts owed to the Master Servicers pursuant to the adjustment of the master servicing fee. In response to this request, the IRS noted that the right to receive an Allocable Share arose from the mortgage loans was a contract claim created by the rights of each Taxpayer in its status as a REMIC. As such, each Taxpayer's right to receive such Allocable Share is not characterized as a new asset that was acquired by a REMIC after its startup date. Therefore, the IRS ruled that the none of the four points mentioned above would cause any Taxpayer to fail to meet the REMIC asset requirements or the prohibition of new contributions to the REMICs.

Second, the Taxpayers sought a ruling that the receipt of an Allocable Share will be treated as a payment received on a qualified mortgage. The IRS ruled that the receipt of such Allocable Share will be treated as a payment received on a qualified mortgage. In so holding, the IRS analogized the payments to those received as a payment for a defective obligation, stating that the Taxpayers' rights to an Allocable Share is "akin to a payment received by such Taxpayer from a sponsor or prior owner in lieu of the sponsor or prior owner's repurchase of such a defective obligation."

Third, the Taxpayers sought a ruling that the distribution of an Allocable Share pursuant to either the governing documents or the settlement agreement would not cause any interest in such Taxpayer to fail to qualify as a "regular interest" or as the sole class of "residual interest" in such Taxpayer. The IRS noted that the distribution provisions of the settlement agreement did not alter the rights or obligations of any of the Taxpayers or the Investors. Further, such distribution provisions were consistent with the distribution provisions of the governing documents. As such, the distribution of the Allocable Shares did not cause any regular interest or sole class of residual interest to fail to qualify as a regular interest or sole class of residual interest, respectively.

Finally, the Taxpayers sought a ruling that none of the facts described above would result in a "prohibited transaction" or a contribution that is otherwise subject to tax under the REMIC provisions. The IRS found that since the receipt of the Allocable Share arose from the mortgage loans as well as each Taxpayer's status as a REMIC, the Allocable Share should not be considered as a contribution of cash to the REMIC or as a prohibited transaction. Further, the master servicing fee adjustment was found to merely be an amount reimbursed in connection with compensation for services provided to the Taxpayer in the Taxpayer's ordinary course of business. As such, the IRS held that neither the receipt of the Allocable Share, nor the adjustment to the master servicing fee, is treated as a prohibited transaction or as a contribution otherwise subject to tax under the REMIC provisions.

It is important to note that this ruling may only be used by the taxpayers that requested it, and may not be cited by other taxpayers as precedent. As many originations (or successors in interest) enter into settlement agreements for breaches of representations and warranties relating to the origination of mortgage loans, it is encouraging to know that the IRS has, in this ruling, taken a reasonable position with respect to the receipt of the settlement fees. However, given the time and expense associated with obtaining a private letter ruling, it would be particularly helpful if the Treasury Department released similar guidance on which other taxpayers could rely. In the absence of such guidance, however, this ruling should act as a good tool in analyzing the IRS' potential treatment of the receipt of certain settlement fees by a REMIC.

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