COMMISSIONER OF INTERNAL REVENUE, PETITIONER V. FEDERAL NATIONAL MORTGAGE ASSOCIATION No. 89-1987 In The Supreme Court Of The United States October Term, 1989 The Acting Solicitor General, on behalf of the Commissioner of Internal Revenue, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the District of Columbia Circuit in this case. Petition For A Writ Of Certiorari To The United States Court Of Appeals For The District Of Columbia Circuit TABLE OF CONTENTS Question Presented Opinions below Jurisdiction Statutory provisions and regulation involved Statement Reasons for granting the petition Conclusion OPINIONS BELOW The opinion of the court of appeals (App., infra, 1a-19a) is reported at 896 F.2d 580. The opinion of the Tax Court (App., infra, 20a-52a) is reported at 90 T.C. 405. JURISDICTION The judgment of the court of appeals was entered on February 20, 1990. On May 9, 1990, Chief Justice Rehnquist extended the time within which to file a petition for a writ of certiorari to and including June 20, 1990. The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). STATUTORY PROVISIONS AND REGULATION INVOLVED The relevant portions of Sections 165 and 1001 of the Internal Revenue Code of 1954 (26 U.S.C. (1982)) and Section 1.1001-1(a) of the Treasury Regulations on Income Tax (26 C.F.R.) are set out in a statutory appendix (App., infra, 53a-55a). QUESTION PRESENTED Whether a financial institution realizes a deductible loss for income tax purposes when it exchanges a group of mortgage loans for a substantially identical group of mortgage loans held by another financial institution. STATEMENT 1. Respondent was originally established in 1938 as an agency of the government. In 1968, it was transformed into a for-profit, privately owned corporation that is subject to regulation by the Department of Housing and Urban Development. Respondent has a congressional mandate to "provide supplementary assistance to the secondary market for home mortgages by providing a degree of liquidity for mortgage investments, thereby improving the distribution of investment capital available for home mortgage financing." 12 U.S.C. 1716(a). It advances this goal of providing liquidity for mortgage investments primarily by purchasing mortgages from lenders, using funds it acquires by issuing stock and debt securities. Respondent's mortgage purchases have made it the largest investor in home mortgages in the United States. App., infra, 2a, 22a-23a. In the early 1980s, respondent's mortgage loan portfolio included many fixed-rate, long-term home mortgage loans that had been issued at interest rates significantly lower than those charged on more recent loans. As a result of the high interest rates of the early 1980s, the fair market value of these older, low-interest loans fell far below their face amount. App., infra, 2a. For respondent, like other financial institutions holding older, low-interest loans, this situation created a tax incentive for disposing of its depreciated mortgage loans. A disposition of the loans would enable respondent to realize for tax purposes the loss that resulted from these market changes; it could then utilize the resulting loss deductions to offset current taxable income and produce loss carry-backs that would generate tax refunds from prior years. App., infra, 3a. For the many savings institutions holding older, low-interest loans, however, there was a problem with disposing of the loans. Most of the savings institutions with which respondent dealt were regulated by the Federal Home Loan Bank Board (Bank Board). Id. at 25a. Many of these savings institutions were in such precarious financial condition that a sale of the loans and consequent recognition of the losses -- however beneficial for tax purposes -- would for regulatory accounting purposes have caused them to fail to meet the Bank Board's minimum reserve and liquidity requirements, raising the prospect of closure by the Bank Board. Id. at 3a, 25a-26a. On June 27, 1980, the Bank Board's Office of Examination and Supervision (OES) issued Memorandum R-49, a regulatory accounting principle that adopted the rule that savings institutions could make "reciprocal sales" of depreciated "substantially identical mortgage loans" without having to record a loss for regulatory accounting purposes. Memorandum R-49 established a list of criteria that would render loans "substantially identical," including that the mortgages be of similar type with the same terms and interest rates. /1/ The admitted objective of Memorandum R-49 was to allow savings institutions to engage in transactions that would generate deductible losses for federal income tax purposes, but that would not be treated as giving rise to losses for financial reporting and regulatory purposes. See App., infra, 26a-27a; San Antonio Savings Ass'n v. Commissioner, 887 F.2d 577, 579-580 (5th Cir. 1989), petition for cert. pending, No. 89-1928. /2/ 2. In 1980 and 1981, respondent engaged in 71 transactions with one or more of 50 different financial institutions in which respondent, in effect, exchanged a package of 90% participation interests in a group of mortgage loans for a package of 90% participation interests in a group of mortgage loans held by the other institution. /3/ The loans involved in each transaction were "substantially identical" according to the criteria set forth in the Bank Board's Memorandum R-49. /4/ Respondent selected the loans to be exchanged by running a computer analysis of its portfolio to find loans that would match, according to the Memorandum R-49 criteria, the loans that other lenders proposed to swap. App., infra, 3a-4a, 28a-29a. /5/ Respondent performed no "underwriting" of the loans it was to receive, i.e., it did not investigate individual loan files, employment and credit histories of the individual borrowers, or the underlying value of the property securing the individual loans. See id. at 30a n.11; C.A. App. 414. The pricing or valuation of all of the loans was established by applying a common discount factor based on then-current interest rates to all of the loans on each side of each transaction. C.A. App. 414-415. Each transaction was consummated in the form of a "reciprocal sale" by conveyance of the 90% participation interests together with a simultaneous transfer of money by both parties in the amount of the fair market value of the interests acquired. App., infra, 29a. Respondent claimed deductions for losses on the transactions for the years 1980 and 1981 in the amounts of $194,573,659 and $70,042,179, respectively (id. at 4a). Respondent did not report any loss for financial accounting purposes (id. at 36a). 3. On audit, the Commissioner determined that respondent was not entitled to its claimed deductions for losses on the mortgage exchange transactions. Respondent sought redetermination of the resulting income tax deficiencies in the Tax Court. App., infra, 2a, 4a. After a trial, the Tax Court held for respondent on this issue (id. at 42a-48a). /6/ The Commissioner's primary argument was that a loss is "realized" for tax purposes on an exchange of property only if the exchanged properties are "materially different" and that mortgages that were "substantially identical" under the Memorandum R-49 criteria were not materially different. The Tax Court concluded that the loans taxpayer transferred were "materially different" from the loans it received because the loans had different borrowers and were secured by different collateral (App., infra, 43a-45a). The Tax Court also rejected the Commissioner's argument that, because the mortgage exchange lacked economic substance, deduction of the loss was not authorized by Section 165 of the Internal Revenue Code (26 U.S.C.) (App., infra, 47a-48a). /6/ The court of appeals affirmed (App., infra, 1a-19a). Relying heavily on the Fifth Circuit's recent decision in San Antonio Savings Ass'n v. Commissioner, supra, the court held that a financial institution realizes a deductible loss on a Memorandum R-49 mortgage exchange transaction (App., infra, 5a-9a). The court specifically noted that the Fifth Circuit and the Sixth Circuit (see Cottage Savings Ass'n v. Commissioner, 890 F.2d 848 (6th Cir. 1989), petition for cert. pending, No. 89-1965) had reached contrary conclusions on this issue, and stated that the Fifth Circuit's decision in San Antonio "provides the correct evaluation of the tax consequences" of an R-49 transaction (App., infra, 5a). Thus, like the Fifth Circuit, the court of appeals concluded that in order for a loss on an exchange to be realized, "the property exchanged must be materially different" (id. at 6a), but it proceeded to hold that the loans exchanged here were materially different because the differences in obligors and the property securing the loans "foreclose any argument that the exchanged mortgages were identical" (id. at 7a-8a). The court also rejected the Commissioner's argument that the transactions lacked economic substance and therefore the losses were not deductible under Section 165 (App., infra, 8a-9a). REASONS FOR GRANTING THE PETITION This case presents the same question that is presented in three petitions pending from the decisions of the Fifth Circuit that were relied upon by the court below -- United States v. Centennial Savings Bank (Resolution Trust Corporation, Receiver), No. 89-1926 (Question 1); United States v. First Federal Savings and Loan Ass'n, No. 89-1927; Commissioner v. San Antonio Savings Ass'n and Subsidiaries (Resolution Trust Corporation, Receiver), No. 89-1928 -- namely, whether a financial institution realizes a deductible loss for income tax purposes when it exchanges a group of mortgage loans for a "substantially identical" group of mortgage loans. As we explain in detail in our petition in Centennial, review of this question by this Court is warranted because there exists a square conflict in the circuits and the issue is of considerable importance to the administration of the federal tax laws. /7/ We have accordingly urged that the Court grant plenary review in Centennial and in First Federal (see Centennial Pet. 13 n.10). Because the question presented here is the same as that already presented in First Federal and in Centennial, we believe that there is no need for the Court to grant plenary review in this case as well but that it would be appropriate for the Court to hold this case pending the outcome in Centennial and First Federal. CONCLUSION The petition for a writ of certiorari should be disposed of as appropriate in light of this Court's disposition of United States v. Centennial Savings Bank (Resolution Trust Corporation, Receiver), No. 89-1926, and United States v. First Federal Savings & Loan Ass'n, No. 89-1927. Respectfully submitted. JOHN G. ROBERTS, JR. Acting Solicitor General /8/ SHIRLEY D. PETERSON Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General ALAN I. HOROWITZ Assistant to the Solicitor General RICHARD FARBER BRUCE R. ELLISEN Attorneys JUNE 1990 /1/ Memorandum R-49 specifically provided in part (App., infra, 27a; C.A. App. 10): A loss resulting from a difference between market value and book value in connection with reciprocal sales of substantially identical mortgage loans need not be recorded. Mortgage loans are considered substantially identical only when each of the following criteria is met. The loans involved must: 1. involve single-family residential mortgages, 2. be of similar type (e.g., conventionals for conventionals), 3. have the same stated terms to maturity (e.g., 30 years), 4. have identical stated interest rates, 5. have similar seasoning (i.e., remaining terms to maturity), 6. have aggregate principal amounts within the lesser of 2 1/2% or $100,000 (plus or minus) on both sides of the transaction, with any additional consideration being paid in cash, 7. be sold without recourse, 8. have similar fair market values, 9. have similar loan-to-value ratios at the time of the reciprocal sale, and 10. have all security properties for both sides of the transaction in the same state. /2/ A memorandum from the Director of OES to an officer of the Bank Board described the "objective" of Memorandum R-49 as "to structure a transaction which was as close as possible to the IRS 'materially different' definition which would still not change the economic position of the association after it engaged in the swap." See San Antonio Savings Ass'n v. Commissioner, 887 F.2d at 580. /3/ Transactions designed to take advantage of Memorandum R-49 often involved exchanges of 90% participation interests, rather than the entire loan, so that the original mortgagee could maintain its relationship with the obligor on the loans. See Cottage Savings Ass'n v. Commissioner, 90 T.C. 372, 381 (1988), rev'd, 890 F.2d 848 (6th Cir. 1989), petition for cert. pending, No. 89-1965. /4/ The mortgages also satisfied four additional criteria imposed by respondent. These requirements related primarily to the payment history of the loans and were designed to establish minimum quality standards for the exchanged loans. App., infra, 27a-28a. /5/ In addition, the computer analysis was designed to give preference to receiving loans with urban postal zip codes and transferring loans that lacked urban zip codes, because respondent had been criticized by the Secretary of Housing and Urban Development for having insufficient holdings of urban mortgages. App., infra, 29a, 32a-33a. /6/ The litigation in the Tax Court also involved a second, distinct issue. Respondent had also entered into certain "Resale/Refinance" transactions in order to improve its financial position in the wake of the interest rate changes of the early 1980s. The Commissioner had disallowed loss deductions claimed by respondent as a result of these transactions, which were entirely unrelated to the Memorandum R-49 transactions in issue here. The Tax Court sustained the disallowance of those deductions (App., infra, 48a-52a), and the court of appeals affirmed that ruling (id. at 9a-19a). /7/ We are supplying respondent's counsel with copies of our petitions in Centennial, First Federal, and San Antonio. /8/ The Solicitor General is disqualified in this case. APPENDIX