By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
On May 24, 2012, the IRS issued a private letter ruling addressing the treatment of "excess servicing spreads" (ESS) in the hands of a real estate investment trust (REIT). PLR 201234006 ruled that ESS purchased by a REIT from a loan originator were interests in mortgages on real property for purposes of §856(c)(5)(B) and that income received by the REIT from such ESS would be treated as interest on mortgages for purposes of §856(c)(3)(B).
Why is a REIT ruling under §856 of interest to an international tax practitioner, you may wonder? As it happens, the ruling sheds light on how to define the activity of loan origination, a vexed question in international tax circles.
PLR 201234006 describes the transactions that gave rise to ESS as follows:Originators of mortgage loans often bundle and sell the mortgage loans they originate. Buyers of mortgage loans will typically either service the mortgage loans themselves or enter into a servicing agreement with respect to the loans. The servicer under the servicing agreement may be the originator of the mortgages or a third-party servicer.
In consideration for performing mortgage servicing activities, a servicer will generally retain the right to receive a portion of the interest payments made by the borrower with respect to the pool of mortgages being serviced. The amount of interest retained by the servicer (the Mortgage Servicing Spread), will be treated in part by the servicer as reasonable compensation for services performed. The portion of a Mortgage Servicing Spread that exceeds reasonable compensation for services performed (the Excess Servicing Spread) represents a continuing investment in the interest component of the underlying mortgage pool.
The ruling goes on to state that mortgage servicers may sell all or a portion of the ESS to third parties, such as the REIT here in question. Although the ruling does not say so, it seems evident that selling ESS is a form of financing for the servicer, with the purchaser of the ESS acting in substance as a factor (and likely paying a discount to present value).
The ruling discusses two types of ESS that were sold to the REIT. Under a "current spread agreement," the REIT acquires an ESS that already exists at the time the agreement is entered into, and presumably pays in full at that time. The other type of ESS is a "future spread agreement" pursuant to which the REIT has either the right or the obligation to acquire an ESS that arises in the future, either from refinancing of underlying mortgages with respect to which the REIT already owns the ESS, or from new loans. The ruling states that payment terms under future spread agreements can vary: the REIT may make payment at the time the agreement is entered into, or only later when the ESS is actually acquired. In the latter case, the purchase price may or may not be predetermined. Worth noting here is that a future spread agreement resembles an agreement to advance funds at the original issue of the underlying mortgage loan (or pool of mortgage loans). In contrast, under a current spread agreement, the REIT is buying into property that has already been created.
The ultimate ruling in PLR 201234006 is that income denominated as paid for "services" may, in substance, consist of two components - a portion being treated as interest on a mortgage loan and a portion being treated as reasonable compensation for services. This much of the ruling was nothing new. The private ruling cited a much earlier published ruling, Rev. Rul. 91-46,1 which addressed the issue in the context of determining the portion of a mortgage servicing spread treated as interest for purposes of the stripped coupon rules of §1286. In the revenue ruling, a loan originator sold mortgage loans to an agency that repackaged the loans for sale to investors, with the purchaser entering into a contract with the originator under which the originator agreed to service the loans. In the published ruling, unlike in the PLR, the originator retained the full mortgage servicing spread, including the ESS portion. The published ruling took note of the fact that the amount of the spread that the seller retained exceeded reasonable compensation for the services it performed,2 and treated the excess amount - the ESS retained - as the equivalent of interest.
The IRS's bifurcation of mortgage servicing spreads into compensation for mortgaging services provided to the owner of the loans and some excess amount makes sense. Rev. Rul. 91-46 enumerated the types of services that the owner of the loans might expect the servicer to perform for an arm's-length fee: collecting monthly mortgage payments from borrowers, remitting those payments to the mortgage holders, accumulating escrows for the payment of insurance and taxes, disbursing those payments as they come due, maintaining records relating to the mortgages, and handling delinquency problems. It ruled that, to the extent that the amounts received by the servicer were treated as reasonable compensation for these services, those amounts were treated as having been received by the mortgage buyer from the borrowers and paid to the servicer as compensation.
However, the published ruling's treatment of the excess income retained by the originator/servicer seems questionable. The ruling treated the excess as interest on the underlying debt, and concluded that, to the extent the amounts were treated as interest, they were treated as received directly by the servicer from the borrowers. Given that the servicer retained no portion of the underlying debt, this conclusion seems strained. It seems evident that the mortgage servicer would not have become entitled to earn the ESS unless it had first originated the loans. This implies that the "interest" portion of its income must have been attributable to its activity of originating, rather than owning, the loans.
Whatever the flaws of Rev. Rul. 91-46 may have been as applied to ESS retained by the originator/servicer, the PLR is correct insofar as it found that the REIT did not receive servicing income. The REIT provided no mortgage servicing services at all. However, it remains a stretch to find that the REIT was the owner of an interest in mortgages that it never owned. The better view is that the REIT acquired a stream of payments that itself constituted property. An alternative and equally reasonable approach would treat the REIT as providing financing to the loan originator, which seems particularly apt in respect of future spread agreements.
Whether the REIT was treated as acquiring loans to the ultimate borrowers, as the PLR implies, or as providing financing to the loan originator, which seems the better analysis, the PLR was correct not to consider the REIT to be engaged in loan origination. Loan originators are compensated for making credit available, for facilitating liquid markets for loans, and for the underlying due diligence and evaluation of potential loans. In most cases, the loan originator will earn for these activities what are commonly labeled "origination fees," often up to 1% of the amount borrowed. As the PLR clearly acknowledged, a loan originator may or may not retain any ownership interest in loans it originates. (It is equally true that a mortgage servicer may or may not have originated the loans it services; if it did not, one would not expect it to earn any ESS.) As the ruling states, a loan originator will "often bundle and sell the mortgage loans" it originates. Such sales do not serve to convert the purchasers into loan originators.
Loan origination is a trade or business like any other, such as making widgets or selling legal services. Whether a person is engaged in the business of loan origination is a question of fact, just as it is in any other case. The mere fact that one person lends money to another, standing alone, does not lead to the conclusion that the lender is in a business, even if that activity is done regularly. Such a lender may be simply an investor, just as an investor that frequently purchases stock would be. What distinguishes a person who is engaged in the trade or business of loan origination from a mere investor in loans is the provision of services for a fee and having "customers," both in the sense of the borrowers and the ultimate purchasers of the originated loans.
There is no suggestion anywhere in these rulings that the REIT was in the business of loan origination or that it was earning fees in a business. Indeed, if that had been the case, the income would have been properly characterized as falling within §856(c)(3)(G) (applicable to amounts received as consideration for agreeing to make loans) and not, as the private ruling found, within §856(c)(3)(B).
What does this tell us about loan origination and whether a foreign person who makes loans to borrowers at original issue should be treated as engaged in a business? It tells us that simply making loans, even at original issue, is not a business. In order to be engaged in a business, the foreign person should be performing real loan origination activities.3 If the foreign person is merely the passive recipient of an opportunity to be part of the day one lender syndicate, no business is involved, no matter how regular and continuous that activity may be.
This commentary also will appear in the November 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, and in Tax Practice Series, see ¶7130, Foreign Persons - Effectively Connected Income.
1 1991-2 C.B. 358.
2 In accompanying Rev. Proc. 91-50, 1991-2 C.B. 778, the IRS set forth safe harbors for determining what constituted reasonable compensation for mortgage servicing services.
3 A foreign person may originate loans through an agent, as was asserted in AM 2009-010, but that is clearly not a fact pattern implicated here.
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