Recent Financial Products Developments Jeff Callender Partner Deloitte Tax LLC June 25, 2008

1 Copyright © 2008 Deloitte Development LLC. All rights reserved. Agenda Prop. Reg (e) withdrawal Debt market turmoil and tax straddles Other developments

Proposed Reg (e) Withdrawal

3 Copyright © 2008 Deloitte Development LLC. All rights reserved. Burbank Liquidating Corp.  In Burbank Liquidating, the Tax Court in March 1963 considered whether mortgage loans originated by Burbank in its trade or business were acquired “for services” such that they were within the scope of sec. 1221(4) (current 1221(a)(4))  The Tax Court concluded that such mortgage loans were “for services”, because the “business of a savings and loans company could properly be described as “rendering the service of making loans.””  Ninth Circuit court affirmed this holding in July 1964.

4 Copyright © 2008 Deloitte Development LLC. All rights reserved. Fannie Mae  Tax Court in June 1993 directly considered whether the “for services” rationale of Burbank Liquidating should apply to Fannie Mae’s facts.  Unline the taxpayer in Burbank, Fannie Mae did not originate loans, but instead purchased mortgages and mortgage-related securities in the secondary markets to further its US Government chartered purpose of providing liquidity to the mortgage markets (i.e., to the originators of mortgage loans).  Tax Court held that the mortgages and related securities in Fannie Mae’s portfolio were acquired “for services” with the meaning of sec. 1221(4)

5 Copyright © 2008 Deloitte Development LLC. All rights reserved. Proposed Reg. sec (e)  On August 7, 2006, the Treasury Dept. and the IRS published this proposed regulation under sec. 1221(a)(4).  These proposed regulations sought to “clarify” the circumstances in which accounts or notes received are “acquired … for services rendered”.  Defined to not include the acquisition of a note in the provision of services to the secondary market (i.e. the Fannie Mae fact pattern).  The Proposed Reg. was effectively a public statement that Treasury and the IRS were not going to follow the Fannie Mae case because they believed it was not Congress’ intent and was bad tax policy.

6 Copyright © 2008 Deloitte Development LLC. All rights reserved. Withdrawal of the Proposed Regs  Treasury/IRS withdrawal of the Proposed Regs was announced April 22, 2008 (published as Announcement on May 12, 2008).  Overwhelming positive response from taxpayers and practitioners.  In Announcement, Treasury/IRS stated that they would not challenge tax return positions that apply existing law re sec. 1221(a)(4), including positions based on Burbank Liquidating and Fannie Mae.  Treasury/IRS will continue to study this area and may issue guidance in the future.

Debt market turmoil and tax straddles

8 Copyright © 2008 Deloitte Development LLC. All rights reserved. Sec – Tax straddles  Tax straddle defined as offsetting positions which effect a “substantial diminution” of risk of holding the other position (in property “of a type” that is actively traded).  Significant discussion as to how much risk reduction is required in order to form a tax straddle.  Various views abound, but most conservative view is to use a standard similar to the “substantial authority” opinion standard, i.e. 35 – 50% risk reduction is enough to constitute a straddle.

9 Copyright © 2008 Deloitte Development LLC. All rights reserved. Client straddle question – March 2007  Client hedge fund was pursuing a strategy of acquiring certain debt and mortgage pools and mortgage backed securities and reducing the interest rate risk by entering into interest rate swaps.  Client maintained that they were reducing only a small percentage of the overall risk of their investments, and therefore did not have straddles.  Client provided stress tests of various risks, including interest rate, liquidity and counterparty risks, increasing and decreasing the basis point stresses by 50 bp increments.

10 Copyright © 2008 Deloitte Development LLC. All rights reserved. Tax straddle – Conclusion, March 2007  After reviewing the client produced stress tests of all the types of risks, we agreed that reducing the interest rate risk using swaps only reduced a small fraction, like around 5 -8%, of the overall risk, and thus we agreed that there were no tax straddles.

11 Copyright © 2008 Deloitte Development LLC. All rights reserved. Tax straddles – Final result  Unfortunately, the client’s assertions and our conclusions were born out with the debt market turmoil starting in the second half of  The fund suffered severe liquidity losses and closed in early  Moral of the story: Don’t assume that if a debt security has interest rate exposure removed with interest rate swaps, that a straddle is always formed. The debt market turmoil we are experiencing is proving that there are many other types of risk that must be taken into account.

Other Developments

13 Copyright © 2008 Deloitte Development LLC. All rights reserved. Speaker information  Jeff Callender, ,

About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, and its network of member firms, each of which is a legally separate and independent entity. Please see for a detailed description of the legal structure of Deloitte Touche Tohmatsu and its member firms. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Copyright © 2008 Deloitte Development LLC. All rights reserved.