125 T.C. No. 12
UNITED STATES TAX COURT
FEDERAL HOME LOAN MORTGAGE CORPORATION, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 3941-99, 15626-99. Filed November 21, 2005.
P received commitment fees for entering into prior approval purchase contracts with mortgage originators. The contracts obligated P to purchase mortgages from originators during a specified period of time pursuant to a pricing formula but did not require the originators to sell mortgages to P. The commitment fees equaled 2.0 percent of the principal amount of the mortgages. The commitment fees consisted of a 0.5- percent nonrefundable portion and a 1.5-percent refundable portion. In the taxable years 1985 through 1990, P treated the 0.5-percent nonrefundable portion of the commitment fees as premiums received for writing put options. As a result, when an originator sold a mortgage to P, P treated the 0.5-percent portion of the fee as a reduction of its purchase price and reported this amount as income over the estimated life of the mortgage. If an originator failed to sell the mortgage to P, P reported the 0.5 percent of the fee in the year - 2 -
in which the originator failed to exercise its right to sell the mortgage. R determined that the nonrefundable commitment fees should have been reported in the taxable year that P received the payment.
Held: In substance and form, P’s prior approval purchase contracts were put options, and P properly reported the nonrefundable portion of the commitment fees as option premiums.
Robert A. Rudnick, James F. Warren, Alan J. Swirski,
Richard J. Gagnon, Jr., and B. John Williams, Jr., for
petitioner.
Gary D. Kallevang, for respondent.
OPINION
RUWE, Judge: Respondent determined deficiencies in
petitioner’s Federal income taxes in docket No. 3941-99 as
follows:
Year Deficiency
1985 $36,623,695 1986 40,111,127
Petitioner claims overpayments of $9,604,085 for 1985 and
$12,418,469 for 1986.
Respondent determined deficiencies in petitioner’s Federal
income taxes in docket No. 15626-99 as follows:
1987 $26,200,358 1988 13,827,654 1989 6,225,404 1990 23,466,338 - 3 -
Petitioner claims overpayments of $57,775,538 for 1987,
$28,434,990 for 1988, $32,577,346 for 1989, and $19,504,333 for
1990.
In this Opinion, we decide whether certain nonrefundable
commitment fees that mortgage originators paid to petitioner to
enter into Conventional Multifamily Prior Approval Purchase
Contracts (prior approval purchase contracts) are to be
recognized when those fees are paid or should be treated as
premium for “put” options, which would defer recognition until
after delivery or nondelivery of the underlying mortgages.1 This
issue is one of several involved in these cases.2
Background
The parties submitted this issue fully stipulated pursuant
to Rule 122.3 The stipulations of fact and the attached exhibits
are incorporated herein by this reference. At the time it filed
the petitions, petitioner maintained its principal office in
1 The adjustments proposed in the notices of deficiency for 1985 through 1990 pertaining to the commitment fee issue included a small amount of commitment fees related to single-family optional delivery mixed in with the prior approval program. The parties have since resolved the commitment fee issue as to the single-family program. 2 See Fed. Home Loan Mortgage Corp. v. Commissioner, 121 T.C. 129; 121 T.C. 254; 121 T.C. 279 (2003); T.C. Memo. 2003-298. 3 All Rule references are to the Tax Court Rules of Practice and Procedure, and all section references are to the Internal Revenue Code in effect for the taxable years in issue. - 4 -
McLean, Virginia. At all relevant times, petitioner was a
corporation managed by a board of directors.
Petitioner was chartered by Congress on July 24, 1970, by
title III (Federal Home Loan Mortgage Corporation Act) of the
Emergency Home Financing Act of 1970, Pub. L. 91-355, 84 Stat.
450. Petitioner was established to purchase residential
mortgages and to develop and maintain a secondary market in
conventional mortgages. A “conventional mortgage” is a mortgage
that is not guaranteed or insured by a Federal agency. The
“primary mortgage market” is composed of transactions between
mortgage originators (lenders, such as savings and loan
organizations) and homeowners or builders (borrowers). The
“secondary market” generally consists of sales of mortgages by
originators, and purchases and sales of mortgages and mortgage-
related securities by institutional dealers and investors. Since
its incorporation, petitioner has facilitated investment by the
capital markets in single-family and multifamily residential
mortgages. In the course of its business, petitioner acquires
residential mortgages from loan originators. Petitioner’s
business is a high-volume, narrow-margin business.
A. Multifamily Mortgage Program
A multifamily mortgage loan is a loan secured on a property
consisting of an apartment building with more than four
residences. Petitioner offered originators two programs for - 5 -
selling multifamily mortgages: (1) The immediate delivery
purchase program, and (2) the prior approval conventional
multifamily mortgage purchase program (prior approval program).
1. Immediate Delivery Purchase Program
Petitioner designed the immediate delivery purchase program
to accommodate the purchase of mortgages already closed and on an
originator’s books at the time an originator enters into a
purchase contract with petitioner. Although this program is
designed for portfolio mortgages, an originator may enter into an
immediate delivery purchase contract with petitioner before
actually closing on the mortgage. However, if for some reason
the mortgage cannot be delivered, petitioner can impose sanctions
on an originator.
To participate in the immediate delivery purchase program,
an originator telephones petitioner to make an offer for a
purchase contract. When petitioner receives a telephone offer
from an originator, that offer is “an irrevocable offer that the
[originator] may not modify.” Petitioner may accept an offer
within 2 business days of receiving the telephone offer. When
petitioner accepts an offer, it executes two copies of the
purchase contract and mails the contract to an originator.
Within 24 hours of receiving the purchase contract, an originator
must execute the contract and mail one copy along with a $1,500
nonrefundable application/review fee or 0.1 percent of the - 6 -
purchase contract, whichever is greater, to petitioner’s
applicable regional office. If an originator failed to
acknowledge and submit a copy of a purchase contract, petitioner
may disqualify or suspend an originator as an eligible seller to
petitioner. After completing a documentation review,
underwriting, and property inspections, if any, petitioner’s
applicable regional office will contact an originator. The
mortgages acceptable to petitioner will be identified and
purchased.
An originator must deliver the mortgages to petitioner
within the 30-calendar-day commitment period. In most cases, the
penalty for nondelivery is disqualification or suspension of an
originator from eligibility to sell mortgages to petitioner.4
Under the immediate delivery purchase program, petitioner
established its required net yield when originators offered the
4 Petitioner’s Sellers’ & Servicers’ Guide, which is part of the contract, states that petitioner “may disqualify or suspend a * * * [an originator] for * * * [an originator’s] failure to deliver any documents under a * * * mandatory delivery purchase program, as required by section 0601”. Sec. 0601 of the Sellers’ and Servicers’ Guide states that “Delivery under the * * * immediate delivery purchase programs is mandatory. * * * Delivery is not mandatory under the home mortgage optional delivery purchase programs.” The guide also provides that petitioner may disqualify or suspend an originator for “failure to observe or comply with any term or provision of the purchase document”. In addition to disqualification and suspension, petitioner “reserves the right to take whatever other action it deems appropriate to protect its interests and enforce its rights”. - 7 -
contracts. The required net yield is the interest rate that
petitioner will receive from the mortgage it purchases from an
originator. Petitioner did not charge an upfront commitment fee
in its immediate delivery purchase program.
2. Prior Approval Program
Alternatively, originators may sell multifamily mortgages to
petitioner under the prior approval program, which began in 1976.
Under this program, petitioner entered into contracts with
originators to purchase a multifamily mortgage before the closing
date of the mortgage. In general, each executed prior approval
purchase contract pertained to a single mortgage, as opposed to a
pool of mortgages. Petitioner’s promotional pamphlets state that
this program offered originators the “peace of mind” of knowing
that petitioner would purchase the loan once it closed. The
pamphlets also explain that once an originator entered into a
prior approval purchase contract with petitioner, “delivery of
the loan is still optional, so [the originators] don’t have to
worry if the deal hits a snag or falls through completely.”
Under the prior approval program, originators were not
obligated to deliver the multifamily mortgage to petitioner.
Petitioner’s Sellers’ & Servicers’ Guide is part of the contract
between an originator and petitioner. Petitioner’s Sellers’ &
Servicers’ Guide states: “Delivery under this program is
optional. However, unless the optional delivery contract is - 8 -
converted to a mandatory delivery contract within the 60-day
optional delivery period, the mortgage may not be delivered and
[petitioner] will retain the entire 2-percent commitment fee
required pursuant to section 3004.” The Sellers’ & Servicers’
Guide also provides:
The optional delivery date stated in the purchase contract will be within 60 days from the date [petitioner] issues the purchase contract plus the 10- business-day period in which the [originator] may accept the purchase contract. During the 60-day period, if the [originator] intends to deliver the mortgage(s) to [petitioner], the [originator] must convert the optional delivery purchase contract to a 30-day mandatory delivery purchase contract. * * *
To receive a prior approval purchase contract from
petitioner, an originator must submit a request for prior
approval of a specific multifamily project. Along with the
request, an originator paid a nonrefundable loan application fee
of the greater of $1,500 or 0.10 percent of the original
principal amount of the mortgage (but not in excess of $2,500).
After completion of processing, including underwriting and
property inspections, petitioner would determine whether the
mortgage was acceptable. Id. If acceptable, petitioner would
execute a prior approval purchase contract (also called Form 6),
which it mailed to an originator. An originator wishing to
participate in the prior approval program would execute the Form
6, and mail or deliver it to petitioner no later than 10 business
days from the - 9 -
date of petitioner’s offer. Form 6 would set forth details of
the specific mortgage that an originator could deliver.
Between 1985 and 1991, petitioner required an originator to
submit a 2-percent commitment fee with the executed prior
approval purchase contract. During the years at issue, the 2-
percent commitment fee consisted of a 0.5-percent nonrefundable
portion and a 1.5-percent portion that was refundable if an
originator delivered the mortgage under the prior approval
purchase contract.5 Petitioner was entitled to keep the
nonrefundable portion when it entered into the agreement. The
0.5-percent portion of the commitment fee received by petitioner
was not held in trust or escrow and was subject to unfettered
control by petitioner.
If an originator did not deliver the specific mortgage to
petitioner, it forfeited the 1.5-percent refundable portion of
the commitment fee. Forfeiture of the refundable portion of the
fee in the event of nondelivery functioned as a delivery
5 In 1982, petitioner charged a commitment fee equal to 2 percent of the commitment amount (the principal amount of the mortgage to be delivered), which was fully refunded to a mortgage originator if the mortgage was delivered. In September 1983, the commitment fee was changed so that the amount charged to a mortgage originator was still 2 percent, with 1 percent being nonrefundable and 1 percent refundable when the mortgage loan was delivered. The commitment fee structure was changed again for the years in issue. - 10 -
incentive consistent with petitioner’s business preference to buy
mortgages in the secondary market.6
Under the prior approval program, an originator had the
right, but not the contractual obligation, to elect at any time
during the ensuing 60 days (or in some cases 15 days) to enter
into a mandatory commitment to deliver a conforming mortgage to
petitioner. Under this program, petitioner committed to
purchasing a mortgage when an originator delivered it to
petitioner within the delivery period.7
Petitioner required originators to service the mortgages
they sold to petitioner. Originators received compensation for
performing this service (the compensation is known as the minimum
servicing spread). For the years at issue, the minimum servicing
fee (the originator’s retained spread over the life of the
mortgage) was 25 basis points (bps)8 on mortgages less than $1
million, 12.5 bps on mortgages between $1 and $10 million, and
was negotiable on mortgages more than $10 million.
6 For Federal income tax purposes, the 1.5-percent refundable portion of the commitment fee was treated by petitioner as a payable upon its receipt and was taken into income only if the underlying mortgages were not delivered to petitioner. Petitioner’s tax accounting for the 1.5-percent refundable portion of the fee is not at issue. 7 The Sellers’ & Servicers’ Guide does not use the term “put options” or “put option” to describe these commitment arrangements. 8 A basis point (bp) is 1/100th of a percent. - 11 -
To exercise its delivery right under a prior approval
purchase contract, an originator was required to give notice of
conversion to petitioner and enter into a 30-day “mandatory
delivery contract” on Form 64A, Conventional Multifamily
Immediate Delivery Purchase Contract and Prior Approval
Conversion Amendment. An originator could elect to deliver the
multifamily mortgage at petitioner’s maximum required net yield
or at an alternate required net yield.9 Petitioner’s required
net yield was the rate at which originators could contract to
deliver a mortgage under the immediate delivery purchase program.
The maximum required net yield was the fixed rate, or locked-in
interest rate, that petitioner and an originator had previously
agreed upon in Form 6.10 The alternate required net yield was
the rate at which an originator could contract to deliver a
mortgage to petitioner under the immediate delivery purchase
program as quoted by petitioner on any day during the 60-day (or
9 Effective July 1986, upon electing to effectuate delivery with a mandatory delivery contract with an alternative required net yield, an originator could request an increase in the maximum amount of the mortgage to be delivered. The amount of any increase was at the sole discretion of petitioner. Upon the request for an increase, an originator was required to remit $1,000 plus 2 percent of the increased mortgage amount within 24 hours. Of this 2 percent, 0.5 percent was nonrefundable and, if approved, petitioner was entitled to retain the fee. Upon purchase of the mortgage, petitioner refunded 1.5 percent of the total mortgage amount as increased. 10 The maximum required net yield is the maximum interest rate that petitioner may receive from the mortgage delivered by an originator. - 12 -
15-day) optional delivery period; if the required net yield moved
downward, an originator could select the lower required net
yield. The purchase price and net yield to petitioner became
fixed upon an originator’s selection of either the maximum
required net yield, or the alternate required net yield on any
day during the 60-day (or 15-day) period that an originator
elected an alternate required net yield. The purchase price
either would reflect a discount from par (100 percent of unpaid
principal balance (UPB)) or would be at par, depending on the
relationship of the rate on the mortgages (coupon rate) actually
tendered by an originator to the “minimum gross yield”, which was
the sum of the required net yield selected and the minimum
servicing spread.11
For example, suppose an originator and petitioner entered
into a prior approval purchase contract with respect to a
mortgage in the maximum amount of $6 million. The originator
paid the 2-percent commitment fee in the amount of $120,000. The
mortgage was subject to a maximum mortgage interest rate of
12.595 percent, and the maximum required net yield to petitioner
was 12.470 percent. The difference, 0.125 percent or 12.5 bps,
represents the minimum spread to be retained by an originator for
11 When an originator serviced a mortgage for petitioner, it received the amount of interest on the mortgage in excess of the required net yield. The minimum servicing spread is the difference between the maximum mortgage interest rate and the maximum required net yield. - 13 -
servicing the mortgage, or $7,500/year. If an originator
contemplated selling the subject mortgage to another buyer in
lieu of petitioner, it would have to consider the effect of
forfeiting the otherwise refundable portion of the commitment
fee, or $90,000, in comparison to the spread it could obtain with
another purchaser.
In the event that petitioner’s required net yield on any day
during the 60-day (or 15-day) period exceeded the “maximum
required net yield”, petitioner could be required on that day to
contract to purchase conforming mortgages at the maximum required
net yield stated on the Form 6, instead of at its current day
required net yield. This arrangement effectively ensured that an
originator could make a mortgage loan to a borrower at a
particular rate, and would be protected against having to sell it
to petitioner at a discount from par, or at an additional
discount as a result of an increase in petitioner’s required net
yield during the 60-day (or 15-day) period. Because it could
select the maximum required net yield if market rates increased,
an originator was assured of dealing at a rate that was no higher
than was specified in the prior approval purchase contract.
Thus, an upward movement in interest rates normally would not
prevent an originator from delivering a mortgage under the prior
approval program. Alternatively, if interest rates went down, an
originator would have the benefit (whether in the form of a - 14 -
greater spread or less of a discount from UPB) of selecting an
alternate required net yield in lieu of the higher maximum
required net yield as stated in the prior approval purchase
contract.12
If an originator selected an alternate required net yield,
it was required to give notice of this selection no later than
the date of conversion to mandatory delivery. If an originator
failed to give notice of conversion to a mandatory commitment
within 5 business days of selecting an alternate required net
yield, the prior approval purchase contract would be terminated,
and petitioner would retain the entire 2-percent commitment fee.
Nondelivery generally occurred when the borrower repudiated
or defaulted on its arrangement with the originator so that the
originator did not have the mortgage to deliver.13 Unlike
originators who entered into an immediate delivery purchase
program, when an originator participating in the prior approval
program failed to deliver a mortgage, it was not disqualified or
suspended as an eligible seller of mortgages to petitioner.
12 If petitioner’s required net yield on the day of delivery election was lower than the maximum required net yield, an originator holding a higher than current market-rate mortgage would normally obtain a spread greater than the minimum servicing spread specified in sec. 2603 of petitioner’s Sellers’ and Servicers’ Guide. 13 An originator finding a more attractive opportunity for disposing of a mortgage had to consider the forfeiture of the 1.5-percent refundable portion of the commitment fee. - 15 -
In computing its taxable income for the years 1985 through
1991, petitioner treated the 0.5-percent nonrefundable portion of
the commitment fees as premium received for writing put options
in favor of the various mortgage originators. Petitioner
generally did not include in taxable income amounts received for
the 0.5-percent nonrefundable portion of the commitment fee in
the year of receipt. Petitioner deducted such nonrefundable
amounts from the cost basis of mortgages purchased when
originators delivered mortgages to petitioner. Petitioner
amortized these amounts into income over multiyear periods of 7
or 8 years (i.e., the estimated life of the mortgages in
petitioner’s hands).14 If an originator failed to elect
mandatory delivery of the specified mortgages within the
prescribed period, petitioner recognized the nonrefundable
portion of the commitment fee in the current year if the last day
of the 60-day (or 15-day) period was within the current year.
During the years 1985 through 1991, petitioner received the
0.5-percent nonrefundable portion of the commitment fees pursuant
to the prior approval program in amounts totaling $9,506,398,
$16,489,524, $9,408,907, $4,525,606, $4,892,445, $2,805,392, and
$41,257, respectively. On its corporate returns for the years
14 When a mortgage was delivered in the same year that petitioner received the commitment fee, petitioner recognized the nonrefundable portion of the commitment fee in the year of receipt, to the extent of amortization for that year. - 16 -
1985 through 1993, petitioner included taxable income of
$5,636,762, $16,627,101, $2,035,928, $2,601,628, $3,213,184,
$3,563,858, $3,569,015, $3,569,015, and $3,569,015, respectively.
The adjustments in dispute in the 1985-90 taxable years are the
net differences between the amounts of nonrefundable commitment
fees received and reported for tax purposes, as follows:
Nonrefundable Amount in Commitment Fees Received Reported Dispute 1985-90
1985 $9,506,398 $5,636,762 $3,869,636 1986 16,489,524 16,627,101 (137,577) 1987 9,408,907 2,035,928 7,372,979 1988 4,525,606 2,601,628 1,923,978 1989 4,892,445 3,213,184 1,679,261 1990 2,805,392 3,563,858 (758,466)
In computing its taxable income for the year 1985,
petitioner overstated its income attributable to such receipts
under its method of accounting in the amount of $883,638 as a
result of a computational error.
During the years 1985 through 1988, and 1990, originators
failed to deliver at least 67 mortgages specified in prior
approval purchase contracts to petitioner.15 See appendix, which
lists these 67 contracts. As a result, the 1.5-percent
refundable portion of the 2-percent commitment fee was forfeited
to petitioner. During the relevant period, these 67 contracts
15 Petitioner was unable to locate records of the prior approval purchase contracts executed in 1989 that would identify the mortgages from that year, if any, where the specified mortgages were undelivered. - 17 -
represent approximately 1 percent (by value and number) of all
the contracts that petitioner entered into in the prior approval
program. Petitioner was not necessarily informed of the precise
reason for the nondelivery; petitioner believes that the typical
reason for nondelivery was failure of the underlying mortgage to
have been consummated.
Discussion
Petitioner argues that the 0.5-percent nonrefundable
portions of the commitment fees that originators paid to enter
into prior approval purchase contracts constitute “put” option16
premiums, the tax treatment of which could not be determined
until originators either exercised the options or allowed them to
lapse. Respondent disagrees, arguing that the 0.5-percent
nonrefundable portions of the commitment fees are not option
premium because the prior approval purchase contracts are not
option contracts. Respondent argues that petitioner had a fixed
right to the nonrefundable portion of the commitment fees when
the prior approval purchase contracts were executed and that
section 451 requires petitioner, as an accrual basis taxpayer, to
recognize the nonrefundable commitment fees in the year of
receipt because its right to retain the commitment fees was fixed
and determined.
16 A “put” option gives the option holder the right, but not the obligation, to sell something at an agreed upon price or pricing formula for a limited period of time. - 18 -
Section 451(a) generally provides that “The amount of any
item of gross income shall be included in the gross income for
the taxable year in which received by the taxpayer, unless, under
the method of accounting used in computing taxable income, such
amount is to be properly accounted for as of a different period.”
Accrual method taxpayers normally recognize income when “all the
events have occurred which fix the right to receive” income and
the amount of income “can be determined with reasonable
accuracy.” Sec. 1.451-1(a), Income Tax Regs. However, as more
fully explained, infra, payments of option premiums are not
recognized when received, even when the recipient has a fixed
right to retain the payments, because the character of those
payments is uncertain until the option has been exercised or has
lapsed. E.g., Old Harbor Native Corp. v. Commissioner, 104 T.C.
191, 200 (1995). Because of the unique facts in this case, we
must examine the rules governing the tax treatment of option
premiums and the policy underlying those rules to decide whether
a prior approval purchase contract constitutes an option for
Federal income tax purposes.
“An option has historically required the following two
elements: (1) A continuing offer to do an act, or to forbear
from doing an act, which does not ripen into a contract until
accepted; and (2) an agreement to leave the offer open for a
specified or reasonable period of time.” Id. at 201 (citing - 19 -
Saviano v. Commissioner, 80 T.C. 955, 970 (1983), affd. 765 F.2d
643 (7th Cir. 1985)). “The primary legal effect of an option is
that it limits the promisor’s power to revoke his or her offer.
An option creates an unconditional power of acceptance in the
offeree.” Id. (citing 1 Restatement, Contracts 2d, sec. 25(d)
(1981)). An option normally provides a person a right to sell or
to purchase “‘at a fixed price within a limited period of time
but imposes no obligation on the person to do so’”. See Elrod v.
Commissioner, 87 T.C. 1046, 1067 (1986) (quoting Koch v.
Commissioner, 67 T.C. 71, 82 (1976)). An agreement that purports
to be an “option”, but is contingent or otherwise conditional on
some act of the offering party, is not an option. Saviano v.
Commissioner, supra at 970.
An option contract grants the optionee the right to accept
or reject an offer according to its terms within the time and
manner specified in the option. Estate of Franklin v.
Commissioner, 64 T.C. 752, 762 (1975), affd. on other grounds 544
F.2d 1045 (9th Cir. 1976); 1 Williston on Contracts, sec. 5:16
(4th ed. 2004). Options have been characterized as unilateral
contracts because one party to the contract is obligated to
perform, while the other party may decide whether or not to
exercise his rights under the contract. U.S. Freight Co. v.
United States, 190 Ct. Cl. 725, 422 F.2d 887, 894 (1970). Courts
have found that the holder of an option must have a “truly - 20 -
alternative choice” to exercise the option or to allow it to
lapse. Id. at 895; see also Halle v. Commissioner, 83 F.3d 649,
654 (4th Cir. 1996), revg. and remanding Kingstowne L.P. v.
Commissioner, T.C. Memo. 1994-630; Koch v. Commissioner, supra at
82. Thus,
the clear distinction between an option and a contract of sale is that an option gives a person a right to purchase [or sell] at a fixed price within a limited period of time but imposes no obligation on the person to do so, whereas a contract of sale contains mutual and reciprocal obligations, the seller being obligated to sell and the purchaser being obligated to buy. [Koch v. Commissioner, supra at 82.]
Option payments are not includable in income to the optionor
until the option either has lapsed or has been exercised.
Kitchin v. Commissioner, 353 F.2d 13, 15 (4th Cir. 1965), revg.
T.C. Memo. 1963-332; Va. Iron Coal & Coke Co. v. Commissioner, 99
F.2d 919 (4th Cir. 1938), affg. 37 B.T.A. 195 (1938); Elrod v.
Commissioner, supra at 1066-1067; Koch v. Commissioner, supra at
89. In Rev. Rul. 58-234, 1958-1 C.B. 279, 283-284, the
Commissioner has reiterated these same principles:
An optionor, by the mere granting of an option to sell (“put”), or buy (“call”), certain property, may not have parted with any physical or tangible assets; but, just as the optionee thereby acquires a right to sell, or buy, certain property at a fixed price during a specified future period or on or before a specified future date, so does the optionor become obligated to accept, or deliver, such property at that price, if the option is exercised. Since the optionor assumes such obligation, which may be burdensome and is continuing until the option is terminated, without exercise, or otherwise, there is no closed transaction nor ascertainable income or gain realized by an optionor upon mere receipt of a premium for granting such an - 21 -
option. The open, rather than closed, status of an unexercised and otherwise unterminated option to buy (in effect a “call”) was recognized, for Federal income tax purposes, in A. E. Hollingsworth v. Commissioner, 27 B.T.A. 621, * * * (1933). It is manifest, from the nature and consequences of “put” or “call” option premiums and obligations, that there is no Federal income tax incidence on account of either the receipt or the payment of such option premiums, i.e., from the standpoint of either the optionor or the optionee, unless and until the options have been terminated, by failure to exercise, or otherwise, with resultant gain or loss. The optionor, seeking to minimize or conclude the eventual burden of his option obligation, might pay the optionee, as consideration for cancellation of the option, an amount equal to or greater than the premium. Hence, no income, gain, profits, or earnings are derived from the receipt of either a “put” or “call” option premium unless and until the option expires without being exercised, or is terminated upon payment by the optionor of an amount less than the premium. Therefore, it is considered that the principle of the decision in North American Oil Consolidated v. Burnet, 286 U.S. 417 * * * (1932), which involved the receipt of “earnings,” is not applicable to receipts of premiums on outstanding options.
Rev. Rul. 58-234, 1958-1 C.B. at 284, 285, summarizes the tax
treatment of put option premiums as follows:
[T]he amount (premium) received by the writer (issuer or optionor) of a “put” or “call” option which is not exercised constitutes ordinary income, for Federal income tax purposes, under section 61 of the Internal Revenue Code of 1954, to be included in his gross income only for the taxable year in which the failure to exercise the option becomes final.
* * * * * * *
[W]here a “put” option is exercised, the amount (premium) received by the writer (issuer or optionor) for granting it constitutes an offset against the option price, which he paid upon its exercise, in determining his (net) cost basis of the securities that - 22 -
he purchased pursuant thereto, for subsequent gain or loss purposes. * * *
See also Rev. Rul. 78-182, 1978-1 C.B. 265.
A contract is an option contract when it provides (A) the
option to buy or sell, (B) certain property, (C) at a stipulated
price, (D) on or before a specific future date or within a
specified time period, (E) for consideration. W. Union Tel. Co.
v. Brown, 253 U.S. 101, 110 (1920); Halle v. Commissioner, supra
at 654; Old Harbor Native Corp. v. Commissioner, 104 T.C. at 201;
Estate of Franklin v. Commissioner, supra at 762-763; Rev. Rul.
58-234, supra. To determine whether a contract constitutes an
option, courts look at the contractual language and the economic
substance of the agreement. Halle v. Commissioner, supra.
Petitioner’s prior approval purchase contracts exhibit the
following characteristics of an option for tax purposes: (1) The
prior approval purchase contracts satisfy the formal requirements
of option contracts; (2) the economic substance of the prior
approval purchase contracts indicates that the contracts are an
option; and (3) the rationale for granting open transaction
treatment to option premium applies to petitioner’s transactions.
1. Formal Requirements of the Option
Petitioner’s prior approval purchase contracts provide for
the optional delivery of mortgages by an originator. The
Sellers’ and Servicers’ Guide states: “Delivery under this
program is optional. However, unless the optional delivery - 23 -
contract is converted to a mandatory delivery contract within the
60-day optional delivery period, the mortgage may not be
delivered”. (Emphasis added.) The contractual terms
specifically provide that an originator has the right, but not an
obligation, to sell the mortgage to petitioner. The prior
approval purchase contract specified the mortgage that petitioner
was obligated to purchase if an originator exercised its option.
To participate in the prior approval program, an originator would
execute and deliver to petitioner a Form 6, which set forth the
details of a specific mortgage to be delivered.
Despite the language of the prior approval purchase
contracts, respondent argues that the form of the contracts does
not create an option. In support of his argument, respondent
quotes the Sellers’ & Servicers’ Guide, which states: “‘Under
this program, [petitioner] will contract with the [originator]
before the closing date of the mortgage to purchase a multifamily
mortgage on a specific existing project.’” Respondent argues
that the terms contain an explicit offer to purchase by
petitioner and an explicit acceptance by an originator.
We agree that petitioner has made an explicit offer to
purchase an originator’s mortgage; this is consistent with an
option contract. In fact, an essential characteristic of an
option contract is that one party is obligated to perform, while
the other party may decide whether or not to exercise his rights
under the contract. U.S. Freight Co. v. United States, 190 Ct. - 24 -
Cl. 725, 422 F.2d 887 (1970). Respondent’s position ignores both
the reality and the language in the Sellers’ & Servicers’ Guide
that delivery of the mortgage by an originator is “optional”.
Respondent argues that the prior approval purchase contracts
are not options because these contracts lack a fixed purchase
price that petitioner will pay in the event an originator
delivered a mortgage. Respondent contends that the price was not
fixed because an originator could deliver a mortgage at either
the maximum required net yield or the alternate required net
yield, which was not fixed until an originator converted a prior
approval purchase contract into a mandatory delivery contract.
The prior approval purchase contracts establish a formula to
determine the price, which petitioner and an originator agreed to
use. Form 6 identified the amount of the mortgage that
petitioner was obligated to purchase. The maximum required net
yield provides the minimum price that petitioner would pay to an
originator to purchase the mortgage. While the alternate
required net yield allowed an originator to potentially receive a
more favorable purchase price, we do not think that this feature
of the contract changes the fact that the parties to the prior
approval purchase contracts agreed to a formula that determined - 25 -
the stipulated price. See Estate of Franklin v. Commissioner, 64
T.C. at 763-764.
In an option contract, the seller agrees to hold an offer
open for a specified period of time. Old Harbor Native Corp. v.
Commissioner, supra at 201. It is clear that the prior approval
purchase contracts establish a specific time for an originator to
exercise its right to sell the mortgage to petitioner.
Petitioner granted an option for consideration. The
Sellers’ and Servicers’ Guide states:
A commitment fee of 2 percent of the amount of the purchase contract must be submitted by the [originator] with the executed purchase contract. Three-fourths of the commitment fee is refundable on the Freddie Mac funding date, when the mortgage, meeting all of the terms of the purchase contract and section 3803, is delivered to the applicable Freddie Mac regional office on or before the delivery date stated in the purchase contract.
When petitioner and an originator entered into a prior approval
purchase contract, petitioner was entitled to retain the 0.5-
percent nonrefundable portion of the commitment fee. This
nonrefundable portion of the commitment fee constitutes
consideration to petitioner for granting an option.
2. Economic Substance of the Option
An essential part of any option is that its potential value
to the optionee and its potential future detriment to the
optionor depends on the uncertainty of future events. An
optionee is willing to pay for potential future value, and the
optionor is willing to accept a potential future detriment for a - 26 -
price. For example, in a typical put option, the optionee is
willing to pay a premium to the optionor for the right to sell a
security to the optionor at an agreed price sometime in the
future. If the market value of the security falls below the
exercise price, the optionee can sell the security to the
optionor at a price greater than its value on the exercise date.
That potential opportunity is what the optionee paid for.
Likewise, the premium received by the optionor is compensation
for accepting the potential risk of having to purchase at an
unfavorable price. If the market value of the security rises
above the exercise price, the option will not be exercised, and
the optionor keeps the option premium for having accepted the
risk associated with uncertainty.
The prior approval program involves an option to sell
exercisable by an originator. An originator (optionee) can
choose to enforce its rights to sell a mortgage to petitioner
(optionor) at an agreed pricing formula but is under no legal
obligation to do so. During the period when it can exercise its
option to sell, the originator can choose between the agreed
maximum yield for petitioner or, if interest rates fall, a lesser
yield for petitioner. If interest rates rise above the agreed - 27 -
maximum yield, petitioner is required to purchase the mortgage on
terms less favorable than they would have been at current rates.
The option of whether to sell the mortgage also protects an
originator from the risk it might not close the subject mortgage,
making the sale to petitioner impossible. Without the option,
the originator’s failure to deliver could result in serious
sanctions including the originator’s disqualification from
further dealings with petitioner. An originator could avoid the
commitment fee altogether by entering into an immediate delivery
purchase contract; however, a failure to deliver the mortgage to
petitioner under an immediate delivery purchase contract can
result in sanctions including disqualification of an originator
from future mortgage sales to petitioner. In most cases, the
penalty for nondelivery is disqualification of an originator from
eligibility to sell mortgages to petitioner. Given petitioner’s
prominent position in the secondary mortgage market,
disqualification of an originator would seem to be of great
importance to an originator and would explain why an originator
is willing to pay the nonrefundable commitment fee in return for
retaining the option to deliver the mortgage. The uncertainty of
an originator’s ability to deliver a mortgage that has not closed
and the potential detriment to be suffered in that event,
constitutes a future contingency that the optionee is willing to
pay to protect itself against. This contingency, while
apparently unlikely to occur, is obviously of sufficient concern - 28 -
to originators to justify selection of the prior approval
purchase contract and payment of the nonrefundable portion of the
commitment fee, rather than entering into an immediate delivery
purchase contract and risk default and the related sanctions.
Petitioner, on the other hand, is willing to make delivery
optional, and thereby give up the rights and remedies it would
have had under an immediate delivery contract, in return for the
nonrefundable portion of the commitment fee.
Respondent argues that the possible forfeiture of the 1.5-
percent refundable portion of the commitment fee makes it
virtually certain that the mortgage sale will be consummated,
negating any real option for an originator. Petitioner
acknowledges that potential loss of the refundable portion of the
commitment fee was intended to encourage an originator to sell
the mortgage if there was a mortgage to sell. Indeed, an
originator’s agreement to forfeit the nonrefundable portion
indicates its intent to follow through with the sale if possible.
But the possible inability to deliver and related sanctions were
apparently of sufficient concern to originators to justify
payment of the 0.5-percent nonrefundable portion in order to make
delivery optional. If such risk were not significant,
originators could simply have entered into mandatory delivery
contracts and avoided the nonrefundable fee.
Respondent cites Halle v. Commissioner, 83 F.3d 649 (4th
Cir. 1996), as authority for his argument that there was no - 29 -
option. In Halle, a corporation owned land, which the taxpayer
wanted to purchase. The taxpayer formed a limited partnership to
purchase all the stock of the corporation. The limited
partnership and the corporation entered into a stock purchase
agreement, which stated that “‘Seller hereby agrees to sell to
Buyer, and Buyer agrees to purchase from Seller’” the stock of
the corporation for $29 million. The agreement required the
limited partnership to pay a $3 million deposit and the balance
at settlement. The agreement permitted the limited partnership
to defer the settlement date by paying monthly installments of
$225,000. If the limited partnership defaulted, the contract
provided that it would forfeit the downpayment and monthly
installments already paid. The limited partnership paid the
seller $900,000 to defer settlement and deducted those payments
as settlement interest on its income tax returns. The
Commissioner disallowed the claimed interest deduction, arguing
that the agreement was an option.
The Court of Appeals for the Fourth Circuit examined the
language of the stock purchase agreement and the economic
substance of the transaction to determine whether the contract
was an option. The Court found that under the terms of the
agreement, the seller had an unconditional obligation to sell the
stock, the limited partnership had an unconditional obligation to
purchase the stock, and the agreement did not expressly provide
the limited partnership with the option to withdraw from the - 30 -
transaction. The court also found that the economic substance of
the stock purchase agreement created indebtedness. To find that
the contract created indebtedness, the court relied on “(1) the
amount of the contractually specified liquidated damages, (2) the
extent to which [the limited partnership] assumed real economic
burdens of ownership before settlement, (3) [the limited
partnership’s] peripheral activities before settlement, and (4)
the absence of apparent motives for creating an option contract.”
Id. at 655.
Unlike Halle v. Commissioner, supra, we find that the terms
and the economic realities of the prior approval purchase
contracts indicate that these contracts were options. The
Sellers’ & Servicers’ Guide indicates that the prior approval
purchase contract offers an alternative to the immediate delivery
purchase program when an originator and the borrower have not
closed on a mortgage. By entering into an immediate delivery
purchase contract, an originator could receive a commitment from
petitioner without paying the 0.5-percent nonrefundable fee.
However, originators who participated in the prior approval
program chose to pay the commitment fee to protect themselves
from fluctuations in interest rates during the period when the
option was open and the uncertainty associated with the
possibility that the mortgages might not close within the
delivery period. Had originators been absolutely certain that
they could deliver the mortgages, they could have entered into an - 31 -
immediate delivery purchase contract and avoided any commitment
fee. The prior approval purchase contracts provided an
originator with protection in the event it could not deliver a
mortgage to petitioner. Thus, despite the fact that originators
delivered mortgages to petitioner in approximately 99 percent of
the prior approval purchase contracts, originators were
apparently willing to pay a premium for the option because they
were uncertain about when or whether they would in fact have a
mortgage to sell to petitioner.
3. Rationale for Option Treatment
The policy rationale for the tax treatment of an option as
an open transaction is that the outcome of the transaction is
uncertain at the time the payments are made. That uncertainty
prevents the proper characterization of the premium at the time
it is paid. See Dill Co. v. Commissioner, 33 T.C. 196, 200
(1959), affd. 294 F.2d 291 (3d Cir. 1961). “Since the optionor
assumes such obligation, which may be burdensome and is
continuing until the option is terminated, without exercise, or
otherwise, there is no closed transaction nor ascertainable
income or gain realized by an optionor upon mere receipt of a
premium for granting such an option.” Rev. Rul. 58-234, 1958-1
C.B. at 283.
Respondent argues that open transaction treatment is
inappropriate because petitioner had a fixed right to the
nonrefundable portion of the commitment fee at the time the prior - 32 -
approval purchase contracts were executed. However, the fixed
right to a payment does not determine the tax treatment of an
option premium. In Va. Iron Coal & Coke Co. v. Commissioner, 37
B.T.A. 195 (1938), affd. 99 F.2d 919 (4th Cir. 1938), the
taxpayer received payments for an option and had a fixed right to
retain them. The Court explained that these payments were
entitled to open transaction treatment, despite the taxpayer’s
right to retain the payments, because the taxpayer did not know
whether the funds would represent income or a return of capital
when they were received.
The uncertainty associated with the 0.5-percent
nonrefundable portion of the commitment fee is similar to the
uncertainty described by the Board of Tax Appeals in Va. Iron
Coal & Coke Co. v. Commissioner, supra. In that case (involving
a call option), the Court stated:
Had the option been exercised, they [the premium] would have represented a return of capital, that is, a recovery of a part of the basis for gain or loss which the property had in the hands of the seller. In that event they would not have been income and their return as income when received would have been improper. * * * But in case of termination of the option and abandonment by the Texas Co. of its right to have the payments applied as a part of the purchase price, it would be apparent for the first time that the payments represented clear gain to the petitioner. In that case, since no property would be sold, there would be no reason to reduce the basis of that retained.
Id. at 198. In the instant case, when an originator delivered a
mortgage, petitioner properly treated the nonrefundable portion
of the commitment fee as a reduction in the consideration that it - 33 -
paid for the mortgage. See Rev. Rul. 78-182, 1978-1 C.B. 265,
266; Rev. Rul. 58-234, 1958-1 C.B. at 285 (“[W]here a ‘put’
option is exercised, the amount (premium) received by the writer
(issuer or optionor) for granting it constitutes an offset
against the option price, which he paid upon its exercise, in
determining his (net) cost basis of the securities that he
purchased pursuant thereto, for subsequent gain or loss
purposes.”). In those instances when an originator failed to
deliver a multifamily mortgage to petitioner within the delivery
period, petitioner realized income in the year that an originator
allowed the option to lapse. See Rev. Rul. 58-234, supra.
Finally, respondent relies on Chesapeake Fin. Corp. v.
Commissioner, 78 T.C. 869 (1982), to support his argument against
treating the nonrefundable portion of the commitment fee as
option premium. In Chesapeake Fin. Corp., the taxpayer made
construction and permanent loans available to developers and
received commitment fees. Typically, a borrower would apply for
a loan for a proposed project, and the taxpayer would determine
whether the project was economically feasible. If the taxpayer
decided the project was feasible, it would obtain the borrower’s
authorization to place a loan with an institutional investor. If
the institutional investor approved the loan, it issued a
commitment to the taxpayer; upon acceptance, the commitment
constituted a contract between the institutional investor and the
taxpayer. The commitment specified the terms of the proposed - 34 -
loan and generally required the taxpayer to pay a nonrefundable
commitment fee. Most commitments also required the taxpayer to
pay an additional “deposit fee” in the event the loan failed to
close. The “deposit fee” usually equaled 1 percent of the
proposed loan. When the taxpayer received the commitment from
the institutional investor, the taxpayer issued its own
commitment to the borrower, which incorporated the terms and
conditions of the institutional investor’s commitment. The
borrower was required to pay a commitment fee and an additional
fee equal to the nonrefundable fee that the taxpayer paid to the
institutional investor. The taxpayer had a fixed right to the
commitment fee when the borrower accepted its commitment;
however, the taxpayer reported the fees in income when the loans
were permanently funded. The taxpayer argued that under the “all
events” test, it had not earned the fees until the loans were
actually funded.
The Court found that the taxpayer’s “commitment fees were
received as a payment for specific services rendered to the
borrower in arranging for a favorable loan package for the
borrower with an institutional investor.” Id. at 878. The Court
explained that the commitment fees compensated the taxpayer for
“evaluating the economic potential of the proposed project,
finding a willing investor to provide financing and then
negotiating two separate commitments, one from the institutional
investor and one that it issues to the borrower.” Id. The Court - 35 -
held that the commitment fees were taxable in the year of
receipt.17
The commitment fees in Chesapeake Fin. Corp. are
distinguishable from the nonrefundable portion of the commitment
fees received by petitioner for granting options. Whereas the
taxpayer in Chesapeake Fin. Corp. acted as a loan originator for
the borrower, petitioner agrees to purchase a mortgage from an
originator.18 Chesapeake Fin. Corp. involved a factually
different type of transaction, and does not govern the tax
treatment of petitioner’s commitment fees. Indeed, in Chesapeake
Fin. Corp., there was apparently no argument and certainly no
consideration or discussion by the Court about whether the fees
might constitute option premiums. Instead, the taxpayer in
Chesapeake Fin. Corp. argued that the “all events” test was
satisfied when the loans were actually funded, not when it
received the fees.
17 In addition to the fees in issue, petitioner also received a nonrefundable application/review fee of the greater of $1,500 or 0.10 percent of the original principal amount of the mortgage (but not in excess of $2,500). This fee, which is not at issue, appears to compensate petitioner for the type of services for which the taxpayer received commitment fees in Chesapeake Fin. Corp. v. Commissioner, 78 T.C. 869 (1982). 18 Loans are not sales transactions. “When a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date. Because of this obligation, the loan proceeds do not qualify as income to the taxpayer.” Commissioner v. Tufts, 461 U.S. 300, 307 (1983). Petitioner did not make loans to the originators; instead, petitioner agreed to purchase a mortgage from the originators. - 36 -
Conclusion
Because the terms and the economic substance of the prior
approval purchase contracts indicate that petitioner and
originators entered into option contracts, we hold that
petitioner properly treated the 0.5-percent nonrefundable portion
of the commitment fees as option premiums.
To reflect the foregoing,
An appropriate order will
be issued. - 37 -
APPENDIX
Mortgages Not Delivered to Petitioner Under the Prior Approval Program
During the taxable years 1985 through 1988, and 1990, the 67
mortgages, which the originators failed to deliver to petitioner,
are as follows:
Expiration of 0.5 Percent Contract 60-day (or 15-day) Nonrefundable Contract No. Amount Period Fee
1 8504030076 $1,000,000 5/17/85 $5,000 2 8501170017 153,000 6/7/85 765 3 8510110117 430,000 ll/10/85 2,150 4 8505100095 100,000 11/15/85 500 5 8511050016 560,000 12/5/85 2,800 6 8511210097 4,200,000 12/21/85 21,000 7 8605200051 2,939,000 6/2/86 14,695 8 8602070074 269,000 8/11/86 1,345 9 8607310296 1,365,000 8/30/86 6,825 10 8512120155 600,000 9/9/86 3,000 11 8606130126 539,000 9/10/86 2,695 12 8607170569 1,145,000 9/10/86 5,725 13 8602260159 100,000 9/17/86 500 14 8609220258 2,450,000 9/30/86 12,250 15 8609090420 194,000 10/9/86 970 16 8609100388 2,365,000 10/10/86 11,825 17 8609150342 4,020,000 10/15/86 20,100 18 8607110490 1,145,000 10/23/86 5,725 19 8609290083 504,000 10/29/86 2,520 20 8608060428 1,312,000 11/3/86 6,560 21 8610270173 396,000 11/4/86 1,980 22 8610300720 297,000 11/7/86 1,485 23 8610300728 250,000 11/7/86 1,250 24 8603260291 1,635,000 11/12/86 8,175 25 8610140245 750,000 11/13/86 3,750 26 8605160050 250,000 11/14/86 1,250 27 8607140072 379,000 11/17/86 1,895 28 8610210279 738,000 11/20/86 3,690 29 8611200558 350,000 11/24/86 1,750 30 8610200110 410,000 11/25/86 2,050 31 8610310637 354,000 11/30/86 1,770 32 8611040013 605,000 12/4/86 3,025 33 8612150095 268,000 12/17/86 1,340 34 8611210206 300,000 12/21/86 1,500 35 8612240362 1,565,000 2/4/87 7,825 36 8704300034 537,000 7/14/87 2,685 37 8708100024 355,000 10/9/87 1,775 38 8708120349 1,600,000 10/11/87 8,000 39 8708120350 850,000 10/11/87 4,250 40 8708120351 255,000 10/11/87 1,275 41 8708200206 1,400,000 10/19/87 7,000 - 38 - 42 8708200328 515,000 10/19/87 2,575 43 8709255114 1,080,000 10/25/87 5,400 44 8712075071 525,000 1/6/88 2,625 45 8801225093 2,602,000 2/21/88 13,010 46 8802085188 700,000 3/9/88 3,500 47 8803245036 450,000 4/23/88 2,250 48 8805105385 1,712,000 6/9/88 8,560 49 8808055045 2,900,000 9/4/88 14,500 50 8808265106 2,000,000 9/25/88 10,000 51 8809305154 3,400,000 10/30/88 17,000 52 8810045195 800,000 11/3/88 4,000 53 8810175155 585,000 11/16/88 2,925 54 8811215091 700,000 11/28/88 3,500 55 8811085234 3,600,000 12/8/88 18,000 56 8811095145 750,000 12/9/88 3,750 57 8912125085 4,240,000 1/ll/90 21,200 58 8912115094 985,000 1/26/90 4,925 59 9001105083 970,000 2/9/90 4,850 60 9001255072 835,000 2/24/90 4,175 61 9002055068 2,335,000 3/7/90 11,775 62 9001195042 700,000 4/10/90 3,500 63 9002205045 130,000 5/22/90 650 64 9001175071 5,490,000 6/29/90 27,450 65 9007115075 100,000 8/10/90 500 66 9002215058 256,000 10/1/90 1,280 67 9008135001 667,700 12/31/90 3,335
Total $77,961,700 $389,905